Sagging Stocks Aren’t the Only Threat to Pension Plans

Last year was a great time to manage a pension fund. Thanks to strong stock market gains, plans around the country pulled in returns that exceeded 30 percent in many places, bringing their overall funding levels almost back where they’d been before the Great Recession of 2007 to 2009.

“This is probably the best news that state and local pension plans have received in many years,” says Richard Johnson, director of the retirement policy program at the Urban Institute. “These returns have greatly improved their funding levels.”

It’s hardly time to break out the champagne, however. What the stock market giveth, it can also taketh away. Major indices are down so far in 2022, suffering big drops six trading days in a row before registering slight gains on Monday.

Even if the market were to quickly regain its footing, it’s highly unlikely it will match the great gains of 2021, with economists predicting multiple interest rate hikes this year. And even if the market weren’t swooning, one big year’s worth of gains isn’t enough to solve decades’ worth of underfunding.

You need money to make money, and the programs long in trouble didn’t have enough assets on hand to take full advantage of a banner year. Say your plan started 2021 with a funding level of 80 percent (meaning you had enough assets to cover 80 percent of your anticipated liabilities). With a 30 percent return, your plan would then be 104 percent funded. But if you only started with a 30 percent funding level, the same percentage gain would bump you up only to 39 percent funded.

“The problem of a deeply underfunded plan is that they don’t have a lot of assets, so big returns aren’t as helpful to them,” says Donald Boyd, co-director of the Project on State and Local Government Finance at the University at Albany. “They’ve still got a huge way to go.”

Even if stock market returns end up being disappointing this year, however, pension plans potentially have one other thing going for them. States, and to a lesser extent localities, are flush right now, thanks to billions in aid from Washington and strong revenue collections. Many are choosing to use some of their extra cash to pay down longstanding pension debt.

“One part that’s important for a well-funded pension is return on the assets,” says Kurt Winkelmann, CEO of Navega Strategies, an investment research firm, “and the second is states making the contributions.”

State of State Pensions

Historically, making contributions hasn’t been a strong point for states. Some states have maintained healthy funding levels, such as Wisconsin and South Dakota. Some that got themselves into trouble have made painful adjustments that are starting to pay off, such as Pennsylvania. And then there are the perennial laggards, such as Illinois and Kentucky.

Returns of about 25 percent last year dropped Illinois’ pension debt by about $14 billion, but its remaining hole is still the nation’s largest. Altogether, state pension plans ended the last fiscal year with funding levels above 80 percent for the first time in more than a decade, according to the Pew Charitable Trusts. That still left their unfunded liabilities hovering around the $1 trillion range.

“Despite a historic year in returns for many public pension plans, it’s worth keeping in mind that one good year of returns will not make up in most cases for decades of systematic underfunding,” says Leonard Gilroy, senior managing director of the Reason Foundation’s Pension Integrity Project.

Most pensions smooth out their returns over five years or more, so that one good or bad year isn’t going to move things that much. That makes sense, because they’re trying to game out likely returns over a time horizon of about 30 years.

If things keep going up, that obviously solves a lot of problems. But pension plans typically expect returns that are overly optimistic – generally counting on gains of about 7 percent a year. Let’s say they fall short and only gain 2 percent. That means the next year they still will have to gain 7 percent – plus the 5 percent they missed the previous year, plus interest.

Having to keep chasing optimist projections is one reason why so many pension plans fall short. “To really manage these pension funds right, it’s not just one year,” Gilroy says. “You need to keep the fiscal discipline to make your contributions over the long run to maintain solvency.”

What Governors Are Planning

Maintaining discipline has been hard. When pension plans have a good year, as in 2021, there’s a temptation for legislators to skip contributions. This would be akin to an individual seeing her retirement account gain $10,000 and figuring she can skip that year’s $5,000 contribution.

The problem is that you have to maximize your gains in good years, not fritter them away, because inevitably you’re going to have to make up for bad years at some point. “When politicians have a lot of money around, they tend not to put it in the fund,” says the Urban Institute’s Johnson. “When things are bad, they kick the burden down the road and let future taxpayers worry about it.”

Scared by trillion-dollar deficits, states have generally gotten better about making their contributions in recent years. With healthy budgets, there’s an effort in many places to do more of the same. Last year, the Texas Legislature authorized $510 million a year in additional funding for the state’s employee retirement system through 2054 to address its $15 billion shortfall.

Like any number of such moves in recent years, the Texas bill stripped benefits from new hires, in this case enrolling them in a cash-balance plan akin to a 401(k) account. “Sometimes benefits for new hires are quite paltry,” Johnson says. “It really calls into question the type of retirement security workers are going to get, even if they spend a number of years in the plans.”

Other states are looking to make additional investments in sagging pension plans this year. Last week, the Vermont House approved a pension overhaul that includes an additional $200 million payment. In Rhode Island, Democratic Gov. Daniel McKee has called for $62 million to help make up for deferred contributions from prior years. Missouri Republican Gov. Mike Parson wants to make an additional $500 million payment.

But it’s an election year for most governors and some will be unable to resist the temptations to hand out goodies. Michigan Democrat Gretchen Whitmer, for example, wants to end the state tax on pension benefits, while Georgia Republican Brian Kemp would like to offer a substantial inflation bump to pensioners. “You have to make sure that when funds are flush they are not all of a sudden promising more benefits,” Winkelmann says.

Some plans have made smart moves with last year’s great returns. States including Arizona, California, Maryland and New York have all lowered their expected rate of return – in Maryland’s case, from 7.4 percent to 6.8 percent. That may not sound like a lot, but the lower the expected returns, the easier it is to make the target.

It’s a good idea, but it’s painful. Pretending that large returns are inevitable lowers the amount of cash that states have to put away. But that’s one big reason they’re collectively still short.

It was great for states to enjoy big returns last year, but it was just one pearl in a long strand of good news their pension plans will ultimately need.

Originally published by Governing. Republished with permission.