Market Volatility Continues to Impact Public Pension Funding
As fiscal year 2022 concludes for many state and local governments this month, public pension funding levels are again on the decline due to the recent market selloff. Milliman reports that the 100 largest US public pension funds experienced investment returns of -3.4% during quarter 3 of FY 2022 and another -4.8% in April alone. S&P Global Ratings estimates that typical public pension investment performance for FY 2022 overall will be around -7% and funding levels will fall to approximately 72%. This effectively wipes out the historic FY 2021 investment performance of more than 25% that drove average funding levels above 80% for the first time since the Great Recession in 2008.
Despite this recent volatility, market-driven swings in plan funding do not immediately impact required contributions. Plans typically employ asset smoothing policies that recognize investment gains and losses over time—most commonly over a five-year period according to the National Association of State Retirement Administrators (NASRA). Understanding how near-term investment gains and losses will impact contributions in the future is critically important for budget forecasting purposes and also for avoiding near term decisions that can reduce pension funding levels and drive up contribution requirements over time.
Pension COLA Policies in the Spotlight Amid Rising Inflation
Rising inflation is the top concern for Americans, according to a recent poll by the Pew Research Center that found 70% of respondents view inflation as a “very big problem.” Between January 2021 and May 2022, the Consumer Price Index has accelerated from 1.4% to 8.6% according to the Bureau of Labor Statistics. The 8.6% increase from May 2021 to May 2022 was the largest annual increase in more than four decades.
Given the fact that inflation can quickly erode the value of a fixed pension payment, both retirees and policymakers have given increased attention to a common plan feature that is intended to help maintain the value of the benefit over time—the Cost of Living Adjustment (COLA). As noted in a recent report on COLAs published by NASRA, COLA designs vary significantly from plan to plan. Two of the primary considerations around COLA design are 1) whether the increases occurs automatically or on an ad-hoc basis and 2) how the value of the increase is calculated.
Automatic COLAs are the most common, which generally means there is a law or policy in place documenting the conditions under which a COLA will be granted. On determining the value of the increase, the most common approach is for the COLA to be linked to the actual inflation rate, up to a pre-determined cap that limits the size of the increase in any given year. Other approaches include tying the COLA benefit to plan funding levels or setting a fixed rate that is unrelated to other variables.
As NASRA notes, the current levels of inflation exceed the current COLA caps in place for most plans. So even for retirees that have access to a COLA, this means inflation will erode a portion of their benefit value. Another point NASRA highlights is that since 2009 more than half of the states have made adjustments to COLAs aimed at maintaining costs and ensuring plan sustainability, including changes in 17 states that impacted current retirees.
Thoughtfully designed COLA policies are important both for protecting the value of retiree benefits and ensuring plans are sustainable and affordable. With inflation at current elevated levels, analyzing the forward-looking impact of potential COLA changes will be particularly important for policymakers considering adjustments.
Fiscal Strength Creates Opportunity for Pension Debt Reduction
A recent survey of state finance officials conducted by the National Association of State Budget Officers (NASBO) found that state governments are in strong fiscal positions following record tax revenue growth in FY 2021 and revenues that are on track to exceed forecasts once final collections are reported for FY 2022. States are now in the process of allocating the proceeds of these budget surpluses across a mix of spending programs, tax cuts and rainy day fund deposits while at the same time planning for slower growth moving forward.
A number of states are using this fiscal strength to pay down pension debt. In Connecticut and Indiana, existing rules on the books automatically divert a portion of surplus funds to each state’s pension plans when certain thresholds are met. These arrangements triggered additional contributions of $3.6 billion in Connecticut and $550 million in Indiana over the past year.
In Arizona and Missouri, policymakers approved supplemental pension debt reduction payments of $1.1 billion and $500 million respectively as part of each state’s FY 2023 budget. Officials in California continue to negotiate the FY 2023 budget, where the Governor’s budget proposal allocated $3.4 billion to pension debt reduction.
Effective pension and budget forecasting is essential for making informed decisions around how best to allocate surplus funds across a range of priorities in a manner that is sustainable over the long term.
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