U.S. public pension funds can expect to see hurdles from the coronavirus crisis similar to those experienced in past recessions, according to a new report by Cerulli Associates.
In the past two recessions, public plans saw a decrease in their funded statuses. “According to survey data gathered form the National Association of State Retirement Administrators, public plans’ funded status continued to worsen for four years following the 2002 crash and for five years following the 2008 crash. The prolonged period of decline is due to pensions’ frequent use of smoothing mechanisms; by making the increase in liabilities drawn out, they protect plans from drastic swings in required contributions from the government sponsor.”
When investments fail to perform as expected, plan sponsors must boost contributions. “The problem with a recession is that a government’s ability to raise revenue via taxes is impaired just as the pension requires additional contributions,” said James Tamposi, senior analyst at Cerulli, in a press release. “During the 2002 and 2008 recessions, state governments were not able to collect nearly as much revenue because taxable income evaporated.”
The two past financial crises also changed the behaviours of many public pension funds. For example, lower interest rates pushed these funds out the risk spectrum and funds revised return expectations downwards.
Since public equity markets fell drastically in February and March during the current crisis but have since recovered, pension plan sponsors won’t need to record the large investment losses for the June 30, 2020 fiscal year, the report said. As such, they’ll be able to avoid the corresponding spikes in unfunded actuarial liabilities and increases in pension costs.
That said, in 2020, issues are more likely to result from a strain on government budgets where other spending items take precedence over pension contributions, said the report, noting high unemployment rates will also cause difficulty in collecting revenue. Further, the current low interest rate environment, combined with the likelihood that government contributions fall short, will prompt many plan sponsors to consider alternatives for yield.
The Cerulli report pointed to an April 2020 Preqin Ltd. survey, which found 63 per cent of investors said they intend to stay the course and 29 per cent planned to increase allocations to alternatives in the long term. But private equity managers may see a lack of pickup in the short term. “Asked about the near term, most investors (59 per cent) told Preqin they plan to reduce the number of commitments they make this year,” the report noted. “As markets remain volatile and uncertainty rampant, these investors are hesitant to lock up capital. Indeed, with government contributions expected to decline, pensions will lose one source of liquidity. Many, particularly smaller pensions, will need to make up for this lack of liquidity somewhere else, perhaps by holding more cash or short-term securities.”
Another difference between the coronavirus crisis and past recessions is that, since 2008, risk assessment and portfolio diversity have been key focuses for pension plan sponsors and many set aside liquidity pools for situations like the current one. “Aside from rebalancing on the margin, public pensions are making minimal changes to their investment portfolios,” the report said.