Marked Improvement in US State Pension Plan Funding?
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:
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.
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.
So what? Pensions are long-term investors, they can ride out any storm, even if stocks and yields plunge again.
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.