Most U.S. public pension plans are likely to post flat returns for the fiscal year ended June 30 despite markets rallying in the second quarter, a report from Moody’s Investors Service said.
Moody’s estimates that the effects of the COVID-19 pandemic will lead to the returns for most public plans being between zero and 1%, well below the average return target of 7%.
Although individual results will vary, Moody’s projects that returns of zero for FY 2020 will result in the cost to maintain pension obligations rising by about 15% for the fiscal year ending June 30, 2021, and that reported unfunded liabilities and adjusted net pension liabilities will both rise by more than 20%.
“The pandemic-related economic shock has caused widespread declines in state and local governments’ tax revenues, producing large budget gaps that will be especially challenging for those with high fixed costs for pensions and other debt,” said Tom Aaron, vice president at Moody’s, in a news release announcing the report. “Investment returns for FY 2020 fell short of targets, which will create higher unfunded pension liabilities and necessitate higher contributions to keep pension system assets from declining.”
While many sponsors of public plans do not contribute enough to maintain their pension obligations, the actuarially determined contributions that their pension systems calculate will still rise next year due to investments underperforming in fiscal year 2020, the report said.
Moody’s reports that an increasing number of underfunded public plans are reducing their annual investment return targets and making other actuarial changes that increase governments’ actuarially determined contributions. Florida, Illinois, Michigan and Utah are states that have joined Indiana and South Dakota in cutting their return targets below 7%.
Still, with interest rates low and return targets high, plans like the $396.9 billion California Public Employees’ Retirement System, Sacramento, are relying on riskier investments to keep state contribution obligations from rising.
But Moody’s notes that this strategy increases exposure to market losses, which could drive up contribution obligations. And while significant asset derisking could reduce the chances of sharp investment losses for poorly funded retirement systems, asset derisking is unlikely to materially improve a long-term funding trajectory of an underfunded pension system alone.
Unless state sponsors increase taxes, which is challenging and politically risky in an environment of increased unemployment, state revenues are unlikely to return to fiscal year 2019 levels even by fiscal year 2024. States that are dependent on sales, income and capital gains taxes will likely suffer more severe revenue challenges.
“For many U.S. public pension systems, particularly those with very negative non-investment cash flow, higher future contributions are key to improving pension funding trajectories,” Mr. Aaron added.
