The Consequences of Long-Term State Pension Underperformance

The financial health of state pension plans has worsened and advisors should avoid municipal bonds from certain issuers.

Each year Cliffwater LLC prepares an annual report on the financial condition of state pension plans over time. This year’s report covers 66 state pension plans and almost $3 trillion in assets. Following is a summary of some of the key highlights of the report, which covers the 19 fiscal years ending June 2019:

  • Following the great bull market of the 1980s and 1990s, pension plans began the period almost fully funded, with a funding ratio of 96%. Unfortunately, they ended the period with a funding ratio of just 68%. (The funding ratio measures the ratio of plan assets to the net-present value of its liabilities.)
  • The erosion in the funding ratio was caused to a great degree by the plans earning an asset-weighted annual return of only 5.91%, badly trailing their 7.73% collective asset-weighted actuarial assumptions.
  • Other contributors to the decline in the funding ratio included the failure of some states to make required contributions, outdated mortality tables, and unfunded benefit improvements.
  • Not a single individual state pension investment return met or exceeded its unique actuarial rate over the period. The average asset/actuarial return deficit was an annualized -1.87%, and the smallest deficit was an annualized -0.38%.
  • Over the final 10 years of the period, the plans’ U.S. equity investments returned 14.11% per annum, underperforming the Russell 3000 Index return of 14.67% per annum. However, international equity investments returned 7.75% per annum, outperforming the MSCI EAFE Index return of 7.40% per annum and the MSCI Emerging Markets Index return of 6.17% per annum. Real estate investments returned 9.34% per annum, dramatically underperforming the Dow Jones U.S. Select Real Estate Securities Index, which returned 15.32% per annum.
  • Over the full 19-year period, U.S. equity investments returned 6.39% per annum, slightly outperforming the Russell 3000 Index return of 6.13% per annum. International equity investments returned 4.45% per annum, outperforming the MSCI EAFE Index return of 3.81% per annum, but underperforming the MSCI Emerging Markets Index return of 7.49% per annum. Weighting international equities (75% developed and 25% emerging) resulted in a benchmark return of 5.68%. Real estate investments returned 8.21% per annum, underperforming the Dow Jones U.S. Select Real Estate Securities Index, which returned 10.43% per annum.
  • State pension fixed-income returns outperformed the Bloomberg Barclays Aggregate Bond Index, returning 5.57% and 5.18% over the last 19-year and 10-year periods, respectively, compared to index returns of 4.96% and 3.90%. However, they did so by taking considerably more credit risk. For example, the Bloomberg Barclays High Yield Bond Index returned 7.35% and 9.24% for the same 19-year and 10-year periods.
  • Private equity outperformed public equities using a 70/30 U.S./international benchmark (MSCI ACWI ex-U.S.) by 4% and 3% per annum over the 19-year and 10-year periods.
  • Absolute return funds did not come close to living up to expectations, delivering returns of just 3.87% per annum over the final 10 years (no data was available for the full period).
  • Given current bond yields and equity valuations, the actuarially assumed asset-weighted return of 7.11% appears to be too aggressive, risking further deterioration in the average funded ratio.