Equity Market Impact on Public Pension Funding

As we discussed on our 2019 Market Outlook Call in January, we are expecting more variability in the performance of various municipal sectors this year after what was a benign environment in 2018. The reemergence of pension funding issues is one of the reasons why.

Public pension systems have benefited from positive investment performance during the current long-running economic expansion. Investment performance has been driven by strong equity returns. For example, the total return of the benchmark S&P 500 index has exceeded 300% over the last 10 years. Equity returns do not always follow a straight line upward, however, as evidenced by the 13.5% decline of the S&P 500 in Q4 of 2018. While the Q4 equity sell-off has unfavorably impacted pension returns, most pension contributions and funding ratios are based on fund balances at the end of the fiscal year, which (fortunately for most municipalities) occurs on June 30. This will potentially enable the pension systems to offset some mid-year losses during the subsequent two quarters of the fiscal year.

The impact of the sell-off on pensions will be driven by each plan’s exposure to equities and the potential for a rebound in equity prices in Q1 and Q2. According to Bloomberg, through Wednesday February 6, “The median government employee pension, whose assets are heavily weighted toward U.S. stocks, lost 7.5 percent in the fourth quarter, according to data released…by the Wilshire Trust Universe Comparison Service. Public pensions have lost 4.9 percent since the beginning of the fiscal year on July 1.” While these returns are certainly unfavorable, equity returns since January 1 have benefited plans that are invested in equities. Through the first five weeks of the new calendar year, the total return of the S&P 500 has been approximately 9%. With the rebound this quarter, the return of the S&P 500 since July is now back in positive territory at about 1.5%.

As there is a high level of volatility in equity prices, the prospects for improved funding levels over the next few months to the close of the fiscal year are uncertain. Despite market volatility, the strong gains in equity prices have driven investment returns and improved funding levels for a vast majority of pension systems. We are more concerned for those pension plans that have continued to flounder in a period of economic expansion and solid investment returns. We expect that the systems most negatively impacted will be those sponsored by state and local governments who make annual pension contributions at levels below actuarially determined contributions. Potential market downturns will exacerbate their low funding levels, and further pressure those systems. Examples of such pension systems include the states of New Jersey and Illinois, as well as the City of Chicago.

Source: Bloomberg