Public and Private Pension Plans Face Funding Gap

By Randy Myers

Each year, researchers at investment consulting firm Wilshire Associates study the health of the nation’s largest public and private pension plans. Lately, their findings have been discouraging.

“It’s not great,” Wilshire managing director James Neill told participants at the 2010 SVIA Fall Forum. “At the end of the last decade, things were in pretty good shape; the average plan was more than 90 percent funded. Unfortunately, we’ve had two pretty substantial downturns in the financial markets since then, and that has resulted in a sharp reduction in funded ratios.”

Based on its extrapolation of available public plan data, Wilshire Associates estimates that the median funding ratio for state pension plans–the market value of plan assets divided by plan liabilities–was just 65 percent at the close of the fiscal year ended June 2009. It estimates that the median funding ratio for city and county plans stood at 74 percent. Corporate plans are doing slightly better. Wilshire tracks 308 of them at companies in the Standard & Poor’s 500 index, and through mid-2009, Neill said, the funding ratio for the median plan in that group was 79 percent. Corporate plans are in better shape, he said, partly because many companies have frozen their plans, meaning they are no longer accruing benefits for some or all of their employees. On the downside, declining short-term interest rates have, for accounting purposes, increased the value of corporate-plan liabilities by about 15 percent to 18 percent over the past decade.

In total, Neill said, the 308 private and 229 public plans that Wilshire tracks were underfunded to the tune of $1.5 trillion as of June 30, 2009.

There is, he said, some reason to hope for a brighter future, especially for private plans. They are discounting the value of their liabilities by about 6 percent right now, Neill noted, but Wilshire forecasts that their plans will earn 6.5 percent over the next 10 years. If that spread holds, their funded conditions will improve in the decade ahead.

The outlook for public plans isn’t as cheery. Based on Wilshire’s analysis, Neil explained, none of the city or county plans in its database should earn more than the discount rate they are using for their liabilities in the decade ahead.

Little change in investment strategies While seriously underfunded, pension plans have been making only modest changes to their investment portfolios, Neill said. Their most notable decision, he said, has been to reduce their exposure to U.S. equities while allocating more to international equities, real estate, private equity funds, and hedge funds. Wilshire expects that trend to continue over the next few years, he said, although corporate plans are likely to boost their allocations to fixed income investments, too, once interest rates start to rise.

Neill predicted that public plans will be challenged to make up their funding deficits simply through better investment returns. The only other options for paring their funding deficits, he said, are to increase their contributions to their plans or reduce future benefits. Those are steps corporate plans are already taking, he said, and two things “that public plans need to focus on.”

Neill noted that the Pennsylvania House of Representatives did recently pass a pension bill aimed at reducing their funding deficit by $16 billion over the next 20 years, largely by reducing future benefits. But, he said, contributions may have to be bumped up too.

Given their predicament, Neill predicted that states will eventually follow the lead of their corporate counterparts again by starting to make greater use of defined contribution retirement plans rather than defined benefit plans.

“I think these conversations are happening pretty broadly across America,” Neill said in summary. “Hard decisions will have to be made.”