State, municipal pension funding dropped 6% in 2022: New approaches are needed

A new review found that 2022 was a volatile year for managing pension funds. Economic upheaval, uncertainty due to the pandemic, a war in Europe—it all added up to poor investment returns and in some cases, a reversal of gains seen in 2021.

The analysis is spelled out in a research brief called “The State of Pensions 2022 Year End Update,” published by Equable Institute, a bipartisan think tank. The analysis estimated that U.S. state and municipal retirement systems saw their aggregate funding ratio fall to 77.3% at the end of 2022, down from the 83.9% funded ratio during fiscal year 2021.

Overall, the study said, there are a number of warning signs about the health of pension plans, including:

• Most major public market indices are effectively flat over the last six months.
• Private equity returns get reported on a lag of up to six months, and with each update in 2022 values were coming down — which means 2022 numbers were including overstated private equity asset valuations and 2023 numbers are going to incorporate those losses.
• The Federal Reserve is signaling more interest rate hikes with persisting inflation, war in Ukraine continues, and the end of China’s Zero-Covid policy will create near-term pressures on global commerce in 2023.

“This means that, to-date, it is unlikely that most pension funds are on track to hit their assumed rates of return for 2023, even if they do generate a positive overall return,” the report said. “Pension fund trustees should be considering lower investment assumptions and state legislatures should be looking at larger contribution rates.”

Plans are struggling on, but show a lack of resilience

The report found that most pension funds are unlikely to hit their projected rates of return for 2023. Unfunded liabilities have fluctuated in recent years, starting in 2007 and the Great Recession. In 2021, the situation improved with unfunded liabilities decreasing to $986.6 billion. For 2022, that number is estimated to be back up to $1.45 trillion.

“Most state and municipal pension plans in the U.S. are distressed or fragile,” the report said. It noted that funded ratios and unfunded liability levels vary considerably between states.

The analysis found that for 2022, the top five states for healthiest funded ratio were:

• District of Columbia (with a funded ration of 103.4%)
• Washington (102.9%)
• South Dakota (100%)
• Tennessee (99.5%)
• Nebraska (96.1%)

The bottom five states were:

• Kentucky (47.3%)
• Illinois (50%)
• New Jersey (50.1%)
• Connecticut (51.5%)
• South Carolina (57.8%)

More than one path forward

According to Anthony Randazzo, the Equable Institute’s executive director, the findings confirm that pension funds need to adopt more realistic investment assumptions, pointing to the example of the New York Common Fund, which lowered its assumed rate of return to 5.9%.

Related: SECURE 2.0 can help revive corporate defined benefit plans

For other funds, different approaches may be needed, given the costs involved. “We think it is reasonable to take a parallel approach of walling off current liabilities with a specific plan to cover shortfalls and secure resources to pay benefits, as well as a separate go-forward policy for newly earned benefits,” he said. “Those new benefits could be risk-managed pensions, guaranteed return plans, hybrid plans, or any combination that meets the larger workforce goals in offering retirement benefits.”

Randazzo also mentioned the example of states like Colorado, South Dakota, Wisconsin, and others, where trustees have been given more authority to use risk-sharing and cost-sharing tools. Again, improvements or changes in benefits may be worth exploring, he added. “Many pensions are not working well for those who serve less than 20 years of service (which is most public workers) and not all pensions offer inflation protection for those who do earn a full pension,” he said. “There are better ways to design public retirement plans for the 21st Century. Plus, with the mobility of the workforce today, it is logical to create options of other retirement plan types that trade off guarantees for more portability (like in Michigan, South Carolina, and Utah).”