Public Pension Plans Won’t Be Able to Invest Their Way Out of Financial Losses, Unfunded Liabilities

Public pension investment returns are going to be hard hit this year.  Anticipated low asset returns will negatively affect debt to asset ratios for even the healthiest pension plans across the country. Still, public comments by pension plan managers reflect optimism about how their plans will fare during the economic downturn.

The most common justification given by plan managers is that pension assets are invested for the long-term and the market drop will not affect funding in the long-run. However, this attitude ignores the far-reaching effects that even one year of poor returns has on the funding status of troubled retirement systems.

In Illinois, where the state’s Teachers Retirement System (TRS) is only 41 percent funded, Dave Urbanek, the spokesman for TRS, says that they are “prepared for an eventuality like this” and “our [systems’ leadership] priority is to protect assets, so we’ve been in what we call a ‘defensive posture’ for the last several years.”

In reality, the Illinois TRS’ “defensive posture” portfolio is not that different from many other pension systems in terms of diversification and funds committed to “safe” assets like public equities.

Similar rhetoric has been heard from the State Retirement System (SRS) of Illinois.  Tim Blair, the system’s executive director, says that “we [the system] outperform in down or choppy markets, compared to our peers.” He also adds that “there’s absolutely no danger whatsoever of missed benefit payments.”

Although the rhetoric might sound reassuring, and it is in fact important to know that there will be no immediate interruptions with pension payments, this is not addressing the continued fiscal decline of a pension system that is currently just 38 percent funded. This means the fund has enough to cover only 38 cents of every dollar of benefits it has already promised to current and retired workers. When it comes to Illinois, such optimism is particularly surprising in light of the state’s recent request for a federal bailout of its poorly-funded pension systems.

Like Illinois, the leadership of the better-funded—86.4 percent funded—North Carolina Teachers and State Employees Retirement System (NC TSERS) cite a “conservative” investment strategy as grounds to believe that the pension systems “will survive the COVID-19 economic downturn better than other states.” Nonetheless, the asset allocations in the pension portfolios of both systems have what has become a rather standard market exposure—committing about a third of assets in public equities.

While Illinois’ teacher plan and NC TSERS have vastly different funded ratios, they have relatively similar asset allocation, meaning they are likely to see similar year-to-year results in terms of actual rates of return. However, there is a clear difference in how the systems will be able to recover because of the vastly different current asset-to-debt ratios.  NC TSERS has been responsive to changing market conditions and lowered its assumed ratio of return to 7 percent.

Nonetheless, as the Reason Foundation’s Pension Integrity Project noted in a recent analysis, NCTSERS is more likely to hit returns closer to 6 percent over the next 20 years. This is considerably lower than its long-term assumed investment return of 7 percent. The underperformance of assets could lead to unexpected additions to unfunded liabilities and increases in contributions from the state. Even if the pension plan meets it’s targeted assumed rate of return (ARR) on average in a 30-year window, the timing of returns impacts the plan’s ability to reach a 100 percent funded target. Low returns this year could throw the plan off the trajectory of being fully funded within its targeted timeframe.

To the west, both the Arizona State Retirement System (ASRS) and Iowa Public Employee Retirement System (IPERS) reassured the public that they have enough money in their systems to cover outgoing benefits without any disruption. But neither public pension system addressed the existing—and growing—underfunding issue or what a recession could mean for their pension systems’ long-term solvency. The funded ratio for ASRS is currently 71 percent, which is around the national average funded ratio for public pension plans, whereas IPERS is currently 84 percent funded.

A number of other public pension plans around the country have encouraged patience amid the ongoing coronavirus pandemic and fiscal crisis. The California Public Employee Retirement System (CalPERS) leadership called for the public to “resist ‘resulting bias’ (by) looking at recent results and then using those results to judge the merits of a decision.” Like other systems, CalPERS emphasized that it is a long-term investor, which requires them to “think differently.” The system, which is currently 71 percent funded, will certainly see a jump in unfunded liabilities in light of this year’s market downturn.

Texas Teachers Retirement System (TRS) Chief Information Officer Jase Auby said that although the system is expecting a negative 8.3 percent return for 2020, the long-term “plans (for handling down markets) are working exactly as we intended.” The system, sitting at the national average assumed return of 7.2 percent, will have to show significant investment gains in the next few years to bounce back from this year’s losses. This outcome appears to be increasingly unlikely in an environment of “new normal” low investment returns. A lower-yield investment environment has already impacted plans across the country even before the current market downturn.

Generally, public pension funds in most states are too fragile in the face of market crashes. They often lack the resiliency to climb back to full funding after suffering setbacks during a recession and, as a result, they are often not ready to face whatever the next unforeseen event that will challenge them in the coming years or decades. This problem is most evident in looking at how the country’s public pension plans, on average, still had not fully recovered from the Great Recession of 2008 when the coronavirus pandemic and economic downturn arrived in 2020.

Although some public pension plans across the country have gradually lowered their investment return assumptions, most are still too high, which keeps them exposed to both year-to-year volatility and long-term market underperformance. Pension plans are long-term investors, but they should not depend fully on historic norms by assuming that markets are going to revert to the same investment earnings experienced in the 1980s. This reversion to the mean is unlikely to be achieved because of structural changes in the economy and resulting slower economic growth.

More than 10 million people in the United States rely on the benefit payments promised by public pensions. Furthermore, taxpayers depend on their governments to avoid exorbitant costs as they are managing these benefits. This creates a delicate balancing act, but it is possible to provide secure and affordable retirement benefits to public workers.

The previous two decades of declining public pension funding and the damaging effects of the current market turmoil demonstrate that policymakers need to take a closer look at the policies that are intended to ensure the long-term sustainability of these pension plans. They should seek better ways to prepare funds to face multiple market shocks over the next 30 years and they need to find methods to soften the blow of downturns and one bad year of returns.

Overall, public pension plans remain vulnerable in the face of underperforming investments. This won’t be the last market downturn of our lifetimes. Based on historical patterns, public pension systems should assume the next financial crash will happen in 10-to-15 years rather than 20-to-30 years from now. In order to improve pension resiliency, public pension plans must first adopt lower investment expectations. This does not necessitate changes in investment strategies, but by setting a lower target for average investment returns, public pension funds would be better able to weather market shocks and avoid any insurmountable underfunding of their systems.

Public pension managers are understandably urging their members to remain calm and explaining that there will be no disruption of benefit payments in the face of the current notable level of societal and market turbulence. In the short-term, it is largely true that retirees will continue to see their retirement checks as promised. The long-term outlook for some of these public pension plans, however, is beginning to look even worse and is calling out for pension reforms.