Despite market losses during the COVID-19 pandemic, most state pension plans met or exceeded their net amortization benchmarks in 2020. These policies avoid trade-offs between state budgets and pension costs. This is a big deal.
Contributions
As of fiscal year 2020, most states’ pension plans had received, in the aggregate, contributions sufficient to cover their liabilities (plus interest) for the first time since 2007. This stabilization is due to an impressive increase in employer contributions: from 2007 to 2020, those contributions grew by an average of nearly 7%, more than doubling.
Unfortunately, these increases sucked up public funds that could have been used for other purposes, making it harder for states to balance their budgets.
Nonetheless, there is room for improvement in how well State Pension Fund’splans manage costs and investment volatility. Top tier states-Idaho, Nebraska, South Dakota, and Tennessee-implement policies that allow them to keep employer contribution rates relatively stable from year to year despite economic volatility.
These policies include applying budget surpluses to pension debt and building a buffer; setting realistic and reasonable investment return assumptions; designing benefits that adjust with market conditions, such as a cost-of-living adjustment; and using stress testing to help policymakers understand risk.
These states can also use flexibility to reduce pension contributions during economic uncertainty. For example, with a budget surplus and a fully funded rainy day fund, Connecticut applied its excess funds to accelerate the process of paying down pension debt, thus reducing the size of future payments.
Such efforts can ensure that states rely on something other than outsize investment returns to cover pension shortfalls and avoid burdening employers and taxpayers in future recessions.
Benefits
While most states have moved closer to funding sustainability over the past 18 years, significant differences remain between the best and worst-funded systems. The ten top-tier systems largely owe their success to fiscal discipline.
In particular, Idaho, South Dakota, Nebraska, Tennessee, Wisconsin, and Oregon implemented policies that helped keep employer contribution rates low and stable over the economically volatile 2007 to 2020 period while catching up to their actuarial recommendations and amortization benchmarks.
This allowed those systems to avoid financially burdening state and local employers during economic downturns and prevented pension contributions from crowding out other important public investments.
Another key policy is to use additional contributions, rainy day funds, and budget surpluses to pay down pension debt as needed. This approach allows states to take advantage of investment windfalls and reduce the reliance on high expected returns.
In addition to adopting sound investment and funding policies, states must manage fees and other costs. For example, many state retirement systems have significantly reduced or eliminated hidden fees.
Administration
Most state retirement and pension system provide defined benefit plans, which promise retirees a lifetime annuity. To pay for their promises, pension funds must invest in the assets they manage.
The investments of these pensions are subject to market fluctuations, resulting in significant investment risk. Two-thirds of pension systems’ assets are in risky securities: publicly traded stocks (equities) and alternative investments like hedge funds and private equity strategies.
Many states are increasing their allocations to these more volatile investments to offset negative pension funding trends caused by low expected return expectations. But these higher-risk investments also come with much higher potential rewards and losses. In addition, chasing high investment returns by taking on more risk in volatile markets can be unsustainable.
Most State Pension Fund’s plans still have enough money to cover 90% or more of their promised benefits, even with this year’s losses. But the era of soaring stock markets and near-zero interest rates may have ended, and these funds must adjust accordingly. State governments should provide clear information about their pension investment strategies, performance and fees to help stakeholders assess whether state funds are achieving the needed returns.
Investments
The State Pension Fund’s, which manages the assets of seven public retirement systems, has a net asset value of $87.5 billion.1
In addition to the state’s 401(k)-style defined contribution plan and 457 deferred compensation plans, it also administers the state’s cash balance and defined benefit pension plans.
Like other investors, state pension funds directly impact the profits and losses of firms they invest in. While this may not seem like a problem, it is a significant factor in state budgets. Especially during boom markets, increased investment gains in pension assets translate into greater corporate profits. Conversely, during declining returns, losses are more likely to offset these gains.
Another important factor is the level of fees incurred by the State Pension Fund’s. Certain research finds that three-quarters of pension funds make substantial investments in risky, high-fee alternatives such as private equity. These fees can vary widely across funds and are often hidden. These fees sometimes include unreported accrued carried interest (performance fees).