Market volatility in Q1 2020 has contributed to a steep drop in financial asset prices which has likely impaired the funded levels of many public defined benefit (DB) pension plans. In the Q&A below we provide some observations around recent market events, what they mean for public DB pension plans and state and local governments, and actions plan sponsors may be contemplating in the current environment.
The dramatic drawdown in financial asset prices has been painful for all investors, and public DB plans have not been immune. While many public DB plans maintain substantial allocations to private assets, and while the marks on those may take some time to be adjusted, we estimate that many public plans have experienced 2020 year-to-date asset declines of around 13% – 15%1. It is safe to assume that many public DB plans have experienced asset drawdowns around that level, even if actual marks on private portions of the portfolio may be delayed.
There will obviously be great variation around that estimate as some public DB plans maintain higher exposures to equity beta through both their public and private holdings. Every plan’s asset allocation is different, and those with greater exposure to equities will likely have done worse while those with higher allocations to US interest rates or other diversifying asset classes will have likely done better.
If we assume an aggregate public pension DB system-wide funded status of 73% on a reported GASB basis as of the beginning of 2020, then an estimated 14% 2020 YTD decline in asset values means aggregate funded status for the system may have fallen to around 63% on a market value basis. To put this in context, right after the impact of the 2008 global financial crisis was reflected in plan results in 2009, the aggregate reported funded status of the public DB pension system was around 78%.
As most public pension plans value their liabilities based on the expected return on assets (EROA) assumption related to their plan assets, the recent volatility in interest rates has not had a direct and immediate impact on the reported valuation of their liabilities. As such, the recent decline in funded levels estimated above has been primarily attributable to asset declines.
Nonetheless, many public pension liabilities grow around 7% – 9% annually due to 1) interest accretion on the liability, which is based on the aforementioned EROA assumption and is around 7% for many plans, and 2) new benefit accruals. As a result, in any environment, irrespective of whether plan assets are rising or falling, many public plans face an increase in liabilities which places further downward pressure on funded ratios.
We estimate US public DB plans may be underweight around $150 billion of global equities. When it comes to rebalancing estimates, we need to make a number of assumptions. In particular, for the purposes of this exercise, we have assumed that no rebalancing had already occurred earlier in the quarter and that any rebalancing was intended to bring plans back to the asset allocations they had at the beginning of the year.
The timing of those rebalancing actions are a bit uncertain. Given the wild daily swings in financial markets, combined with significantly wider bid/ask spreads in various markets making transacting very costly, some may choose to hold off of any significant rebalancing until markets calm down and leg into rebalancing activities over several months or quarters. This may not be inappropriate, as discussed later in this note.
Separately, US public DB plans are certainly not the only retirement-related investors that are likely underweight global equities today. We estimate US corporate DB plans are underweight around $100 billion, while target date funds in defined contribution plans are approximately $80 billion underweight. As with public DB plans, the timing of rebalancing actions by these investors may be uncertain given current volatility in the financial markets. Nonetheless, it does speak to the potential demand for global equities that may reappear at some point from retirement-related asset pools.
First and foremost, we point out that rebalancing is not re-risking in this exercise. Rather, it is a prudent risk management tool. The dramatic fall in equity prices has been sharp and painful for many plans, but we view rebalancing back to strategic targets, at some point, as an appropriate tool in the pension risk management toolbox.
Nonetheless, we suspect some plans may re-examine the underlying composition of their equity allocations given recent volatility. The move to passive in recent years has been substantial. As a result, many plans are experiencing 100% of the drawdown in equity markets given passive exposure. If active managers perform relatively well in the current environment, it may lead some investors to re-examine those strategies.
We also note that there are several strategies that can be implemented to help change the distribution of equity returns without reducing the allocation to the asset class. While we would argue that many of these strategies are strategic as opposed to tactical, and therefore may be applicable in any market regime, we acknowledge that some plans may be more receptive at this moment given recent volatility.
The good news for defined benefit plans is these are long-term liabilities with obligations that stretch out many decades into the future. While the recent widening of any deficits is disconcerting, the long-term nature of the obligations enables defined benefit plans to truly be long-term investors. This is especially relevant in the public space given that many of these plans are open and accruing new benefits for members.
However, a key risk for these plans is a sustained period of lower financial asset prices. A common characteristic of many public DB plans is that they are cash flow negative, i.e., annual outflows for benefit payments exceed annual contributions from employers and employees. As such, there is a natural decline in plan assets each year from these net outflows. Even if financial asset prices were not to fall further, but rather stayed at current levels for, say, the next 12 – 24 months, the pool of assets for many plans would likely shrink given net outflows.
At a certain point, it becomes a math problem. Earlier we noted liabilities for many plans grow around 7% – 9% per year from interest accretion and new benefit accruals. If over a multi-year period the pool of assets is shrinking while liabilities are growing at that rate, funded levels decline to such a point that simply “earning” out of the deficit becomes mathematically unattainable. This is why, although they are long-term investors, avoiding sharp and sustained drawdowns in asset values is critical for public DB plans.
Forecasts as of late-March call for a sharp and deep contraction in US GDP. This obviously may have a notable impact on the finances of state and local governments, including as it relates to sales and income tax revenues. Financial strain may impede the ability of some governments to contribute as much as they need to their DB plans as dictated by actuarial standards.
We note that, in the past, some state and local governments have contributed less than their Annual Required Contributions, or ARCs. This was particularly apparent in the period after the terrorist attacks of 9/11 as well as in the years after the global financial crisis. Academic work has pointed out that some public DB plans with the lowest reported funded ratios are also those that may have underfunded their ARCs in the past. If the current (and upcoming) economic environment impedes the ability of some sponsors to make contributions equivalent to their ARCs, that could place further strain on reported funded ratios.
There were several measures in the stimulus that should alleviate some of the near-term pressures on state and local government finances. For example, the Coronavirus Relief Fund provides $150 billion to states, local and tribal governments to use for expenditures incurred due to COVID-19. In addition, states and municipalities may be eligible for part of the $454 billion designated for loans, loan guarantees and other investments under the US Treasury’s Exchange Stabilization Fund.
Nonetheless, additional assistance from the US Federal government may be required, in particular if the crisis extends beyond current expectations. It is possible that additional economic assistance for state and local governments could be included as part of any further stimulus actions undertaken in Washington.
Pension obligation bonds (POBs) have been a controversial topic through the years in the public pension space. Some organizations, such as the Government Finance Officers Association (GFOA), have recommended against the issuance of POBs for a variety of reasons. Academic work has demonstrated that there has been a wide dispersion in the success or failure of this strategy in the past. Often, that success or failure was based on when the bonds were issued and, correspondingly, when the assets were deployed within the pension plan.
Borrowing in the capital markets to fund pensions has been a strategy that has been used successfully by many corporate pension plans in recent years. Often times, these are part of a de-risking strategy whereby the issuing corporation contributes the proceeds to the plan and allocates most of it to liability-matching investments, generally longer-dated fixed income. This, in the corporate space, better aligns plan assets with plan liabilities since corporate DB plans value their obligations based upon market yields of high-quality corporate bonds. As such, future performance of equities, interest rates and credit spreads becomes somewhat irrelevant as plan assets and liabilities rise and fall as interest rates and credit spreads rise and fall.
We acknowledge crucial differences between public and corporate plans. For example, while many corporate plans are closed, frozen and in “de-risking” mode, many publics remain open and accruing. In addition, corporate plans value their liabilities based upon market interest rates, which makes investing in fixed income a natural hedge. Since public plans do not report their liabilities in the same manner, fixed income investments do not hedge their liabilities from an accounting and reporting perspective.
Nonetheless, in the current environment we suspect everything is on the table with respect to tools that may be considered. We noted earlier that academic work has pointed out that, at times, the success or failure of previous POBs has been linked to the timing of the investments. With almost every asset class substantially in the red year to date, the timing of deploying assets into a plan may be more favorable today.
First, rebalance as appropriate. As discussed earlier, many plans likely find themselves under-allocated to equities in comparison to their strategic targets. Current volatility is around global financial crisis levels and bid/ask spreads in many markets, including many areas of the fixed income markets, are 4–5 times normal levels. This may make rebalancing impractical or too costly in the near-term, a not insignificant factor that should be taken into consideration. Nonetheless, plans should have a methodology in place to implement rebalancing actions over some period of time, even if that period of time ends up being longer than usual.
Second, consider tactical actions that may allow sponsors to take advantage of current dislocations in the markets. The current environment has led to drawdowns in almost every asset class, potentially allowing long-term investors to exploit short-term opportunities.
We acknowledge that some public DB plans may not have governance structures in place to allow them to make tactical changes to their portfolios. This may be a topic that some state and local governments may wish to re-visit post the current crisis as they explore what may be, for them, the appropriate oversight and governance their plans.
Third, while these are uncertain times, one thing that is always certain for plan sponsors is the benefit payments that need to be made to retirees on a monthly basis. In the current environment, some sponsors may need to liquidate parts of their portfolio, potentially at inopportune times, in order to fund outflows. A cash flow matching strategy that aligns a portion of a plan’s assets with several quarters or years of expected benefit payments may allow a sponsor to ride out extreme volatility without having to make undesired or costly liquidations of existing portfolio assets.
Finally, as discussed earlier, the current drawdown in equity valuations may lead some sponsors to re-visit the composition of their underlying equity exposure. This could include reexamination of active strategies, inclusion of defensive strategies that tilt allocations to lower beta securities, or options-based strategies that may serve to narrow the distribution of outcomes.