Pension unfunded liabilities rising with market volatility

The markets giveth and the markets taketh away. Unfunded liabilities for state pension funds are expected to climb from $783 billion in 2021 to $1.3 trillion in 2022. The funded ratio of state pensions would fall from 85% last year to 75% in 2022.

That’s according to the Reason Foundation, which states that after the market expansion of 2021 helped pensions; the rather lackluster performance of markets this year could see an average rate of return for state pensions at -6%. Should that be the case, Reason Foundation estimates that some of the nation’s largest pension funds, California, New York, Texas, Ohio, Florida and Illinois, would see their unfunded pension liabilities jump by more than $20 billion compared to 2021.

“The nation’s largest public pension system, the California Public Employees’ Retirement System, provides a good example of how much one bad year of investment returns can significantly impact unfunded liabilities, public employees, and taxpayers,” write Zachary Christensen and Jordan Campbell of Reason Foundation’s Pension Integrity Project. “If CalPERS’ investment returns come in at -6% for 2022, the system’s unfunded liabilities will increase from $101 billion in 2021 to $159 billion.” That would equal a debt burden of $4,057 for every Californian. Its funded rate would drop from 82.5% to 73.6% in 2022, and state employers would have less than three-quarters of the assets they need to pay for pensions already promised to workers.

The significant levels of volatility and funding challenges pension plans are experiencing right now support the Pension Integrity Project’s position last year that most state and local government pensions are still in need of reform, despite the strong investment returns and funding improvements in 2021.

The Foundation stated three reasons for pension reform, including:

1. 2021 investment returns will have limited impact on long-term pension funding
2. Long-term returns are expected to remain low
3. Many plans remain vulnerable to increasingly volatile market outcomes

Also, the Foundation notes that many observers mistook a single good year of returns as a sign of stabilization in what was a bumpy couple of decades for public pension funding. However, this year’s returns, as well as the growing signs of a possible recession, “lend credence to the belief that public pension systems should lower their return expectations and view investment markets as less predictable and more volatile.”

One area state pensions have been dropping the ball, according to the Reason Foundation, is in building resilient pension plans. It is no longer okay to accept the notion of “investing our way out of it” or “reversion to the mean.” In their commentary on Seeking Pension Resiliency, Leonard Gilroy, vice-president at Reason and Christensen states pension plans must start: “Adopting assumed rates of return tied to short-term forecasts and abandoning rates framed around long-term forecasts — not because we don’t believe the funds can achieve that, but because it’s a prudent way to build shock absorbers against certain risks, especially when taxpayers are exposed to such prominent financial risks associated with underfunded pensions.”

Related: Wall Street secrets pit $75B pension plan against trustee tasked with protecting it

They add that this also means abandoning 30-year amortization periods to pay down future unfunded liabilities and containing pension debt payments to shorter (15-year or less) periods. This means using discount rates divorced from assumed rates of investment return to get a more realistic picture of the true liabilities that are going to be paid out to beneficiaries no matter what happens in the market, and then budgeting for that much larger, yet less risky, number.

Underfunded pension plans remain an issue and will continue to do so while markets remain volatile to market shocks. Seeking ways to minimize risks, with a view toward long-term investing (not relying on one good year), can make state systems more resilient to a future of unknowns.