Pension Funds’ Silver Lining Has a Touch of Gray
(Bloomberg Opinion) -- There has been an unusual burst of good news for State pension plans in the past week. New Jersey, one of the shakiest plans in the country, reported a 28.6% return for the fiscal year ended June 30, the highest in more than 20 years. Other funds have reported or are estimated to have returns around 25%. The Pew Charitable Trust estimates that State and local pension funds have finally recovered from the 2008 market crash and are back up to 80% funded, meaning assets currently in the fund could cover 80% of the benefits owed under optimistic assumptions about investment returns.
Moreover, reforms adopted in the last decade such as increasing taxpayer and employee contributions, and limiting benefits for new hires, mean funds as a group are now in “positive amortization,” with more cash is collected net of benefits than the present value of new benefits added, shrinking the funding gap.
This proves many forecasters, including me, wrong when we predicted back in the depths of the March 2020 market crash that the State pension fund system might have been the tipping point from which recovery would be impossible for the most troubled plans. A 65% gain in the S&P 500 Index while interest rates fell (meaning bond prices rose) moved funds from the critical list to, if not the full health of 100% funded under realistic assumptions, at least to the walking wounded state that has been the norm since the 2000 stock market crash.
But every silver lining has a touch of gray. The bad news about the stock market rally is that it is only in stock prices; corporate revenues, profits and book values have not kept pace. As a result, the cyclically adjusted price earnings ratio (the best well-known measure of stock valuations) stands at 37.2—far above the high of 31.3 just before the Black Friday stock market crash that was the harbinger of the Great Depression, and only exceeded by the 43.8 in 1999 that marked the top of the dot-com bubble. Unless there is a miracle recovery in actual business profits and economic growth, it seems inevitable that there will either be a major stock market crash, or at least a period of many years of mediocre stock market returns rather than the robust gains necessary to maintain pension plan funding levels.
The reforms increasing employee contributions and limiting benefits for new hires means an increasing share of covered employees have no stake in maintaining the current system that threatens to pay generous benefits to older and retired workers, then run out of money before younger workers retire. Taxpayers for the first time are experiencing the consequence of paying in full for promised future benefits to State and local workers. This seems likely to tilt the political calculations toward pension “reforms” that cut benefits promised to older and retired workers—benefits already accumulated.
This is obviously a difficult step both ethically and legally (in most States pension benefits have legal protections beyond normal debts, up to and including provisions in State constitutions). But if the alternatives are losing younger employees, or intolerable tax increases and service cuts, my prediction is ways will be found to cut benefits. Historically this has been blocked not by an unwillingness of politicians to break promises, but by a unified bloc of State and local workers—including popular groups such as teachers, police and firefighters—that not only commanded public sympathy but delivered lots of votes and money. I think that bloc will fracture into older workers wedded to the old system and younger employees who see it as a burden on them rather than a support.
If I’m right, it’s obviously better to cut the deal now when assets are relatively high and the shared pain relatively low. The sooner the system is made sustainable, the longer time people have to adapt their plans. We know it’s possible to run prudent plans, and States such as Wisconsin, South Dakota and Tennessee have done it for decades. We also know it’s possible for the worst States to improve. Illinois, Kentucky, New Jersey and Pennsylvania are still deeply troubled, but have been among the leaders in enacting reforms.
I am a pessimist on this issue. This year could go down in history as the year the State and local pension funding crisis was finally resolved, with pain shared fairly among taxpayers, older employees and younger employees. But history suggests that great stock market rallies are used to both give out more cash today and to promise more cash in the future. I don’t expect to see much of that this time, but I do sense than the pressure to continue improvements has slackened. I think it’s more likely 2021 will be remembered like 2000 and 2007, as the peaks before the next leg lower.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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.
©2021 Bloomberg L.P.