At Last, Signs of Progress for State Pension Funds | Lord Abbett
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Fixed-Income Insights

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.

 

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

 

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

 

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest-rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

 

The Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, is a $2.2 trillion economic stimulus bill enacted in March 2020 in response to the impact on the U.S. economy of the COVID-19 pandemic.

 

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

 

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

 

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

 

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