State of Pensions 2021

State retirement systems in America improved from last year, but are still Fragile. 

This an annual report on the current status of statewide public pension systems, put into a historic context. State and local governments face a wide range of challenges in general – and some of the largest are growing and unpredictable pension costs. The scale and effects of these challenges are best understood by considering the multi-decade financial trends and funding policy decisions that have brought public sector retirement systems to this moment. 

The financial market volatility over the past 18 months of the COVID-19 pandemic has ultimately been a positive investment climate for institutional investors like state pension plans. And the federal government has provided substantial financial aid to states and municipalities, smoothing over what could have been seismic budgetary shortfalls in some jurisdictions due to tax revenue declines. The combined historically unprecedented nature of these events continues to create an unpredictable environment for state pension plans. However, in this report Equable uses patterns of behavior from the past two decades as a guide to what might happen in the coming decade while also a means to identify areas of concern that should be monitored closely or acted upon immediately.

So what are the trends in public pension funding in 2021? 

• Preliminary 2021 investment returns for state plans that have reported preliminary results (25.7% on average as of early December 2021) show most far exceeding the average assumed return (7.03% for this year). This is the highest average investment return for public plans this century by a wide margin.

• Investment returns this year have balanced out underperformance from 2020. But they still leave plans with historically high contribution rates and do not change any of the demographic dynamics public plans are facing. Plus, states are realizing they need to use lower investment assumptions (a good thing) and that will mean even more contribution rates in coming years (an unfortunate thing). The range of policy interventions that could help improve the trends outlined in this report vary from state to state, but almost every state has some work to do.

The aggregate funded ratio for statewide plans collectively is at its highest point since 2008 (using market valued assets).

We estimate that the average funded ratio will increase from 70.9% in 2020 to 80.8% in 2021. This dramatic increase in funding levels can be attributed to record investment returns in the volatile Covid-19 market environment. 

The pension asset shortfall for statewide plans grew in 2020 (to a historic high) but will improve notably in 2021 (to roughly where unfunded liabilities were in 2009 at the end of the Great Recession). 

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Total unfunded liabilities for statewide plans back in 2001 were roughly $100 billion. The shortfall grew to $1.15 trillion at the end of 2009 (the bottom of the financial crisis), and hit a peak of $1.49 trillion in 2020. 

We estimate that unfunded liabilities will decline to  $1.12 trillion in 2021 due to historic market investment return performance.

Several states with significant pension funding shortfalls face unfunded liability levels greater than 15% of their total GDP. 

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Funded ratio and unfunded liability levels on their own are not perfect indicators of a retirement plan’s fiscal health.

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 retirement plan funded status.

While the Covid-19 pandemic did not result in a prolonged recession as many feared, the realities of the pandemic economy will continue to affect public retirement systems in the following ways: 

1. Investment volatility in 2020 meant only two of the 112 state retirement plans with a June 30 fiscal year-end earned their assumed return, and this caused unfunded liabilities to grow. By contrast 24 of the 31 plans with December 31 fiscal year-ends beat their investment assumptions. 
2. Most plans will far exceed assumed returns in 2021, according to preliminary reports. These returns will improve funded ratios to a better place than 2019; however, depending on how many plans decide to adopt lower investment returns this year, the net effect may be less improvement than currently anticipated. 
3. Federal stimulus helped most states avoid reducing their contributions into pension funds, however concerns about overall volatility and forecasts of low future returns have meant states are still looking to:
   
   • Reduce benefits (where legal), such as cutting retiree COLAs & lowering future worker benefits
   • Reduce assumed return rates, which means recognizing higher unfunded liability levels.
   • Utilize alternative investments like hedge funds and private equity to chase higher returns. 

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Financial market volatility meant most plans saw reduced funded ratios from 2019 to 2020, but these will be more than balanced out with 2021 investment performance. 

We estimate that there will be varied levels of improvement from 2019 to 2021 once final numbers are available. Only New Mexico, North Dakota, and New Hampshire are likely to have their state plans collectively in worse financial condition in 2021 than in 2019 (primarily because of insolvency forecasts for certain pension plans that influence how actuaries account for their unfunded liabilities).

Equable estimates the average 2021 investment return for statewide plans is 25.7% (based on actual preliminary reports. This is 1,867 basis points above the average 7.03% assumed return for the fiscal year.  

The funded status for 2020 could have been a lot worse. And returns in 2021 are a huge help for state pension funds. Those positives should not be overlooked. However, the strong investment performance has not saved state pension funds. 

Pre-existing unfunded liability levels were high enough that 2021 returns are likely only going to bring funded ratios back to 2008 levels, which was a Fragile funded status.

How Should The Strong Investment Returns for Pension Funds Be Interpreted?

States and pension boards have been slow to reduce their assumed rates of return, relative to declining interest rates.

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If assumed returns had kept pace with declining interest rates since 2001, the average assumption in 2021 would have been around 4.3%.

The growing gap between interest rates and assumed rates of return reflects as an increased amount of risk that pension funds are accepting.