How the Market Downturn Could Affect Public Pension Funds

State and local governments are playing a critical role in managing the COVID-19 pandemic and their top priorities right now are leading and supporting public health and safety efforts. But over the next several months, policymakers will have to examine the impact of current economic conditions on the budgets they oversee, particularly dramatically reduced revenues and the effect of financial market volatility on public pensions.

Nationwide, state pensions hold 75% of their assets in stocks and alternative investments, the vehicles most correlated with swings in the financial markets. As a result of the stock market’s recent decline and economic conditions more generally, most public pension funds are on pace for their first fiscal year loss since 2009.  In the aggregate, they are currently short of annual return targets by 10 to 15 percent. Absent positive returns in the next three months, overall state pension debt, currently $1.2 trillion, could increase by $500 billion, reaching an all-time high. 

It’s impossible to forecast precisely the magnitude of the coming recession, and every state will face unique issues managing its pension funds at a time of economic turmoil and in the aftermath of the pandemic. But every jurisdiction can expect to be challenged with how to best meet funding obligations and effectively manage plan health going forward.

Most public pension systems will have to grapple with these four key issues:

Difficulty making required contributions

The most pressing issue for policymakers will be meeting expected annual payments to their funds in light of projected declines in revenue for the upcoming fiscal year.

Although recent investment shortfalls will require increased contributions to make up the losses over time, most state and local governments have already set or proposed annual contributions for the next fiscal year. That means this effect will not be immediate. Still, if revenues decline as expected, efforts to meet even these funding requirements—which are expected to increase by an average of 6% over current levels—would have the effect of crowding out spending for other government services as spending for health and safety net programs are likely to increase. As a result, states will have tough choices to make in terms of balancing their plans to reduce pension debt with preserving core services.

The pressure to meet pension funding targets will be most acute in jurisdictions that had severely underfunded pension systems before the pandemic took hold. In Illinois, for example, nearly 1 in 5 state tax dollars is already going to pay for pensions before factoring in any revenue declines. And in New Jersey, the state’s current pension funding schedule calls for an increase of more than $800 million in state contributions next year, 20 percent above this year’s requirement. 

Municipalities and school districts in California face similar challenges, as many were already anticipating double-digit contribution increases. And while the risk of pension plan insolvency is generally low, there are exceptions: Chicago’s system, for example, is only 23% funded and was already struggling to keep assets from becoming depleted. 

Although the need to make difficult decisions to preserve critical services is understandable, reductions in required contributions will increase pension costs over the long term and may also present challenges for funds in meeting their investment policies and goals in the short term. State contributions are the largest source of funds used to make benefit payments to retirees. That means any reductions or delays may require plans to sell additional assets to meet payment requirements. Doing so could necessitate additional rebalancing of portfolio funds to align with asset allocation targets, which could then hinder their ability to meet performance goals.

Lower assumed rates of return

As plans manage the short-term effects of market volatility and revenue pressures, they will likely also need to consider continued downward adjustments to assumed rates of return on investments. Pension funds are long-term investors that base return targets on long-term expectations, rather than a single year of gains or losses. Projections were already resulting in downward revisions of return assumptions before the outbreak. Many lowered expectations based on predictions of slower long-term economic growth in the aftermath of the long recovery that followed the Great Recession.

Although the timing and shape of a new recession is uncertain, long-term macro projections are unlikely to improve, and so we anticipate this downward trend to continue. These reductions would continue the three-year trend, which already saw assumed annual return rates decline from 7.5% to 7.2%. However, Pew and other experts had estimated that long-term returns would be closer to 6.5% for current portfolios—before factoring in the potential impact of the pandemic.

A need for stress testing

The scenarios examined in pension stress tests, the simulations that build on existing actuarial projections to help budget decision-makers examine and plan responses to economic downturns, typically include sharp stock market drops followed by a recession. The tests are designed to help policymakers develop effective long-term approaches that can withstand real-world conditions.

Scenario modeling starts with a standard framework to capture the economic and financial market variables that drive outcomes.  This provides a foundation to incorporate state-specific pension policies as well as revenue projections and budget impact to account for possible recession scenarios. This approach can help ensure that short-term decisions on pensions are informed by a longer-term perspective and better prepare state and local budgets for periods of economic uncertainty.

States with existing methods in place—10 now have statutes that require pension stress testing—are well positioned to update projections based on the expected impact of COVID-19. They can serve as models for other states looking to adopt similar practices.

Monitoring effectiveness of cost sharing

Although the impact of the pandemic on asset prices and government revenue will hit all state and local pension plans, the severity is expected to vary, with some jurisdictions likely to remain relatively stable because of policies put in place before the downturn. Wisconsin and South Dakota in particular may weather the current downtown better than many others, in large part because of variable benefit features known as cost sharing.

These mechanisms distribute risk among employers, employees, and retirees to protect plan fiscal health and stabilize employer costs. The outcomes for Wisconsin and South Dakota, as well as states that recently adopted cost-sharing policies, may influence whether similar provisions are considered in other jurisdictions in the years ahead.   

Greg Mennis directs The Pew Charitable Trusts’ public sector retirement systems project.