State of Pensions 2023

Positive Trends

• Funding Policies: There are now 95 state and local plans that assume investment returns below 7%, as of announcements through June 2023. This is up from 65 plans in 2020 and 84 plans in 2022. While the median assumption is still 7%, just a quarter of state and local plans are still using investment expectations above 7%. Overall, this downward trend in investment assumptions is translating into more accurate accounting of future liabilities and better contribution in-flows. States also continued in the past year a recent trend of using surpluses for one-time supplemental contributions into state pension funds to shore up their funding levels.
• Paying the Bills: While a few states did not fully fund their required contributions in 2022 there were enough plans that overpaid required contributions that the average amount paid was 100% of actuarially determined rates. This continues a trend that was gradually improving over the past few years.
• Funded Ratio: There was an improvement in the funded ratio between 2022 and 2023, going up from 74.9% in 2022 to an estimated 78.1% in 2023. While this is a positive jump in funded status, persistent unfunded liabilities and underperforming investments temper the long-term outlook for pension funds.

Negative Trends

• Investment Returns: Preliminary 2023 investment returns are 7.47% on average for state and local plans, which is above the average 6.9% assumed rate of return. Although this is an improvement over the negative -5.9% returns for 2023, a deeper look shows a wide variance in pension fund investment performance. Just 53% of plans who have reported actual returns for fiscal year 2023 beat their assumed return target, while the rest have underperformed.
• Asset Allocations: Asset allocations continue to shift toward risky alternatives, including private equity, hedge funds, and real estate as pension funds attempt to invest their way out of their funding shortfalls. Roughly one-third of all pension assets are in alternatives as of 2022, up from around 10% before the global financial crisis.
• Contribution Rates: Negative trends from the past decade continue to persist for both member and government employer contribution rates. In fact, employer contributions have now exceeded 30% of payroll on average for the first time.
• Cash Flows: As demonstrated by the bear market of 2022 and subsequent volatility, it is going to be harder and harder to earn large investment returns going forward. This will put a lot of pressure on state retirement plans that are cash flow negative from growing benefit payments.

In the context of public pension investing, environmental, social, and governance (ESG) considerations are a broad management framework that can guide corporate and government decision making.

Similar frameworks include “stakeholder capitalism” or “sustainable investing.”

There are several ways in which ESG potentially becomes relevant to state and local pension funds. State pension fund trustees could use ESG factors to guide their asset allocation decisions. Financial asset managers could use ESG factors when making investment decisions. Ratings agencies commonly provide “social scores” for different companies that consider ESG factors, which could guide asset manager decisions. Pension funds could also encourage corporate behaviors (through proxy voting) based on ESG factors.

Examples of some ESG factors encompass a wide range of issues and concerns – from climate change to “vice products” to corporate transparency.

There are several ways in which ESG has been addressed in states across the country, ranging from laws directing investment decisions to pension fund trustees prioritizing certain ESG-related investment goals.

In the past year:

• 13 states have adopted a bill, issued a joint resolution (LA), or had an executive order (NH) related to ESG during the spring 2023 legislative session.
• 9 of the above bills/resolutions/orders adopted in 2023 require investment decisions to be based solely on financial (pecuniary) factors and also make some negative reference to ESG.
• 1 state (IL) adopted a pro-ESG law requiring investment fund managers to consider environmental and sustainability factors.
• 6 other states have pending ESG legislation as of June 2023, including proposals to divest from fossil fuel companies (CA, VT) and proposals to require financial factors only in investment decisions (OH, SC).

Why is this happening?

There is no way that pension funds can meet their investment targets using simple stock and bond passive portfolios. The probability of earning just a 6% return over the next decade is less than 50%. This is particularly notable since public retirement systems have done a better job lowering their assumed returns over the last two decades but they are still unrealistically high.

There were 197 major public pension plans with assumed rates of return higher than 7% in 2003. Today, that number has fallen to just 60 plans, including 19 plans using a 7.5%+ return assumption. The median assumed return in 2003 is 7%, but the average is 6.88% and continuing to decline.

Still, just 37 plans have assumed returns of 6.5% or less. These plans are leading their peers in adopting more realistic future expectations.

Therefore, the choices are to either (a) increase contributions into pension funds beyond their currently historically high levels, or (b) roll the dice and take on more risk.

In total, $1.6 trillion in pension fund assets are exposed to valuation risk as of the end of 2022.

Below, is a visualization of the states with the largest investments in alternatives by dollar value.

State and local employee contributions to their own retirement plans have continued to steadily increasing.

State and local employee contributions to their own retirement plans have been steadily increasing. Public sector workers who are also enrolled in Social Security paid 161 basis points more (a 35.7% increase) during the 2023 fiscal year than they did during the 2001 fiscal year and 21.8% more than they did in 2008 before the financial crisis.

Those who do not participate in Social Security paid 19.9% more this year than in 2001 and 13.7% more than in 2008. For Plans Not Participating in Social Security or with Mixed Levels of Participation For Plans Participating in Social Security

Note: Public employees are not uniformly covered by Social Security. Some states never opted into Social Security and, therefore, typically have higher valued benefits and relatively higher contribution rates than for statewide systems where members also have access to Social Security benefits.

Government employer contributions have steadily increased over the past two decades, mostly because of increased unfunded liability amortization payments.

Combined state and local employer contributions in 2001 were 9.15% of payroll. During the fiscal year ending 2023, employer contributions are 30.05% of payroll.

On a dollar basis, unfunded liability payments have risen 2,089% during the same two-decade period from under $4.6 billion in 2001 (or $7.6 billion, adjusted for inflation) to over $100 billion annually in 2021.

Negative net cash flows from contributions and benefit payments have steadily increased over the past two decades, reflecting more “mature” pension plans.

The average assumed rate of return in 2023 is 6.88%, down from 6.92% in 2022.

By comparison, there were 197 major public pension plans with assumed rates of return higher than 7% in 2003. Today, that number has fallen to just 60 plans, including 19 plans using a 7.5%+ return assumption. The median assumed return in 2003 is 7%, but the average is 6.88% and continuing to decline.

Still, just 37 plans have assumed returns 6.5% or less. These plans are leading their peers in adopting more realistic future expectations.

Most public pension unfunded liabilities reside within statewide retirement systems, primarily because they are simply larger, with more members and more promised benefits.

The funded ratios for state and local plans also have tended to move together, as the same dynamics of underperforming investments and changes to actuarial assumptions have influenced overall finances.

The aggregate funded ratio for municipally-managed plans is more volatile than statewide only plans. But while the funded ratios is under 80% in 2023 this is still near its highest point in recent history.

The aggregate funded ratio for statewide plans collectively is slightly worse than the national average. However, like the national combined data, the trend from 2019 to 2023 still shows some improvement.