US Pension Festivus?

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Michael Katz of Chief Investment Officer reports US public pensions could suffer years from pandemic losses:
US public pension plan sponsors and administrators are likely entering a period of fiscal stress, and rising pension obligations caused by the sudden pandemic-induced recession are expected to be felt for years by US state and local governments, according to a report from S&P Global Ratings.

S&P said US public pension funds in aggregate lost approximately $850 billion during the first quarter of the year, and that they would need to rebound sharply during the second quarter to maintain the average funded ratio from a year ago.

 “In the public sector, market returns are built into the funding model and thus make up a large part of pension plan inflows,” the report said. “Should market returns remain below past peaks, the effect of poor returns will result in an increase in employer contributions.”

The report looks at how the recession is likely to impact public pensions during three periods—immediately, over the near-to-mid-term, and over the long term.

The immediate concern for US public pensions is their liquidity position, according to the report, as a pension plan’s liquidity position mitigates near-term shocks. Pension asset portfolios without enough cash to cover benefits could be forced to sell return-seeking assets at inopportune times.

A pension plan’s liquidity-to-assets ratio can help determine how much liquidity risk it is carrying. A plan with a negative liquidity-to-assets ratio needs additional money to maintain operations and make benefit payments. And the further below zero the ratio is, the more assets that may have to be converted to cash.

During the near-to-mid-term, a plan’s funded level indicates the range of impact the recession will have. “Many public sector pension plans measure their assets in June and are recognized on employer financial statements the following year,” the report said. “Though markets have seen some gains in April, funded ratios are likely to decline in the near future.”

According to estimates from the Federal Reserve, US public sector pension assets were $4.8 trillion as of the end of last year and were allocated between market risk-mitigating investments—such as cash, fixed costs, and hedge funds—and return-seeking investments, which includes all other investments.

During the fourth quarter of 2019, the approximate aggregate return for return-seeking investments was 9.9%; however, during the first quarter of this year, those investments lost 23.5%. Meanwhile risk-mitigating investments returned 0.6% during the fourth quarter of 2019 and lost only 4.6% during the first quarter of 2020. The average target allocation for risk-mitigating investments for US pensions is 31%, while their average target allocation for return-seeking investments is 69%.

In its most recent surveys of states and the 15 largest cities, S&P Global Ratings found the average funded ratio to be 73%. For the plans to maintain that funded ratio, they would have to return nearly 30%, the report said. This would bring the annual return back from its current -12% up to the average assumed rate of 7.25%.

 However, “if returns stagnate, we estimate the funded ratio for the average state and local government pension plan could decrease to 60% from 73%,” S&P said.

Over the long term, plans will likely have to consider adjustments to reduce plan costs and contribution increases to alleviate budgetary pressures, the report said.

 “Though employer audits may not show the impact of the sudden-stop recession for months,” S&P said, “experience from the Great Recession of 2008 gives a sense of what’s to come.”

 This includes methods such as five-year asset smoothing or “collars” that limit rapid contribution increases. While this doesn’t reduce losses, S&P said, it delays contributions and budgetary adjustments to make up for market losses.

Additionally, benefit tiers, employee contribution increases, and cost of living reductions are all options that are likely to be used to reduce contributions. However, additional actions may be limited since many of these actions have already been used, said S&P, citing a report by the National Association of State Retirement Administrators.

“Plans that have either taken actions in the past to reduce contributions or lacked action when actuarial recommendations increased are seeing increased stress now,” S&P said. “With tightening budgets and operating cost pressures, pension contributions may be an outlet for temporary budget relief at the risk of plan funding.”

The report warns that while deferring costs in the near term may provide budgetary flexibility and could be a liquidity management tool, it will increase long-term pension costs.
You can read the S&P Global Ratings report on liquidity concerns for US public pensions here (subscription required).

Nothing in this report will likely surprise me. Pensions are all about managing assets and liabilities. When assets get clobbered and more importantly, liabilities soar because long-term interest rates decline to record levels, it's a perfect storm for pensions as it translates to deteriorating funded status.

And as I keep reminding you, it's the decline in interest rates which has a much more pronounced negative effect on pensions' funded status because the duration of pension liabilities is a lot bigger than the duration of pension assets, so even if assets recover on a sustained basis, as long as rates remain at historic low levels, the increase in liabilities swamps any recovery in asset values.

This is why after the tech meltdown of 2000-2001 and Great Financial Recession of 2008, the funded status of US public pensions kept deteriorating long after assets recovered from their bottom.

Moreover, as Jim Leech, OTPP's former CEO, once told me, pension deficits are path dependent, meaning the starting point matters.

If US public pension were 70% funded going into this pandemic, they will likely slip to 60% or below in the years ahead. And many chronically underfunded US public pensions are in much worse shape because their funded status is at 50% or lower.

There is no doubt in my mind that US public pension bailouts are coming. They might not be around the corner but there is no way many US public pensions will sustain the liquidity crunch they will suffer from this pandemic.

Unlike Canada's large public pensions which are fully funded or over-funded, many US public pensions will not be able to sustain a prolonged hit to assets and record low rates over the next decade.

I know, the inflationistas are all warning of hyper inflation and the Great Stagflation of 2021, but I'm far more concerned about a prolonged period of debt deflation.

US public pensions have not heeded my deflation warnings seriously and they can continue to ignore them or prepare for negative rates and a long bout of debt deflation (never mind the Fed's denials, negative rates are coming to America).



Still, there is a lot of volatility in long-term bond rates which explains the popularity of this ETF:



Interestingly, when you look at US corporate plans which use a much lower discount rate and have largely derisked their plans with a heavy weighting in fixed income, their funded status actually rose in March:
Defying forecasts of another grim month due to global market volatility, the funded status of the 100 largest US corporate pension funds surprisingly increased $93 billion in March despite deteriorating economic conditions amid the COVID-19 pandemic.

Just a month after hitting its lowest level in more than three years the Milliman 100 Pension Funding Index (PFI), which tracks the funded ratio for the 100 largest corporate pension plans in the US, rose to 85.6% from 82.1% at the end of February. Consulting firm Milliman said the funding improvement was the direct result of a strong surge in the monthly discount rate to 3.39% from 2.69%.

 “It’s a stunning twist of fate that a month so turbulent as March—given the market conditions and the ongoing global pandemic—actually resulted in positive funding news for corporate pensions,” Zorast Wadia, author of the Milliman 100 PFI, said in a statement. A month ago, Wadia predicted that “March will likely be another dismal month for corporate pension funding.”

During March, the tumbling stock markets led to an $85 billion decline in the market value of the pension funds’ assets to $1.516 trillion from $1.601 trillion at the end of February. This is based on a monthly loss of 5.08%. Milliman said there were only five other months during the last two decades when there has been larger investment losses, and the last one was October 2008 during the Great Recession.

At the same time, the projected benefit obligation (PBO), or pension liabilities, decreased to $1.771 trillion at the end of March.

While February’s discount rate was the lowest discount recorded in the 20-year history of the Milliman 100 PFI, March’s discount rate increase was the fifth largest ever recorded in the study. The last time the discount rate posted a comparable increase was in December 2009.

For the first quarter of 2020, a 5.7% investment loss caused the assets of the pension funds to fall by $103 billion compared to plan liabilities, which increased $48 billion. Discount rates increased 19 basis points (bps) during the quarter and helped limit the funded status erosion. The net result was a funded status worsening of $55 billion as the funded ratio of the Milliman 100 companies decreased to 85.6% at the end of March from 89% at the beginning of the year.

Over the last 12 months through March, the cumulative asset return for the pensions was 2.6%, and their funded status deficit has widened by $81 billion. The funded status loss is the combined result of declines in discount rates during most of 2019 and investment losses experienced during the first quarter. Discount rates fell 39 basis points over the past year to 3.39% as of March 31.

Milliman said if the companies in its index earn the expected 6.6% median asset return per the 2019 pension funding study, and if the discount rate stays at 3.39% through 2021, the funded status of the surveyed plans would increase to 88.1% by the end of 2020 and 91.6% by the end of 2021. For purposes of the forecast, the firm assumed 2020 and 2021 aggregate annual contributions of $50 billion.

It also said that under an optimistic forecast that has interest rates rising to 3.84% by the end of 2020 and 4.44% by the end of 2021, with annual asset gains of 10.6%, the funded ratio would climb to 96% by the end of 2020 and 112% by the end of 2021. However, under a pessimistic forecast that assumes a discount rate of 2.94% at the end of 2020 and 2.34% by the end of 2021, with 2.6% annual returns, the funded ratio would decline to 81% by the end of 2020 and 74% by the end of 2021.
While US corporate pension plans are doing relatively well, I foresee trouble ahead as they too will struggle to deal with record low rates.

In fact, Barron's had a piece today on how US corporate plans continue to fade away. This trend has been going on for years as companies look to derisk their plans and offload them to insurers.

Sadly, while pensions are vanishing for most American workers, corporate executives know all about the value of a great golden pension:



Maybe it's time for a US pension Festivus, where corporate executives sit down with private and public sector union leaders to air out their pension grievances.

Below, Chris Ailman, CIO of CalSTRS, joins "Squawk Alley" to discuss the state of the market amid the coronavirus pandemic.

Second, hedge fund investor Paul Tudor Jones said Monday the economy would be in a "Second Depression" if the coronavirus pandemic doesn't get contained for another year.

Lastly, Jerry Stiller, who played two of American television’s most cantankerous fathers on the sitcoms “Seinfeld” and “The King of Queens,” has died aged 92, his son Ben Stiller said on Twitter on Monday. 

I love Seinfeld and thought Frank Costanza was one of the funniest characters on that show. I embedded a couple of my favorite clips below beginning with the story of Festivus. 



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