Public Pensions in ‘Fragile’ State in 2023: What’s the Outlook for All Pensions in 2024?

State retirement systems remain fragile as of the end of the third quarter, with investment performance of state and local pension funds falling short of targets. This is a concerning trend, as each year investment returns underperform expectations, a vicious cycle perpetuates wherein contributions are being fully consumed by benefit payments, pension funds rely on investment returns to make up the balance, and pre-fund benefits for active members are not being fully funded, according to Equable Institute.

State and local pension funds were impacted by the bear market in 2022 followed by the community bank uncertainty before markets rebounded this past summer. The average funded ratio for U.S. state and local pension funds is expected to improve from 75 percent to 78.8 percent this year, and unfunded liabilities will decline slightly, from $1.59 trillion last year to $1.39 trillion this year, according to Equable Institute’s State of Pensions midyear update.

The average investment return for 2023 is 5.6 percent, according to the report. This represents an improvement from a negative 5.9 percent return last year but is still below the 6.9 percent average assumed rate of return for U.S. pension plans. In addition, the average 10-year return is now 7.3 percent, the lowest it has been since 2018.

“It’s nice to see pension fund investments rebound from losses in 2022,” said Equable Institute executive director Anthony Randazzo. “And it’s particularly noteworthy as markets were still trending down at the start of the 2023 fiscal year, suggesting that pension funds used the second half of their fiscal year to make a strong recovery. However, it is still concerning that the average 2023 actual return is below the assumed rate of return for 2023. It is likely that persistent unfunded liabilities will remain a threat in the coming years unless we see significant improvements in returns or increases in contributions.”

Positive trends in public pension funding include an increase in the number of state and local plans that assume investment returns below 7 percent, which leads to more accurate accounting of future liabilities and better contribution in-flows, said Equable. On the downside, asset allocations continue to shift toward risky alternatives—including private equity, hedge funds, and real estate—as pension funds attempt to invest their way out of funding shortfalls.

An emerging concern for public pension funds is the possibility of valuation risk, Equable noted. This is the risk that currently recorded asset values, which are based on valuations rather than market prices, eventually will turn out to be overstatements. The share of pension fund portfolios exposed to this type of risk has grown significantly, from 9 percent in 2001 to 34.1 percent today.

In addition to managing valuation risk, pension funds will have to contend with continued market volatility and increasing politicization of asset management activities, the firm said.

“As we look to 2024, investment performance outlooks are muddled as the markets balance high interest rates with persistently strong economic indicators,” said Randazzo. “For pension funds specifically, the outlook for 2024 is mediocre—there is little risk of an insolvency, but there is also a significant chance that contribution rates will increase to cover persistent pension debt.”

Private Pensions and 401(k)s

Private pension funds are not as fragile as state and municipal pension plans because they have tighter regulations that govern their accounting and contribution rate requirements, said Randazzo.

“Private pension funds have to use conservative methods for calculating the value of their promised benefits, and there are federal rules that kick in to ensure appropriate contributions are made,” he said. “State and local pension plans have no meaningful federal regulations, and each state can determine how it wants to calculate the value of its benefits and choose how much to contribute. The approach that most states use to estimate the value of their liabilities would be illegal for a private pension fund (e.g., using the assumed rate of return, averaging 6.9 percent as a discount rate for measuring accrued liabilities).”

From a benefits perspective, pension funds usually provide a strong benefit to those who work two to three decades with the same employer in the same state, while defined contribution plans like 401(k)s often provide a stronger benefit for those who spend 15 years or less working at the same job—as long as there are sufficient contributions into that 401(k), noted Randazzo,

“From an investment standpoint, pension fund investments are typically more stable than actively managed 401(k) accounts but have similar volatility to defined contribution plans invested in index funds and target-date funds,” he explained. “That’s because public pension fund returns, despite having diversity across a range of asset classes, tend to have total performance that follows trend lines in public markets. In theory, pension funds should get slightly higher annual returns than the average 401(k) because institutional investors can have more liquidity to make long-term investments. However, in practice, liquidity challenges at some pension funds erase this benefit, and it is possible that individual investors can outperform them.”

From: BenefitsPRO