Defined Benefit, Institutional Investors, Pension Funds, Performance Measurement, Public Funds, Retirement Income

Underfunded Plans and Poor Returns Go Hand in Hand: CRR Study

A recent study released by The Center for Retirement Research at Boston College, titled Stability in Overall Pension Plan Funding Masks a Growing Divide—which looks at the funding ratios of state and local pension plans around the country—finds that the pension plans that ranked lowest in terms of funding status also reported the lowest returns on their investments. “The worse off plans that stand out have achieved worse returns on average than the other two groups (of pension funds that have higher funding levels),” said Jean-Pierre Aubry, associate director of state and local research and the lead author of the report. The CCR also found that the amount of benefits being paid to retirees had little relation to a plans funded status.

Jean-Pierre Aubry, associate director of state and local research, The Center for Retirement Research at Boston College

The CRR collects data annually on changes in the average funding level of all the pension plans it charts combined, typically by a percentage point move up or down. But this year, for the first time, it ranked the country’s public pension plans into three separate categories, those with the highest funding level status, the middle-range and lowest. It also (for the first time) analyzed the funds’ benefit levels and investment returns. “We track 180 of the largest state and local pension systems in the country. “Ninety five percent of all state and local workers are covered in these plan, so we are talking about almost the whole state and local (public) workforce across the U.S.,” Aubry said.

The researchers found that in 2017, the average funded ratio for the bottom third of funded pension funds was 55 percent, 73 percent for the middle third, and 90 percent for the top third. The numbers are quite startling considering that in 2001 (the year the Center started collecting data) were at or above 90 percent. The CCR also found that the plans that were closest together in terms of funding levels in 2001 (the year the Center started collecting data) have since been growing apart. “There has been a steady separation of funds over time, so the question now is, ‘What is driving the dispersion?’” Aubry stated. The answer, according to the research, is lower state funding of certain plans combined with poor investment performance.

It’s not rocket science; a lack of state funding results in lower funded plans

The main reason that a third of (yes?) pension funds are less funded than their peers is that, plainly stated, “the worst funded plans don’t pay their annual contribution,” (is it the plans or the states that don’t pay?)  Aubry said. “They know what the bill is, the actuary tells them, but they don’t make the payments,” he said. “States have to mandate what they need to pay to fund their plans—the actuary presents a suggested number, a benchmark, based on how much employees put in each year combined with what the plan needs to pay its unfunded promises that will need to be paid out over the next 30 years,” Aubry explained. However, the benchmarks are merely a suggestion for sound funding, and not all states actually make those suggested payments. So, it should come as no surprise that the funds located in states that make the suggested payments are better funded than those that don’t.

In fact, much of the problems that the funds face come back to a lack of adequate funding. “The real problem is that funds are not putting aside the money for whatever promises they make,” according to Aubry. The CRR researchers found that “contributions to the worst-funded plans have fallen well short of what is required to maintain reasonable funded levels.

The problem lies more at the state level than with smaller local governments, Aubry stated. “It’s not a hard and fast rule, but when the localities are presented with a bill they typically pay it, but at the state level, there are a lot more budgetary negations that happen, so you often find that it’s the states that are not paying the contribution levels,” he said.

As part of its research to investigate the adequacy of contributions being made to plans, the CRR compared annual government contributions with the amount needed to both fund accruing benefits and pay off the existing unfunded liability within 30 years, in level dollar payments.  According to the report, “from 2001-2017, the average contribution for all three groups was less than this funding benchmark, with the best-funded group receiving 80-90 percent of the benchmark in most years, and the worst-funded receiving 60-70 percent in most years.”

Don’t blame the employees

The CRR’s findings also debunked an oft-held view that some plans are suffering because employees are demanding too generous of benefits. “Many believe that the benefit promises being made are what is bankrupting some plans, but there is no real relationship between the benefit generosity and the funding ratio of a plan,” said Aubry. “It’s not clear that benefits across the board are too high or too low, and it’s not clear that the benefits are what is dragging things down,” he said. “In fact, what we found is that the benefit generosity between the best and worst funded plan isn’t that different,” he noted.

To assess the impact of retirement benefit levels on a fund, the CRR examined the average normal cost of benefits as a percentage of payroll for each group. According to the report, “the normal cost measures the present value of retirement benefits earned by active workers in a given year, and is often used as a single measure to compare the complicated benefit provisions offered by plans. [The data] shows that the normal costs for the three groups are relatively similar and that the worst-funded plans generally had the lowest normal cost. These results suggest that difference in benefit levels is not driving the widening gap in funded status among the three groups.”

To add fuel to the fire, the researchers found that the better-funded plans typically offered better benefits to their employees than the worse-funded ones. In short, “the data shows that the worst-funded plans have not provided higher levels of benefits over the past 17 years,” the report stated.

Poor investment decisions

On the investing side, the correlations continued, with the average investment returns for the worst-funded plans lagging behind the other groups. “Our narrative, over time, has been that all plans invest relatively similarly and that the difference in performance is not that large,” said Aubry. “But it now turns out that over 17 years there has been some meaningful differences in performance and that has played a role in some of these plans being at the bottom of the group,” Aubry said.

The plans that turned in the worst returns were basically overweight in equities leading up to the financial crisis, so were more vulnerable when the crisis hit, Aubrey observed. “After the crisis, they shifted into hedge funds and commodities, both of which have under-performed since the crisis,” he said. “Part of it was poor timing. Everyone was afraid of equities at the time, because the market was mispriced. There was nothing better than an index fund, but hedge funds bet against that,” Aubry noted. Plans that went into alternatives earlier, like private equity, were also less exposed to the stock market, when the financial crisis hit. “It was great for those that rode it out, but it was the timing of the alternatives investment that mattered too,” he said.

Based on simple projections, if the worst funded plans had achieved returns similar to the best-funded group, their funded ratio would be about 11 percentage points higher–eliminating about one-third of the gap in funding between the two groups, according to the CRR report.

Solutions are slim

Across the country, policies are being designed to shore up the state pension systems and many benefit reforms have been made since the financial crisis, Aubry noted. “The challenge is still that the returns are the returns, and in some cases it’s the luck of the draw (in terms of market timing),” he said.  But while investment officers cannot always control the outcome of their investments, “You can control the promises being made and the amount of money you put in to fund your system,” Aubry stated.

Today, many states (yes?) are now being more stringent about figuring out how much more money to put into their employee pension plans and are actually putting that money aside to make improvements in funded status of the plans, (yes?) said Aubry. “The rules around how to pay down the underfunded liabilities have tightened up, and there are certain ways to calculate what you need, that are best practices,” he noted. But at the end of the day, “it all boils down to putting in more money.”

Aubry also cautions pension officers against thinking that cutting benefits to employees will be a quick fix. “Lots of plans have cut benefits, but in most states cutting benefits for current employees is hard. There are legal protections,” he noted. “You can do it with the new hires, but they trickle in, while it takes 30 years for the old force to get replaced. So, new hires are only going to represent a sliver of the cut costs for a long time.”

As a short term fix, “many plans are increasing the amount that employees must contribute to the plan and are saying ‘you pay for it, instead of we pay for it,’” he noted. “That’s an immediate way to reduce costs.”

What’s ahead?

Looking forward, “The top third of plans now has an average funded ratio of 90 percent and should remain on track with continued maintenance,” according to the report. “The average funded ratio for the middle third of plans has remained relatively steady, around 70 percent since the crisis, and these plans can improve by adopting more stringent funding methods. However, the average funded ratio for the bottom third of plans is currently 55 percent and has continued to decline in the wake of the crisis. These worst-off plans will likely require intervention beyond traditional reforms to change the trajectory of their funded status.”

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