Public DBs May Lose Ground on Funding Progress

“If markets remain at their current levels until June, most state and local pension plans will end fiscal year 2020 with negative annual investment returns, reduced asset values, lower funded ratios and higher actuarial costs,” says a report from researchers at the Center for Retirement Research at Boston College, with support from the Center for State and Local Government Excellence (SLGE).

However, the researchers note, while this outcome is a step backward in public defined benefit (DB) plans’ funding progress, most plans will have enough to pay benefits indefinitely.

They estimate that the ratio of assets to liabilities for public plans slipped from 71% in 2019 to 69.5% in 2020. As a result of this drop in the funded ratio, the average actuarially determined contribution is estimated to rise from 18.8% to 19.7% of payroll.

Pension researchers—and some practitioners—have questioned the adequacy of actuarially determined contributions as they are commonly calculated. The report says they question the use of “overly optimistic investment return assumptions and relatively lax methods for amortizing the unfunded liability.” According to the researchers, if plans were to use investment return assumptions that more closely reflect their actual performance since 2001 and use more stringent approaches to amortize unfunded liabilities, the average actuarial contribution in 2020 would rise from 19.7% of payroll to 37.6%. “The future trajectory of plans’ funded status will depend crucially on the ability of governments to meet contributions based on more conservative investment return assumptions and more stringent amortization methods,” they say.

Projections from 2020 to 2025 show that the average funded ratio for public plans will steadily decline but, even if markets do not fully recover until 2025, most plans will emerge with enough assets to pay benefits indefinitely. The researchers extended projections under two possible market scenarios. Under the first, markets remain at current levels until June 2021 and then steadily climb to their previous peak by 2023 and, from that point forward, plans achieve their assumed return—roughly 7.2%. Under the second, more pessimistic scenario, markets remain at current levels until June 2021 but the recovery takes longer, with markets steadily climbing to their previous peak by 2025.

The result of the first scenario is that the aggregate funded status of public plans declines to 62.7% in 2025, and the actuarially determined contribution rises to 25.1% of pay. Under the more pessimistic scenario, the funded ratio drops to 55.5% and required contributions rise to 29.1% of pay. In addition, the average ratio of assets to benefits—what the researchers say is a rough measure of trust fund health—drops from 11.6 in 2020 to either 9.4 or 7.9 in 2025—meaning public pensions will have on hand assets equal to roughly eight to nine years of benefits in 2025.

However, the researchers say it is important to note that plans can sustain asset levels as long as annual investment returns exceed their cash flow. The projections show that cash flows fall from negative 3% of assets to either negative 3.8% or negative 4.5% in 2025. “Given these relatively attainable thresholds, no plans are projected to exhaust their trust fund within the next five years,” they conclude.

That conclusion is for plans in the study sample, but the researchers also looked at what would happen for plans with already extremely low funded ratios in 2020 if markets are slow to recover. For the 20 worst-funded plans, the average ratio of assets to benefits is projected to decline slightly from 5.6 in 2020 to 3.9 in 2025. That figure means that, in 2025, they will have on hand assets equal to roughly four years of benefits. Two plans in particular which have severely negative cash flows, will see their asset-to-benefit ratios deteriorate even more dramatically—ending the 2020 to 2025 period with assets equal to less than two years of benefit payments. Five plans will end up with less than three years of benefit payments saved as assets.

The researchers add that for plans that exhaust their assets soon after 2025, the potential pay-go costs are significantly greater than current contributions—in some cases, more than 50% higher.