By Judith Ugwumadu | 20 September 2013

State, provincial and local governments across the developed world could ‘feel the pinch’ of risky defined benefit pension plans without major reforms, Moody’s has warned.

The ratings agency examined sub-sovereign DB pensions in Australia, Canada, Germany and the US. Comparing the credit risks posed by the DB schemes, Moody’s found large variations not only in the size of liabilities but also in the steps administrations were taking to reform. These variations were observed not only between countries, but also within them.

DB pension reforms are needed over the long term in order to reduce the risk to financial stability, Moody’s said. The best way to achieve this would be to focus on reducing benefits for new employees or alter employees’ future contribution rates, but it noted that this could be difficult politically.

Moody’s analysis found that the most severe outliers, in terms of the size of reported underfunded obligations, were in the US. Pension burdens were greater for US local government than state governments because local governments had more labour-intensive operations and less financial flexibility.

German Laender (state governments) also stood out because they neither fund long-term accruals nor report pension liabilities, creating uncertainty about future funding requirements. Although Laenders’ pension costs appeared to be manageable in the short term, Moody’s noted that payments are rising faster than revenues.

Laender pensions are funded on a pay-as-you-go basis, meaning payments come straight out of annual budgets. As such, reforms to benefits are needed in order to stop rising costs crowding out other spending areas, Moody’s said.

In Australia, the shift from DB to more predictable and less risky defined contribution plans meant state governments unfunded liabilities would be tapering off in coming years, Moody’s concluded.

Canadian provinces were praised for the good transparency they achieved in their pension plan reporting and a ‘reasonable level of stability’. Moody’s said this stability suggested that Canadian provinces overall remain committed to pension plans even during times of market turbulence and budget deficits.

But the agency said it expects those Canadian provinces that are facing the highest liabilities to enact reforms. ‘If they do not, the credit risk could rise,’ Moody’s warned. Among the provinces facing the largest pension risks in Canada are Quebec, Newfoundland and Labrador.