Pension Fallout of COVID

The state has plenty of immediate fiscal problems to deal with in responding to COVID. But like the virus itself, a “second wave” of impact looms in the state’s future.

Whenever the pandemic ends and the state returns to some sense of economic normalcy, the budget impacts are sure to linger.   That’s because the fiscal consequences include not just the extraordinary budget actions federal, state, and local governments are now employing, but “tails” which will have to be tackled in the future.   Pension funding is at the top of that list. 

State pension fund health has largely been out of the public spotlight for a while.   Thanks in part to TCJA-juiced, buyback-fueled stock market returns, state and local pension funds across the nation — holders of about $2 trillion in tradeable equities — have been major market beneficiaries.   The situation, to put it mildly, has changed.  A recent report from Moody’s Investor Service estimated U.S. public pension funds are facing an average investment loss of about 21% in the fiscal year that ends June 30.   The best case scenario is a sharp but short recession and the market comes roaring back sooner rather than later with a vengeance.   Recent market rebounds (as of this writing) and record insider buying levels suggest this may not be out of the question.  But even if we are fortunate to have this scenario materialize, the challenges Minnesota pension funds now face are still greater than they were coming out of the Great Recession.  That’s because of the lack of improvement in our existing unfunded liabilities in spite of the decade-long bull market and our reduced capacity to defer any new costs.

Pension-wise Minnesota is still dealing with the fallout of the Great Recession.   Smoothing the costs and backfilling pension investment losses over multiple decades defines our recovery strategy.   It was a response driven by political reality rather than the aggressiveness actuaries recommend and circumstances demanded.   The state’s response was further handicapped by our unwillingness during the subsequent years to make our annual required contributions so as to reduce the imposition on current government operations, retiree benefit increases, and employee paychecks.   

The increasing maturity of our plans compounds the problem.  Our margin for error in dealing a really bad investment year or two (or a series of “less that what we assumed” years) is significantly reduced.   Thirty years ago, well over a dollar of cash flow was coming into state pension funds per dollar of outlay helping the state weather difficult investment periods.  Today it’s about $.50.   Non-investment annual cash flow (contributions paid into a pension system, minus the benefits and expenses that are paid out) for the state plans is now a negative $2.46 billion per year and has been growing at an average of about $80 million per year — despite the phased in contribution increases which have been enacted over the years.   Based on the latest valuation reports, collectively the first 3.35% of annual investment return is needed just to have asset levels tread water. 

The reality of all this can be seen in comparing the state pension fund valuation reports two years into the recovery after the end of the Great Recession (June 30, 2011) and the most recent report (fund conditions as of June 30, 2019).  During this eight-year period, the state realized generally excellent investment returns easily beating the assumed return of 7.5%.   As an example, the Russell 3000 - the State Board of Investment’s primary benchmark for its domestic equity portfolio — increased 162% — an annual growth rate of 12.78%.   Yet over this same period, total unfunded liabilities of the state plans (PERA, MSRS, and TRA) on a current market value (i.e. “non-smoothed”) basis increased $12.08 billion to $15.17 billion, or 25.6%.  There are several contributing factors, but the story can best be summed up this way: market recoveries only help pension funds to the extent that they have the assets available to take advantage of them.  Minnesota’s funding results reflect what happens when a pool of assets unsupported by adequate contributions tries to chase down a pool of liabilities many billions of dollars larger automatically accreting at 7.5% annually.

Are POBs the Answer?

Potential public pension funding strategies include ideas that fail the majority of the time but can prove to be quite successful when they do work.    One such idea is “pension obligation bonding”: an interest arbitrage play in which the state issues bonds at low interest rates and puts the money in trust to invest in capital markets at highly distressed levels.  The idea is that a stock index portfolio purchased in times of major market corrections can reasonably be expected to earn far more than the interest rate the government is paying to borrow the money.  It’s been done here before.  Several years ago Minnesota created a window of opportunity for stressed local governments to issue OPEB bonds (“other post-employment benefits”) to address their unfunded retirement health care obligations.  

The Government Finance Officers Association recommends “extreme caution” in using this tool because timing is critical.    There is significant risk in adding more debt and buying too late in the recovery cycle.   Nevertheless, one public finance expert and public pension authority, normally critical of this approach, has argued that the narrow window of time when this strategy actually works exists right now and should be pursued. [1]  

We asked Kurt Winkelmann -- former Managing Director at Goldman Sachs and currently Chair of the Advisory Board for the Heller Hurwicz Economics Institute at the University of Minnesota where he is directing the university’s pension policy initiative – what he thought of this idea.   He cautioned against this course of action for both political and policy reasons.    First, he noted, given the very real challenges facing the self-employed and small businesses, the idea of using government debt to sustain a government retirement plan (which we note is increasingly foreign to private sector employers and employees) is almost assuredly a political non-starter.   From a policy perspective, he said he is far less sanguine about macro conditions than POB advocates are.  “None of these people think about the consequences of a prolonged period of low real growth,” he said.  “Low real growth has consequences for asset returns and tax revenue.”

“St. Paul, We Have a Problem”

After the passage of the 2018 pension sustainability bill our plans were described as “on track to be fully funded within 30 years.”  That assessment is only accurate in an alternate world where our risk assets and alternative investments behave like bonds yielding predictable 7.5% returns every year for decades.    More accurately, our plans are on a course of managed perpetual underfunding in which permanent low interest rate environments and economic circumstances far less momentous than “black swan events” can do serious damage.

From a public finance perspective, it seems misguided to devote energy and attention to this issue at this extraordinary moment given what is happening around us.   As Tom Hanks said in Apollo 13, “There are a thousand things that have to happen in order; we are on number 8, you're talking about number 692.” 

But the long term health and welfare of the state is very much influenced by pension policy which happens to be excellent host for a different type of infection — a bipartisan political one that has plagued Washington, D.C. for years.   As one example, according to news reports, long before the COVID 19 made its presence known, advisers were trying to convince President trump of the importance of tackling the exploding national debt by highlighting the consequences in the not-too-distant future, Waving off these warnings, President Trump replied, “Yeah, but I won’t be here.” 

That’s another contagion we don’t need afflicting Minnesota.  

 

[1] Gerald Miller, “The Time is Ripe for Public Pension Obligation Bonds” Pensions and Investments” March 25, 2020