US public pension plan sponsors and administrators are likely entering a period of fiscal stress, and rising pension obligations caused by the sudden pandemic-induced recession are expected to be felt for years by US state and local governments, according to a report from S&P Global Ratings.
S&P said US public pension funds in aggregate lost approximately $850 billion during the first quarter of the year, and that they would need to rebound sharply during the second quarter to maintain the average funded ratio from a year ago.
“In the public sector, market returns are built into the funding model and thus make up a large part of pension plan inflows,” the report said. “Should market returns remain below past peaks, the effect of poor returns will result in an increase in employer contributions.”
The report looks at how the recession is likely to impact public pensions during three periods—immediately, over the near-to-mid-term, and over the long term.
The immediate concern for US public pensions is their liquidity position, according to the report, as a pension plan’s liquidity position mitigates near-term shocks. Pension asset portfolios without enough cash to cover benefits could be forced to sell return-seeking assets at inopportune times.
A pension plan’s liquidity-to-assets ratio can help determine how much liquidity risk it is carrying. A plan with a negative liquidity-to-assets ratio needs additional money to maintain operations and make benefit payments. And the further below zero the ratio is, the more assets that may have to be converted to cash.
During the near-to-mid-term, a plan’s funded level indicates the range of impact the recession will have. “Many public sector pension plans measure their assets in June and are recognized on employer financial statements the following year,” the report said. “Though markets have seen some gains in April, funded ratios are likely to decline in the near future.”
According to estimates from the Federal Reserve, US public sector pension assets were $4.8 trillion as of the end of last year and were allocated between market risk-mitigating investments—such as cash, fixed costs, and hedge funds—and return-seeking investments, which includes all other investments.
During the fourth quarter of 2019, the approximate aggregate return for return-seeking investments was 9.9%; however, during the first quarter of this year, those investments lost 23.5%. Meanwhile risk-mitigating investments returned 0.6% during the fourth quarter of 2019 and lost only 4.6% during the first quarter of 2020. The average target allocation for risk-mitigating investments for US pensions is 31%, while their average target allocation for return-seeking investments is 69%.
In its most recent surveys of states and the 15 largest cities, S&P Global Ratings found the average funded ratio to be 73%. For the plans to maintain that funded ratio, they would have to return nearly 30%, the report said. This would bring the annual return back from its current -12% up to the average assumed rate of 7.25%.
However, “if returns stagnate, we estimate the funded ratio for the average state and local government pension plan could decrease to 60% from 73%,” S&P said.
Over the long term, plans will likely have to consider adjustments to reduce plan costs and contribution increases to alleviate budgetary pressures, the report said.
“Though employer audits may not show the impact of the sudden-stop recession for months,” S&P said, “experience from the Great Recession of 2008 gives a sense of what’s to come.”
This includes methods such as five-year asset smoothing or “collars” that limit rapid contribution increases. While this doesn’t reduce losses, S&P said, it delays contributions and budgetary adjustments to make up for market losses.
Additionally, benefit tiers, employee contribution increases, and cost of living reductions are all options that are likely to be used to reduce contributions. However, additional actions may be limited since many of these actions have already been used, said S&P, citing a report by the National Association of State Retirement Administrators.
“Plans that have either taken actions in the past to reduce contributions or lacked action when actuarial recommendations increased are seeing increased stress now,” S&P said. “With tightening budgets and operating cost pressures, pension contributions may be an outlet for temporary budget relief at the risk of plan funding.”
The report warns that while deferring costs in the near term may provide budgetary flexibility and could be a liquidity management tool, it will increase long-term pension costs.