It’s a basic principle of investing: the greater the risk an investor takes, the greater the potential reward. But as any experienced investor can attest, increased risk can also bring bigger disappointment. That’s the case with state pension funds. To elevate returns, public-sector pensions have taken on more and more risk for nearly two decades. The result, however, has been lower returns, higher debt, and a mess for taxpayers, according to a new study by Fitch Ratings.
Since 2001, the study found, most government pension funds have boosted their share of investments in riskier financial vehicles, from volatile stocks to real estate. During this period, pension funds achieved median annualized returns of just 6.4 percent, well below the goal of 7.5 percent to 8 percent returns. Only one pension system has met its investing goals since 2001. No wonder, then, that the indebtedness of state systems increased from $33 billion to a staggering $1.5 trillion.
The problem stems from politicians squandering the strong investment returns of the 1990s. Rather than banking pension systems’ rising surpluses in those flush years, elected leaders in California, Illinois, New Jersey, South Carolina, and elsewhere expanded worker benefits—promising that financial markets could underwrite the new costs. But economic downturns inevitably ensued, with market crashes in 2001 and 2008. The declines drained the systems of valuable assets, and when the Federal Reserve lowered interest rates, returns languished in safer investments, such as government bonds. The so-called risk-free rate of return—that is, the return that an investor earns from putting money into such instruments—fell from 5 percent in 2001 to just 2 percent today.
Forced to seek bigger gains elsewhere, pension funds have gambled more. Since 2001, the portion of state pension-fund portfolios invested in stocks and alternate financial vehicles rose by 10 points, to 77 percent. Portfolio managers chased these investments even as the pension systems matured, with a growing percentage of members nearing retirement. This approach departed from that of just about every other type of pension fund. As a 2014 study by the Society of Actuaries noted, “Public sector plans in the U.S. are unique in that they have taken additional risk as the plans have become more mature, compared to private sector plans in the U.S. and private and public sector plans in Canada, UK and the Netherlands, which have taken less risk as plans have matured.”
The investment shortfall has sent pension obligations, or what systems owe, racing relentlessly ahead of assets. Liabilities have grown since 2001 at a compounded annual rate of 5.2 percent. By contrast, assets in the system, including investment gains and contributions by workers and employers (governments), have grown at an average rate of just 3.4 percent, compounded annually. The effect of that shortfall over many years has proved devastating, accounting for much of the reason that pension systems have failed to recover from the market’s recent volatile swings. In 2001, state pension systems were 98 percent funded. By 2007, funding levels had shrunk to 87 percent. Today, state pension funds in the aggregate are only about 70 percent funded, despite a ten-year bull market in stocks.
Some state funds have fared much worse than others. Seven states (Arizona, Connecticut, Hawaii, Maryland, New Hampshire, New Jersey, and Rhode Island) have recorded average investment gains 2 percentage points below their projected returns for the past 17 years. New Jersey’s gap was the largest—nearly 2.5 percentage points between projections and actual results. South Dakota, meanwhile, has been the only state to hit its investment return goals. Not surprisingly, the state’s pension system had the lowest percentage of its assets invested in risky financial products during that period. Among the others, Colorado, Utah, and Wisconsin came closest to matching returns to projections.
The retirement benefits that many states and cities handed out over the last 30 years have changed pension math. Once upon a time, more than half of what pension systems promised was supposed to come from contributions by government employers and workers themselves, with much of the rest generated by investing those contributions in relatively safe financial products. Today, however, most state pension systems project that more than 60 percent of the money they need to pay retirees must come from investment gains. That has been an unrealistic goal, and it’s not likely that states will do better in the market anytime soon. Fitch, for instance, predicts that investment returns will remain “below long-term historical averages” for the near term.
Clearly, the public-employee pension model is broken. If the market can’t provide, the burden will fall on taxpayers. This is already the case in states where governments have sharply increased taxpayer contributions into these systems. Bigger, more painful burdens are coming, unless states and cities do something soon to curtail the relentless growth of pension debt.