The past few weeks have seen America’s leaders wrestle with the human costs of inaction in the face of the COVID-19 pandemic. And in the next few months, state and local leaders will have to step up again and act decisively to avoid the financial effects of this pandemic from creating long-term damage to their public sector retirement systems.
Unlike the demographics most vulnerable to succumbing to the physical effects of the virus, those with the biggest cause for concern about state and local pensions aren’t America’s senior citizens and retirees. It’s today’s active public workers who should be worried. Not only are many of them on the front lines of this invisible war against coronavirus – from police officers and firefighters to the public health officers and municipal employees who are keeping the government running – but they’re doubly exposed to the disasters on the financial side of this crisis.
Consider that before 2020 started, state and local governments had reported a $1.6 trillion shortfall in the funding needed to pay promised retirement benefits to public workers. And that was fully accounting for the bull market that ran from 2009 through 2019.
Measured another way, public pension funds hold just 73 cents on average for every dollar promised, minus the losses that have been piling up the past few weeks.
That means there is enough money for retired public servants to get their pension checks tomorrow, next month and next year. But the only way to meet all future promises is for states, cities and counties to increase their contributions into public pension funds while hoping for sufficient future investment returns.
Hoping being the operative word.
The average annual investment returns during the past decade simply haven’t been anywhere close to the growth rates seen during the 1990s or before, even with historic market performance. It’s not that pension funds were losing money, but their investment returns didn’t perform well relative to long-term assumptions about how much they would earn.
The largest public plans have earned on average 5.9 percent since 2001, according to Public Plans Data. During that same time frame those same plans were assuming returns between 6.5 percent and 8.5 percent.
There have been states working to reduce the investment assumptions of their pension funds, such as Michigan (from 8 percent down to 6.8 percent) and South Dakota (7.75 percent to 6.5 percent). But between 2001 and 2019, the average assumed rate of return for America’s largest pension funds fell just 78 basis points — from 8 percent to 7.22 percent, according to the National Association of Retirement Plan Administrators. To put that in context, during the same timeframe, the yield on 20-year treasuries – a proxy for interest rates and fixed income investment returns – fell 375 basis points.
That 8 percent average investment assumption might have made sense in an era with double digit interest rates, but even by the early 2000s there was at best a 50-50 chance of this kind of long-term return for most pension funds. And in the decade since 2008, states and their public pension funds have had ample time to adjust investment outlooks and prepare for a world with lower annual investment returns paired with more volatile market shocks.
There was plenty of time to embrace a new normal of lower historic annual returns and improve contribution rate policies to build funding levels back up toward 100 percent before this “COVID Crash” shook the system. In reality, states on average maintained an overly optimistic investment outlook.
Because pension funds invest for the long-term, they shouldn’t overreact to any one bad event. But this COVID Crash isn’t an event to react to — it is a reminder of fragility in the status quo. There have been warnings blaring about the lack of resiliency among the nation’s public pension systems for the past several years. No one could have reasonably predicted a biological pandemic would trigger such a crash in 2020, but the vulnerability to such a low risk is itself the problem.
To think about the risk levels another way, if the Texas Teachers Retirement System – one of the largest pension funds in the country – were to assume 6.25 percent on investments instead of 7.25 percent, they would be reporting around $75 billion in unfunded liabilities instead of the $49 billion currently on the books. That $26 billion difference is more than 50 percent of the payroll for all public school employees in Texas.
The net result of states having made so few steps toward being prepared for the new norms of the 21 century is that state and local budgets are going to be heavily stressed by an increase in required pension payments over the next few years. That will not only reduce the quality of services for taxpayers, but limit salary increases for public workers and likely mean public sector layoffs in 2021 and 2022.
The full scope of how COVID-19 will affect financial markets, the global economy and state and local government revenues is not yet known. But we can be sure this isn’t the last pandemic. It’s novel coronavirus now, it could be Australia-style wildfires sweeping across the East Coast or some ecological threat to European capitals that next undermines market confidence.
At a time when public sector workers are on the front lines of fighting the COVID-19 pandemic, it is important that they do not face an added stress about the security of their retirement benefits. States should signal now that they are willing to take steps to more responsibly manage the financial risks of their pension funds, even if that means more budgetary cost in the near-term.
Anthony Randazzo is executive director at Equable Institute, a bipartisan non-profit working to support sustainable public retirement systems without sacrificing income security.