By Lisa Lambert
WASHINGTON (Reuters) - The ability of U.S. public pensions to cover their liabilities weakened again, although the deterioration is slowing, two major rating agencies said on Tuesday.
Both Fitch Ratings and Standard & Poor's Ratings Service added that they expect improvements in pension finances in the near future.
Since most systems use an accounting mechanism known as "smoothing" to spread changes in assets over many years, losses related to the 2007-09 recession have persistently hurt pensions' funded levels, they said. Recent stock market gains will likely bolster improvements, but the agencies warned that public pensions still face large obstacles, namely state budget strains, an aging population, accounting rule changes and legal challenges to reforms.
The average funded ratio for all 50 states' pension plans was 72.9 percent in 2011, a drop of 1 percent from the previous year, and the median ratio was 69.8 percent, 2.2 percent lower than the year before, according to S&P. The funded ratio represents how much in assets pensions have to cover liabilities.
S&P said the declines in previous years were larger. The national average fell 1.6 percent in 2010 and 7 percent in 2009, according to the rating agency, which said 2011 was the latest year complete data was available.
The smaller declines could lead some "to believe that the worst is over and that pension funded levels have bottomed out," but the road to improvement "will be bumpy," it said.
Public pensions receive most revenue - more than 60 percent - from earnings on investments, which were devastated by the financial crisis. Over the last decade, funded ratios dropped from a peak of more than 100 percent in 2000, S&P said.
In its report, Fitch found states' median unfunded pension burden is equal to 3.6 percent of personal income. Wisconsin has the lowest unfunded pension obligation at zero percent of personal income and Illinois, considered the worst state for pension funding, had the highest at 19.1 percent. The agency uses personal income as a measure because it represents the "resource base that will ultimately cover the obligations."
"Pensions remain a growing pressure for numerous states' budgets. Nearly all states are pursuing reform and remain well-positioned to address these burdens. While the positive effects of reform for most are decades away, a proactive approach to managing pension challenges is a credit positive," said Douglas Offerman, a senior director at Fitch, in a statement.
Fitch said investment performance in 2012 "was relatively flat for most plans and well below their investment return assumptions," but that 2013 will likely show gains.
For the 100 largest public-employee retirement systems, cash and security holdings totaled $2.93 trillion in the first quarter of 2013, the highest on records going back to 1968, according to a U.S. Census report released last month. The previous peak was just before the financial crisis in the fourth quarter of 2007, $2.929 trillion.
For years, states had shortchanged their public pensions. When their own revenues collapsed during the recession, they pulled back further while laying off employees, effectively shrinking the pool of contributors to the pension system. Fearing public employees would not see retirement money and funds for key services would have to be diverted to pensions, almost all states rushed to reform their systems.
According to Fitch more than 38 statewide plans dropped their investment return assumptions, lowering funded ratios but reflecting "a more prudent approach to estimating the long-term asset performance of a plan."
"The vast majority of states have pursued reforms lowering benefits for future hires, which are much easier to enact, although the beneficial impact of such reforms will only manifest itself in pension metrics over decades," it added.
Meanwhile, the board overseeing governments' accounting is changing pension obligation calculations. Implementing the changes "will result in the reporting of a greater and more volatile unfunded pension liability," S&P said, especially because pensions will have to use a market valuation of assets.
The third major rating agency, Moody's Investors Service, took a slightly different tack while reviewing pensions, saying in a report last month that for more than half the states their pension liabilities are equal to at least half their annual revenue.
(Reporting by Lisa Lambert; Editing by Tim Dobbyn)