Many public pension funds are facing a reckoning day.
The strong ongoing equity market rebound from March lows helped plans with fiscal years ended June 30 eke out positive returns at least — albeit well below assumed rates of return — but more pain is on the horizon without congressional help.
Equity markets might be near all-time highs again, but state and local governments are confronting a harsher reality. Both are facing huge shortfalls in revenues due to the coronavirus-ravaged economy, and unlike the federal government, they cannot print their own money to keep pension contributions and essential spending in line.
Many state and local governments were already stretched thin before the coronavirus struck. Now, the National Conference of State Legislatures projects tax revenue declines across large swaths of the country, and it could take years for states to fully recover to pre-pandemic times. On top of that, pension contributions will likely take a back seat to more urgent spending on health and safety, exacerbating the underfunding problem. Colorado and South Carolina have already pulled back from making additional pension contributions.
The 100 largest public pension plans were only 71.2% funded as of June 30, according to Milliman. With interest rates expected to be around zero for years and an uncertain future facing red-hot equity markets once federal support programs expire, public plans could be facing at least a second consecutive year of subpar returns. And the worst-funded public plans will be squeezed even more.
The Federal Reserve recently lowered the borrowing rate in its Municipal Liquidity Facility, which could be a boost for states. But adding more debt is just going to prolong the revenue struggles, and credit rating downgrades could be coming.
Congress needs to get creative and provide states with assistance as it has for the financial markets, even if it comes with plenty of safeguards and caveats. Partial loan forgiveness should be part of that; the lost revenue will be too difficult to make up.
This movie has played out before. Pension funding ratios plummeted during the global financial crisis, and despite an 11-year bull market that followed, they are still only 71% funded in the middle of this unprecedented crisis. If funding falls to 60%, 50%, when does it become too big of a hole to dig out of? What falls by the wayside to ensure promised benefits are funded?
It's also on governments to get creative with plan design, whether that is adopting hybrid plans that share risk across employers and employees, or adjusting accrued benefits on a yearly basis depending on investment performance, similar to what a very well-funded Wisconsin retirement system already does.