(Bloomberg Opinion) -- The 14 percent drop in the S&P 500 Index last quarter has big implications for state and local pension funds, which probably saw the value of their assets fall by about 7 percent. Investors with the benefit of a long-term horizon have the ability to ignore market dips, and pension funds are among the longest-term investors, but their problems are not long-term and further short-term declines could precipitate a crisis.
The table below shows pension fund assets and liabilities as compiled by Pew Charitable Trusts. There is a large and growing gap, but that’s not the primary problem. Although the value of those assets is known with reasonable accuracy, the liability figure is based on assumptions about the future. The actuarial and political assumptions are uncertain, but it is the investment assumptions – plans assume an average discount rate of 7 percent – that are the most problematic.
Average returns for pension-fund-like portfolios only generated returns of 7 percent or greater for 50-year periods twice since 1871,(1) for investors who started soon after World War I or World War II. Starting at a random time generated an average return of 5.30 percent, ranging from a low of 3.16 percent to a high of 7.99 percent.
The problem is worse for two reasons. First, cumulative returns are lower than averages. A return of 7 percent grows $100 to $114.49 in two years. A 50 percent return in the first year and a loss of 36 percent in the second results in an average of 7 percent, but causes that $100 to decline to $96.
Second, an extended period of bad returns cannot be made up even with astronomical returns later. Suppose a fund has 50 years of level monthly payments and assets to support them assuming a 7 percent return. If the fund earns zero over the first 15 years, one might think the fund needs to average 10 percent over the final 35 years to meet its obligations.(2) In fact, the fund is broke in less than 15 years, and it doesn’t matter what returns are afterwards.
Due to those two effects, if a fund started on the best possible date, June 1949(3) — earning an average 7.99 percent – it went broke in 1986. The fund’s final 13 years of obligations went unpaid even though its average return was almost 1 percent above the normal assumption. Even if pension funds were fully funded according to assumptions, there is no chance existing assets are enough to pay already-contracted liabilities.(4)
But worrying about the next five decades is pointless, because there’s also no chance the current system will survive long enough to discover what the next 50-year average returns will be. Once total assets start to decline, as they did in 2016 (the last year for which we have aggregated national data), you can get a death spiral with an ever-shrinking base of assets failing to produce the needed income, leading to asset sales and further declines in income.
We’re nowhere near the tipping point on an aggregate national level, but aggregate national flows will not trigger a crisis. New Jersey added $27 billion in liabilities in 2016, and lost $6 billion of assets because contributions and investment earnings couldn’t even cover benefit payments, much less build the fund to pay for additional benefits earned.(5) The chart below shows the assets and liabilities for New Jersey state and local pension funds.
A simple extrapolation of the lines suggests a crisis around 2023,(6) when pension fund assets are wiped out. That’s an extrapolation, not a prediction. Market returns and political actions could move the date a few years in either direction. Moreover, action will be forced before assets go to zero. We don’t know when or how or what will happen, but it won’t depend on average investment returns over the next few decades.
This brings us back to the recent decline in the stock market. This commentary uses 2016 pension fund data. Most pension funds use a June 30 fiscal year, so fourth-quarter calendar 2018 results will be reported in late 2019 or 2020. The two major aggregations of the thousands of fund reports(7) will be published in mid-2021. If stocks continue down to the point that a major state passes the tipping point to crisis, the crisis will be well advanced before we see it in aggregate pension financial reports.
The state and local pension crisis has passed from a long-term actuarial crisis to a medium-term cash flow crisis. Forget about liability projections and aggregated national numbers. Look at the least responsible big states and focus on asset values, inflows and outflows. That’s where disaster will force a new regime.
(1) These are my estimates based on stock, bond and inflation returns reported by Yale University Professor Robert Shiller .
(2) Earning 10 percent for 70 percentof the period, 35 out of 50 years, averages 7 percentper year.
(3) Getting the 1950s, 1980s and 1990s bull marketsand ending at the height of the dot-com bubble.
(4) Increased funding is still a good idea. The earlier the problem is addressed, the less painful the adjustments. But full funding according to existing accounting will not prevent an eventual crisis.
(5) The general picture is similar, although not as extreme, for states such asIllinois, California, Connecticut, Kentucky and Colorado.
(6) We’ve already seen financial disasters in Detroit, Puerto Rico and numerous smaller places, but in these cases pension underfunding was part of larger fiscal and governance problems. These events will certainly continue, but will not force a major nationwide policy realignment.
(7) The Pew Charitable Trusts cited above and the U.S. Department of Census Annual Survey of Public Pensions.
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Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
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