Protecting the Nest Egg
Public pensions are now well funded. But with the buildup in equities, they have taken on more investment risk.
For years, public pension reformers have argued that the retirement funds should invest more in equities. The reasoning was simple. Pensions have very long-term and predictable liabilities, because employees' benefit payments are paid out only after many years of service. That means they are ideally suited to absorb short-term fluctuations while earning higher overall returns. Increasingly, pension investment managers took heed and shifted their assets from bonds to stocks. Today, about two-thirds of all public pension system assets are in equities, both foreign and domestic. We're talking big money here, some $2 trillion (out of $3 trillion) in assets.
It worked like a charm. This reallocation of assets over the past decade has powered state and local retirement funds to ever-greater returns, and that has been a huge benefit, especially in times of subdued inflation and modest salary increases. Public pensions on average are now well funded. But with the build up in equities, they also have more investment risk. How they will contend with a down cycle in the stock markets and pressures for heftier benefits will be a key fiscal policy issue in the coming years.
According to a recent survey by the Public Pension Coordinating Council, the average funding level of public systems (that is, assets on hand versus actuarial liabilities for future benefit payments) leapt from 82 percent in 1992 to more than 95 percent in 1998. That's in stark contrast to the 1970s when, with many public systems on a "pay-as-you go" basis, the funding levels averaged only 50 percent. Most public pensions are the traditional "defined-benefit" plans, where the amount of the benefits is promised regardless of how well the fund's investments perform. But when they perform well, then the amount that must be contributed annually decreases. And, that has been the big fiscal plus for many state and local government employers over the past few years.
Several factors have contributed to the strong performance. First have been the massive asset reallocations from fixed income to equities. Investors in common stocks were richly rewarded in the 1990s and public pension systems regularly exceeded double-digit annual returns.
But there have been favorable trends on the benefit side as well, most notably the slow growth of benefit levels. One measure of benefit levels is the "benefit factor." The general idea is that an employee's benefit payment is calculated by the number of years of service times the benefit factor. Thus, 30 years of service at a benefit factor of two means that the pension payment will be 60 percent of the final years' wages. According to the Council survey, the benefit factor crept up only slightly during the 1990s, rising from 1.95 in 1992 to 2.08 in 1998. While an increasing number of systems have adopted cost- of-living increases, low rates of inflation have kept growth in the COLA modest--so far.
The key payoff for governments is that the annual employer contributions have been greatly reduced. These shrank from 15.5 percent of covered payroll in 1994 to 11.6 percent in 1998. This nearly 4 percentage point drop is huge in terms of its impact on state and local budgets. As of the end of 1998, it was worth an estimated $1.5 billion in reduced employer yearly contributions. In fact, several fully- or over-funded plans have been able to take holidays in employer contributions for the time being.
The golden age of public pension investment performance will not last forever, of course. So far in 2000, the investors in equities have begun to see more of the risks than the returns. With chaotic markets in the spring of this year, the major indices have struggled to regain the levels of the end of last year. Barring a strong revival in the last quarter, stocks will show little, if any, net return for the year.
The point, however, is that one year's results shouldn't count for much.
After all, the bond markets, where the pension funds used to bet most of their money, have taken severe dives in years gone by. But, the much heavier allocation in stocks means that year-to-year changes in investment performance will be greater. The good news is that at the high funding levels, the pension systems are in much better shape to absorb yearly fluctuations in returns. Yet, a prolonged period where pensions are earning less than 7 or 8 percent on their assets will mean increasing the contribution levels. A renewal of inflation or a continuing enrichment of benefits would exacerbate that problem.
Most public systems still have prudential limits on the proportion of assets that can be invested in equities. A down year or two in stock returns may be a healthy reminder that the systems cannot expect to out-perform the historical averages indefinitely. The larger challenge will be to resist increasing benefits. But, barring disaster in the equity markets and a fueling of inflation, public pensions are likely to stay in solid shape and well funded, thus keeping budgetary pressures to a minimum.