Over the 20-year period ending 1999, the S&P 500 returned almost 18% per year. Long-term government bonds also experienced a long bull market, returning almost 11% per year. Thanks to the two-decade-long rally in stocks and bonds, and the strong economy, state pension plans were in great shape—on average, they were fully funded. Unfortunately, the succeeding period has not been as kind.
Cliffwater LLC recently released its annual report, “An Examination of State Pension Performance.” The report covers the 18-year period ending June 2018. Due to overestimating future expected returns (perhaps relying on historical returns instead of using current valuations, which were at historic highs), underfunding of known liabilities, two bear markets and the slow recovery from the great financial crisis, the funding ratio had fallen from 100% to an average of just 73%.
Cliffwater also found that the asset-weighted actuarial interest rate (the expected return on the portfolio) used by state plans was 7.75%. The actual return earned over the period was just 5.87%, a gap of almost 2%. Note that even the highest return earned, 7.34%, was below the actuarial interest rate. On the other hand, the lowest rate of return was just 3.60%, more than 4% below the actuarial rate.
Given that the global CAPE 10 stood at 23.4 at the end of February 2018, the real expected returns to global stocks is estimated to be about 4.3%. Adding expected inflation results in an expected nominal return to stocks of about 6.5%. And with yields on U.S. intermediate- to long-term bonds of about 2.5-3%, it’s hard to see how state plans can justify using an actuarial return of 7.75%. Doing so increases the risk that plans will become even more underfunded over time. Note that for European pension plans, accounting standards would prohibit such aggressive return assumptions.
There was another interesting finding from Cliffwater’s report. “Allocations to alternatives increased dramatically soon after the 2008 Financial Crisis, rising from 10% of total assets in 2006 to 21% in 2011, and thereafter steadily increased to 30% of total assets at June 30, 2018. Most of the increase in alternatives had come from public equities, which fell from 61% in 2006 to 47% in 2017.”
The alternatives receiving increased allocations included private equity (which more than doubled, from 4.1% in 2006 to 9.4% in 2018), private debt, real assets (making up about 5% of assets and including substrategies such as commodities, energy, mining, infrastructure and agriculture), real estate (which grew from 4.4% in 2006 to 6.7% in 2018) and hedge funds (which grew from just 0.3% in 2006 to 3.2% in 2018).
Unfortunately, the increased allocations to alternatives did not help improve returns. While private equity provided slightly higher returns than U.S. stocks over the last 10 years covered (10.1% versus 10.0%), real estate returned 5.3%, and absolute return funds (hedge funds) returned just 3.3%. One reason for their failure is that they typically come with high fees.
Risks To Municipal Bond Investors
The risks to state budgets have become so great in some cases that there are now seven states for which my firm, Buckingham Strategic Wealth, will not buy even their general obligation bonds. The reasons are very low funding ratios and very high adjusted net liabilities. Illinois was in the worst shape by far with, according to Moody’s, adjusted net liabilities to state revenues of more than 600%—an all-time high for any state.
Unfortunately, municipal bond investors are not the only ones facing increased risks. Individuals depending on pension benefits from these states, and perhaps others, are at risk, as it seems unlikely these plans can meet all their obligations. Either states will default on their obligations or investors will face defaults on their investments. Forewarned is forearmed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.