Pension plans remained severely underfunded during the 11-year bull market that followed the Great Recession. The slide into insolvency and high-yielding markets has led fund managers to take risky bets in hopes of staying afloat. Now, the recent liquidation has left the funds struggling to meet their future obligations.
The 100 largest public pension funds in the United States had been funded at just 78.6% of their total obligations at the end of the second quarter, compared to 85.5% at the end of 2021 according to analysis by Milliman, a actuarial and consulting firm. The funds lost $220 billion between March and April alone as Russia’s invasion of Ukraine rattled markets.
Public pensions are borrowing increasing amounts to meet their payment obligations. Nearly $13 billion in pension bonds were sold in 2021, more than in the past five years combined. Now they are taking more risk by investing that leveraged money.
The California Public Employees’ Retirement System (CalPERS), which operates the largest public pension fund in the United States, with about $440 billion in assets under management, began leveraging some of its debt this this month.
“We need all the arrows in the quiver we can get, and private debt is one of the most critical,” said Dan Welcome, deputy chief investment officer of CalPERS. “There is no choice without risk.”
The Teacher Retirement System of Texas, the nation’s fifth-largest public pension fund, has also been using leveraged funds since 2019.
Leverage can help multiply market gains in bull markets, but it can also increase losses during down periods.
While the majority of pensions still do not use borrowed funds, there has been a sharp increase over the past four years. Prior to 2018, none of the largest funds used leverage.
At the same time, funds began to acquire riskier assets during the bull run and low rate environment to compensate for some insolvency.
Instead of increasing fees or costs to compensate for a funding shortfall, pension plan managers have chosen to increase their target annual growth rate and engage in riskier investment behavior to achieve it. In many states, if funds end up failing because of this strategy, the burden of meeting payment requirements will fall on taxpayers, according to research by the Boston Federal Reserve.
Analysts say pension funds now operate more like hedge funds and operate on risky bases. It is also generally the most financially distressed funds that take these trades.
“Risk-taking behavior is most pronounced among funds whose sponsors have the least capacity to bear additional risk,” the Fed said.
Some funds, like the Houston Firefighters Relief and Retirement Fund, have started investing in cryptocurrency, according to a Reuters report. A lack of transparency makes it difficult to assess the amount of money lost in the crypto crash this spring. The funds don’t release second quarter returns until later in the summer.
As interest rates rise and market stability declines, these repos could face more challenges.
Of the approximately $4 trillion in assets managed by public pension funds in the United States, more than two-thirds are allocated to risky investments like stocks and alternative vehicles, including private equity, real estate and hedge funds, according to Pew research. This means that the ability of pension systems to honor their commitments is subject to stock market fluctuations.
“It’s like the gambler who is on a losing streak but continues to bet in hopes of making up some of the losses,” wrote Merrill Matthews, a research fellow at the conservative-leaning Institute for Policy Innovation, ” If most public pension funds were already underfunded last year, what does that mean today when the market has been down for six months?
But some researchers say the crisis seems bigger than it is. The pension funding gap is “often a huge and frightening number,” said Louise Sheiner, director of policy at the Hutchins Center on Fiscal and Monetary Policy. But “for most (certainly not all) plans, there is no impending crisis in the sense that the plans are likely to exhaust their assets within the next two decades.”