- Michigan has adopted payment methodologies, assumption changes, and other reforms that could help address legacy liabilities and improve long-term pension funding.
- Pension cost pressures are typically greater for school districts than for counties and municipalities, though some negative rating actions have been driven, in part, by very poorly funded systems.
- The state is shouldering an increasing share of school district pension contributions, limiting growth in budgetary pressure for districts.
- Retiree health care benefits are not constitutionally guaranteed in Michigan and some local governments have reduced or eliminated retiree benefits to reduce budgetary distress.
Credit Fundamentals By Sector
State of Michigan
We consider Michigan's unfunded pension liabilities moderate compared with its GDP and income levels. Despite its weak funded ratio, we view the State Employees' Retirement System's (SERS) funding status positively, primarily due to reforms over the past several decades that will limit the growth of liability, reduce investment risk, and ensure contribution predictability. Contributions cover our calculation of minimum funding progress (MFP), indicating material progress toward full funding, which we expect will continue. Our calculation of the state's total net pension liability includes its statutorily required portion of employer contributions to the Michigan Public School Employees' Retirement System (MPSERS), which we do not expect will be a cost pressure for the state in the near term.
Local governments either participate in the state's agent multiple-employer plan, the Municipal Employees' Retirement System (MERS) or administer their own single-employer plan. We expect that governments in MERS as well as those with single-employer plans that use weaker assumptions, such as an aggressively high assumed return, could face cost volatility or escalation over the long term. While on average funded status is not weak and costs are manageable, there are several very poorly funded plans across the state. The ability to absorb rising costs can vary significantly, but credit risk is greatest where there is limited revenue-raising flexibility, management has no credible plan of action to tackle pensions, and the budget is already crowded out by high fixed costs due to existing debt and capital needs.
Pension contributions represent an increasing proportion of school district budgets and remain a pressure due to lower revenue-raising flexibility and lower reserves, on average. However, we do not view pensions as an increasing source of budgetary pressure for school districts given large pass-through payments from the state that are covering much of the increased costs.
Most issuers in Michigan participate in one of the following two statutorily established pension plans:
- MPSERS: A cost-sharing, multiple-employer plan that provides retirement benefits to school district and certain charter school, library, college, and university employees.
- MERS of Michigan: An agent multiple-employer retirement system that provides retirement benefits to employees of participating local governments, which includes counties and municipalities.
Improved Forward-Looking View Reflects Steps Taken To Reduce Cost-Escalation Risk
Over the past several decades, the state has enacted various reforms and adopted more conservative assumptions and payment methodologies. While changes to actuarial assumptions and payment methodologies appeared to have worsened funding progress over the near term, they have improved our overall view since they reduce cost-escalation risk.
- MPSERS closed its defined benefit plan to new employees in 2010. Since then, the plan has incentivized employees to participate in lower-cost, defined-benefit or hybrid plans.
- In 2017, MPSERS began lowering its discount rate from 8.0% to 6.0% in 2022, in line with our guideline and indicative of changes to the target portfolio that reduce market risk.
- In 2018, MPSERS began the gradual shift to level-dollar amortization, a contribution methodology that does not defer costs under the assumption of increasing payroll. The new amortization method will be fully implemented by the Sept. 30, 2025 valuation.
State Shouldering More Of The Burden Of Increased Contributions For MPSERS
The state has adopted more prudent assumptions in recent years for MPSERS that in the near term lowered funded levels and increased employer contributions (this includes defined contribution and state pass-through payments). MPSERS pension costs grew to 12% of total governmental fund expenditures in 2022 from 10% in 2017, but the assumption changes are expected to lead to more stable contributions for both districts and the state. Michigan's absorption of a growing portion of these costs has muted the impact of assumption changes on school district budgets. Act 300 of 2012 capped the school district contribution at 20.96% of payroll and committed the state to paying the remainder of the actuarially determined contribution (ADC). As a result of this legislation and additional legislation in 2017, the state is paying an increasing share of employer contributions; state appropriations toward MPSERS in 2022 were $1.8 billion, or 48% of actual employer contributions.
Senate Bill 401, passed in 2017, committed the state to additional funding. To incentivize employees to join plans where investment risk is either partially or fully borne by the employee, the employer contribution for the defined contribution plan increased to 7% from 3%. The statute requires that the state cover the additional 4% match for the defined-contribution plan indefinitely. In addition, lawmakers chose to make schools whole for increased normal costs associated with a lowered assumed discount rate. While the state only committed to this through fiscal 2019, in practice it has continued to cover these costs and has given no indication that it will cease to do so.
The state's 2023 budget appropriated a one-time lump-sum payment of $1 billion toward the MPSERS unfunded liability, reflecting its increased prioritization of reducing MPSERS' liability and the cost burden to schools.
Costs Will Likely Increase For Local Governments As Assumptions Are Often Weak
Within our rated universe, 16% of municipalities and counties do not participate in a pension plan. For those that do, the largest plan for most local governments is MERS, with single-employer plans more commonly the smaller plan, and the MERS dominance has increased over time. Costs and funding status for the typical Michigan local government are moderate, as reflected by the 73% average funded ratio across the top two largest plans in fiscal 2022, and average pension costs across all plans at 6% of total governmental funds expenditures.
While pensions are not a universal pressure across the state, there are several issuers in our portfolio where the rating has been historically constrained due to poorly funded pensions. In 2022, approximately one quarter of retirement systems had funded ratios below 65%. Credit risk from pensions is often greatest where governments have other weak fundamentals that exacerbate the negative effect of weakly funded pensions or rising costs, such as poor management, a weak tax base with less likelihood of passing voter-approved levies, or already high fixed costs. Higher-rated entities are not immune from pension pressure: 10% of Michigan cities in our rated universe have pension contributions exceeding 15% of total governmental funds expenditures, and most are rated 'A' or above. However, many of these entities are better equipped to absorb rising costs.
While funded status is not weak and costs are manageable for the majority of retirement systems, we see cost volatility and escalation risk due to generally weaker assumptions, particularly discount rates above our pension guidance of 6.0%. As of fiscal 2022, MERS' assumed rate of return was 7.35% and the median assumed rate of return for single-employer plans was 7.00%. This indicates an acceptance of market volatility that could lead to budgetary pressure.
Until recently, a growing trend among Michigan municipalities and counties was the issuance of pension and other postemployment benefits (OPEB) obligation bonds. However, this trend has subsided recently. For more detail, see "U.S. Public Pension Fiscal 2023 Update: Funded Ratios Stable, Inflation Retreats, And POB Issuance Stops," published July 11, 2023, on RatingsDirect.
In 2016, the state treasury implemented Public Act 202, the Protecting Local Government Retirement Benefits Act, to ensure oversight, monitoring, and strategic planning of local government pensions. The act requires all local governments to file information about their plans with the state treasury. Those local governments with pension systems that are less than 60% funded and have an ADC greater than 10% of governmental fund revenue are required to submit a corrective action plan to the treasury, which then monitors compliance. Under this act in budget year 2023, the state appropriated $750 million to fund qualified retirement systems with metrics below the Act 202 thresholds. We view this increased oversight and awareness as a positive factor that should help improve funded levels and funding discipline.
OPEB Not Always Guaranteed In Michigan
We generally do not view OPEB as a significant source of budgetary pressure in the state, though funding status and pressure of OPEB plans vary by local government.
Retiree health care benefits are not constitutionally guaranteed in Michigan and there have been several instances where local governments, often under the state fiscal emergency program, have eliminated or reduced OPEB to relieve budgetary stress. Courts ruled that a local government's ability to cut OPEB is determined by language in the collective bargaining agreement stipulating, or not, an employee's vested right to lifetime health care benefits. Should an employer be able to cut benefits, it often takes the form of shifting employees to a high-deductible plan or converting OPEB to a stipend.
The state began prefunding MPSERS' OPEB plan in 2012. As of fiscal 2022, the plan was 86% funded.
|Michigan--Defined benefit pension plan details|
|Funded ratio (%)||60.95||NA||Poorly funded plans increase the risk of rising contributions for employers.|
|Discount rate (%)||6.00||7.35||An assumed return higher than our 6.0% guideline indicates higher maket-driven contribution volatility than what we view as within typical tolerance levels around the country.|
|Total plan ADC (mil. %)||3,181,516||NA||Total contributions to the plan recommended by the actuary.|
|Total actual contribution (mil. %)||3,843,216||NA||Total contributions made by employers and members.|
|Actual contribution as % ADC||121||NA|
|Actual contribution as % MFP||98||NA||Under 100% indicates funding slower than what we view as minimal progress last year.|
|Actual contribution as % SF||123||NA||Under 100% indicates negative funding progress in the year and expected increasing unfunded liability if this continues.|
|Period||Closed||Layered||We view closed or layered amortizations as the most prudent practice. Closed funding period ensures the obligor plans reach funding goal during the amortization period.|
|Length||17||15||We view amortization lengths of less than 20 years as the most effective paying down of unfunded liabilities.|
|Basis||Level % of pay||Level $ of payroll||Level $ explicitly defers costs, often allows growth in unfunded liabiliy, which leads to acceleration in future costs.|
|Payroll growth assumption (%)||2.75||3.00||The higher this is, the more contribution deferrals are incorporated in the level-percent funding methodology. There is risk of market or other adversity causing unforseen escalations to contributions, and of hiring practices not keeping up with assumped payroll growth, leading to contribution shortfalls.|
|Longevity||Static||Generational||A generational assumption reduces risks of contribution "jumps" due to periodic updates from experience studies. In contrast, static projections incorporate a set number of years into today's valuations and become quickly outdated, and when revised frequently result in increased liaibilities and costs.|
|NA: Not applicable|
This report does not constitute a rating action.
|Primary Credit Analysts:||Diana Cooke, Chicago +1 3122337052;|
|John Sauter, Chicago + 1 (312) 233 7027;|
|Alex Tomczuk, Hartford 1-617-530-8314;|
|Secondary Contacts:||Todd D Kanaster, ASA, FCA, MAAA, Englewood + 1 (303) 721 4490;|
|Christian Richards, Washington D.C. + 1 (617) 530 8325;|
|Geoffrey E Buswick, Boston + 1 (617) 530 8311;|
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