According to a recent Barron’s article written by Thomas Donlon, there are 23 U.S. States whose inflation-adjusted revenues remain below pre-recession levels.  This is shocking to me given that we are in year eight of the “recovery”. Unfortunately, there also remain 18 U.S. States that have lower employment levels than they had in 2007, further stressing state budgets, as tax revenue declines.

This unfortunate combination of lower revenue and weaker economic growth will make funding public DB plans even more challenging than it already has been.  Contribution costs continue to escalate for many public pension systems despite the 8-year recovery in equity markets and the use of a discount rate that averages 7.6%.

Given current valuation levels for both bonds and stocks, it is unlikely that we can expect outsized gains from the capital markets.  Furthermore, given the pressure on state budgets, it is unlikely that our public pension system will be cured of its underfunding by just allocating more of the state budget to the problem through contributions. We have seen most, if not all, state plans address their troubled systems with changes to contribution rates for employees, new tiered benefits, longer required retirement ages, elimination of COLAs, etc., and in many cases, funding levels continued to deteriorate.

As we’ve frequently said, these plans are much too important to the individual participants and their local economies to subject them to undue risk. Pursuing the ROA in this market environment is adding considerable risk to the traditional asset allocation process.  At KCS we espouse a much different approach: one designed to stabilize both contribution costs and the funded status.  Once those objectives have been met, a plan can begin to de-risk.

I don’t believe that most public pension systems can survive another 2000-2002 or 2007-2009 equity market decline, especially if is accompanied by declining U.S. interest rates.  Putting in place a lower risk investment structure and asset allocation will reduce the risk of such an occurrence.  DB plans need to get a better handle on their plan’s liabilities.  With this greater knowledge, more informed asset allocation decisions can be taken.  We are ready to assist you.