State pension plan investments largely recovered by the end of June after several dramatic market drops linked to the economic effects of the COVID-19 pandemic. At the same time, the spread of the novel coronavirus has caused steep declines in economic activity and state revenue, which will complicate states’ efforts to make expected annual contributions to worker retirement programs.
Although state pension plans’ investments were down by double digits earlier this year, they came back to just above breakeven for the fiscal year that ended June 30. Still, a Pew analysis estimates that the typical pension fund likely fell short of target returns by between 4 and 5 percentage points for the 2020 fiscal year, based on estimated market returns of 2 to 3% for such plans.
The investment numbers represent a significant improvement from initial estimates through the first nine months of the fiscal year. During the volatile first quarter of this calendar year, state pension plans experienced returns of approximately minus 11%. Financial markets, particularly U.S. equities, have largely bounced back, but remain below the average 7.2% assumed rate of return for these plans.
As a result, Pew estimates that the aggregate funding gap for state-run plans will be about $1.37 trillion after 2020 numbers are reported. That’s a more than $100 billion increase from 2018, the latest fiscal year for which full numbers are available.
The hike represents the change in investment markets alone, and states could adjust to economic shocks related to COVID-19 with a range of responses, such as lowering assumed rates of return or finding ways to cut back on pension payments. States also could use the market downturn as an impetus to put in place regular stress testing to understand pension risks and plan for potential fluctuations. Some states also could add risk-sharing policies to plan designs.
Although recent investment shortfalls will require increased contributions to make up the losses over time, most state and local governments have already set or proposed annual contributions for fiscal year 2021. That means the impact of the shortfalls in investment returns will not be immediate and any increase in contributions in response to the increased funding gap will have a delayed impact on state budgets. In the near term, policymakers will need to focus on managing investment volatility and meeting current contribution requirements at a time of dramatic reductions in revenue.
State pension plans depend on market performance, with approximately three-quarters of pension funds invested in risky asset classes, including stocks and alternative investments. Their balance sheets benefited from a strong rebound in U.S. stocks—which make up more than one-third of all public pension fund assets—during the last quarter of the fiscal year.
However, those state plans with significant global exposure might not see a comparable bounce back because international equity markets have not experienced similar results. For example, the Morgan Stanley Capital International (MSCI) for U.S. stocks was up 5.5% from July 1, 2019, through June 30, 2020, while the MSCI index for international stocks was down 8% for that same period.
With the 2020 fiscal year for most states at an end, Pew has updated estimates of the pension funding gap, incorporating the impact of pandemic-related market volatility. These projections are based on the latest publicly available data (the most recent comprehensive data are from 2018), market performance through June 30, and cash flow and actuarial trends for state pension plans.
Although plan liabilities are expected to continue to grow steadily, assets increased only slightly from 2018 to 2019 and barely held steady from 2019 to 2020. Those diverging numbers are boosting the funding gap, now estimated at a national total of $1.37 trillion.
The more immediate pandemic-related challenge for states may be significant revenue shortfalls, and the impact they will have on governments’ ability to make actuarily required contributions to pension plans. The Center for Budget and Policy Priorities estimates that state revenues will drop by more than 10% in fiscal years 2020 and 2021 because of lost taxes and fees. State governments also will have to continue responding to serious public health issues while maintaining other important services.
Reflecting that reality, some states have begun to make adjustments to planned pension contributions in order to free up funds for other purposes. For example, South Carolina has delayed scheduled contribution increases that would have gone into effect July 1, 2020; New Jersey has pushed pension contributions until later in the 2021 fiscal year; California has redirected state pension debt payments to support school districts and local governments; Colorado has suspended a $225 million supplemental pension contribution; and Oklahoma has lowered the statutory contribution rate for its plans.
These actions will ease budget pressures in the near term but boost pension costs in the future. States now are primarily responding to reductions in revenue, and will also face a combination of investment shortfalls, deferred contributions, and changes to assumptions that will lead to increased contribution requirements in fiscal years 2022 and 2023. Planning ahead can help budget officials and policymakers manage the expected rise in pension costs amid ongoing public health and economic pressures.
David Draine is a senior officer, and Keith Sliwa and Emma Wei are senior associates with The Pew Charitable Trusts’ public sector retirement systems project.