US Public Pensions Less Than 60% Funded?
reports that Goldman Sachs estimates public pensions are now less than 60% funded on average:
Average funding ratios for public pension funds have declined to 60% and below, down from 74% before the crisis, according to Goldman Sachs Senior Pension Strategist Michael Moran.Mike Moran isn't telling me anything I didn't already know and neither is Lance Roberts who wrote a lengthy comment on the arrival of the "unavoidable pension crisis".
In an interview with Yahoo Finance, Moran discussed the most prominent issue pension funds will face: hitting their return targets. Usually set at about 7%, today’s extremely low interest rates will make that all the more difficult to attain in the future.
“What potentially changes [with public pension funds] is how they think about asset allocation and liquidity going forward,” Moran said. “Many of these plans have a 6.5% to 7% nominal return target, and I think many of them are questioning, ‘How do I hit that target in an environment where 30-year Treasury bond yields are below 1.5%.’”
“It just becomes more challenging and I think they’ll have to become more nimble, more tactical, certainly many of them have moved to alternatives over the past number of years, and I think that just accelerates going forward,” he said.
Hitting their return targets becomes even more difficult to achieve as local governments restrict their spending as a result of constrained budgets, which mean less money being funneled into the pension plans they’re associated with.
“A big issue for the public sector is not just what’s going on with their asset portfolios … [but also] what’s going on with state and local finances,” Moran said. “Because, as we have a recession, as state revenues decline, their ability to fund their pensions becomes a lot more challenged.”
The fiscal distress facing these local governments will make it more difficult for pensions to stay solvent, as it had in the past, Moran explained.
“Our work would indicate that coming into the year, public pensions were in aggregate funded about 72-73%, that has now dropped to below 60%,” he said.
“When we look at previous recessions—the period after September 11, or the period after the global financial crisis, for several years, many state and local governments under-contributed to their plans because they had budgetary stress and I think that’s going to be a key concern going forward,” he explained. “Their ability to make contributions, not just in 2020, but really over the next couple of years.”
The coming US public pension crisis is something I wrote about last year and the pandemic only accelerated the deterioration in their funded status.
It's simple. Just keep these points in mind:
- Pensions are all about managing assets and liabilities.
- The duration of pension liabilities is a lot bigger than the duration of pension assets because liabilities go out 75+ years at a typical pension.
- This effectively means a drop in long-term interest rates will increase liabilities A LOT MORE than any increase in assets, so even when assets recover, as long as rates remain at record lows, underfunded pensions are in big trouble.
- The perfect storm for pensions (all pensions) is when assets get hit and rates drop precipitously, but again, it's the drop in rates which really hurts pensions.
- Unlike corporate plans, US public pensions use a very high discount rate (not market rates) to discount their future liabilities. Many have lowered their discount rate from 8% to 7% but it remains way too high.
- In order for US public pensions to make up for the shortfall, contribution rates have to up (ie. discount rate needs to be lowered), benefits have to be cut or both.
- On top of this, many states have not topped up their public pensions because they are fiscally challenged but all this does is make the problem a lot worse over the years.
- Public pension deficits are path dependent, meaning the starting point matters. If these US public pensions were 70% funded prior to the COVID-19 crisis, they were taking a lot of equity risk and now they're 60% funded. In fact, in October 2019, the Fed warned US public pensions reaching for yield that they will run into trouble, and they have.
- In Canada, large pension plans are fully funded because they got the governance and risk sharing right. They manage public and private assets internally because they got the compensation right and if they ever run into trouble, they have adopted conditional inflation protection to get their plan back to fully funded status. Conditional inflation protection ensures the risk of the plan is equally split between retired and active members, effectively ensuring intergenerational equity.
This means to make their 7% return target, US public pensions need to take more risks across public and private markets.
Stocks are very volatile, as we have seen over the last two quarters, so expect pensions to invest more in private equity, real estate, infrastructure and hedge funds.
The problem? Private equity has reached its Minsky moment and there is a paradigm shift going on in real estate. Infrastructure assets related to transportation (airports, ports, toll roads) are also getting hit and hedge funds continue to underperform.
What about private debt or credit funds? I guess if you're taking a big stake in Apollo's new fund you will be fine but some areas of private debt worry me as we haven't yet felt the solvency crisis.
The other problem with US public pensions is their compensation structure doesn't allow them to hire more qualified people to do more co-investments in private equity, lowering the fee drag.
Always going via funds is expensive and it impacts long-term performance.
The truth is Canadian pensions have seen better performance from their large co-investments than their fund investments in the last few years and this won't change.
Anyway, I can go on and on about US public pensions but I've said enough. While I know they positively contribute to the overall economy, there is no US pension festivus and when the going really gets tough, expect massive US public pension bailouts.
Below, Mike Moran, Senior Pension Strategist at Goldman Sachs Asset Management joins Yahoo Finance's Alexis Christoforous and Brian Sozzi to discuss what pension managers are doing right now to ensure they're able to fund plans going forward.
And yours truly recently updated Ed Harrison and Real Vision viewers on the state of the global pension system with a specific focus on whether state pension funds will go bankrupt or get bailed out (filmed on April 24, 2020).