The coronavirus pandemic’s economic impacts are just beginning. A record-setting 22 million Americans filed first-time unemployment claims over a four-week period. With most Americans under stay at home orders and economic activity stalled, state and local governments are seeing their revenues collapse. And these governments are preparing for even worse times ahead, especially when it comes to public pension system debt. Most public pension systems, despite a decade straight of economic and stock market growth, have massive unfunded liabilities and structural problems that are now going to be exacerbated.
The primary culprit of growing public pension debt has been the across-the-board investment underperformance of pension investments relative to plans’ own investment return targets. This lower yield, higher risk investment environment has become the “new normal” for public pension plans. Most financial advisors suggest that investment return expectations for equities and fixed income products over the next 10-to-15 years will be lower than it has been over the past 30 years. However, in defiance of this clear trend, pension plans have been slow to adjust their investment return expectations. Now, with the economy headed downward, the implications of further inaction could be severe.
In a 2012 poll, 38 of 39 leading economists agreed, “By discounting pension liabilities at high-interest rates under government accounting standards, many U.S. state and local governments understate their pension liabilities and the costs of providing pensions to public-sector workers.”
This observation is even more germane today, with ever-growing costs of servicing and paying down pension debt. Unrealistic investment return assumptions produce a plethora of cascading effects downstream. For example, setting a high investment return target can result in undercalculating contribution requirements to the extent that even making 100 percent of actuarially-required contributions into a plan will still fall short of reducing its unfunded liabilities. When annual pension contributions fail to cover even the interest payments on past pension debt it is called negative amortization.
Failing to meet a plan’s assumed rate of return has long-term consequences. The Pension Integrity Project at Reason Foundation finds that overly optimistic investment return assumptions caused over 50 percent of the $6.3 billion unfunded liabilities that the Teachers’ Retirement System of Louisiana (TRSL) added between 2000 and 2019. Another roughly 10-to-15 percent of TRSL’s debt percent comes from negative amortization.
Unfortunately, this debt inducing combination is not unique to Louisiana and has been experienced by many state and local pension plans across the nation.
Keeping investment return targets higher than recommended — 7 percent or lower should be viewed as the “new normal” — can bring government’s short-term relief because it allows them to reduce the amount of money they put into the system in a given year. If the plan assumes investment returns will cover the costs, employer and/or employee contributions can be lower, the theory goes. But in the long-term, overly optimistic assumed rates of return cause mounting pension debt that increases with shortfalls in either of the pension plans’ core two revenue sources: investment returns and contributions. If, for example, pension trustees are wrong on the expected investment returns, then the deferred normal cost—which is usually shared between employees and employers—gradually multiplies into additional unfunded pension liabilities, which are usually borne solely by taxpayers.
Furthermore, overly optimistic investment return expectations misalign with liability durations and undermine retirement plans’ future cash flows. This is mainly due to America’s aging population and the number of mature state pension plans expecting to pay out a significant amount of their pension benefits to retirees over the next 10 years. This means that large portions of current pension assets will be used to pay for retiree benefits and will not be around to be invested over the next 10-30 years to make up for the lower investment returns over the next decade. Adjusting return assumptions per mid-term projections, as opposed to the long-term, should help curb investment losses and better align assumptions with the average timing of pension payouts.
Adjusting assumed rates of return is a tough political decision and will not come without costs for state and local governments. Lowering rates increases pension contributions in the short-term. However, adjusting to the new normal should be done sooner rather than later to help pension trustees avoid paying costly compounding interest on pension debt. This would drastically reduce the long-term financial burden for taxpayers by stabilizing contribution requirements. It would also improve the solvency of retirement systems and help governments keep the pension promises they’ve made to public employees.
Each state and local government pension plan has its own unique set of problems. In an economic downturn, budget trade-offs are always a large part of the equation. Properly estimating promised pension liabilities and adopting strong funding policies designed to pay off legacy unfunded liabilities as fast as possible to minimize the risk of new debt materializing are in the best interests of active and retired public employees, as well as taxpayers.