A stock market fall may squeeze public pensions, experts say

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AUSTIN — A falling stock market may mean politically difficult choices for public pension systems that rely on equity investments to reduce unfunded liabilities, experts told this week's Bond Buyer Texas Public Finance Conference.

“Those asset classes that carry higher expected returns also carry higher risk,” said Thomas Aaron, the dedicated public pension specialist for Moody’s Investors Service. “If we suffer another significant downside, there’s less smoothing capacity to handle a downturn.”

"Asset classes offering expected returns near public pension systems’ portfolio return targets, such as public and private equities, carry far greater expected volatility," said Thomas Aaron, the dedicated public pension specialist for Moody’s Investors Service.

After scaling back their expected investment returns from the historical 8% following the 2008 financial crisis, the so-called discount rates may still be too high at the typical 7%, analysts warn.

Faced with the prolonged low-interest-rate environment, pension funds have reduced holdings of Treasurys and other low-risk assets in favor of riskier equities. That has been helpful in the bull market, but raises problems in a market retreat.

Aaron said that many state and local governments' credit quality today is more susceptible to pension investment losses because of lesser capacity to “smooth” or defer contribution hikes.

The 2020 mapping of expected return volatility for investment portfolios with return targets at or near the 7% used by most U.S. public pension systems points to material probability of investment losses, Aaron said.

“With interest rates now ‘lower-for-longer,’ public pension systems cannot achieve their target returns of around 7% with heavy portfolio allocations in low-risk securities, such as high-grade bonds,” Aaron said. “Instead, the asset classes offering expected returns near public pension systems’ portfolio return targets, such as public and private equities, carry far greater expected volatility, or standard deviation of returns.”

As bond industry executives and government finance officers were meeting in Austin, the Dow Jones Industrial Average marked the largest two-day percentage slide for the index since Feb. 5, 2018. The skid put the Dow 8.4% away from its Feb. 12 record-high close of 29,551.42.

As stocks fell, Treasury rates hit record lows, and the yield curve between three-month Treasury notes and 10-year bonds inverted. It was the second yield-curve inversion since September. Such inversions have always preceded recessions, but the onset of the recession could not be predicted with certainty.

“A history of reforms since the last recession has led to a majority of plans retaining sufficient assets to withstand a market shock,” according to S&P analyst Joshua Travis. “State and local governments are expected to continue discussions around pension reforms to control costs and manage risk.”

Marc Joffe, senior policy analyst at the Reason Foundation, noted that "Texas has been a leader in moving to alternative investments, and that may not really be a good thing.

"It could really blow up on us if there's a major recession."

Joffe said his research shows that pension issues may have to be sorted out in court when crunch time comes.

The Rhode Island Supreme Court last year upheld the city of Cranston’s decision to suspend cost-of-living-adjustments on police and fire pensions even though these COLAs had been written into collective bargaining agreements, he noted.

“The state Supreme Court’s ruling may set a precedent for fiscally distressed local governments grappling with unfunded pension liabilities since it upheld reductions in otherwise legally sacrosanct pension benefits in the interest of sustaining the fiscal solvency of the plan’s governmental sponsor,” Joffe said.

In San Francisco, voters will decide March 3 whether to take on the pension obligations of the San Francisco Housing Authority as part of the city’s takeover of the authority after the U.S. Department of Housing and Urban Development found SFHA in default on two federal contracts.

“As a result of this municipal takeover, the city has hired many former Housing Authority employees,” Joffe said. “These employees were covered by an SFHA retiree healthcare plan for which they are now no longer eligible.”

The market risk comes as most pension systems are demographically maturing, meaning their benefit outflows are increasingly heavy, Aaron pointed out.

By 2035, the U.S. Census Bureau projects people age 65 and over will outnumber those under the age of 18 for the first time in the nation's history.

The demographic shift will increase generational dependency, creating economic, fiscal, and social challenges for U.S state governments, according to a Feb. 24 report by S&P.

"We consider generational dependency a long-term social credit factor that may result in state credit deterioration as an aging population leaves the workforce, placing a larger share of the burden for funding government services and economic growth on younger generations," said S&P Global Ratings credit analyst Timothy Little. However, demographic destiny is not predetermined. Prudent fiscal management of coming demographic headwinds will ultimately dictate the direction of state credit quality."

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