Marked Improvement in US State Pension Plan Funding?

Chris Flood of the Financial Times reports markets rebound boosts US state pension plans:

The record breaking rally for US equities last year has helped America’s largest state pension plans to recover from the wounding punch delivered by the coronavirus pandemic which had threatened to damage parts of the US retirement system. 

The aggregate funded ratio for US state pension plans reached 78.6 per cent at the end of December, a jump of 16 percentage points from the 30-year low of 62.6 per cent registered in March 2020, according to estimates by Wilshire Consulting, the investment advice and research provider. 

The funded ratio illustrates the gap between the assets held by a pension plan and its expected liabilities, providing an estimate of the future retirement benefits schemes will have to pay.

Liquidity unleashed by the Federal Reserve in response to the pandemic combined with a series of emergency relief spending programmes helped the S&P 500 to rebound 63 per cent by the end of December from its low point last March. Strong recoveries for US bonds, international equities and alternative investments in the second half of 2020 also boosted the financial position of US state pension plans. 

 “A third consecutive quarterly increase in the value of assets held by state pension plans more than fully reversed the decline in the funding ratio registered in the first quarter of 2020,” said Ned McGuire, a managing director at Wilshire. 

A more detailed picture has emerged of the strains caused by coronavirus on US public pension plans which tend to release their annual financial updates long after their official year end, making any assessment backward looking. State pension plans also have a range of year ends for their annual reports which complicates data aggregation. 

The latest reported data from 134 state pension funds with combined assets of $3.2tn showed that the aggregate funded ratio stood at 70 per cent at the end of June 2020, down from 72.7 per cent in June 2019. 

“The decline ended a streak of three consecutive years of increases in the aggregate funded ratio,” said McGuire. 

Liabilities for the 134 state pension funds have increased by $459bn, or 11 per cent, over the past five years to a record $4.6tn while assets have risen just $178bn, or 5.8 per cent, over the same period to an all-time high of $3.2tn. 

The plans together paid out $252bn in benefits to retirees in the 12 months ending June 30 but only took in just under $162bn in contributions from employers and scheme members. 

More US public pension plans have gone “cash negative” as they pay out more in benefits than they gather in contributions, leaving them more dependent on investment returns to meet pension promises. 

The pandemic appears to have had a bigger impact on pension plans with weaker funding positions which are more likely to already be cash negative. 

A quarter of the 134 public pension plans had sunk into the “distressed” category with a funding ratio of 60 per cent or less at the end of June 2020, up from a fifth over the previous 12 months, according to Wilshire. 

Tyler Bond, research manager at the National Institute on Retirement Security, a Washington-based think-tank, said the decline in the funded position of US public pension plans due to coronavirus was not as dramatic as the deterioration caused by the 2007/08 global financial crisis. 

 “Public pension plans have made design changes over the past decade and adopted more conservative assumptions about future growth that have helped them to become more resilient. The rally in the US stock market means we are likely to see an improvement in the funded status of more public pension plans once data for the current fiscal year ending in June 30 are reported,” said Mr Bond.

Rob Kozlowski of Pensions & Investments also reports state pension plan funding advances in first quarter: 

U.S. state pension plans' aggregate funding ratio was 81.3% in the quarter ended March 31, according to Wilshire Consulting estimates.

It represents an estimated 2 percentage-point increase from a quarter earlier, and an 18 percentage point increase from March 31, 2019, when disastrous market returns resulting from the economic impact of the COVID-19 pandemic brought the ratio down to its lowest point in 30 years.

The quarterly change was the result of a 3.3% increase in asset values and 0.8% increase in liability values, according to Wilshire.

"The first quarter's increase in funded ratio capped an unprecedented trailing 12-month asset returns with the Wilshire 5000 Total Market index up over 60% over this period," said Ned McGuire, managing director at Wilshire Consulting, in a news release "The funded ratio, as of the end of the first quarter, is at its highest level since Wilshire has been aggregating data for state pension plans on a quarterly basis and since Wilshire's 2007 state funding study on an annual basis."

The study's assumed asset allocation of U.S. state pension plans is 30% domestic equities, 22% core fixed income, 18% international equities, 12% real assets and 9% each high-yield fixed income and private equity.

So, US state pension plans' aggregate funding ratio climbed 81.3% as at the end of Q1, the highest level since Wilshire has been aggregating data for state pension plans on a quarterly basis and since Wilshire's 2007 state funding study on an annual basis.

 

This is really good news, right?

 

Yes and no. Ned McGuire, managing director at Wilshire Consulting, only focuses on gains in assets but the real reason the funding gap improved so markedly in Q1 (and over past year) was because the yield on the 10-year Treasury note went from 0.92% at the end of December to reach a high of 1.76% in mid March before tapering off slightly more recently.

 

And remember, when it comes to pension funding, it's the yield on long bonds, more than asset values, that determines the funded status of pension plans.

 

Why? Because the duration of pension liabilities is a lot bigger than the duration of pension assets, so a drop in long bond yields, especially from a low level, will disproportionately impact the funded status of a pension plan. 

 

When rates rise, even if asset values get hit, this is actually good for pensions because their future liabilities fall.

 

The perfect storm is when rates decline sharply and asset values plunge, like last March as the pandemic hit.

 

But unlike 2008 or after the tech meltdown, the S&P 500 came roaring back very quickly because of unprecedented monetary and fiscal policy, and it surpassed its pre-pandemic level and keeps making record highs:

If I told you last year that the S&P 500 ETF (SPY) would basically double in a year, you'd think I'm nuts.

 

But the Fed and other central banks are pumping so much liquidity into the system, there's so much leverage in the system, that it has been an unbelievable run-up over the last year.

 

The problem? A year after the pandemic hit, the risks are higher now than ever before and all the fiscal and monetary stimulus which has gone into risk assets will dry up and that's when reality will hit many momentum chasers.

 

Don't worry, vaccines are rolling out, the economy will come roaring back, stocks and corporate bonds will keep making new record highs, the Fed and other central banks know what they're doing, don't fight the Fed!!

 

Everyone is playing that game and when everyone is playing that game, the game is inherently unstable and fraught with risks.

 

I'm not saying stocks will collapse any time soon, quite the contrary, they seem fine to any causal observer, but I'm keeping my eye on small caps and many other highly levered sectors to see what is going on because I do not trust this market at all:

 

So what? Pensions are long-term investors, they can ride out any storm, even if stocks and yields plunge again.

Well, here I will make a distinction between fully funded Canadian public pensions that keep lowering their already very low discount rate (many are below 5%) relative to US public plans which lowered it from a ridiculous 8% to a still ridiculous 7% or 7.5%.

Amazingly, and quite worryingly, a recent study states fully funded US public pensions are not necessary to ensure benefits:

Most U.S. state and local government pension systems are not facing imminent crisis and do not need to achieve full funding to ensure benefits are paid to retired workers, according to a paper released on Wednesday by the nonprofit public policy Brookings Institution.

Retirement plans for state and local government workers have nearly $5 trillion in assets, but would need an additional $4 trillion to meet all of their obligations to current and future retirees, according to the paper.

Concerns over unfunded liabilities have weighed on credit ratings for some governments and sparked fears that certain systems could run out of money.

The study found that cash-flow pressures should start to ease in 20 years due to pension reforms that lowered or eliminated annual cost-of-living adjustments to pension payments and reduced retirement benefits for new hires.

“We find that pension benefits payments in the U.S., as a share of the economy, are currently near their peak and will remain there for the next two decades,” the paper said. “Thereafter, the reforms instituted by many pension funds will gradually cause benefit cash flows to decline significantly.”

Instead of striving for full funding, the paper suggested that under conservative discounting of liabilities and modest asset investment return assumptions, many systems can achieve financial stability with “relatively moderate” adjustments to their pension contributions.

“Plans can be sustainable in the sense that benefits are payable for the foreseeable future, while pension contributions are stable without being fully funded,” said Louise Sheiner, a Brookings policy director and co-author of the paper.

The study, which examined 40 state and local retirement systems to determine if or when they would become insolvent under their current benefit and funding policies, said reduced pension spending would allow governments to increase funding in areas like education and infrastructure. 

I'm not going to argue with the main findings of this study as I agree, “plans can be sustainable in the sense that benefits are payable for the foreseeable future, while pension contributions are stable without being fully funded.”

But this omits that pension deficits are path dependent and if asset prices plunge and rates hit a new record low as deflation or something worse hits us for many years, it will have a significant impact on US public pensions.

It will also impact Canadian and global pensions but the difference is they're building reserves and lowering their discount rate, preparing for a potential negative shock.

The story at US public pensions is the same, as long as there's no imminent danger, there's no appetite for much needed structural reform on governance and risk sharing to bolster these plans.

80% funded is the new 100% fully funded? Don't get me wrong, 80% is a lot better than 30, 50 or 60% funded but it's all smoke and mirrors, if another crisis hits markets, these US public pensions will be in big trouble again.

No worries, the Fed and other central banks are pumping away, inflation is coming, asset values and rates will keep going higher, and pension deficits will magically be inflated away!

Yes, that is consensus but I'm worried, very worried.  

Let me blunt: the risk of global deflation, not inflation, has never been higher than at any time over the last 10 or 20 years.

Below, MacroVoices Erik Townsend and Patrick Ceresna welcome Jeff Snider back to the show where Jeff makes the case for deflation rather than inflation, against consensus. You can download Jeff's charts here. 

I highly recommend you all take the time to listen to this podcast following along with Jeff's charts, it's excellent. If deflation is coming, many US public pensions are in big trouble, so let's hope the Fed has got this.

Update: Clive Lipshitz who co-authored an important paper with Ingo Walter, Public Pension Reform and the 49th Parallel: Lessons from Canada for the U.S., shared these thoughts with me after reading this comment:

Given disparities in discount rates - and historical investment performance - either Canadian plans are under-estimating their funded status or U.S. plans are over-estimating theirs. The average discount rate of the largest Canadian plans is about 5.5% and that of U.S. plans is slightly above 7%. So, studies that estimate “aggregate funded ratios” should really say “aggregate funded ratios at reported discounted rates” and your point about liability duration is critical, because decreasing discount rates 1% increases gross liabilities by about 15%, materially reducing funded status.

Also, Clive read the Brookings report and said there's a difference between “imminent crisis” and long-term issues. I totally agree.