State retirement systems in America are still Fragile. 

This an annual report on the financial status of state and local 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. 

There should be little surprise that America’s pension funds have taken a financial hit this year, swinging backwards the year following some of the best investment returns in history. Massive returns for public and private equity in 2021 didn’t clearly align with any kind of obvious market fundamentals signaling a persistent future of growth. The volatility and fragility of the past few years point to the clear reality: state and local retirement systems collectively are not going to invest their way out of their poor funded status. The primary path forward for most pension funds with fragile or distressed funded ratios will likely require assumption changes and contribution increases. 

• Despite state and local plans reporting disappointing preliminary investment returns averaging -10.4% in 2022 , there has been a net positive funded ratio trend on net over the past three years. 

• Funded status in 2022 for state and local retirement systems has declined considerably from last year, the sharpest single-year decline since the Great Recession and financial crisis. Investment return volatility is contributing to some significant swings in funded levels, which has been compounded by rising inflation and geopolitical turmoil. 

Positive Trends

• Funding Policies: There are now 84 state and local plans that assume investment returns below 7%, as of announcements through June 2022. This is up from 65 plans expecting 7% or less as of their 2020 valuations. Just 9.2% of state and local plans have assumed returns 7.5% or more. Many states have also made one-time supplemental contributions using supplemental funds, rainy day funds, and budget surpluses to make one-time contributions into state pension funds to shore up their funding levels and buy down their assumed rates of return. 

• Paying the Bills: While a few states did not fully fund their required contributions in 2021, on net states collectively paid closer to the actuarially determined rates (99.8% in the aggregate) than in any year since 2001.

State and local pension plans have reached historic levels of investments in private equity and real estate — doubling down on what has become a high-risk, high reward dilemma for trustees.

This paid off in 2021 but caused a lot of pain in 2022. In an era of volatile financial markets, pension funding is all about risk exposure and risk–mitigation.

Asset allocations have shifted away from relatively safe fixed income investments into riskier categories in a search for stronger investment returns.

Notably, private equity investments are now more than 10% of portfolios — or, at least, they were at the end of 2021 before valuations crashed over the last six months.

Average investment returns were consistently below assumed rates of return over most the past decade. This contributed to the growth in unfunded liabilities for public plans.

We estimate 2022 returns will average -10.4% (for plans through June), which would be the first time since 2009 that state and local plans will post a negative average. Combining 2021 and 2022, the average ten-year return is 7.5%, which is fortunately still above the average assumed return (6.9%).

Fortunately, since 2019 the 10-year average return has remained above assumed returns, and this has helped stabilize funded levels.

The aggregate funded ratio for statewide and municipal plans collectively has lost about half of its gains since 2021. This is the largest single year decline in funded ratio since the Great Recession. 

The change in funded ratio over the past three years is also the sharpest period of volatility since the financial crisis.

The pension asset shortfall for statewide plans declined in 2021 to the lowest amount since the financial crisis but then grew in 2022 to again eclipse $1 trillion in total unfunded liabilities.

Total unfunded liabilities for state and municipal plans exploded from $248.8 billion in 2007 to $1.35 trillion at the end of 2009. The funding shortfall increased to a peak of $1.70 trillion in 2020 before dropping back to $933.0 billion in 2021.

We estimate that unfunded liabilities will increase again up to $1.40 trillion in 2022 due to market underperformance.

Some states are performing better on their funded status than others. Factors among the better performing states include: ramping up contributions, adopting risk-sharing policies for pension plans, and historically strong funding policies.

The state by state weighted average funded ratios as of the fiscal year ending 2021 looked as strong as they’ve been in more than a decade.

There is likely going to be a considerable decline in funded status among most state and local pension funds in the 2022 fiscal year, leading to a decline in aggregate state funded ratio averages.

Of the 95 plans with a funded ratio above 90% in 2021 reported data, we estimate 34 will decline into the 80%s or 70%s.

We also estimate there will be 6 plans that fall from Fragile into Distressed funded status based on 2022 returns.

There will be varied levels of funded ratio change from 2019 (pre-pandemic) to 2022 once final plan numbers are available. However, it’s likely that in 2022 most aggregated state funded ratios will be in a better condition compared to 2019.

Among the states that do have COLA rules, only a select group of public retirees have a reasonable hope that their pension benefits will keep up with inflation: those with automatic fixed-rate COLAs or automatic COLAs linked to inflation.

There are generally three policy frameworks for those who do have automatically granted COLAs:

• Fixed-Rate COLAs: A pre-fixed specific percentage of benefit increase (or minimum dollar amount).

• COLAs Linked to Inflation: A percentage increase to benefits based on the national consumer price index (CPI), a local CPI, or the Social Security inflation rate. The actual amount is typically “up to” a maximum rate, such as 2% or 3%.

• COLAs Linked to Plan Performance: A percentage increase to benefits that is dependent on the funded ratio and/or investment performance of the underlying pension plan. The actual amount is also typically “up to” a maximum rate, but that maximum rate is determined by the specific provisions around plan performance. For example, the maximum COLA rate may be cut in half or suspended if the pension fund is under 80%.

State and local pension plans and hybrid plans currently provide a wide range of cost-of-living adjustment (COLA) rates and rules. Most plans have linked COLA rates to inflation, but roughly 168 of state and local pension plans do not have automatic COLAs.