Public pensions across the U.S. have a big problem: The gap between their assets and liabilities is growing while the outlook for investment returns is worsening.
“For the next 10 years, our expected returns are 6.1%, not 7%,” Chief Investment Officer Ben Meng recently told the board of the California Public Employees’ Retirement System (Calpers).
Calpers, the country’s largest pension at about $366 billion, lowered its long-term investing return target to 7% in late 2016.
Here’s a look at what has happened and what pensions are doing about it:
The Funding Gap Is Widening
Even a record bull stock market hasn’t been enough of a boost, as the average U.S. plan had only 72.5% of its future long-term obligations in 2018, compared with more than 100% in 2001. Recessions, insufficient government contributions and generous benefit guarantees have caused the imbalance to grow, according to the Center for Retirement Research at Boston College, and investing decisions often hurt too.
“The really bad plans went heavily out of equities after the financial crisis,” said Jean-Pierre Aubry, associate director.
Simpler Has Been Better
Pensions that bet aggressively on stocks, especially U.S. companies, outperformed funds that poured into so-called alternative investment vehicles like hedge funds or private equity. “Sometimes diversification, while it’s the right strategy, makes you look dumb,” said Andrew Junkin, president of Wilshire Consulting.
Loading up on stocks may not pay off the same in the future, according to Phillip Nelson, asset-allocation director at pension advisory firm NEPC.
“The discussion we have internally is over the next ten years is do you see an equal amount of Fed support and profit margins increasing by another 50% from this level?” Nelson said. “Both seem really unlikely to us.”
Alternatives Are in Vogue
Public pensions increased private equity allocations to 10.2% on average in 2018 from 5.6% in 2008, a trend likely to continue in the hunt for yield. Mega plans are hiring more staff to internally manage private equity and other alternative assets, which they expect to beat stocks in the future. The Texas Teachers’ Retirement System invests 40% of its portfolio in alternatives and plans to double its staff in five years.
“Our pension liability duration is 20-plus years,” said Mohan Balachandran, senior managing director of asset allocation at Texas Teachers. “We felt that we could invest for the long-term in some of these vehicles where your money’s locked up for seven to 12 years.”
Assumptions Are Getting Scaled Back
About 85% of 129 U.S. public pensions have cut return assumptions since 2014, including recently the Pennsylvania State Employees’ Retirement System. Pensions started scaling back after the last recession. The average target will probably go lower, according to Keith Brainard, research director at the National Association of State Retirement Administrators.
“Each month and each quarter that goes by with low inflation and interest rates remaining low provides more ammunition to justify lower investment returns,” Brainard said.
There Aren’t Any Easy Answers
While easier targets are prudent from a risk perspective, they’re not always politically palatable. A dollar drop in investment projections can mean a dollar out of the pockets of taxpayers.
The Kentucky Retirement Systems’ plan for 123,000 employees in non-emergency jobs has $2 billion in assets for $15.6 billion in liabilities. It has only a 35% allocation to equities and has stopped new investments in private equity because it can’t spare cash on volatile or locked-up holdings. The pension burden is leading to government service cuts, pay freezes and a falling headcount feeding on itself.
“We call it the death spiral,” said Executive Director David Eager. “You can’t earn your way out of this.”
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