Most state and municipal pension plans are labeled 'distressed or fragile'

The complicated relationship between pension funds and munis is becoming more complex, according to recent projections.

"The persistence of the pension funding shortfall is pushing up contribution rates steadily over time, and in most municipalities those costs are growing faster than revenues," said Anthony Randazzo, executive director at Equable, a bipartisan think tank dedicated to public pension education and research.

"Many municipalities have taken steps to make extra payments into the pension plan and reduce future costs. That will change how they approach bond issuance in the future." 

Equable is predicting a decline in the national funded ratio average for U.S. state and local pension funds to 77.3% in 2022 from 83.9% in 2021. They also believe the total pension funding shortfall will increase to $1.45 trillion in 2022, reversing the one-year drop that fell below $1 trillion in 2021. The data comes from a recently released report that refers to the nation's state and municipal pension plans as "distressed or fragile." Most of the blame is placed on overall poor marketplace performance, strict monetary policy, and the war in Ukraine. 

Equable Institute

A drop in interest rates or a rally on Wall Street might blunt the shortfall but Randazzo believes the issues run deeper.

"An improving stock market would help, but not solve the problems that public pension plans are facing. Even after the massive investment returns in 2021 public pension plans were still barely over 80% funded and had nearly $1 trillion in unfunded liabilities. Even if the market downturn stops and growth resumes, pension funds are not going to solely invest their way out of the current fragile funded status."

The projections dovetail with data collected by the National Association of State Retirement Administrators who reported that contributions made to state and local government pension plans in 2021 reached the highest level in 20 years. Pension plans are reliable investors munis, but they can also be issuers. 

Last December the California State Treasurers Retirement System, the second largest pension system in the country offered $15.7 million in tax-exempt bonds with yields ranging from 2.27% to 4.11% for a 4% coupon bond due in 2049. The money will be used to finish CalSTRS new headquarters building in West Sacramento. In 2019, CalSTRS sold $272.6 million of tax-exempt debt. The fund is currently managing nearly $300 billion. 

Where the huge amount of funds is invested was one of the original sparks for the ESG imbroglio as CalSTRS divested from firearm merchants in 2018. Similar skirmishes flared up in Texas but the debate over ESG and fiduciary duties seems to have passed. Randazzo isn't so sure. 

"We do not see the issue of ESG factors settling down, based on the docket of several state legislatures. We anticipate that Republican controlled states like Texas and Florida will debate anti-ESG legislation in the coming months. We also anticipate that Democrat-controlled states will make a more concerted effort to push back on these efforts by creating their own pressure on firms like Blackrock to do more, not less related to ESG." 

Solutions to underfunded pension plans include more thoughtful investment strategies as some funds have assets tied into the crypto market. Starting over from scratch for the more troubled funds is another possibility.

"Some of the approaches to consider would be to wall off existing unfunded liabilities and put all new public employees in a new, well-designed, risk-managed pension plan," said Randazzo. "That plan to pay down unfunded liabilities might include a dedicated revenue source, additional general fund contributions, or a shared sacrifice approach."