State Pensions’ Funded Status Jumped in 2021

While state pensions reached their highest funded status in six years, market volatility and declining markets signal potential difficulty ahead.

State pension funds’ funded status was strong at the end of 2021, but there could be challenges ahead, according to Wilshire. Despite their funded status in 2021 achieving a one-year growth rate not seen since 1990, for plan sponsors, market declines and volatility in 2022 will challenge state retirement systems to maintain those levels. 

U.S. state pension systems’ aggregate funded ratio reached 83.3% in fiscal year 2021, a 13.3  percentage point increase from the prior year, Wilshire research shows. The report, “2022 Report on State Retirement Systems: Funding Levels and Asset Allocations,” reviewed the aggregate funded status and asset allocations for more than 100 U.S. state-sponsored defined benefit retirement systems.

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Ned McGuire, managing director of asset allocation at Wilshire, says that the 13.3 percentage point increase, from 70%, is the highest year-over-year increase since the company started compiling state funding ratio data in 1990. State pension plans’ aggregate funded status increased from 67.4% in 2016 to 70.5% in 2017, 71.9% in 2018, and 72.7% in 2019, before dropping slightly to 70.0% in 2020. 

“[S]tate pension plans are much better funded than they were five or six years ago,” McGuire says. “In aggregate, that means that required contributions may decrease, but it all depends on a plan-by-plan basis how much potential decrease in future contributions there will be to the plan over the next several years.”

Wilshire and McGuire note that for the research, data was collected during Q1 of each calendar year to include the maximum number of reports possible with a June 30 valuation date from the previous year. 

Despite the improvements in 2021, state retirement systems’ approximate funded ratios have “actually slipped [in 2022] by 1.9 percentage points, to 81.4% from 83.3%, and that’s largely due to the global fluctuations in equity values that we’ve experienced in the first quarter of this year,” McGuire adds. The research also pins the decrease on inflation, interest rate hikes by the Federal Reserve, and geopolitical risks from the Russian war on Ukraine.  

McGuire adds that state pension plans’ Sisyphean task is exacerbated by volatile markets. To remain viable for beneficiary payouts, a pension must match its capital market return expectations.  

“If you look at capital market expectations across industries, they are fairly muted at this point, and being able to garner the capital market return versus what you’re assuming over the next several years could be challenging,” he says. “We’ve seen this challenge obviously in the near term, given the steep decline in equity markets year to date.”

Wilshire reports that in 2021, 30.8% of state pension plan assets were allocated to U.S. equities; 22.6% to fixed income; 16.8% to non-U.S. equity; 14.2% to real assets; 9.6 % to private equity; and 6% to “other” asset classes, such as hedge funds and commodities. Wilshire estimates that state pension funds’ aggregate assets increased to $3.96 trillion as of fiscal year-end 2021, up more than 21% from $3.25 trillion as of 2020.

“Significant positive investment returns and contributions drove asset values to record levels for the third consecutive year and the fifth consecutive annual increase,” the report states.

Wilshire also found that contributions increased the asset value by 5% for the year, with nearly 30% coming from plan participants; investment income increased the asset value by more than 27.6% for the year, in the largest percent increase on record; benefit payments are estimated to have decreased asset values by 8.1%; and other items are estimated to have decreased asset values by 2.9%.

State pensions hold retirement assets for about 29 million U.S. workers who have been promised retirement benefits. More than half of the benefits are dependent on earnings from the nearly $4 trillion of assets held by the systems, explains a Pew Research Center brief by Susan Banta, project director for public sector retirement systems.

Despite state pensions funds’ funded status improving, storms may be on the horizon, because more than two-thirds of those assets are allocated to risky investments, she contends.

“Despite this recent rally, pension fund returns have declined fairly steadily this century, and a combination of trends suggests that will continue,” Banta writes. “With stock valuations well above historical averages and the Congressional Budget Office projecting that real gross domestic product growth—a major driver of equity returns—will be lower in coming years than in fiscal year 2021, future returns are likely to drop as stock prices adjust. Additionally, interest rates have hit all-time lows, diminishing expectations for returns on fixed-income investments, such as bonds.”

The Pew report, “State Public Pension Fund Returns Expected to Decline,” finds that in 2019, state pensions allocated 47% of assets to equities, 27% to alternatives and 26% to fixed income and cash; in 1999, 53% was allocated to equities, 18% to alternatives and 29% fixed income and cash.

“With more than two-thirds of those assets allocated to risky investments—publicly traded stocks, also known as equities, and alternative vehicles, including private equity, real estate and hedge funds—retirement systems’ ability to meet their commitments hinges largely on investments that are subject to stock market swings,” Banta writes. 

From 1990 onward, in fact, the total allocations from public pension funds to “risky” assets—as termed by Banta—has accounted for between 70% and 75% of investments. “After shifting away from relatively safe bonds toward comparatively risky stocks from the 1950s to the 1990s, pension funds have turned more and more over the past 15 years to alternative assets to diversify their portfolios and achieve return targets,” she explains. “Investments in these vehicles have doubled since 2006, and in 2019 made up about a quarter of total assets.”

Market volatility highlights the importance of managing pension plan risks and setting realistic return targets, Banta adds.

“Driven by the start of the COVID-19 pandemic, the S&P 500 index fell 34% in February and March of 2020, and pension asset values also plummeted,” she explains. “But by mid-2021 markets were soaring, yielding a two-year 2020-21 fiscal return of 21%. In fiscal 2021, state pension funds saw historic median returns of more than 25%.”

However, Banta cautions against expecting annual returns near 25%. Public pension funds assumed average returns of 6.99% in 2021, according to data reported by the National Association of State Retirement Administrators in March.