In the first half of 2022, U.S. public pension funds have weathered a bear market, geopolitical conflict, and record inflation. Despite these difficult economic headwinds, a new Equable Institute report on national pension funding trends finds that there has been a net positive funding trend over the last three years: even with losses this year, the funded status at the end of 2022 will be better than it was at the end of 2019.
Retirees with public pension benefits do not need to worry that their state will go bankrupt over the next few years. There are concerns about inflation protection of those benefits in some states, but there is enough money in the vast majority of pension funds to pay benefits for decades.
The concerning threat that recent financial market volatility has perpetuated is that costs for funding pension benefits will keep rising, reducing money that would otherwise be used for schools, public works, or government services.
In this post, we will look at pension funding trends and how pension fund health in an increasingly unpredictable market and the core reasons why pension funds are still struggling to keep up after 2021’s once-in-a-century investment returns.
State of Pensions 2022: Public Pension Debt is Volatile
What is the funding gap in 2022?
The national pension funding shortfall (or pension debt) for statewide retirement systems was $933 billion at the end of 2021, per Equable Institute’s State of Pensions 2022 report.
The funding shortfall — formally called unfunded liabilities — is the gap between money held by pension funds and the value of all future benefits it has promised to pay. This is also sometimes called pension debt.
The shortfall was, in part, caused by investment volatility set off by the Covid-19 pandemic. That volatility is reflected in the change in pension funding ratios over the last three years. While pension funding trends are net positive in that time period, 2021 saw a rapid reduction of pension debt (thanks to an average investment return of 25.3%), followed by an immediate and drastic rise in 2022.
Preliminary 2022 investment returns for state and local plans are -10.4% on average. As a result of these disappointing returns, Equable Institute estimates that debt will increase to $1.4 Trillion in 2022.
On average, this means that American public pensions plans are currently holding 77.9% of assets required to pay future retirees their pension benefits. This is positive, but still much lower than the 84.8% funded ratio in 2021 and, more importantly, the pre-Great Recession funded ratios of 2007 and 2008.
By contrast, in 2007 before the Great Recession, statewide retirement systems in the U.S. had 93.8% of the money promised to current and future public retirees. Losses because of the Financial Crisis of 2008 knocked this funded ratio down to 80%.
So while pension funds have been able to recoup the losses experienced during the beginning of the Covid-19 pandemic, they have still not recovered from the 2008 recession. And capital market forecasts are warning future returns are likely to be muted.
This means the positive pension funding trend is heavily dependent on states establishing responsible assumed rates of return and appropriately managing the risk-level of their investments.
Why the Assumed Rate of Return Matters
Public pension systems use an assumed rate of return to calculate what dollars will be needed to cover pension benefits due to future retirees. When there is a large gap between (a) the actual returns pension funds receive from their investments, and (b) the rate that they assume they will earn, then (c) pension funding shortfalls grow.
For several years, a significant gap between projected earnings and fiscal reality has existed for public pension plans in many states. Still, the assumed rates of return used by many statewide retirement systems have remained significantly higher than actual investment earnings. A handful of states have meaningfully reduced their assumed rates of return in response to economic shifts, with the average assumed rate of return at 6.9% in 2022—down from 8.05 in 2001.
Interest rates are considered an indicator of future market performance. Declining interest rates indicate that investments will likely see slower investment return gains in the future. This is important because it means that historic performance is not a good indicator of future performance. Many pension funds report that they have had strong investment returns over the past 30 or 40 years — and this is true. But unfortunately those numbers do not actually mean very much for the future. They include investment returns from the 1980s or 1990s, which were very different economic times.
While interest rates over the past two decades have rapidly declined, pension fund assumed rates of return have not kept pace. Meaning many funds are either over-estimating what their investments will earn or they are making a lot of high risk, high reward investments to try and hit their optimistic targets.
The chart below shows the recent trend in assumed rates of return in tandem with interest rates. They have not kept pace with each other. For the first time in modern history, the average assumed rate of return for statewide pension funds is below 7%, now at 6.9%. However, if assumed returns had kept pace with declining interest rates since 2001, the average assumed rate of return for 2022 would have been around 5.47%.
The often highly optimistic assumed rate of return used by most pension funds to make financial decisions may be increasingly hard to achieve if America’s economic future remains uncertain.
How does national pension debt affect public workers?
The pension debt carried by governments is costly to pay down and creates pressure on the public budget. It may cause an increase in required pension contributions for public employees or benefit reduction like the elimination of cost-of-living (COLA) adjustments for retirees, which in an era of record inflation is increasingly important. Higher employee contribution rates means less money in public workers’ paychecks—and in recent years, the first number has been growing while the latter shrinks.
Public sector workers who are also enrolled in Social Security paid 160 basis points more (a 36.5% increase) during the 2022 fiscal year than they did during the 2001 fiscal year and 23.7% more than they did in 2008 before the financial crisis. Those who do not participate in Social Security paid 14.3% more this year than in 2001 and 10.1% more than 2008.
In times of economic hardship, higher contribution rates for governments may also result in higher property taxes, delayed raises, cuts in school funding, and a reduction in essential services like public sanitation.
State of Pensions 2022: Public Pension Plans Are Managing Their Debt with Risk and Responsibility
How are pension plans investing their assets?
To try and make up for negative pension funding trends like lower projected returns on stocks and bonds, states are continuing to utilize alternative investments like hedge funds and private equity strategies to chase higher returns.
Since 2001, pension funds have placed a higher percentage of their assets into hedge funds, real estate, and private equities, investment categories known for a lack of transparency, as well as volatility in times of economic uncertainty.
Ultimately, as state pension funds are in competition with each other on these deal and market strategies statistically speaking there are going to be plans that lose out on this work. Unless state pension funds have particularly better success than the market, it is likely that the net average result across all plans will be relatively modest performance at best and at worst performance below passive equity investment strategies.
Some of the alternative investments that state pension funds have adopted might produce higher returns and might help hedge against sharp downturns in the stock market. But they also carry much higher risks that are only justifiable if the objective is to try and earn an unreasonably high assumed rate of return target.
How are states responding to the volatile market’s risks and rewards?
While pension funds are shifting their assets into riskier types of investments, a widespread trend around the country during the past year was to use supplemental funds, rainy day funds, and budget surpluses to make one-time contributions into state pension funds, totaling more than $12 billion in supplemental contributions.
The driving forces behind this trend were the influx of federal stimulus dollars paid to states as a response to the pandemic, states underestimating their tax revenues during the peak of the pandemic in 2020, and rainy day funds (savings that states built up after the last financial crises) exceeding their legal limits.
States also used this “windfall” to responsibly reduce their assumed rates of return. Plans estimate their level of unfunded liabilities based on what they assume they will earn in the coming years. When the assumed rate of return is too optimistic, their estimation of their total pension debt is lower than if the assumed rate of return were realistic. This means that contribution rates are set lower than they realistically need to be in order for pension plans to close their funding gaps.
Lowering the assumed rate of return means that both unfunded liabilities and contribution rates will increase, but states were able to help offset this with one-time supplemental contributions. This year, states have tempered their investment assumptions significantly. The average assumed rate of return is now 6.9%, below the 7% mark for the first time in modern history. There are now 83 state and local plans assuming investment returns below 7%, as of June 2022. In 2020, just 65 plans expected returns of 7% or less.
The State of Pensions 2022: Most Public Pension Systems Are Still Financially Fragile or Distressed
What does pension underfunding mean for states?
Despite the most recent fiscal year’s strong investment returns, it’s unlikely those earnings will do much to cut the number of plans that are financially fragile or distressed—which right now stands at 58% of all statewide plans. Fragile status generally means a retirement plan is between 60% and 90% funded and, while they’re not at immediate risk of insolvency, they will be building up unfunded liabilities that will gradually become a strain on budgets and government revenues. One or two asset shocks could send the plan into a downward spiral.
The funded ratio and pension funding shortfall are not the sole indicators of the health of a pension plan. Understanding the size of unfunded liabilities relative to the size of a state’s economy gives a sense of what scale of resources will be needed from a local tax base to improve funded status.
Prior to the pandemic, unfunded liabilities already accounted for a large share of states’ GDPs. In our previous pension funding trend reports, we predicted the pandemic would lead to higher unfunded liability to GDP ratios because of increasing funding shortfalls and economic contraction. Federal stimulus dollars provided by the American Rescue Plan mitigated some of the expected GDP decline, but the funded ratio dynamics are still at play.
Today, only 42% of all statewide pension plans are considered economically resilient, according to the Equable Institute report, which means holding assets that cover 90% or more of promised public employee pension benefits for at least a few consistent years.
State of Pensions 2022: Public Workers are Highly Likely to Feel The Effects of Inflation and a Recession
How will public workers be affected by inflation?
Public retirees may be more exposed to inflation that many assume, given the limited cost-of-living adjustment (COLA) provisions that are available across the country. 168 plans do not offer or guarantee retirees a COLA. For plans that do offer inflation protection, the average COLA is 1.58% in 2022, which is significantly less than the estimated 8.6% rate of inflation (CPI as of May 2022) nationally.
Read more about this here.
How will underfunded funds cover promised benefits for workers?
There are three strategies that states might take in seeking to ensure they can pay promised benefits to workers: increase contributions into their pension funds, pursue higher investment returns, or reduce the value of benefits.
Cutting benefits is unconstitutional in nearly every state, but in certain places benefits have been reduced by cutting back on the inflation adjustment of pension checks.
Pursuing higher investment returns has been the primary strategy of the past decade. While a few state pension plans were able to recover and some years produced good returns, overall investment returns have not been high enough for everyone to recover. States will continue using this strategy, but it has high risks. And if it doesn’t succeed that leaves only the other two strategies.
The other key strategy is increasing contributions. Usually, when unfunded pension liabilities rise steadily over the years, employer contributions experience an uptick along with required employee paycheck deductions. Just throwing more money into state pension funds doesn’t always help, though, if the underlying reasons that the funding shortfall is growing in the first place are not addressed. That means pension debt and employee contributions may rise unabated until a change in policy mandates a reversal of problematic practices. Even a boon in investment returns has historically offered no guarantee that state and local governments will make debt payments in a timely fashion.
Click Here to Read the Full State of Pensions 2022 Report