While contributions to state and local pension plans are growing steadily, there remains considerable downside risk to the credit quality of sponsoring governments due to volatile investments, said a report from Moody's Investors Service.
The report, "Vulnerability to pension investment losses remains high despite slowing costs," said the returns that state and local plans are achieving due to investments in equities and alternatives should lead to stable contribution growth over the next two fiscal years. However, these same investments can also lead to significant downside risk.
"Pension investment risk remains a key credit issues for many state and local governments," Tom Aaron, vice president and senior analyst at Moody's, said in a phone interview. "Not all, but many, have downside exposure to capital market performance."
The report says that if a market downturn were to occur, it could cause significant credit damage on some governments, especially if combined with a slowdown or decline in revenue.
"If, for example, we do get an equity market correction, that would have huge consequences," Mr. Aaron added.
Lower interest rates this year have caused adjusted net pension liabilities to increase roughly 22% in 2019 from the year before to $2.5 trillion among Moody's sample, according to the report.
Some governments face substantial credit risk from pension investment losses under the scenario of a moderate downside. In an assumed one-year 6% investment loss scenario, aggregate adjusted net pension liabilities for Moody's sample of 56 state and local plans would rise an estimated 15%.
With governments facing increased pension costs since the global financial crisis, the effect on balance sheets would be significantly credit negative for some. Many governments also have less flexibility to defer contribution increases than before the crisis because their pension plans have negative non-investment cash flow via paying out retired participants.
"The likelihood of more governments facing severe pension challenges is material," the report said. "Based on the investment volatility risk inherent in U.S. public pension systems' current asset allocations, we assign about a one-in-six probability to our moderate downside scenario."