(Reuters) — Double-digit annual returns
for most U.S. public pension systems over the past two years have done
little to shrink the yawning deficits facing many of them after a decade
of inadequate funding, according to analysts and recent data.
Thanks to a robust stock market, most systems have enjoyed
windfalls recently, with investment returns far exceeding
projections. Even so, many are still struggling with shortfalls. In
some cases, they have worsened as state contributions fail to keep
pace with what is needed to pay beneficiaries.
Roughly half of U.S. state pension plans have worrying gaps between
what they have promised retirees and the funds on hand to pay
benefits, according to most analyses.
The higher-than-expected returns since 2012 are welcome, but experts
say they don't make up for a legacy of insufficient funding, a
problem that afflicts many states that allow elected officials to
control the process.
"For many public pension funds, the hole is so deep — in the range
of many tens of billions of dollars for some of them — that they
would need decades of double-digit returns to approach full
funding," said Autumn Carter, executive director of California
Common Sense, a non-partisan think-tank founded at Stanford
University in Palo Alto, California. "Realistically they cannot earn
their way out of their shortfalls."
For most states and cities, pension obligations are the biggest
single expense, and the costs are increasing. Unless jurisdictions
find ways to adequately fund such costs, the strain on budgets will
reach a breaking point, Carter said.
That is a view shared by Warren Buffett, the chairman of Berkshire
Hathaway Inc, who last week warned that the crisis in public
pensions will intensify. The main reason, he wrote in a letter to
shareholders, is public entities have promised pensions they cannot
afford.
"During the next decade you will read a lot of news — bad news — about public pension plans," the legendary investor wrote.
Buffett and others believe the recent bankruptcies of Detroit and
other, smaller U.S. cities are just the beginning of a trend that
will soon envelop municipalities around the country.
Pension obligations were a big factor in Detroit's bankruptcy. The
same is true for the bankruptcies of Stockton and San Bernardino in
California.
A major issue in Detroit is whether the city can slash pension
benefits promised to current and retired workers. If the city
prevails in court, its victory might encourage other municipalities
to declare bankruptcy to deal with their pension shortfalls. That's
not an option for U.S. states, which are barred from bankruptcy.
Almost all state constitutions protect pension benefits. Some, most
notably California's, require paying promised benefits to retired
workers before any other debts.
Since the 2008 financial crash, which resulted in huge investment
losses for public pension funds and major strains on budgets
generally, police and firefighting services have been slashed in
many cities, along with other basic services such as libraries,
street maintenance and schools.
To be sure, others are less pessimistic than Buffett, saying a more
robust investment outlook and other economic factors have improved
enough for cities and states to rest easier.
Indeed, there is evidence that the overall health of pension systems
is brightening. A report released by the Federal Reserve last week
said liquidity of pension funds has improved. Pension assets
amounted to $3.88 trillion in the final quarter of 2013, more than a
third higher than the $2.83 trillion reached in 2009.
"I think we're doing fabulously well," said Hank Kim, executive
director of the National Conference on Public Employee Retirement
Systems. "Certainly the stock market and the rise in equities over
the five years since the Great Recession helped tremendously."
Robust returns over the past two years may have stabilized
shortfalls for many systems, said Rachel Barkley, a municipal credit
analyst at Morningstar, but some pension plans will likely struggle
to narrow funding gaps. That's because what is paid into the funds
each year has consistently fallen short of what is required.
"In general, one or two years of good returns is not going to solve
their problems," Barkley said of state funds that were already in
weak shape.
By contrast pension systems that were already well funded have been
able to use investment windfalls to bolster their positions even
more, Barkley said.
COLORADO VS OREGON
Speaking in general, public pension systems are badly underfunded in
states, such as Colorado, that give elected politicians in the
legislature the power to set funding levels. Oregon and other states
that are mandated by law to meet annual funding requirements are in
much better shape.
Over the past five years, only nine states have made the full
required contributions to their pension plans, according to the
nonpartisan Pew Center on the States.
Colorado's public pension funds showed overall investment returns of
12.9 percent in 2012, the most recent figure that's available. It
was well above its projected rate of 8 percent.
Yet the funding ratio, the measure of assets against liabilities,
has remained relatively static, increasing from 61.2 percent in 2011
to 63.1 percent at the end of 2012.
Most economists view a funding
ratio of less than 75 percent as unhealthy. According to
Morningstar, two-thirds of U.S. states currently fall into that
category.
Although Colorado is still absorbing losses from 2009, the main
reason its funding gap is yawning is the state's failure to make the
contributions recommended each year by its own budget experts,
Barkley said.
Between 2008 and 2012, Colorado lawmakers short-changed the state
pension fund by nearly $1.4 billion, and by $3.5 billion over the
past decade.
Likewise, in Illinois, with the biggest funding gaps of any U.S.
state, a pension fund for teachers showed healthy returns of 12.8
percent in 2013. Yet its funding gap worsened between 2012 and 2013.
By contrast, Oregon's retirement system, covering about 95 percent
of the workforce, is required by law to meet the annual funding
recommendation of its own accountants. The mandated recommendation,
known as the "ARC," or "annual contribution rate," takes the issue
out of the hands of policy-makers wrestling over budget choices and
competing constituencies.
The ARC is calculated based on myriad factors, including investment
returns the fund can expect in future years.
In 2010, despite big investment losses, Oregon's system was 87
percent funded. Today it is 96 percent funded.
Even if public pensions realize their projected investment returns
on average over coming years, the failure by many plans "to pay less
than the full ARC ... will produce less than full funding over the
next 30 years," according to a recent report by the Center for
Retirement Research (CRR).
DIRE PREDICTIONS
Buffett and others have made dire warnings about public pensions
before, notably in 2010. Some analysts predicted at the time a
domino effect of municipal pension-related bankruptcies, something
that has yet to materialize. And the $3.7 trillion municipal bond
market has shrugged off the latest warnings.
Chris Mier, managing director of analytical services at Loop
Capital, said Buffett may not have taken into account the full
impact of reforms instituted by about 40 states.
Mier conceded that the reforms, which have cut benefits and
increased contribution rates for workers — mostly for new hires — will take several more years to translate into improved funding
levels for pensions.
Meanwhile, the cumulative budget shortfall of U.S. state public
pensions has surpassed $1 trillion and is still growing, according
to Pew.
"Public debt is continuing to grow, and despite reforms, the
question is if states can manage another downturn or another
recession," said Greg Mennis, director of Pew's public pension
project.
Jean-Pierre Aubry, assistant director of state and local research at
the CRR, said most funds would likely show improvement in shortfalls
beginning in the next fiscal next year, as the end of a five-year
"smoothing" accounting period will finally push the deep losses of
2009 off the books.
Even so, many funds "are still going to be grossly underfunded,"
Aubry said. Improved returns will only give them some short-term
relief, he added.
