As of the writing of this article, global markets have experienced the largest drop since the Great Depression as a result of fallout from the COVID-19 virus, erasing all gains from the economic upswing of the last two years. It is likely that with a global quarantine in effect, markets will continue to reel in the weeks and months to come. The global economy will face a daunting recovery, and although we can rest assured that this crisis will pass, it will take years for certain sectors to regain their footing. Fallout and a change in mindsets and habits after the virus may cause some industries to disappear entirely.
In the face of all this, public pensions and the returns that they are supposed to guarantee to retired public servants will undoubtedly face a funding crisis. While an economic disruption of this magnitude may not have been on the radar of investors and public officials, it demonstrates the unrealistic optimism that states have held for pension fund returns on investment. In an effort to compensate for mounting unfunded liabilities, many state officials have pegged future investment growth to a rosy rate-of-return that assumes annual market growth upwards of 8%, which does not account a recession, now likely approaching. For pensions to meet their mark, this would entail a booming economy for years to come. Even a minor economic downturn that slowed growth by a percentage point would cause pensions to drastically miss their targets, possibly increasing liabilities nationwide by as much as $500 billion. What will they look like now in the face of global economic collapse?
This is not the first time that we have seen such fallout. In the wake of strong economic growth throughout the 1990’s (coupled with the Dot Com boom), many state pension funds were in a stable and financially sound position as investments poured in. Unfortunately, many public officials were reluctant to use this increased revenue to take action to shore up pension funds in the long run or establish “rainy-day” measures, instead opting to boost their political standing by increasing pension fund payouts. One major example of this was in California, where in 1999 the state legislature passed SB 400 which increased pension benefits on the basis of an estimated $17.6 billion in state pension surplus. Soon after the benefits were granted, the economic fallout from the 9/11 attacks dragged the pension fund deep into the red – a fund that was now obliged to make larger payouts to beneficiaries. Given that recessions impact government revenue streams across the board, the infusion of additional public money into the pension fund in an effort to shore up losses becomes much more difficult in lean times. One would think that this failure to account for economic fluctuation in the long term would have been a lesson for public pension fund managers, but given our current situation, this does not appear to be the case.
Unfunded liabilities in public pension plans are a problem that has a tendency to compound upon itself. In order to make up losses and ensure that the fund will be stable in the future, fund managers and public officials are faced with several options: increase contributions from workers, reduce expected benefits, or adjust their investment strategy in an effort to boost returns. Because the first two options are politically detrimental to elected officials who will then face the scorn of public employees, the third choice is usually first on the table. Unfortunately, seeking out investments with a higher rate of return by their very nature increase the risk of the fund and makes it much more susceptible to economic volatility. This is a tradeoff that many states have been willing to make, especially coming off of the last decade of strong economic growth. We are now seeing how these decisions can backfire.
What policy changes could be implemented to prevent such pension funding crisis in the future? First, public officials should begin to move toward realistic actuarial assumptions when calculating future pension fund growth and the contribution levels that will be necessary to correct unfunded liabilities. Fortunately, many states and localities have begun to move in this direction in the wake of the record-low interest rates we have seen since the financial crisis of 2008. This trend needs to expand on a more profound scale. Second, when the COVID-19 crisis passes (and it will) and the economy returns to a positive level of growth, public officials must avoid the immediate political gains of using surpluses to fund larger pension payments and must instead think long-term. If history teaches us anything, the next economic downturn is right around the corner.
Ultimately, the failure to realistically project pension rates of return and to adequately re-invest surplus comes down to a failure in political leadership. No governor wants to tell their constituents that a realistic re-assessment of pension investment returns means that their unfunded liability problem is much worse than before. However, the hard-working public employees who have dedicated their careers to public service in anticipation of stable retirement benefits deserve the truth. Our leaders need to get real. Economic disruptions happen. Recessions happen. And yes, major crisis like pandemics, war, and terrorist attacks happen. To simply ignore this reality when evaluating rates of return in an attempt to cover up underlying problems is a dereliction of the duty that public servants swear to uphold. Hopefully, this pandemic will finally bring about some frank conversations and hard decisions to ensure the stability of public pensions for generations to come.