At Last, Signs of Progress for State Pension Funds
November 4, 2021
Overall, states’ ability to fund pension expenses has risen to multi-year highs. Can the progress continue?
Read time: 3 minutes
[This article is from the forthcoming edition of the Lord Abbett Muni Quarterly.]
Reversing a long-term trend, unfunded pension liabilities for U.S. states, on an aggregate basis, declined for the most recent fiscal year. Although this may be short lived, it is a positive credit factor for municipal bonds, as some states have been facing credit pressure from exposure to unfunded pension liabilities.
The scale of the burden varies widely among the states. In some cases, the annual contributions to the plans account for more than 15% of revenues, crowding out essential-services spending. However, for most states, the annual pension expenses are manageable, in our view.
Unfunded pension-liabilities growth resulted from a combination of states enhancing benefits, shortchanging annual fund contributions, and investing in assets that produced lower-than-expected returns. At the same time, many states tried to boost the funding levels by investing in riskier investments, such as hedge funds, alternatives, and high yield bonds. Investment earnings make up almost two-thirds of public pension funding, so a shortfall in long-term expected earnings must be made up by higher contributions or reduced benefits. Left unaddressed, the liabilities are destined to expand, resulting in higher, required annual payments
Better Fiscal Shape
Unexpectedly, based upon projections made by the Pew Charitable Trusts, the U.S. states completed fiscal 2021 (June 30) in their best condition since the Great Recession of 2007-09. (See Figure 1.) The gap between the cost of pension benefits that states have promised their workers and what they have set aside to pay for them dropped in 2021 to its lowest level in more than a decade. According to Pew, the plans now have an aggregate funded ratio of more than 80%, the highest since the Great Recession, up from 71% in 2019.
Figure 1. U.S. States’ Pension Funding Continues to Improve Funded ratio (left axis) and assets/liabilities (right axis), as of June 30, 2021
Source: Pew Charitable Trusts. Data as of June 30, 2021.
There are several reasons for the improved performance. One is that over the past 10 years, contributions have increased at an 8% average annual rate. In fact, for the 10 lowest-funded states, the yearly growth in employer contributions averaged 15% over this period. New Jersey’s fiscal 2022 budget included its first full contribution to the pension system in 25 years, which resulted in positive outlook changes and upgrades on its municipal bonds from the rating agencies.
These higher contributions also reflect the fiscal help states received from federal stimulus and higher- than-anticipated tax revenues over the past two years. For the first time since 2000, states are projected, on aggregate, to have attained positive amortization of pension liabilities in 2020, with the contributions made by the states being adequate to provide for current benefits as well as reduce pension debt.
Reducing Future Risk
Another factor is related to the rapid increase in stock prices, which boosted state pension annual returns by almost 27% for the one-year period ending June 30, 2021—their best showing since 1986, according to the Wilshire Trust Universe Comparison Service. Pension funds hold about 50% of their assets in equities.
However, these one-year elevated returns will not, on their own, prevent unfunded pension liabilities from growing again. Investments in risky assets will continue to create volatility risk and low interest rates will push up the present value of total liabilities, which in turn decreases the net asset value.
Many states have taken advantage of this opportunity to reduce future risk by incorporating more conservative investment returns into their pension funding assumptions. This can be achieved by lowering their assumed rate of return on investments, also known as the discount rate. By doing so, they can decrease contribution volatility and market risk. More than half of the state public pension funds have reduced their return assumptions since fiscal 2018, resulting in a median assumed return of 7%, according to the National Association of State Retirement Administrators. This compares to an average discount rate of 8% in 2007. As an example, New York’s retirement fund, the third largest in the United States, cut its annual target to 5.9% from 6.8%, which will enable the fund to have a 54% chance of exceeding its return target versus a 33.5% chance of exceeding their prior return target.
If history is any guide, it is unlikely that the strong equity returns of the past several years can be taken as a given. Therefore, de-risking now, while market returns are high, makes a lot of sense. However, a reduction in the discount rate for plans will initially result in lower funded ratios and higher annual contributions. To moderate the burden on state budgets, some states have applied the lower discount rate incrementally over several years. Even if these changes result in pension fund metrics that at first look worse, the states are ultimately positioned to absorb more risk, which will ultimately allow them to chip away at their unfunded levels.
In addition to making higher annual contributions and de-risking the investment portfolio, many states have also enacted pension reform. Some have lowered the cost-of-living adjustments (COLA), increased taxes, or have created defined contribution programs for newly hired employees.
A Final Word
Although conditions have improved, unfunded pension liabilities will continue to be a headwind for some state credits. However, the actions that states have taken over the past several years will position many of the pension funds to perform better going forward. Careful monitoring of their progress will be a crucial factor in assessing the credit quality of states’ municipal debt in the years to come.
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