After ten years, many public pensions system still suffer wounds from the 2008 financial crisis. For these pension system, the period from then until now has been marked with low contributions and volatile returns. To mitigate this situation, public pensions have turned to alternative investments to reap much-needed returns.
“Some just cannot grow their way out of it. We have had several years of stellar (stock market) returns, and it barely improved the underfunding situation,” said Mikhail Foux, a municipal credit analyst at Barclays in New York.
The benchmark S&P 500 stock index has tripled in the past decade, buoyed by the expansive monetary policies that are in vogue across the globe. The unprecedented zero interest rate strategy was enacted by central banks to spur recovery, but some believe that this has resulted in market imbalances.
“Now what happens when markets are falling 10 to 15 percent?” Foux asked.
In 2007, a year before the crisis began, the median funded level of public pensions was respectively, 92 percent for state retirement and 97 percent for local plans, according to Wilshire Funding Studies. Fast forward 2016, the funding level for state retirement has fallen to 68% while local government has dropped to 72%. As funding rates lower, it will become increasingly difficult for pension systems to meet their obligations.
The low-interest rate environment meant that pensions could not rely on fixed income assets to generate adequate returns. “When the crisis hit, it exposed the kind of precarious nature of the status of plans,” said Jean-Pierre Aubry, state and local research director at Boston College’s Center for Retirement Research.
Even as U.S rates itched higher in 2016 and stocks mounted record highs, public pensions still laggard. Data suggest that another contributing factor is the amount of active working employees vs. retired, the ratio has fallen to 1.42 in 2016 from 2.43 in 2001, according to a November 2017 National Association of State Retirement Administrators (NASRA) Public Fund Survey. This, coupled with poor returns, can increase the cost associated with the public pension fund.
The culmination of public pension problems has resulted in an unprecedented amount of reform efforts including measures that would increase contributions or cut benefits. “Just as these pension funds required higher contributions as a result of the market decline, the plan sponsors were less able to pay those higher contributions,” said Keith Brainard, NASRA’s research director.
Alternative investments have become the investment vehicle of choice for U.S pensions. U. S public pension funds are said to have become the most prominent risk-takers in the international pension fund space, according to one academic study updated in February 2017 (here).
Alternative investment allocation for public pensions increased 24% in 2015 form 9% in 2005, according to the Center for Retirement Research.
“We know for the most part that alternatives have not been the panacea since the financial crisis,” Aubry, noting that hedge funds and commodities have underperformed equities during that period.
Public pension funds’ assumed rates of investment return have failed to reach pre-crisis levels. This has resulted in increased missed targets with local governments being on the hook to make up the difference.
Part of the problem is that public pension targets, or expected rates of return, are far too optimistic. Between 1993 and 2002, as the U. S Treasury yield fell by 4.3 percentage points, sizeable private sector U.S plans reduced their discount rate to 4.4 percent from 8.2 percent. For large public plans, the price only fell from 7.8 percent to 7.7 percent.
Pension Reform has been met with legal hurdles as governments attempt to modify pension obligations. Legal or political constraints have stymied any changes in states like Illinois, Kentucky, and New Jersey, where funding levels are at dangerously low portions.
Lawsuits filed against more than 40 states and local government since 2008 are seeking pension changes on constitutional grounds, according to the Laura and John Arnold Foundation, which tracks these sorts of litigations.
Courts in 13 states have upheld reductions in cost-of-living adjustments(COLA) for retiree’s pension payments, but have been struck down in four jurisdictions.
In California, three lawsuits will go before the state supreme court to contest long-standing ordinances prohibiting the state or local governments from reducing benefits, according to Stuart Buck, the Arnold Foundation’s vice president of research.