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Things Look Good for Public Sector Pensions: But What Does the Future Hold?

January 25, 2022

By Amy B. Resnick, former editor of Pensions & Investments. She has more than 20 years of experience covering public finance and financial markets topics.

While many state pension plans have fared well during the course of the COVID pandemic, trends in investments and retirements mean that no one in the public sector pension world can rest easy. Demographic and fiscal trends, exacerbated by accelerated retirements during the pandemic, pose potential problems that along with ongoing market volatility and projections of lower equity and bond returns could make it harder for the states to hold onto the progress they have made in keeping their pension plans flush with cash.

A little background: In fiscal year 2021, investment returns were at generationally high levels, pushing state pension funds’ average funding status to their highest level since 2008. Research done by the Pew Charitable Trusts indicates that state retirement systems are now over 80% funded. In addition to investment returns, years of benefit reductions for new tiers of state workers and increased contributions from public employers and employees have helped close the liability gap.

As Pew reported: “the average state pension fund earned 3% for the fiscal year ending June 30, 2020, avoiding losses but yielding returns well below targets. Since then… on average, plans earned investment returns of over 25% for fiscal 2021, which translates into gains above expectations of more than half a trillion dollars.”

But this good news has to be put into perspective. Many state pension plans continue to have negative operating cashflow - they pay out more than they take in annually. As a result, contributions are generally used to pay benefits, while returns on investments are channeled back into the fund and invested to increase the funded levels.

Progress was made on this front in the years before the pandemic, especially as some of the worst funded states increased their pension contributions significantly. But there are distinct possibilities that some of the trends that led to the improvements may slow down or reverse themselves.

Consider the employment base. In addition to the ongoing retirement of Baby Boomers in large numbers each year, public sector employment – especially at the state and local government level - declined sharply following the onset of the pandemic in early 2020. And while private sector employment recovered most of its pandemic losses, state and local government employment levels are still below their pre-pandemic numbers, according to data collected and analyzed by the National Association of State Retirement Administrators (NASRA).

This affects the ratio of annuitants – those receiving pension benefits – to active members who are making contributions from their pay to pension plans. Slow growth in the number of active members is driving a long-term reduction in the overall ratio of people contributing to public plans and those claiming benefits from them. That can raise overall pension costs, as there is a smaller base to carry the overhead.

Because a public pension plan’s rate of payroll growth affects the cost of the plan as a percentage of payroll, a reduction in the number of employees who are participating in a plan, and total wage growth well below a plan’s actuarially assumed level, will likely increase the cost of the plan as a percentage of payroll, the NASRA authors wrote.

This phenomenon is making its presence felt even as public pension funds cut their allocations to cash and other liquid investments in an effort to boost investment returns. That means that in addition to having more illiquid, so-called alternative investments in their portfolios – like real estate, infrastructure and private equity – they have fewer options for raising cash, if needed to respond to market volatility.

Moreover, the investment forecast for the coming years is not expected to keep pace with last year’s record returns, as fiscal stimulus fades and the Federal Reserve is likely to raise interest rates from their very low current levels. As a result, Pew projects that the average US public pension fund will earn about 6% annually over the next 20 years, below the average assumed rate of return of 7% for such plans and below the 6.4% return over 20 years that they had projected for the same universe of plans before the pandemic.

All of this comes at a time when state and local governments are dealing with all the challenges of the pandemic and growing demands for revenues. That leaves an important open question: If revenues to the states begin to decline and expenditures continue to grow, will the states (and the cities and counties as well) continue to pour money into their pension plans? Or will they be inclined to fall into the bad habits of the past that led to far higher unfunded levels than we’re seeing now?

Time will tell.