We are in
unprecedented times. Coronavirus. Life and death health threats. Market
upheaval. Economic shutdown. And now: talk of states potentially filing for
bankruptcy. But whatever happens with bankruptcy proposals, public pensions
will still have to be paid, and state and municipal governments should continue
making their pension contributions.
When the dust
begins to settle after current market turmoil, public pensions’ funded status
will come into view. In some cases, it will likely be quite disturbing. A
hypothetical pension portfolio of 60% stocks and 40% bonds would be down -8.4%
since January 31, 2020. If that pension had been 70% funded then, it was
approximately 64% funded through April 23.
Surely there will be criticisms by political leaders and policymakers:
Why wasn’t the investment staff more conservative? Didn’t they know a crash was
coming? Weren’t we supposed to rebalance? How did we get so heavily weighted to
equities? Why do we have so much in the stock market anyway? This is for
retirees — shouldn’t it be safe?
But the real problem in U.S. public pension underfunding is
not related to investments — as long term investors, pensions have actually
done pretty well. The real problem in public pension underfunding is the
failure of governments (the plan sponsors) to make the necessary contributions
to the pension plan in the first place. Going forward, pension funding status
will depend as much on state and local governments’ meeting funding obligations
as it will on investment performance.
Unfortunately, in the current economic environment, state and
local governments will be tempted to cut back on pension contributions. With
funded status as low as it is now, that could put enormous strain on already
vulnerable systems.
Underfunding is not caused by investment performance
When the dot-com bubble and the 2008-09 financial crisis hit,
pensions’ funded status fell dramatically — from 102% in 2001 to 89% in 2003,
and from 84% in 2008 to 75% in 2010. Interestingly, the states that kept up
their contributions during those difficult times are among the best-funded
plans today.
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In the years following these crises, investment performance
was relatively strong. After the dot-com bubble burst, the average public
pension investment return for fiscal years 2003-2005 was 11.5%. And public
plans averaged 11.3% in the three years that followed the Global Financial
Crisis, based on data from the Pew Charitable Trusts. In fact, pensions truly
are long-term investors. Their median annualized performance over the last
thirty years is about 8.3%, according to the National Association of State
Retirement Administrators.
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Unfortunately, in the years following these crises, at the
worst time, state and local governments pulled back significantly on pension
funding. That is the danger they must avoid today.
Underfunding is actually caused by ... well, underfunding.
Under the guidelines of the Government Accounting Standards Board (GASB), the
governments that sponsor pension plans are supposed to make necessary contributions
to the plan each year. These contributions have traditionally been known as the
Annual Required Contribution (the ARC). Unfortunately, the problem with the
Annual Required Contribution is that the word “Required” is just a word. In
reality, governments are not required to follow GASB guidelines and,
unfortunately, many have failed to do so.
In the years after the markets tumbled, many states and
cities fell short on pension contributions, and pensions’ funded status has not
recovered. States missed their ARCs by significant percentages and dollar
amounts. The weighted average contribution was about 89% of the ARC in
2003, 87% in 2004, 84% in 2005, and 83% in 2006. The total value of those
missing ARC payments was $27.7 billion. That is money that could have been
growing in those plans all this time.
The situation declined even more after the Global Financial
Crisis. The weighted average contribution was about 81% of the ARC in 2010, 80%
in 2011, 78% in 2012, and 82% in 2013. The total value of those ARC shortfalls
was $68.5 billion.
Not only must
political leaders make the full ARC, they must also calculate the
ARC responsibly. They must choose shorter time horizons to amortize
liabilities. For a plan with a $10 billion unfunded liability, the difference
in total dollars contributed between a 15-year amortization and a 30-year
timeframe would be over $7 billion. They should never roll their amortization
periods into new ones, and they must never allow negative amortization — the
equivalent of capitalizing interest on a mortgage.
These three
methodologies invariably make near-term contributions lower and long-term
liabilities higher. Making a “full” ARC with these methods is not really making
the full ARC. The chief investment officer of one public fund told me that my
using those kinds of methods, “my state legislature is ripping me off by $2 billion
a year!” And that was before the current market turmoil.
One of the
arguments in favor of the current huge Federal rescue legislation is that the
companies are not at fault and that this is a crisis. Similarly, the workers
are not at fault and the public pension system in some states is in crisis. So
even though it will surely be difficult to do so, states and cities must make
the proper contributions and not let their funding practices put their pensions
in further peril.
Amundi Pioneer Asset Management is an Associate Member of TEXPERS.The views expressed in this article are those of the author and not necessarily Amundi Pioneer Asset Management nor TEXPERS.
About the Author:
team and clients on topics related to pension strategy, pension fund regulation, and the
growing interest in Responsible Investing. He is a frequent speaker, writer, and advisor on pension-related issues. Millard has appeared numerous times on CNBC and been published in The Wall Street Journal, Bloomberg, Financial Times and elsewhere on a variety of pension topics.
In addition to working with the institutional team and clients, he works with the marketing team to strategize on speaking opportunities and editorial content. Millard was appointed by President George W. Bush to be the Director of the United States Pension Benefit Guaranty Corp. He was the first Director to be confirmed by the U.S. Senate and carried the rank of Under Secretary.
Subsequently, he was Managing Director and Head of Pension Relations with Citigroup. He also taught pensions and public policy at the Yale School of Management, served as a Senior Advisor for McKinsey, and held various senior roles in the private sector. Earlier in his career, Charles served as the President and Chief Executive Officer of the New York City Economic Development Corporation, and as a member of the New York City Council representing the Upper East Side of Manhattan.
Millard is a member of the Editorial Board of the Journal of Retirement and the Advisory Board of the Georgetown University Center for Retirement Research. He holds a B.A. from the College of the Holy Cross and a J.D. from Columbia Law School.
