Broker Check

Pension Funds Struggle in Low Return Environment

August 03, 2016

It’s not just individual investors who are struggling to find decent returns in the current market environment. The nation’s pension funds are also suffering as low interest rates and weak stock market returns have made it increasingly hard for pension fund managers to meet often unrealistic return targets. This has led to an increase in the number of pension funds that are underfunded and has caused those that were already underfunded to fall well behind their targeted funding levels. Meanwhile, pension funds are experiencing an increased level of outflows as Baby Boomers retire and begin collecting pension payments. Official life expectancy tables have also increased to reflect that people are living longer, increasing the amount that must be set aside to fund future pension payments which has compounded the problem. This may shift more of the burden to employers, especially state and local governments, and ultimately taxpayers to make increased contributions to fill the gap.

For example, the California Public Employees Retirement System (CalPERS), the nation’s largest pension trust with $293.7 billion in assets, reported a small investment gain in the 2014-15 fiscal year and recently reported an investment loss of 2.6% for the 2015-16 fiscal year. This puts CalPERS’ investment return well below its target of 7.5%. The result is that CalPERS’ already underfunded status has deteriorated further. CalPERS is now 70% funded (or 30% underfunded), meaning the pension trust only holds 70% of the assets needed to fund its present and future pension obligations, assuming it is able to achieve its target return of 7.5% per year going forward. This is well below the 80% level that is considered “minimally sufficient” to meet future obligations. To make matters worse, if CalPERS continues to achieve investment results below its 7.5% target, its funding level may continue to decline in future years.

To address its underfunding problem, CalPERS is demanding hundreds of millions of dollars in additional contributions from state and local governments, shifting the burden onto government budgets. Absent pension reform, this burden may then be shifted to taxpayers as state and local government scramble to meet their pension obligations.

CalPERS is hardly alone in facing a pension funding challenge. As of June 2016, the 100 largest pension funds in the nation reported pension funding ratios that declined to 75.7% from 81.7% in June 2015. This represents a total of $447 billion in unfunded pension liabilities. This is the greatest level of shortfall in pension assets since the all-time low of $480 billion in 2012.

The department of labor has reported that 33 private pension systems were required to send out “Critical and Declining Status” notices to participants while 73 were required to send out “Critical Status” notices, and 42 were required to send out “Endangered Status” notices in 2016.

Some of the most distressed public and private pension systems have been forced to engage in pension reform to remain solvent. In some cases, this has resulted in cuts to participants benefits. In other cases, employees have been required to start contributing or increase their contributions to the pension system to supplement existing employer contributions. Still other pension systems have changed the pension benefit formula for new employees so that they contribute the same amount to the pension system but will receive a lower benefit in retirement so that a portion of their contributions can be used to fund the more generous benefits paid to retired and retiring workers.

Given the options available to correct the pension underfunding problem, it is too early to conclude that the nation’s pension systems are in crisis. However, if interest rates remain low and stocks continue to offer below average returns, pension promises may prove to be far more costly to fund than originally estimated.