Public pension funds in an era of low rates and COVID-19 

What is the most prudent strategy for state and local governments confronting low returns on pension investments, aging workforces, and pressure to build portfolios large enough to cover promised future benefits at the same time that these governments face other pressing demands?  

Presentations at the 2020 Municipal Finance Conference provide contrasting answers to this question. 

Louise Sheiner and Finn Schuele of the Hutchins Center at Brookings with co-authors Byron Lutz of the Federal Reserve Board and Jamie Lenney of the Bank of England argued at last year’s conference that, in aggregate, state and local government pension liabilities can be stabilized as a share of the economy with relatively moderate fiscal adjustments. Accordingly, they concluded there is no imminent crisis for most pension funds. 

At this year’s conference, these authors extend their work in two directions in light of the COVID-19 pandemic. First, they examine the impact of the change in the economic landscape—e.g. lower interest rates—on pension sustainability. Second, given the severe fiscal distress most state and local governments currently face, they examine the extent of the deterioration in pension sustainability that would be caused by forgoing pension contributions in the near-term to avoid even deeper cuts to core services. 

Robert Costrell and Josh McGee from the University of Arkansas challenge the Lenney, Lutz, Schuele, and Sheiner view in “Sins of the Past, Present and Future: Alternative Pension Funding Policies” They conclude that given uncertain investment returns, the prescription carries significant risk of pension fund insolvency. “Perpetually rolling over pension debt leaves plans in a precarious financial position and substantially increases the chance that they will run out of asset,” they say 

In traditional defined-benefit pension plans, the employer generally bears investment, inflation, and longevity risks. In defined-contribution plans, such as 401(k)s, the employee bears nearly all these risks. Facing increasing costs and risks in defined–benefit plans, some state and local governments have sought to share some of these risks with employees, during working years or retirement years or both. For instance, cost of living increases in South Dakota and Wisconsin depend partly on the pension funds’ investments; in Pennsylvania, employee contributions depend partly on investment performance. In “Public Pension Plan Risk-Sharing: Options and Consequences,” Don Boyd, Gang Chen, and Yimeng Yin of the Rockefeller College of Public Affairs and Policy at the University of Albany use simulation models to examine the impact of various risk-sharing options on workers, government employers, and pension plan funding. 

They conclude that contingent COLAs (cost of living adjustments) and other approaches currently being tried can “moderately reduce employer pension costs in the long-term,” especially at a time of low investment returns, but create “a significant benefit risk for retirees.”   

Editor’s Note:  

These papers were prepared for the 2020 Municipal Finance Conference on July 13 & 14, 2020. The conference is a collaboration of the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy, the Brandeis International Business School’s Rosenberg Institute of Public Finance, Washington University in St. Louis’s Olin Business School, and the University of Chicago’s Harris Institute of Public Policy. It aims to bring together academics, practitioners, issuers, and regulators to discuss recent research on municipal capital markets and state and local fiscal issues.