Op-Ed: U.S. Public Pension Underfunding—Don’t Make the Same Mistake Thrice

As some lawmakers suggest states consider declaring bankruptcy, governments will be tempted to cut back on pension contributions. Amundi Pioneer senior adviser Charles E.F. Millard urges them not to do so.

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.

And while the current economic, market and health crisis is unprecedented, certain aspects of it are not. When crises and market crashes happen, inevitably some mistakes are made in the rush to put out the fire. That is understandable. But it is not understandable if we make the same mistakes in the U.S. that we have made in the past regarding the funding of public pension plans.

When the dust begins to settle after the 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 11.7% since January 31. If that pension had been 70% funded on January 1, then it is approximately 62% funded today.

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?

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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, the funded status of pensions 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.

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 30 years is about 8.3%, according to the National Association of State Retirement Administrators (NASRA).

Unfortunately, in the years following these crises, state and local governments pulled back significantly on pension funding at the worst time. 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 (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, 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 time frame would be more than $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 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 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.

Charles E.F. Millard is a senior adviser for Amundi Pioneer Asset Management. He is the former director of the U.S. Pension Benefit Guaranty Corporation.


This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.

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