Future still murky for public pensions despite record funding ratios

State and municipal retirements system are on track this year to outperform their investment targets from last year and push up the funded ratio, according to Equable, a non-profit that works with public retirement system stakeholders to solve pension funding challenges.

The public pension funding shortfall will drop to $1.3 trillion this year from $1.6 trillion in 2023, predicted the nonprofit’s annual report published Tuesday. The average funded ratio of public pensions will increase to 80.6% from roughly 76% last year, the group said.

For comparison, S&P Global Ratings reported median pension funding levels were 69.5% in fiscal 2017, in an outlook published in January.

But while no one would argue that seeing the states (and cities) turn the corner on high levels of unfunded liabilities is good news, it was delivered with some caveats.

“Funded ratios are just one number,” said Todd Kanaster, S&P Global Ratings’ director of public pension analytics. “You can’t summarize a pension status in one number. You need to talk about the risk from the investment decisions.”

The improvements were wrought by a combination of investment returns of 7.4% outperforming the assumed baseline of 6.9% for the first six months of the year; and record high contribution rates — state and local governments paid more than 31% of payroll or $180.7 billion into their public retirement systems last year.

A single good year is not incredibly meaningful when contemplating the sustainability of pension systems that need to deliver on promises to retirees that will come due decades from now, market participants said.

“This was a good year for pension plans, but this welcome annual improvement hasn’t been enough to break the country out of its pension debt paralysis as public plans still have over $1.3 trillion in unfunded liabilities,” said Anthony Randazzo, Equable’s executive director, during a briefing held a day before the publication of the firm’s report.

“The plans aren’t losing ground in the long run, but they aren’t gaining much,” said Jon Moody, vice president for research at Equable.

Pension funds face a bevy of headwinds that could throw them off kilter and lead to a funded status reversal next year, said Randazzo, who listed the challenges. They include negative cash flow trends, growing interest on pension debt, and the looming threat of a financial market correction.

Despite the headwinds, pension funds are in much better shape than they were in the years immediately following the 2008 financial crisis, said Howard Cure, partner and director of municipal bond research at Evercore Wealth Management.

Pension liabilities were once the biggest concern of the rating agencies and that is not the case today, Cure said.

But Randazzo said the state of pensions “is still fragile,” despite the progress.

“The volatility in pension plans is approaching that last seen during the 2008 fiscal crisis,” he said. “That volatility means you need to take extra caution when taking stock of the change in unfunded liabilities for one year.”

In order to achieve the higher returns the funds are expected to realize in 2024, estimated at 7.4% by Equable and as high as 10.6% on average by Moody’s Ratings , the pension funds have taken on more risk.

S&P Global Ratings

“The risk profiles of U.S. state and local pension funds have shifted significantly toward alternative investments in recent years,” Equable’s report said. “As of the end of 2023, 27.9% of pension fund assets are invested in alternatives exposed to valuation risk, including: 13.7% in private capital investments, 5% in hedge fund strategies, and 9.2% in real estate. Just 8% of pension fund assets were allocated to these categories combined in 2001.”

Solid investment returns and higher interest rates have been a boon for state and local pension funds, Moody’s said in a July 9th commentary.

Kanaster named all the strides pension funds have taken in recent years to strengthen sustainability, including increasing contributions and reducing market return assumptions, but he is concerned about the opacity on investment risk for some pension funds.

The assumed rate of returns for pensions was averaging about 7.75% in 2013, now that’s between 6.75% and 7.25%, which has increased the contributions made to funds, because it assumes less of a return on investments, Cure said.

“That is good,” Cure said.

Plus, negotiations between new employees and municipalities have resulted in less generous benefits, Cure said.

In addition, “interest rates are up, which helps the fixed-income portion of the portfolio, plus the stock market has been roaring,” he said.

Cure does acknowledge Equable’s point that problems with commercial real estate investments are lagging and don’t usually mark-to-market losses until nine months after the fact. But, he notes, gains in residential real estate might help to lessen the pain there.

“I can’t speak to that hidden risk for individual investments,” Kanaster said. “If we see investments that Equable can measure today, we are going to look at that, because our point is to gather as much data as we can.”

The higher the market risk, the higher the contribution risk, because if pension funds don’t realize gains on investments, it has to come via increases in contributions — the two are tied together, Kanaster said.

“What we have seen is a forward-looking risk mitigation strategy being implemented,” he said. “All have taken a multi-pronged approach with new employee tiers receiving lower benefits, lower discount rates and [states and cities] paying higher contributions and accepting less risk.”

Plus, a range of headwinds from negative cash flows, to growing interest on pension debt, and the looming threat of a financial market correction “could easily lead to a funded status reversal next year,” Randazzo said.

In S&P’s 2024 pension outlook report published in January, analysts highlighted unknown risks from opaque investments, meaning investments with unclear risk profiles, and also increased exposure to a higher concentration of high risk, private equity investments in pension portfolios, Kanaster said.

If investment returns fall on those high-risk investments it can mean “increased contributions for states and cities with already tight budgets,” Kanaster said. “If the market tanks, you have to make up the losses with increased contributions.”

Some pension funds took on riskier investments after inflation spiked in 2022, Kanaster noted.

“After 15 or 20 years of stagnant wages, there were calls for salary increases, because people need to be able to pay their bills,” he said. “That leads to higher pension liabilities, liabilities that are permanent. So, they are now being funded with the risky investments people are talking about.”

“The higher the market risk, the higher the contribution risk, because those two are tied together,” Kanaster said. “If the market is volatile then that means contributions will be volatile.”

Strong market performance and higher interest rates have resulted in a $3 trillion drop in unfunded pension liabilities as of June 30 compared to the peak in 2020, marking the fourth year in a row of such declines, Moody’s said.

That’s a 60% reduction, Moody’s said.

New Jersey is considered a remarkable comeback story, particularly when it comes to pensions. Yet, as of July 2024, the state’s pension fund’s funding ratio is estimated to be 52.4% for the next fiscal year by the State Department of Treasury, significantly lower than that 80.6% median reported by Equable. And this is the case even as the state makes its fourth consecutive full contribution. Its funded ratio is expected to increase to 60.7% in 2029 and to hit 90.4% by 2047.

The number of municipalities systemically underfunding pension benefits annually has declined substantially, said Thomas Aaron, a Moody’s vice president and senior credit analyst, which is a clear indicator of less risk, or improvement, when it comes to pensions.

For instance, he said, Illinois has continued to follow its statutory contribution path, placing it closer to the tread-water mark in Moody’s analysis. In Moody’s last state sector snapshot in September 2023, the difference between Illinois and the tread-water indicator was less than 1%.

Connecticut and New Jersey also improved — and those two states had been associated with recurring shortfalls, Aaron said. In recent years, they have ramped up pension contributions, and it has been a direct driver of credit improvement for both states, he said.

Hawaii also has seen improvement, Aaron said. It enacted a multi-year increase to its statutory contribution rate. The state’s improvements come from it contributing more and sooner, he said.

California’s two major funds, the California Public Employee Retirement System and the California State Teachers’ Retirement System, have both enacted changes to protect their pension systems.

“CalSTRS is now a decade into a long-term funding improvement push that focused on higher contributions from the state and participating school districts to bolster cash flow,” Aaron said. “CalPERS has reined in amortization periods and changed its methods to cause governments to contribute more sooner.”