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It’s not looking good, but don’t panic just yet.
The coronavirus’ potential impact on the global economy has sent shock waves through the U.S. stock market, with successive slides that spell bad news for public pensions.
Over the last month, all the market gains made last year have been wiped away as stocks tumbled by more than 25%. That means pension funds, which rely heavily on public equities to boost investment returns, are likely to have their worst year since the 2008 financial crisis, barring a stunning turnaround in the next few months.
Pension funds won’t officially record their market values for financial reports until the fiscal year ends, which is on June 30 for most. But given the market’s reaction to the economic slowdown forced by the coronavirus, retired investment expert Girard Miller says he expects by this summer most fund assets will be where they were back in December of 2018.
“So it’s probably not going to be as dramatic as the loss we’ve seen over the last month,” he says. “If this continues for another 18 months, and stocks go down 40 to 50%, that’s a different story. But we’re not there yet.”
What would it mean to return to 2018? CalPERS, the largest plan in the country, reported a $337.2 billion market value in December 2018, according to plan financial documents. That’s 9.5% less than its reported value of $372.6 billion at the end of the last fiscal year in June 2019.
The worst-funded plan in the nation, the Kentucky Employees Retirement System, reported a $1.9 billion balance in December 2018. That’s 13% below the reported value of $2.2 billion at the end of the last fiscal year, according to plan financial reports.
How much plans stand to lose depends on how much of their assets are invested in stocks and other potentially volatile holdings. The average plan has about 40% of its portfolio invested in equities, according to the Boston College Center for Retirement Research (CRR). CalPERS follows closely to that. Kentucky’s plan is severely underfunded at 13%, so it has a smaller share in stocks and a higher-than-average share (about 30%) invested in bonds.
Ultimately, the market dynamics over the last 20 years and the low return from bonds has meant that pension funds can’t rely on the stock market to reach their target annual return of more than 7%. Jean-Pierre Aubry, the CRR’s associate director of state and local research, said pension investment returns have averaged well below that—just 5.6%—since 2001. The current downturn puts a fine point on that fact.
“Plans are facing a reckoning in terms of the cost in benefits,” says Aubry. “They have to put in more money to meet benefit goals if they’re going to get more returns like this going forward.”
While these are potentially daunting numbers for pension plans, they won’t directly translate to a budget strain for state and local governments just yet. First of all, the markets could stabilize and even start inching back upward before the fiscal year ends. That would help cut the current losses.
In addition, because of the way pension accounting works, any annual losses or gains are smoothed out over several years so that governments don’t get a huge jump in their annual pension bill. So, it likely won’t be until next year or even 2022 before the numbers begin to hit state and local government budgets.
Following the 2008 crash, for example, many plans lost about one-quarter of their actual value over the course of a year. But the annual funded level of plans as a whole stepped down from 86.5% funded to 78.4% in 2009, and continued down until stabilizing at 72.4% by 2012.
Plans, on average, haven’t gained any of that ground back. They have stayed at or near 72% funded, despite the record stock market run over the last decade and even as many governments have significantly increased their contributions. There are several reasons for this stagnation, but much of it has to do with the fact that the average plan has more retired members than active ones still contributing. That means more money out the door in retiree payments than is coming in from worker contributions. It also may mean that it will be once again difficult to regain any ground that’s currently being lost in the funded status.
According to a Moody’s analysis conducted before the current volatility, a loss of 6.2% in assets in a single year would require a 32% increase in contributions (likely smoothed over a few years) just to keep a plan’s funded status the same.
“The hit, if there is one, will not be felt all at once,” says senior analyst Tom Aaron, who authored the analysis. “Some of the strong returns from a couple years back are still being smoothed in so that’ll help offset it a bit.”
For plans like Kentucky’s that are already low on assets, however, Aaron says the picture isn’t as dire as it seems. The low funding has forced the state to ramp up its annual payments so much that it’s essentially become a pay-as-you go plan: contributions coming in slightly exceed the money going out in payments.
Most other plans are relying on investments to help cover payouts, meaning their decline in assets will factor more into determining the new upcoming payment for governments.
There is a silver lining, notes Miller. Stock prices are abnormally low and so are borrowing costs. Governments could issue pension obligation bonds and put the proceeds into their systems to take advantage of what will hopefully be a market rebound over the next year or so.
“If there was ever a time this made sense for an underfunded plan,” he says, “it would probably be now.”
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Liz Farmer is a journalist and fiscal policy expert who often writes about budgets, fiscal distress, and tax policy. She is currently a research fellow at the Rockefeller Institute’s Future of Labor Research Center.