State and Local Pensions Post Worst Losses Since Great Recession

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Public Finance Update - Aug. 2, 2022

Welcome back to another edition of Route Fifty’s Public Finance Update! I’m Liz Farmer and this week, I’m looking at public pension plans, which just wrapped up their worst year of investment losses since the financial crash in 2008. But—as if we needed any reminder—it’s a very different world today than it was in the late 2000s. This year’s damage hurts, but it isn’t sending people running for the hills. I’ll explain why.

As always, send feedback and tips to: publicfinanceupdate@routefifty.com.

The predictions of just how poorly public pension plans performed in the year ending June 30 range from average losses of 7% to more than 10%. But the bottom line is that the stock market has fallen by more than 20% in value over the past six months and investment losses from that will wipe out all the historic gains pensions made in 2021.

It means that pension funding levels, the share of assets plans have on hand to meet all their promised obligations to current employees and retirees, are likely to dip back down to an average of 72%, according to S&P Global Ratings.

Pension plans rely heavily on investment earnings because annual payments from current employees and governments aren't enough to cover yearly payouts to retirees. More than half (roughly 60 cents) of every dollar paid out to retirees comes from investment income.

Among the retirement systems that have reported preliminary returns, the losses haven’t been quite as low as predicted. The $440 billion California Public Employees' Retirement System (CalPERS), the largest pension plan in the nation, announced a 6.1% loss for the year. Its sister plan, the $302 billion California State Teachers’ Retirement System (CalSTRS) announced a preliminary loss of 1.3%. Between the two retirement systems, losses due mainly to the volatile stock market wiped out $35 billion in assets over the last year.

The story is similar elsewhere as most plans are expected to report their first negative returns since 2009. Oregon’s state retirement plan showed a preliminary loss of 1.4% for the year while San Diego County announced a 9.5% investment loss in its public employees plan. Through the first 11 months of the fiscal year, investment losses across New York City’s five public plans ranged from 2.3% to 5.4% and the state of Wisconsin’s core retirement fund showed an 8.4% loss.

Contrary to public equities, investment returns in alternative investments like hedge funds and private equities were on the other end of the spectrum and posted double-digit gains. Pension plans that had more of their portfolios in these types of investments succeeded in buffering their losses slightly, which is part of the reason pensions invest in alternatives. 

For example, CalPERS and CalSTRS each have about half their assets in public equities, but the latter’s losses were not as steep. The teachers’ fund also invests 32% of its assets in alternatives while the employees’ fund has 20% of assets in that class. 

What the Pension Losses Mean for Budgets

When pension assets go down, liabilities go up and governments are on the hook for making up the difference. But investment gains and losses are smoothed out over a few years when factored into the annual pension bill for governments. So it helps that last year, plans saw gains of more than 20%. 

Most observers say the investment losses in 2022 won’t hit state budgets as hard as they did the last time pension plans posted major losses. In addition to the smoothing, there are a few other factors going on.

For one, pensions systems are in a much fiscally healthier place than they were back in 2008 because most governments have spent the last decade ramping up their pension contributions. 

“We have seen a concerted effort—especially on the part of employers that traditionally had not been paying their full contribution—to begin to do so,” said Keith Brainard, research director of the National Association of State Retirement Administrators. “Quite frankly, there were a number of states that for a number of years were bad actors and not making their required contribution and they’ve really turned that around,” he added, citing California, Kansas, Kentucky and New Jersey as examples.

On top of being more prudent, many governments have reduced their retirement liabilities where they could, mostly by cutting benefits for new hires. As a result, Brainard said he is projecting that pension costs for states have peaked and should at least stay flat, if not begin to decline.

Challenges Remain for Retirement Systems

The national pension funding shortfall (or pension debt) for statewide retirement systems was $933 billion at the end of 2021—the lowest in years, according to the Equable Institute’s State of Pensions 2022 report. But that was short lived. Now, the institute estimates pension debt is up to $1.4 trillion.

Although most plans are on pace to close that gap over the next 20 years, the volatility of the stock market and the economy in general has a greater impact on pension fiscal health than ever before. Most experts say that pension health is better graded on long-term trends, not annual return results. But given the market volatility over the past decade, the long-term picture is becoming harder to assess.

Pension systems in the low interest environment of the last two decades have been shifting more assets away from bonds and into equities and alternatives. According to The Pew Charitable Trusts, more than half of assets in the average plan are in these categories and some, like Alaska’s and West Virginias, have 88% of assets in these higher-risk categories.

This shift towards living and dying by the stock market might play out over time, but is a bigger gamble without much payoff for plans that are less than 50% funded, said Tom Kozlik, a municipal analyst at Hilltop Securities. 

“Even if there’s a year of, say, a 10% return, if your plan is only 20% funded that means you hardly have any assets in the plan and that return doesn’t mean as much or help,” he said. “That’s not going to get you anywhere close to where you would be if you were much more well funded.”

On top of that, widespread difficulties hiring and retaining public workers means fewer employees are contributing to pension plans. If public sector employment doesn’t recover, that shift will have to be accounted for in government pension funding going forward and could lead to more governments again skimping on contributions. 

“I’m worried that pension funding holidays could be in the future,” Kozlik said.

Still, Brainard points out that pension funding levels are still much healthier than they were a decade ago.

“Before fiscal ‘22 ended, pension funds had three good years in a row,” he said. “So obviously the more recent losses are going to take some of that away but it’s important to remember the funds operate over decades and that volatility is an expected part of the funding process.”