The recent financial crisis dramatically changed the situation of public pension plans and the alternatives available to them going forward. Most obviously, the funding levels of these plans are considerably worse now than during the bubble. Asset values have declined substantially, even taking account of the sharp rebound in the financial markets since March of 2009. At the same time, reported liabilities have gone up as well, principally as a result of the passage of time bringing the remaining pension payments closer to the present day.
However, the crisis did not just create a one-time adjustment in values and funding levels. The investment alternatives for plans look different now than they did a few years ago. This is partly because they have changed and partly because we have learned lessons, or sometimes relearned them, about risks and returns from individual asset classes and about overall asset-liability management.
This paper reviews the various changes affecting public pension plans and draws some conclusions for their future . The key changes are in the following areas:
- Lower asset values
- Higher pension liabilities
- Widening pension deficits
- Higher perceived risks on investments
- Larger risk premiums available on investments
Lower asset values
Public pension plans, like private ones, lost a substantial part of their value during the financial crisis. It appears that the public plans in the aggregate suffered investment losses of about 25% of total assets from September 2007 through March 2009. A large chunk of these losses were erased by the rebound in the markets since March 2009, but the net losses were still equal to about 15% of September 2007 assets as of the latest reported figures, which are for September 2009 . Financial markets have recovered somewhat further since then, but the dramatic gains in the rebound were already in place by September of last year, so these figures are reasonable rough estimates of the effects of the financial crisis.
The situation is even worse than those figures show on the surface, because pension funds are essentially walking on a treadmill. They need to earn an expected return each year in order to stay standing in place, since the value in today’s dollars of the pensions they have promised to pay goes up each year as those payouts come closer in time. The situation is analogous to inflation. The public pension funds may have lost 15% over two years on a “nominal” basis, but, if their target return was 8% a year , they lost 31% compared to their targeted level of investment value, excluding the effects of contributions and pension payments.