Featured Research
May 2020
Stephen L. Nesbitt
Asset Class
Asset Allocation

This annual study tracks the financial condition of state pension plans over time. Its purpose is to provide feedback that potentially better informs investment policy. Of course, each state pension has its own set of unique circumstances but understanding the experiences and actions of state pensions collectively should prove valuable to decision makers in executing their fiduciary responsibilities.

The three lines in Exhibit 1 capture the progression of state pensions for the June 30 fiscal years from 2000 to 2019.1 The 2000 start date was selected because (1) state pensions were largely fully funded then, a byproduct of a long and strong bull market of the prior decade and (2) the period includes two significant bear markets and two bull markets, a seemingly fair representation of full market cycles. Since that time, state pensions have collectively earned an asset-weighted annual return equal to 5.91%, badly trailing their 7.73% collective asset-weighted actuarial interest rate assumption. The almost two percentage point performance shortfall contributed greatly to a decline in pension funding ratios (assets divided by liabilities) from close to unity in 2000 to 68% (0.68) in 2019. The ratio of cumulative state pension investment return ($2.98) to cumulative actuarial interest return ($4.11) equals 0.73, roughly equal to the 0.68 collective funded ratio provided in fiscal 2019 state pension financial reports. While other events undoubtedly have impacted pension funding, among them the failure of some states to make required contributions2, outdated mortality tables, and unfunded benefit improvements, the failure of actuaries to properly underwrite long term asset return is clearly the primary factor in pension underfunding today.

Looking forward, consultant 10-year return forecasts for diversified institutional pension portfolios average 6.11%3, which is slightly above the 5.91% actual state pension return over the past 19 years but well below the current (fiscal 2019) 7.19% asset-weighted actuarial interest rate assumption. Achieving the 7.19% collective asset-weighted actuarial rate will be a challenge and a more likely outcome would be continued budgetary pressures as states find they must make up for shortfalls in asset performance through additional unscheduled pension contributions.