Balancing Act

The stabilization in pension-funding gaps marks an encouraging sign for states and municipalities, potentially providing officials with more breathing room to allocate budgetary resources toward services and infrastructure as well as retiree benefits.

They had less leeway in the aftermath of the financial crisis, when local governments shortchanged pension contributions by the most in at least a decade, exacerbating the level of underfunding, according to data from the Center for Retirement Research at Boston College.

The Bloomberg data for 2013, the latest available, underscore the findings in a June report from S&P that said funding levels “have likely bottomed out” and are poised to improve along with climbing stocks.

The S&P 500 index rose almost 30 percent last year, the most since 1997, propping up the pensions as the Federal Reserve’s policy of keeping its benchmark interest rate close to zero suppresses debt yields.

‘Getting Better’

“Things are getting better on the investment side,” said John Flahive, Boston-based director of fixed income at BNY Mellon Wealth Management, which oversees about $20 billion in munis. “It would be nice to have good consistent performance from the equity side plus rates that are closer to the historical norm.”

While retirement plans from Ohio to Oregon rebounded, those with some of the worst funding levels deteriorated.

Illinois, with an A3 Moody’s Investors Service grade that’s four steps above junk, has 39.3 percent of assets needed to cover projected obligations, down from 40.4 percent in 2012 and again the least of all states, Bloomberg data show. New Jersey’s ratio fell to 64.5 percent from 67.5 percent.

The two states are examples of “really dire” situations, Norcross said. “The fact that they have systematically underfunded for so long means they have a hole that’s going to be almost impossible to fill with the tools at their disposal.”

Ratings Reaction

Illinois, led by Governor Pat Quinn, a Democrat running for re-election, made 84 percent of full contributions in 2013, better than the 80.7 percent average, according to a report from Loop Capital Markets. By contrast, New Jersey made 28 percent of the actuarially required payment, the worst in the nation.

Both states have suffered the consequences in the $3.7 trillion municipal-bond market. Illinois pays the most to borrow among the 17 states tracked by Bloomberg: Investors demand 1.57 percentage points above top-rated munis to own its 10-year debt. New Jersey’s yield spread is the second-largest, at 0.5 percentage point.

Last month, it faced an eighth credit-rating downgrade under Chris Christie, a record for a New Jersey governor. Its Moody’s rank of A1 is four steps below the top and below all states except Illinois.

“The rating agencies have certainly incorporated pension liabilities like never before,” said Eric Friedland, a money manager in New York at Schroder Investment Management North America, which oversees $4 billion in munis. “As an investor, following pension behavior is very important.”

Winners, Losers

Massachusetts fell 11 spots in the ranking of pension funding, the largest drop, Bloomberg data show. New Jersey declined seven steps, while Michigan, Pennsylvania and Virginia followed with declines of six levels.

By contrast, Montana improved 13 spots as its ratio jumped to 73.3 percent, from 63.9 percent in 2012. New Mexico, with the 12th-worst funded pensions in 2012, leapt 12 spots as its coverage rose to 66.7 percent from 63.1 percent.

The rankings signal that the worst-funded plans are losing ground while the best-financed are recovering. Among states in the bottom half of the ranking, seven had better ratios than 2012, while 11 of the 25 top-funded systems gained ground. None of the five states with the lowest funding ratios improved.

Illinois Inheritance

“Inheriting a back-loaded pension debt that has seen the state’s annual pension obligations grow from $1.8 billion to $6.2 billion a year since he took office, Governor Quinn made pension reform his top priority and this past December passed a bill to bring the costs under control,” Abdon Pallasch, Illinois’s assistant budget director, said in an e-mail.

It could get worse if the state Supreme Court strikes down the pension fix from December, which would save an estimated $145 billion over 30 years through smaller cost-of-living adjustments and later retirements. The court ruled in July on a separate case that Illinois can’t cut contributions to government retirees’ health-insurance premiums.

“The court has ruled strongly in favor of protecting benefits,” Norcross said. “I’m not too optimistic about reforms being successful.”

In New Jersey, Christie “has consistently called attention to the considerable long-term pension and health liabilities challenging the state’s pension system and the need for further reform,” Christopher Santarelli, a state treasury spokesman, said in an e-mail. A bipartisan commission is set to recommend soon how to address the challenge, he said.

Some pensions are concluding that tackling the funding gap through alternative investments doesn’t pay off. The $295 billion California Public Employees’ Retirement System said last month it would divest the $4 billion it had in hedge funds.

In contrast, the Illinois State Board of Investment, which oversees three of the state’s five plans, had 9.75 percent of assets in hedge funds as of Aug. 31, according to its website.

In states with low funding ratios, rebounding investments won’t be enough to close the pension gap, Norcross said. Lawmakers also need to overhaul benefits and cut costs.

“You can’t grow your way out of this,” Norcross said. “Policy makers are going to have to think outside the box.”

--With assistance from Elise Young in Trenton, Elizabeth Campbell and Tim Jones in Chicago, Francis Yatzun, Kristen Keller, Ruby Sandhu, Kristina D’Alessio and Karen Altamirano in Princeton and William Selway in Washington.