Even As States Return To Health, Pension Funds In Bad Conditions – ValueWalk Premium

Even As States Return To Health, Pension Funds In Bad Conditions

Moody's notes slow and steady state revenue growth, so long as the stock market and economy continue to advance, but for US pension funds the outlook is far more bleak. Updated 9/14/2017

The outlook for state financials is generally healthy, a Moody’s report notes with caveats. So long as the stock market continues to plow higher and the economy is running smoothly, state revenues will continue to grow at modest levels. But even if this Goldilocks economic environment persists, US pension funds continue to struggle with liabilities, a situation that could get much worse if there were an economic downturn, the report noted.

Overall outlook stable, but state-to-state variances exist

Slow and steady was the general outlook for US pension funds over the next 12 to 18 months, as state government revenues continue to grow at 2% to 3%. The generally lethargic pace of government revenue growth – the average from 2010 to 2015 was 5.1% -- reflects “trends of low wage growth and low inflation," noted the Moody's report titled "Stable outlook for states reflects continued slow revenue growth." Personal income tax, dependent on revenue growth, accounts for the largest component of total state tax revenue at 37%.

The trends are regional to various extents, with large swings from high to low growth states.

Louisiana, Oregon and Idaho have seen the strongest revenue growth in the country, seeing increases of 17.6%, 12.5% and 8.3% respectively. Louisiana's large revenue increase was mainly due to state sales tax increase.

Despite the generally upbeat assessment from Moody’s, most states did not meet their revenue forecasts in 2017, if only by a fraction. The median miss was -0.6%. Of the 29 states that missed hitting their revenue forecasts, the median difference was -2.2%.

While there are big revenue winners, North Dakota, Oklahoma and Illinois have seen revenue decline -16.2%, 3.1% and 2.1% respectively. Declines in North Dakota and Oklahoma are due to energy sector weakness, while Illinois is due to more general economic weakness, with the state’s pension fund entanglements finding the center stage. Both the state and city of Chicago recently addressed the issue, with Chicago raising property taxes once and eying further tax increases.

Labor and aging population growth poses hurdles for certain states and their revenue models and for US pension funds. The last jobs report exposed particularly weak labor force participation in West Virginia, Mississippi and Alabama at 53.0%, 56.2% 56.3%, respectively. This compares to the US average of 62.9%.

Washington DC could be a tailwind for state revenue
While there are headwinds for pensions, there could be a surprising tailwind coming out of Washington DC.

Categorizing the federal policy environment “stable, for now,” Moody’s noted potential changes to federal Medicaid policy that could transfer costs from the state to federal government. While total Medicaid costs have been rising, this has been primarily due to the Medicaid expansion program, which is primarily federally supported.

Tax reform, however, is another issue and could result in both positive and negative impacts. The lowering of federal tax rates would create more disposable income for consumers and business spending, boosting state coffers. The downside, however, is that removing the deductibility of state and local taxes, currently under consideration, would result in a negative impact on state revenue.

The US Federal Reserve continuing to gradually increase interest rates would lead to increased borrowing costs. However, because many states utilize long-term funding they likely wouldn’t be impacted to a significant degree.

Regardless of the economic factors going forward, it is demographics that is impacting plans as well. “Heavy pension liabilities will continue to be a challenge for states due to a legacy of insufficient contributions and assets performing on average more poorly than pension plans assume,” the report pointed out. “Most states are managing their rising pension costs despite the growing burden.”

A rising stock market increases tax revenues through personal income tax, a benefit Moody’s expects to continue in 2018. The two most exposed states to both advances and declines are California and New York.

Even with the stock market bull raging for over eight years now, investment performance cannot by itself bail out underfunded pensions. “Even with a healthy investment market for pension plans, we expect pension burdens to weigh on many states' credit profiles through at least 2020,” the report noted.


Cracks among many state US pension funds continues below - last updated 9/14/2017 at 9:15AM EST]

The deteriorating global pensions situation is something we've been following closely here at ValueWalk. Rising pension liabilities, falling fund returns, and high management fees have eaten into pension funds' fiscal reserves. Many corporates, as well as municipal fund, are now struggling to fill a widening gap between assets and liabilities.

As we reported at the end of August, analysis by Willis Towers Watson, which evaluated pension plan data for 410 of the Fortune 1000 companies with defined-benefit pension schemes, had an aggregate pension funded status of 80% at the end of 2016, down from 99% in 2006.

Pension Funds: Trying To Meet Obligations 
Trying to fill this gap is draining company coffers. According to the Towers Watson report, companies contributed $35 billion their pension plans during the year and benefited from an average investment return of 6.7%. However, a 28 basis point decline in discount rates pushed liability values up 3.4%.

Companies are not facing pension problems alone. US pension funds are chronically underfunded with the shortfall between assets and liabilities estimated at just under $3.9 trillion. The gap jumped by $434 billion last year alone. Chicago estimates that underfunded pension liabilities equal 19 years of city tax revenues. Meanwhile, CalPERS projects average government contributions to public safety plans will peak at 40% of payroll in fiscal 2020, up from approximately 32% in fiscal 2015. San Diego's pension assets amount to 259% of its revenues.

Who is to blame for these issues? Well, there are many contributing factors. For a start, people are living longer, which means funds have to pay out more over time than initially planned for.

Second, US pension funds are far too generous to scheme members. As an example, the New York Times' DealBook reported on a study earlier this year which claims that more than three-fourths of all American teachers hired at age 25 will end up paying more into pension plans than they ever get back. Puerto Rico is a prime example. The state owes retired public workers more than $40 billion that it has no immediate way of paying. The Chicago Teachers' Pension Fund has roughly $10 billion in assets to cover $21 billion in future payment obligations. To fill the gap, the fund is currently borrowing nearly a billion dollars a year from taxpayers.

Third, pension fund trustees are terrible investors. A report from The Pew Charitable Trusts published at the beginning of 2017 laid out just how much the poor investment performance of schemes really is. As ValueWalk reported at the time:

"10-year total investment returns for the 41 funds Pew looked at reporting net of fees as of June 30, 2015, ranged from 4.7% to 8.1%, with an average yield of 6.6%. The average return target for these plans was 7.7%. Only one plan met or exceeded investment return targets over the ten-year period ending 2015." 

Fees on investment products ate up a huge portion of returns:

"In total, the US state pension system paid $10 billion in fees during 2014 this figure does not include unreported fees, such as unreported carried interest for private equity. Pew’s analysts estimate that these unreported fees could total over $4 billion annually on the $255 billion private equity assets held by state retirement systems."
US pension funds - Dismal Returns with higher risk

According to a new report from


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