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Public finances update – 2 August 2022
Welcome back to another edition of route fifty‘s Public finance update! I’m Liz Farmer and this week I’m looking at the public pension plans that have just come through their worst year of investment losses since the 2008 financial crash. But – as if we need a reminder – it’s a very different world today than it was in the late 2000s. This year’s damage hurts, but it doesn’t make people run for the mountains. I’ll explain why.
As always, send feedback and tips to: email@example.com.
Projections of how poorly public pension plans have performed in the year ended June 30 range from average losses of 7% to more than 10%. But the bottom line is that the stock market has fallen more than 20% in value over the past six months, and the resulting investment losses will wipe out any historical bond gains from 2021.
This means that pension funding levels, the proportion of assets that plans have available to meet all of their committed obligations to current employees and retirees, are likely to fall back down to an average of 72%, according to S&P Global Ratings.
Pension plans depend heavily on investment returns because annual payments from current employees and governments are insufficient to cover annual payments to retirees. More than half (roughly 60 cents) of every dollar paid out to retirees comes from investment income.
For those pension schemes that have reported preliminary returns, losses have not been quite as small as predicted. The $440 billion California Public Employees Pension Scheme (CalPERS), the country’s largest pension plan, reported a 6.1% loss for the year. Its sister plan, the $302 billion California State Teachers’ Retirement System (CalSTRS), announced a preliminary 1.3% loss. Between the two pension schemes, losses largely attributed to the volatile stock market wiped out $35 billion in assets last year.
Elsewhere, the story is similar, with most plans expected to post their first negative returns since 2009. The Oregon state pension plan showed a preliminary loss of 1.4% for the year, while San Diego County reported a 9.5% investment loss on its public employee plan. For the first 11 months of the fiscal year, investment losses in New York City’s five public plans ranged from 2.3% to 5.4%, and the Wisconsin State Central Pension Fund posted an 8.4% loss.
Unlike public equities, investment returns in alternative investments such as hedge funds and private equity have been at the opposite end of the spectrum, posting double-digit gains. Pension plans that put a larger proportion of their portfolios in these types of investments have been able to cushion their losses easily, which is one of the reasons pensions invest in alternatives.
For example, CalPERS and CalSTRS each have about half their assets in public stocks, but the latter’s losses have not been as severe. The teachers’ fund also invests 32% of its assets in alternatives, while the employees’ fund holds 20% of assets in this class.
What the pension losses mean for the budgets
When pension wealth falls, liabilities rise and governments are on the hook to make up the difference. But investment gains and losses are smoothed out over a few years when factored into annual government pension calculations. So it helps that the plans have posted gains of more than 20% over the past year.
Most observers say investment losses in 2022 won’t hit government budgets as hard as they did last time when pension funds suffered big losses. In addition to smoothing, a number of other factors also play a role.
For one thing, pension systems are much healthier financially than they were in 2008 because most governments have spent the last decade increasing their pension contributions.
“We’ve seen a concerted effort – particularly from employers who traditionally have not paid their full contribution – to get started,” said Keith Brainard, research director for the National Association of State Retirement Administrators. “Honestly, there were a number of states that were bad actors for years and didn’t do their due, and they really turned that around,” he added, citing California, Kansas, Kentucky, and New Jersey as examples.
Not only have many governments acted more prudently, but they have also reduced their pension obligations where they could, mainly by cutting benefits for new hires. As a result, Brainard said he forecast that the cost of pensions for states has peaked and should at least remain flat, if not begin to decline.
Challenges remain for pension systems
The national pension funding deficit (or pension debt) for statewide pension schemes was $933 billion at the end of 2021 — the lowest in years, according to the Equable Institute’s State of Pensions 2022 report. But that was short-lived. The Institute now estimates pension debt at up to $1.4 trillion.
Although most plans are underway to close this gap over the next 20 years, volatility in the stock market and in the economy in general is affecting retirement finances more than ever. Most experts say retirement health is better assessed based on long-term trends than annual returns results. However, given the market volatility over the past decade, it is becoming increasingly difficult to assess the long-term picture.
Pension systems in the low-interest environment of the past two decades have shifted more wealth from bonds to stocks and alternative investments. According to The Pew Charitable Trusts, more than half of the assets in the average plan are in these categories, and some, like Alaska and West Virginia, have 88% of assets in these higher-risk categories.
That shift toward living and dying in the stock market could play out over time, but it’s a bigger gamble without a big payoff for plans that are less than 50% funded, said Tom Kozlik, community analyst at Hilltop Securities.
“Even if there’s a year with, say, 10% return, if your plan is only 20% funded, that means you have very little asset in the plan, and that return doesn’t mean that much or help,” he said. “That’s not going to get you anywhere near where you would be if you were much better funded.”
In addition, widespread difficulties in hiring and retaining public employees mean that fewer employees contribute to pension plans. Going forward, if public sector employment does not recover, this shift will need to be reflected in public pension funding and could lead to more governments saving on contributions again.
“I’m concerned that there could be pension fund holidays in the future,” Kozlik said.
Still, Brainard points out that the level of pension funding is still much healthier than it was ten years ago.
“Before the end of FY22, pension funds had had three good years in a row,” he said. “Obviously, recent losses will take some of that away, but it’s important to remember that the funds operate for decades and that volatility is an expected part of the funding process.”