Market Impact on Fiscal 2015 Public Pension Funding Levels is Mixed

Speaking of pensions, we noticed a report recently that showed the overall funding of state and local government public pension plans actually increased slightly in Fiscal Year 2015, based on traditional standards of measuring the funding status of public pensions. The funding ratio increased from 73% to 74%, according to the Boston College Center for Retirement Research (CRR), despite weak equity market performance during the fiscal year. However, the Governmental Accounting Standards Board (GASB) has adopted new standards for measuring funding levels, and under those new standards, the funding levels actually decreased slightly in FY 2015, from 74% to 72%.

Why are the results different?  Funding ratios have historically been determined by “smoothing” the level of pension assets over a five-year period. GASB has been transitioning to a different calculation method by eliminating the smoothing of assets, and instead using the actual market value of assets on the valuation date. The smoothing method yielded higher funding ratios because strong equity market performance during the prior years of the smoothing period offset the weak market performance in FY 2015.

By 2020, the CRR has estimated that overall funding ratios (using traditional standards) will increase to 77.6%. Plan ratios are expected to improve in part due to benefit cutbacks enacted over the last few years. While recent judicial decisions have restricted the ability of state and local governments to cut most pension benefits for existing employees, the courts have generally granted more leeway to restrict cost of living adjustments (COLAs) in pension plans. The CRR has estimated that the elimination of a 2-3% an annual COLA could reduce lifetime benefits by 15-25%.

The outlook for pensions is also dependent on the future performance of financial markets in which the assets are invested. The CRR estimates that half of public pension assets are invested in equity markets, which drives the assumption that overall plan assets will grow by 7.6% annually. With tepid equity market performance in FY 2015, and again in FY 2016, public pensions may have a difficult time meeting their growth targets. For example, the total return of the investment portfolio of the California Public Employees Retirement System (CalPERS) was only 0.6% in FY 2016, following a return of 2.4% in FY 2015. As a result, CalPERS’ annual returns over the 3-, 5-, 10-year and longer periods are all below CalPERS’ assumed growth rate of 7.5%.

SNW incorporates an analysis of public pensions in its credit review of state and local governments. That review includes pension policies, contribution trends and their impact on budgets, and funding levels. In addition, we look to invest in muni credits that are immune to the possible negative impacts of public pensions.

Source: Bloomberg News, Boston College Center for Retirement Research, CalPERS