As I have been predicting for several years, underfunded pensions are beginning to get attention.
This is a topic that will continue to make more headlines as pension funding problems continue to get worse.
An often-ignored fact relating to pension funding is that the funding problems facing pension plans have largely been brought about by central banking policies around the world.
Many pension funds are still using extremely optimistic return assumptions; returns that are unlikely to be realized over the long term given the artificially low interest rate environment in which we find ourselves.
Given this reality, many state’s pension managers are adjusting their actuarial assumptions to make them more conservative. This from “Chief Investment Officer” regarding the New York State Pension Fund:
In anticipation of a lower return investment environment, New York is lowering the long-term assumed rate of return on investments for the New York State and Local Retirement System (NYSLRS) to 6.8% from 7%.
New York State Comptroller Thomas DiNapoli made the announcement along with the release of the state’s annual report on actuarial assumptions.
“The long-term outlook for investors is changing and requires a more conservative approach,” DiNapoli said in a statement. “As in years past, we’re taking the responsible action of lowering our assumed rate of return now so we can better weather market volatility.”
New York is not alone in taking these steps. In reviewing many of the news reports over the past few weeks, there are a number of states taking similar steps.
In the case of New York, the state’s pension fund has had average annual returns of 9.32% over the past three years and 7% over the past 5 years.
Doesn’t sound like a problem does it?
But it is.
In order to get returns of those levels, pension assets have to be exposed to market risk.
This from “City Journal” (Source: https://www.city-journal.org/state-pension-funds-investments-debt) (emphasis added):
It’s a basic principle of investing: the greater the risk an investor takes, the greater the potential reward. But as any experienced investor can attest, increased risk can also bring bigger disappointment. That’s the case with state pension funds. To elevate returns, public-sector pensions have taken on more and more risk for nearly two decades. The result, however, has been lower returns, higher debt, and a mess for taxpayers, according to a new study by Fitch Ratings.
Since 2001, the study found, most government pension funds have boosted their share of investments in riskier financial vehicles, from volatile stocks to real estate. During this period, pension funds achieved median annualized returns of just 6.4 percent, well below the goal of 7.5 percent to 8 percent returns. Only one pension system has met its investing goals since 2001. No wonder, then, that the indebtedness of state systems increased from $33 billion to a staggering $1.5 trillion.
Back to central bank policies.
Because interest rates have been kept artificially low, the only hope a pension plan has to achieve targeted returns is to take more risk with assets.
Given that a 30-year US Treasury bond yields only about 2%, it’s impossible for a pension to reach its return goals by using safer investment vehicles.
Adding to the problem is this fact: as existing, higher-yielding bonds held by a pension plan mature, they are exchanged for lower yielding bonds. Since there is now about $17 trillion of government debt worldwide yielding negative interest rates, this problem is now unsolvable.
Imagine managing pension fund assets and having some of the bonds yielding 4% in your portfolio mature. Now, you have a choice to make.
You replace those bonds with new bonds with a slightly positive or even negative interest rate or you invest those assets where you have a chance to make a positive return.
Obviously, the latter is the only reasonably rational alternative, although I would argue it’s still not totally rational given the risk to which the pension assets are now exposed. It will take only one, overdue stock market correction to further widen the pension funding gap.
The implications and fallout of pension underfunding are severe and far-reaching. This from “Wirepoints” (Source: https://wirepoints.org/harvey-the-first-domino-data-shows-400-of-illinois-pensions-could-trigger-garnishment-by-state-wirepoints-special-report/) (Emphasis added):
You’d be mistaken to think Harvey, Illinois has a unique pension crisis. It may be the first, and its problems may be the most severe, but the reality is the mess is everywhere, from East St. Louis to Rockford and from Quincy to Danville. A review of Illinois Department of Insurance pension data shows that Harvey could be just the start of a flood of garnishments across the state.
Harvey made the news last year when an Illinois court ordered the municipality to hike its property taxes (already at an effective rate of 5.7 percent – six times more than the average in Indiana) to properly fund the Harvey firefighter pension fund, which is just 22 percent funded.
Now, the state has stepped in on behalf of Harvey’s police pension fund. The state comptroller has begun garnishing the city’s tax revenues to make up what the municipality failed to contribute. In response, the city has announced that 40 public safety employees will be laid off.
Under state law, pensions that don’t receive required funding may demand the Illinois Comptroller intercept their municipality’s tax revenues. In total, 368 police and fire pension funds, or 57 percent of Illinois’ 651 downstate public safety funds, received less funding than what was required from their cities in 2016 – the most recent year for which statewide data is available.
If those same numbers continue to hold true, all those cities face the risk of having their revenues intercepted by the comptroller.
This is not an isolated issue, far from it.
The chart, from the tax foundation, illustrates pension funding levels state-by-state. Only the States of Wisconsin and South Dakota have fully funded pensions.
Kentucky is last in the rankings with a state pension that is only 34% funded.
A stock market correction makes these already desperate looking numbers even worse.
The lesson here?
Interfering in free markets, no matter how noble one’s intent, often leads to intended, more severe consequences eventually.