Pension funds are worried about volatility

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July 31, 2020 Update: It’s widely known that pension funds have been having trouble meeting their return assumptions, and this problem has only gotten worse during the COVID-19 pandemic. Amanda White of Top 1000 Funds interviewed John Adler of the New York City Employees’ Retirement System (NYCERS), and one of the things they discussed was the extreme volatility in the market.

He said the volatility and turbulence in the market have caused “a great deal of anxiety.” He said the last three quarters have brought both record gains and record losses, followed by nearly record gains again. He noted that such extreme volatility is very difficult for defined benefit plans.

He also noted that pension plans have serious budget problems and called on the federal government to provide assistance.

“In any normal situation the government would be ensuring that cities and states can balance their budgets and don’t have to resort to measures like workforce reductions,” he said.

If that situation occurs at the same time that returns are less than anticipated, they may have to boost contributions. NYCERS uses smoothing, so that doesn’t happen right away. He hopes that by the time they must start looking at contributions, the economy will start to recover, which is what happened in 2008.

How close are public pension funds to insolvency?

July 17, 2020 Update: Experts appear to have differing opinions when it comes to whether public pension funds will become insolvent. Given the wide range of funding levels at public funds, some are certainly closer to insolvency than others, but some experts believe only minor changes are needed to fix the problem, while others believe most public pension funds are teetering on the edge.

The Brookings Institute looked at a number of papers presented at the 2020 Municipal Finance Conference. Louise Sheiner and Finn Schuele of Brookings’ Hutchins Center and Jamie Lenney of the Bank of England argued last year that only moderate fiscal changes are needed to stabilize the funds liabilities. They also said most pension funds are not in any imminent danger of crisis.

This year they looked at public funds in light of the COVID-19 pandemic, studying the economic impact of certain changes like interest rate cuts on the sustainability of pensions. They also looked at the extent most funds’ stability is deteriorating due to the pandemic and what would happen if governments forego their contributions in the near term to avoid cutting essential services now.

The University of Arkansas’ Robert Costrell and Josh McGee argue in their paper entitled “Sins of the Past, Present and Future: Alternative Pension Funding Policies” that due to the uncertainty of investment returns, pension funds are at high risk of insolvency. They argued that perpetually rolling over pension debt leaves funds in a precarious position and greatly increases the possibility that they will run out of money.

In their paper “Public Pension Plan Risk-Sharing: Options and Consequences,” Don Boyd, Gang Chen and Yimeng Yin of the University of Albany’s Rockefeller College of Public Affairs and Policy looked at the impacts of risk-sharing options for employees and governments in plan funding.

They argue that risk-sharing approaches being tried like contingent cost of living adjustments could “modestly reduce employer pension costs in the long term,” especially during a time such as this when investment returns are low. However, they also note that these approaches create a major risk for retirees.

Pensions struggle with real estate valuations, dive into debt

July 10, 2020 Update: Unfunded liabilities and a stretch to meet optimistic return assumptions have led pension funds to invest in places where they didn’t used to invest. Two of these areas include real estate and private debt. The coronavirus pandemic has made an already difficult situation even harder.

In the case of real estate, the pandemic has caused serious problems with valuing properties. The Wall Street Journal reports that pension funds are struggling to determine how much the real estate assets they hold are worth.

For example, the California Public Employees Retirement System (CalPERS) expects malls to lose some of their value during the second quarter. Meanwhile, the Arizona State Retirement System expects e-commerce distribution centers to increase in value as consumers shop more online. Additionally, the Chicago Teachers’ Pension Fund expects student housing to decline in value.

Unfunded pension liabilities amount to $4.9 trillion as of the first quarter, according to data from the Federal Reserve. In an effort to take a bite out of those unfunded liabilities, pension funds have turned to alternative assets like real estate, which now makes up 6.1% of U.S. public pension portfolios, according to data from Wilshire Trust Universe Comparison Service.

That amounts to over $240 billion of the $4 trillion in state and local government pension holdings tracked by the Federal Reserve. Because of the difficulties that funds are having in determining what their real estate holdings are worth, it’s unclear just how well they are doing against their unfunded liabilities and return assumptions.

CalPERS is getting into banking and private debt as another way to fight back against its unfunded liabilities, according to Cal Matters. CalPERS wants a piece of the private debt pie, which is currently taken up by shadow bankers like private equity financiers since traditional lenders now have to place their money in less risky places.

Critics call the $400 billion pension fund’s move desperate, but pension fund staff and critics agree that the fund is being pressured to perform. The fund is cutting out the middlemen on loans and holding the loans on its own books. The board approved the fund to place 5% or $20 billion of its total value into “opportunistic” investments, which includes private debt.

Should public pension funds invest in bitcoin?

June 25, 2020 Update: Pension funds have been struggling to meet their return targets for years, even in years when the markets have done well. As a result, unfunded liabilities remain a crisis even though some funds have managed to reduce their funding gap in recent years.

Now in a letter spotted by CoinTelegraph, Morgan Creek Digital co-founder Anthony Pompliano suggested that pension funds should invest in bitcoin. Specifically, he mentioned the California Public Employees’ Retirement System (CalPERS), suggesting that a small allocation could make a big difference in the fund’s returns.

CalPERS management said recently that they’re taking on leverage in order to meet their target returns, but Pompliano argues that bitcoin would be a better solution. He suggests that public pension funds allocation 1% to 5% of their portfolio to the cryptocurrency.

He cited a recent white paper from Bitwise, which looked at the impact a small allocation to bitcoin could have on a diversified portfolio. The study considered 1%, 5% and 10% allocations to bitcoin within a traditional 60/40 equity/ bond portfolio since Jan. 1, 2014.

It found that a bitcoin allocation would have significantly boosted the portfolio’s risk-adjusted returns if the portfolio was rebalanced over time. The result was true of all three allocations using rebalancing strategies.

Further, the impact was sizable, with just a 5% allocation to bitcoin almost doubling the Sharpe ratio of the portfolio. Total returns more than doubled, and the maximum drawdown was greatly reduced.

Biggest US pension fund borrows to meet return target

June 19, 2020 Update: The California Public Employees’ Retirement System, the largest pension fund in the U.S., has announced its plans for dealing with concerns about how to meet its obligations. In an op-ed piece for The Wall Street Journal, CalPERS Chief Investment Officer Ben Meng said the pension fund has improved its liquidity position and redeployed $64 billion to cut back on its risks in the public markets.

Those moves with a number of changes in asset allegation enabled CalPERS to reduce the impact of the COVID-19 recession by about $11 billion. The pension fund also saved $115 million in fees per year by reducing its use of external asset managers.

However, even before the pandemic hit, CalPERS management knew that reaching their target of a 7% risk-adjusted return would require them to address the low interest rate environment, high valuation of assets and low economic growth.

Meng said the fund must diversify and increase its exposure to private equity and credit and other private assets because they could earn higher returns with lower volatility than publicly traded assets. CalPERS also plans to borrow to increase the base of its assets generating returns.

By utilizing leverage, the pension fund can take advantage of the low interest rates and hopefully buy assets with higher returns. He said they will leverage the fund’s assets by 20% in an attempt to meet their return target.

Updated pension gap calculator reveals state gaps

June 15, 2020 Update: The Institute for Pension Fund Integrity updated its Pension Gap Calculator recently with the latest data on state public pension funds. The calculator is based on data from the Comprehensive Annual Financial Reports for all 50 states. It enables users to calculate the amount of pension liabilities their state is on the hook for. It also includes actuarial assumptions.

The pension gap calculator is designed to inform people about the public pension crisis and to increase transparency in the pension process. By making the process more transparent, the Institute for Pension Fund Integrity aims to get managers to use realistic assumptions when valuing their pension liabilities.

The institute said funds with unrealistic assumptions tend to undervalue their plan liabilities. As a result, states do not contribute as much to the funds as they should. This issue racks up problems year after year, resulting in the soaring unfunded liabilities that states currently have.

The Pension Gap Calculator allows people to adjust two assumptions and see what happens to unfunded liabilities in their state. One of the assumptions in the assumed rate of mortality, which indicates the probability that people of certain ages will die in the following year. The other assumption that can be adjusted is the assumed rate of return. Some experts have suggested that plans should reduce their assumptions to 5%, although most plans have assumptions of around 7%, leading to soaring unfunded liabilities.

Experts Begin Taking Action Against Pension Scams

June 4, 2020 Update: XPS Pensions recently launched the XPS Member Engagement Hub, XPS’s solution to scammers during the current COVID-19 pandemic. According to Member Engagement Hub Director Colin Miller, “members are even more vulnerable to being targeted by scammers who are increasingly using social media as a channel to target victims,” hence the launch of the Hub.

The Member Engagement Hub (MEH) will grant trustees with access to XPS’s scam-identification service, along with direct phone communication for members wanting to transfer pensions or have any questions.

The creation of the MEH only sheds light on the fact that many citizens’ pension funds are at a higher risk of having their funds stolen. Since the beginning of the pandemic, many cybercriminals have taken it upon themselves to drain the funds of many citizens.

Clark Hill PLC member once wrote that cybersecurity is the biggest risk for public pensions. For example, many cybercriminals use phishing scams to steal the information of the victim and use said information to drain their pension funds.

Other cybercriminals use remote access to gain access to devices. Some use malware to steal information. Point is, these risks have only grown since the COVID-19 pandemic. Many have fallen to these scams over the past few months.

There are ways to protect yourself, however. For one, you can use a VPN to encrypt your data, making it impossible for hackers to steal your data. Making yourself aware of what phishing scams look like will go even further.

As scams around pension funds grow in number, it’s important to do what you can to protect yourself.

Should pension funds invest with an ESG focus?

May 27, 2020 Update: Public pension funds have been increasingly focusing on environmental, social and corporate governance principles, but perhaps they shouldn’t be. A survey conducted by State Street Global Advisors last year found that over one-third of pension funds listed reputational risk as one of the top three factors driving their shift toward ESG.

However, funds should probably think more deeply about how their ability to generate strong returns affects their reputation. The Institute for Pension Fund Integrity argues against funds investing in firms with an ESG focus.

ESG investments often eat into returns because they come with higher fees, according to the organization. IPFI President Christopher Burnham told ValueWalk in an email that pension funds should be more focused on returns than on whether or not investments fit into one of the ESG buckets.

“Public pension funds are invested for one reason only—the benefit of our hardworking men and women who labor to provide the essential services to us, including teaching our children and protecting our communities,” he said. “There is never any room for politics in the management of pension plans, either as a trustee or money manager. ESG is an essential tool for management of companies both large and small. However, to use it to make a political statement, such as anti-energy or anti-tobacco, is a violation of fiduciary responsibility to the pension beneficiaries and to the taxpayers who help fund our public pension plans.”

The biggest U.S. public pension fund sold Facebook

May 22, 2020 Update: The California Public Employees’ Retirement System, also known as CalPERS, sold some of its stakes in Facebook, Bank of America and Walt Disney during the first quarter. That’s according to the pension fund’s latest filing with the Securities and Exchange Commission, as cited by Barron’s.

CalPERS sold more than 300,000 shares of Facebook but continues to hold a sizable stake in the social networking giant at more than 5 million shares. The pension fund sold 1.54 million shares of Bank of America during the first quarter, bringing its holding to 18.4 million shares. It also sold 1.31 million shares of Walt Disney, cutting its stake to less than 4 million shares.

On the other side of the spectrum, CalPERS added to its stake in Verizon with the purchase of 3.1 million more shares, bringing its position to 23.6 million shares in the mobile service provider.

Public pension fund losses soar to new record in Q1

May 15, 2020 Update: March was a brutal month for the markets, and most funds got hammered. Public pension funds have been struggling under unfunded liabilities for years, and the first quarter didn’t do them any favors.

The Wilshire Trust Universe Comparison Service released data on public pension fund losses earlier this week. The firm said public pensions declined a median 13.2% during the first quarter. That’s a little more than the losses they racked up in the fourth quarter of 2008. In fact, the decline in March resulted in the largest one-quarter fall for plans in at least the last 40 years.

According to The Wall Street Journal, data from the Federal Reserve indicates that before the first-quarter losses, public pensions were $4.1 trillion short of the $8.9 trillion they would need to pay for future benefits that have been promised. The longest bull market in history failed to fix decades of mismanagement, insufficient contributions and overoptimistic return assumptions.

The National Association of State Retirement Administrators found in a survey that the average return target by public pension funds is about 7%. However, for the 20 years that ended at the end of March, returns by funds have come up at a mere 5.2% median, according to data from Wilshire.

Trump wants to keep federal pension fund from investing in China

May 1, 2020 Update: The White House is trying to prevent a federal pension fund from investing in Chinese equities. WJLA reports that President Trump has asked top aides to block the Thrift Savings Plan from expanding to include Chinese equities in its portfolio. The pension fund controls $700 billion in assets for the federal government’s 5.5 million employees, including National Guard members and other members of the armed forces, members of Congress, and Executive Branch officials.

A source who reportedly spoke to Trump about the issue said he was “incredulous” that U.S. service members would see their paycheck deductions going to fund the Chinese military. The source quoted Trump as saying that “we can’t allow this to move forward” and that “this needs to stop.”

The Trump administration didn’t say what they were working on with the federal pension fund. However, WJLA said an executive order from Trump is the most likely course of action to block the fund from investing in China. However, administration officials also said such an order wouldn’t hold up to a court challenge because the federal pension fund is governed by an outside agency.

The Thrift Savings Plan is moving to change its benchmark index from the MSCI Europe, Australasia and Far East Index to the MSCI All Country World Ex-US Investable Market Index. That change would send tens of billions of dollars into Chinese stocks, which the Trump administration wants to prevent.

Public pensions struck by stock plunge, falling tax revenue

April 16, 2020 Update: Public pension funds’ underfunded status has been well-documented, and the situation is only going to get worse. The COVID-19 pandemic has shut down multiple industries, resulting in falling tax revenues for state and local governments. Further, the stock market has taken a plunge in response to the crisis, dragging the value of the funds’ holdings down even more. Lower tax revenues mean governments may not be able to make up the shortfall in funding levels either.

Moody’s Investors Service estimated public pension investment losses at nearly $1 trillion in March. According to Bloomberg, the Moody’s composite that was used to make that projection now suggests a -9% return after April’s rally, which is an improvement from the -21% that was estimated before. However, market volatility remains high.

Data from the Federal Reserve indicates that state and local governments’ unfunded pension liabilities stood at about $4.1 trillion before the coronavirus pandemic struck. Some states had been planning to contribute extra funds to their pensions as they continue trying to recover. However, those extra funds could end up being reduced due to tax revenue shortfalls.

Governments face higher pension costs in 2021

April 9, 2020 Update: There’s no denying that public pensions are taking a major hit in the current market volatility. However, it may be a while before they feel the worst effects of it. City, state and local governments are being hit hard by significantly lower tax revenues because large swathes of the economy are shut down.

The San Diego Union-Tribune points out that many local governments won’t have to boost their annual pension payments until at least summer 2021. That’s because many pensions are a year behind when it comes to calculating agencies’ annual payments.

The newspaper adds that most pension funds are dealing with less severe losses now than what they dealt with during the market crash in 2008 and 2009. That’s because many have reduced their returns projections and transitioned their portfolios into less risky holdings.

Public pensions are especially hit hard during market downturns because agencies face tumbling tax revenues paired with spiking pension costs. Those costs increase because investments lose value when the market plunges. For example, the California Public Employees’ Retirement System, or CalPERS, lost approximately one-fifth of its value during the latest market crash.

The problem is exacerbated by the underfunded status of many pension systems. Many governments were faced with increased costs already to deal with unfunded liabilities.

Pension funds call for ESG and long-term approaches

March 31, 2020 Update: Some of the world’s biggest pension funds are highlighting the importance of a long-term investing approach, even as the coronavirus eats away at returns. The California State Teachers’ Retirement System, the Government Pension Investment Fund and USS Investment Management signed a joint letter about long-term investing and the importance of environmental, social and governance issues.

Since the letter was released, several other big pension funds have signed. It was written before the coronavirus pandemic broke out, but it seems even more timely in light of current events.

“If we were to focus on short-term returns, we would be ignoring potentially catastrophic systemic risks to our portfolio,” they wrote, referring to climate change and other ESG issues. “… As asset owners with the longest of long-term investment horizons, more inclusive, sustainable, dynamic, strong and trusted economies are critical for us to fulfill the responsibility we have to multiple generations of beneficiaries.”

The letter argues that companies which don’t think about how their business impacts environmental and other social issues put their own long-term growth at risk. That makes them unattractive investment targets for pension funds.

“Similarly, asset managers that only focus on short-term, explicitly financial measures, and ignore longer-term sustainability-related risks and opportunities are not attractive partners,” they added.

Pensions didn’t run with the bulls, so what now?

March 26, 2020 Update: The last 11 years have seen the longest bull run in history. However, the last several years have also seen soaring unfunded liabilities for pensions, especially public pensions. Forbes contributor Edward Siedle noted that during the dotcom boom in the late 1990s and early 2000s, many public pensions increased their benefits because their investments performed very well as the bubble inflated. Of course, the dotcom bubble eventually popped, but those increased benefits continued.

Now that the longest bull run seems to be over, it’s worth noting that many pensions weren’t able to increase their benefits during the market boom. For some reason, funds did not see their investments soar as much as the market did.

He blames mismanagement of investments for the different experience this time around. He also said that about half of all state and local pension funds slashed their benefits since the 2008 financial crisis. The average public pension fund is just 70% funded currently.

Pointing out the struggle these funds had during the bull run leaves a big question unanswered now. If they struggled while the markets were soaring, what will happen to these funds now that the bottom is falling out of the market during the coronavirus pandemic?

Lawmakers convicted of felonies may not collect pensions

March 13, 2020 Update: Sen. Thom Tillis of North Carolina introduced a bill on Thursday to keep lawmakers who have been convicted of felonies from receiving pensions. The bill follows the guilty plea from California Representative Duncan Hunter earlier this year. Media reports indicated that he would probably still receive retirement benefits from his time serving in Congress, including a sizable pension.

Tillis noted that the system is broken because Hunter was able to delay his resignation date so he could qualify for another year of eligibility for his congressional pension. According to The Hill, the bill would apply to lawmakers who either plead guilty to a felony committed while they were in office or are convicted of a felony while in office. The bill would also amend ethics rules to make misusing campaign funds a crime that keeps lawmakers from being eligible to collect their pensions.

Too little, too late for reform in Illinois

Mar. 3, 2020 Update: The need for public pension reform has been apparent for many years. However, real changes that will bring about lasting, sustainable solutions have been elusive. Illinois, which is among the worst-funded systems in the U.S., has been trying to tackle the problem for a while. However, a ratings agency says that what the state plans to do won’t fix its pension problems, disappointing anyone hoping for a solution that could be repeated elsewhere for the nation’s public pension crisis.

Illinois Gov. J.B. Pritzker wants to devote $200 million in new revenue to the state’s pension systems as part of his suggested graduated-rate income tax plan, which goes up for a vote in November. However, Fitch Ratings said while the extra contribution “would be helpful,” it will not “materially affect” its view that Illinois’ budget remains “structurally unbalanced.”

Corporate pensions could undergo accounting overhauls

Feb. 28, 2020 Update: As the public pension crisis continues with few signs that the massive unfunded liabilities are being handled, there could be some major overhauls to corporate pensions. The Wall Street Journal reported this week that low interest rates could convince more chief financial officers to change their pension accounting styles.

Lower interest rates on high-quality corporate bonds has increased plan obligations, offsetting companies’ returns on plan assets. If pension expenses suddenly increased, CFOs might change accounting methods so that the loss is in the past instead of amortized over several years, according to CFRA analyst Dan Mahoney.

As discount rates fall, debt increases because the current value of upcoming payments increases. That pressures companies to increase their assets via investment in stocks and bonds. This enables them to offset their liabilities.

Currently, most companies with pensions amortize their gains and losses over multiple years, which results in older pension losses hanging around. However, many companies have already switched to the mark-to-market method of accounting, especially since the Federal Reserve cut interest rates essentially to zero. Mahoney expects more and more companies to make this change as interest rates remain low.

Call on Trump to battle underfunded public pensions

Feb. 24, 2020 Update: The public pension crisis is no secret by this point as many of the nation’s state and city pensions are deeply underwater. A solution to the crisis has been evasive, with many systems choosing to kick the can further down the road. Now one writer is calling on President Trump to tackle the issue with a bold call to cancel every single one in systems that are underwater.

In a post for The Hill, Douglas MacKinnon argues that one benefit of having a businessman in the White House should be managing the nation’s public pension crisis. The site fights back against the argument that pensions are needed for public jobs because they are underpaid. However, many public employees are compensated quite well.

For example, nearly 17,000 public employees in Massachusetts made at least $100,000 a year, according to state payroll records for 2019  (via the Boston Herald). Massachusetts’ public pension system is significantly underfunded, and MacKinnon argues that it and other states’ underwater pensions should be canceled.

The site notes that many counties and states must stop or significantly cut back programs to help the disadvantaged because they must pay their pension liabilities. MacKinnon describes the public pension crisis as “perhaps the most destructive financial crisis of our time.” He also answers the argument that public employees paid for their pensions by saying most of them paid “pennies on the dollar for these generous plans.” He suggests paying employees exactly the amount they paid into their pensions and no more.

Further, he points out that when states with unfunded systems go bankrupt because of their pension problems, the federal government and American taxpayers will have to bail them out.

“President Trump is aware of that socialist strategy,” he argues. “Let’s hope he slams on the brakes to protect the fiscal health of our nation.”

Pension assets on the rise with alternative asset allocations

Feb. 12, 2020 Update: Global pension assets bounced back last year with a 15% climb to US$46.7 trillion, according to a survey released this week by Willis Towers Watson’s Thinking Ahead Institute. The U.S. remains one of the fastest growing pension markets in the world, trailing only South Korea and Hong Kong.

Over the last two decades, allocations to private markets and other alternative investments have also been rising. Allocations climbed from 6% 20 years ago to 23%. Pension funds have been shifting allocations from stocks and bonds and toward alternative investments. Allocations to equities were down 16%, while allocations to bonds declined 1% last year. The average asset allocation for pensions in the seven biggest markets is 45% equities, 29% bonds, 12% alternatives, and 3% cash.

Despite the increase in allocations to other investment types, the Thinking Ahead Institute said the recovery in pension assets in 2019 was partially driven by strong equity market gains during the year. The gains in 2019 mark a strong rally from 2018 when global pension assets declined 3.3%.

Public pensions on track for a positive fiscal year

Feb. 6, 2020 Update: State and city pensions in the U.S. recorded a median return of 6.1% for the second half of 2019, according to data from the Wilshire Trust Universe Comparison Service. A spokesperson said in a press release that interest rate cuts by the world’s central banks, ongoing growth in the economy, and progress in the trade negotiations with China raised stock prices.

Most states start their new fiscal years in the middle of the year, which means the second half of 2019 was the first half of their current fiscal year. According to Bloomberg, public pension funds usually expect to see an annual return of approximately 7.25% so they can keep up with their required payments to retirees. A return of 6.1% for the first half of the year means most public pension funds are on track to meet their expected returns for the current fiscal year.

The public pension crisis continues, although adjusted net pension liabilities declined in fiscal 2018. Although 2019 brought more declines in adjusted net pension liabilities, 2020 is expected to bring about a significant shift, according to Moody’s Investors Service.

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Pension liabilities were down, but they will rise

In a recent report, the firm said that in fiscal 2018, adjusted net liabilities declined in 37 of the 50 biggest local governments ranked by amount of outstanding debt. Moody’s expects that this trend continued in fiscal 2019 but predicts that adjusted net pension liabilities will increase in fiscal 2020.

The firm adds that now 10 years into the current economic expansion, some of the biggest local governments have limited pension risks. However, weak funding for pension and retiree healthcare and other post-employment benefits results in credit quality that is more vulnerable to market volatility for some local governments.

For most of the biggest local governments, unfunded pensions remain the most significant long-term liability. The 50 biggest local governments have a total of $450 billion in adjusted net liabilities, compared to $238 billion in debt and $167 billion in other post-employment benefits.

On their own, pensions were the largest long-term liability for 29 of the 50 biggest governments in fiscal 2018. Debt led the way for 20 of them, while other post-employment benefits was the biggest liability for one government.

Unfunded pension crisis continues

Moody’s expects falling interest rates to drive increases in pension liabilities for many local governments this year after two years of declines. Many governments report their pensions with a lag of up to one year, which is why their liabilities are likely to decline in their fiscal 2019 results and then spoke in 2020.

For many of these governments, the increase could be quite significant, the firm warned. The firm’s analysts added that the FTSE Pension Liability Index declined steeply in 2019. Further, revenue growth has been strong recently, so affordability ratios won’t skyrocket.

Not even treading water

Local governments aren’t even doing enough to tread water, let alone take care of their unfunded liabilities.

According to Moody’s, contributions relative to revenues ranged from about 1% to 17% among the 50 biggest local governments. Even though most of them had discount rate assumptions at or higher than 7%, 34 of them had tread water gaps in fiscal 2018. The firm also said higher discount rates tend to reduce tread water thresholds.

One concern related specifically to underfunded teacher pensions is the ongoing shift in costs. State governments have been responsible for K-12 education, but K-12 school districts now face risks of these costs being shifted to them. Such a shift could help rebalance the state budget. Some states have considered but not acted on such legislation, while Illinois has taken the opposite approach. Some states have taken on even more responsibility in the underfunded teacher pensions.

A warning about volatility in investments

Moody’s also warned that volatility in pension investments is a credit risk. The governments that are at a higher risk of material new unfunded liabilities have pension assets that are large compared to their own budgets. They also have return targets requiring heavy allocations to volatile investment classes.

“The governments with very underfunded pension systems with weak non-investment cash flow (NCIF) have very little flexibility to reduce their annual contributions without risk of severe pension asset deterioration,” Moody’s warned.

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