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Continuing to fall

Public pension funding ratios still tumbling

Only three of largest public pension plans were above 100%

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Continuing: Alicia Munnell doesn’t anticipate any significant changes in public plan funding levels until 2013.

The average funding ratio of the largest 100 public pension plans continued its descent in fiscal year 2011.

Among the top 100 that Pensions & Investments tracks, the average funding ratio dropped slightly during the fiscal year, to 73.64% from 74.29%. The median funding ratio, while higher than the average at 74.59%, also slid 204 basis points from fiscal 2010.

In aggregate, the top 100 plans had unfunded liabilities of $793 billion as of their latest actuarial valuation date. That amount is up 4.1% from the previous year. Of the 94 plans to have reported actuarial data in their fiscal 2011 reports, only three funds had funding ratios above 100%.

One investment consultant noted that funding levels have been slow to rebound because plans are still suffering from the impact of 2008 and 2009 returns on their actuarial models. Depressed funding levels have resulted from governments not making contributions, along with poor investment returns.

Alicia Munnell, director of the Center for Retirement Research at Boston College, said, “We don't envision funding ratios leveling off until 2013, when the effects of 2008 and 2009 have rolled out of actuarial valuations.”

Market values

Total net assets of the top 100 plans reporting audited fiscal 2011 data at the time of publication were $2.72 trillion, up 14% from 2010. More than three-quarters of the assets were as of fiscal year-end dates of June 30, 2011 — before market turmoil stemming from the U.S. credit downgrade took effect in the third quarter of 2011 — because of public retirement systems' slow disclosure of audited financial data.

Based on aggregate asset allocation data and market returns through Aug. 31, 2012, P&I estimates assets to be approximately $2.81 trillion now.

Average funding ratio of P&I's 100 largest public plans

In 2011, employee and employer contributions totaled $110.9 billion — $35.2 billion coming from employee contributions and the remainder from the employers. Total retirement benefit payments were $181.9 billion, meaning current contributions account for only 61% — in line with 2010, but down from a recent high of 67% in 2008.

Data compiled by P&I highlight the difficult time public pension funds have had achieving their assumed rates of return over the past 10 years. The median 10-year annualized return was 5.6% among plans that disclosed investment performance over the period. Those returns are in line with the median policy benchmark over the same period, but trailed the average assumed rate of return by 224 basis points.

In fact, only three plans exceeded a 7% annualized rate of return. The Fairfax County (Va.) Retirement System (Employees) had 10-year returns of 7.6%, the Missouri State Employees' Retirement System, Jefferson City, had gains of 7.1%, and the South Dakota Investment Council, Pierre, had gains of 7%. All three plans had a June 30 fiscal year-end date.

Jay Kloepfer, executive vice president and director of capital markets and alternatives research at Callan Associates, San Francisco, said he thinks public plans have done a reasonable job of pointing their investment portfolios toward growth but have been challenged over the past 10 years. Return expectations, he said, “are more subdued now and will likely be more difficult to achieve in the next 10 years.”

Plan sponsors seem to agree with this view, and have adjusted their assumptions accordingly. The average actuarial assumed rate of return fell eight basis points in 2011 to 7.84%, from 7.92% a year earlier. Average assumed rates of return have decreased steadily since 2007, from a high of 7.96%.

Mr. Kloepfer stressed the need for plan sponsors to maintain a focus on the long term, noting that over a 30-year period, funds have been able to achieve returns in excess of a 7% to 8% expected rate of return.

The Wilshire Trust Universe Comparison Service reveals that public pension funds with a total market value greater than $5 billion in assets had a median total return of 10.29% in the 30-year period ended June 30, 2012.

Investment trends

The weighted average asset allocation of P&I's top 100 plans for fiscal year 2011 was 51.7% equities (21.6% U.S. equities, 16.9% global equities and 13.2% international equities); 23.9% fixed income; 20% alternatives; 4.4% cash and other. The breakdown of alternatives, where provided, was 7.5% private equity, 6.3% real estate, 2.3% hedge funds, 1.2% real return and 0.4% commodities.

In 2007, the asset allocation was 59.9% equities (36.5% U.S. equities, 17.4% international equities, and 6% global equities); 25.3% fixed income; 12% alternatives; 2.8% cash and other. The breakdown of alternatives was 5.7% real estate; 5.2% private equity; 0.9% hedge funds; and 0.2% commodities.

The 2011 weighted average target asset allocation of P&I's top 100 plans was 49% equities (15.7% U.S. equities, 23.6% global equities and 9.7% international equities); 25.2% fixed income; 22.9% alternatives; and 2.9% cash and other. Alternatives target allocation, again where provided, was 7.6% real estate; 7.3% private equity; 2.8% hedge funds; 1.6% real return and 0.6% commodities.

Robert Parise, managing director and Midwest region head at J.P Morgan Asset Management in Chicago, said the biggest trend among public plans remains investment in alternatives as plan sponsors continue to seek “unique sources of alpha.”

Among particular alternative strategies, he noted that private core real estate continues to be in favor with public plan sponsors. “On a weekly and monthly basis, we are seeing plans looking to put money to work in this space,” Mr. Parise said.

He cited the real estate's income-generation properties as well as its ability to hedge inflation as particular selling points for plan sponsors — many of whom see inflation ticking up in the next three to five years. Asked about opportunistic and value-added real estate, he noted there was “a little bit of an appetite, but interest is more spotty; certainly not a trend.”

Hedge funds, he said, should continue to remain popular among plans and the trend away from funds of funds is likely to continue as sponsors look for diversified sources of alpha.

Callan's Mr. Kloepfer sees the trend toward illiquid investments continuing as well, noting an asset mix of “40% liquid equities, 20% fixed income and 40% in all other strategies, including illiquid investments, such as real estate, timber, agriculture, hedge funds, private equity, commodities and other real assets appears to be the new steady state” among public pension funds. “Portfolio betas are unlikely to move below 60%, and part of that is due to the limited opportunity set among illiquid investments,” he said.

A potential area for growth, Mr. Parise noted, lies with emerging managers in the private equity arena, given that many public plans have programs to increase commitments to minority- and women-owned managers. Finding these types of managers is fairly easy for traditional asset classes, but becomes more difficult among alternative investment strategies, notably hedge funds and real estate. Private equity firms, he said, could be well-positioned to take advantage of such mandates.

One traditional asset class where Mr. Parise has seen increasing interest among public funds is emerging markets equities. The foundation for the investment thesis, he said, is the growth in developing economies. But sponsors are also attracted to the greater likelihood of market inefficiencies that active managers can exploit in emerging equity markets.

Outlook for funding

M. Barton Waring, former chief investment officer for investment strategy at Barclays Global Investors and author of “Pension Finance: Putting the Risks and Costs of the Defined Benefit Plan Back Under Your Control,” said he thinks funding levels will remain at depressed levels.

When plans are funded at these levels, he said, they are clearly running behind on their assumptions and that “the neutral position is downhill.” His view is that there are only three levers to pull to improve the situation — higher contributions, diminished benefits or what he called “excellent luck” over the long-term with risk-seeking investments. He noted that small steps have been taken to address the first two, but plan sponsors should not rely solely on the hopes they will achieve 7% to 8% annualized returns from higher risk assets.

To truly guarantee benefits to participants, Mr. Waring contends that a risk-free interest rate should be used to calculate liabilities and investments in such assets will prevent large drawdowns in assets during future crises. The cost of such a move will increase through much higher contributions, but he said participants are likely to accept those higher costs in exchange for guaranteed benefits.

Chris Mier, managing director, analytical services at Loop Capital Markets LLC, Chicago, said he is not in the “catastrophe camp” when it comes to public pension plans and he noted that people involved with the resolution of the issue need to realize it is a plan-by-plan issue and is not a systemic problem.

Mr. Mier said he envisions states gradually gaining footing from a budget perspective, and becoming more comfortable with making 100% of the actuarially required contributions.

In fact, data released by the U.S. Census Bureau on Sept. 25 reveal that tax revenues for state and local governments were up 3.3% during the second quarter of 2012 compared with the same period last year. The increase represents the 11th consecutive quarter of year-over-year growth.

A combination of higher annual required contribution funding payments, along with greater efforts by states and municipalities to chip away at benefit costs is likely to improve funding ratios going forward, Mr. Mier said.

This article originally appeared in the October 1, 2012 print issue as, "Funding ratios still tumbling".