My colleagues, JP Aubry and Yimeng Yin, have recently conducted an in-depth examination of state and local pension plans. Their comprehensive analysis compares the year 2023 to 2019, serving as a reference point before the onset of recent disruptive events. It is hard to ignore the turbulence that unfolded during these years, including: 1) the advent of COVID; 2) the subsequent COVID stimulus; 3) plummeting interest rates; 4) surging inflation; and finally, 5) the unpredictable rise in interest rates.
Remarkably, despite the rollercoaster ride experienced by asset values throughout this period, the funded status of state and local pension plans in 2023 stands at approximately 78%. This represents a significant increase of 5 percentage points compared to the figure recorded in 2019 (refer to Figure 1). It is important to note that the numbers for 2023 are estimations based on detailed plan-by-plan projections. However, these projections have consistently displayed a high level of accuracy and reliability.
Although the aggregate funded ratio offers a valuable snapshot of the overall landscape of public pension plans, it often conceals variations in funding at the individual plan level. To provide a clearer picture, Figure 2 illustrates how the plans can be categorized into three distinct groups based on their current actuarial funded status. The average funded ratio for each group in 2023 was as follows: 57.6% for the bottom third, 79.5% for the middle third, and an impressive 91.1% for the top third.
Through this analysis, we gain insight into the state and local pension plans, exploring both their resilience and the diversity in funding levels among different plans.
Improving Funded Status for State and Local Pensions
Despite the economic turbulence, there has been a noticeable improvement in the funded status of state and local pensions. This positive trend can be attributed to the rise in total annualized returns of major asset class indexes from 2019 to 2023 (see Figure 3). These returns include interest and dividends and have increased for almost all asset classes, with the exception of fixed-income assets, which have declined in value.
However, the impact of this decline in fixed income on overall portfolio performance has been modest. This is because, since 2019, fixed income has accounted for only about 20% of pension fund assets (see Figure 4).
It is worth noting that the funded ratios of state and local pensions are partially biased upward. This is because these plans use an assumed return on their portfolios, which is typically around 7%, to discount promised benefits. Nevertheless, despite this bias, the overall trend is positive.
Another encouraging development is that annual state and local benefit payments as a share of the economy are approaching their peak. There are two reasons for this. First, most pension plans do not fully index retiree benefits for inflation, meaning that the real value of benefits decreases over time. Secondly, the benefit reductions introduced for new hires after the Great Recession are starting to have an impact.
In conclusion, while there are still challenges ahead, the improving funded status of state and local pensions is a promising sign. The rise in total annualized returns, coupled with benefit adjustments, has contributed to this positive trend. As these pensions continue to navigate uncertain economic conditions, it is crucial to monitor these trends and ensure stable financial security for retirees.
The Promising Future of State and Local Pension System
With a careful management of liabilities and impressive asset performance, it's time to take a breather and feel more confident about the future of the state and local pension system.
