By: Ted Dabrowski and John Klingner
The stock market’s nearly 30 percent collapse will create significant problems for many of Illinois’ 665 state and local public pension funds.
Even before the recent market plunge, the funded ratios of many Illinois plans – including the five state-run plans – had collapsed to 40 percent and below, with several falling into the teens. Some, like the Chicago’s police pension plan, were so underfunded that their assets were equivalent to only four years of future pension payouts.
Now the drop in the stock market and the collapse in bond yields – if they are sustained – threaten the solvency of those plans. Many have little room to maneuver and can’t afford more losses. And with bond rates now below 1 percent, the funds will have a hard time making money if they play it safe. With limited ability to earn investment income, the risk of a liquidity crunch for Illinois’ struggling pension funds has jumped.
That’s the predicament many Illinois funds find themselves in, especially if the crisis becomes a full-fledged recession. We highlight the challenges Chicago’s police pension fund faces as an example below.
Illinois’ pension plans failed to benefit from the nation’s 11-year bull market, its longest ever. Shortfalls rose by the billions across the state, despite a tripling of the stock markets. Illinois’ five state-run pension funds alone saw their shortfall increase by $56 billion, or 72%, from 2009 to 2018. The city of Chicago’s shortfall jumped by more than $16 billion, or 130 percent over the same period. And downstate and suburban public safety pension shortfalls grew by nearly $5 billion, or 70 percent.
Those shortfalls have left many Illinois funds unprepared to weather what has quickly become one of the nastiest market drops in recent history.
Illinois’ unhealthy funds can be found at every level of government. The state legislators’ pension plan is just 15 percent funded. Chicago firefighter pensions are at 18 percent. East St. Louis’ public safety funds are also at 18 percent. The Chicago municipal workers fund is at 23 percent. Kankakee’s public safety funds are at 24 percent. And the fund for state employees is just 36 percent funded. Every one of them is already technically insolvent and trapped in a downward spiral – one that will accelerate if current market conditions persist for too long.
Chicago’s police fund has few options
One of those “trapped” plans is the Chicago Police Pension Fund. As of Dec. 2018, the latest full year of data available, the fund should have had $13.2 billion in assets on hand to ensure the retirement security of the city’s active and retired policemen. The fund pays out about $760 million in pension benefits to members each year.
Unfortunately, the plan had just $3.1 billion set aside, less than a quarter of the money it needed. That’s a $10 billion shortfall.
With so few assets, the fund can’t afford to make any investment mistakes. The $3.1 billion in assets is equivalent to only four years’ worth of pension benefit payouts.
Being underfunded to such an extent has put the Chicago police plan in a predicament – whether to grow assets by investing in riskier markets or to protect what little money the fund has left by playing it safe.
On the one hand, the police fund must grow what assets it has if it wants to get out of the hole it’s in. And that means investing in the stock market.
But that can lead to serious losses. In 2018, for example, the police fund ended with full-year investment losses of $128 million after the markets crashed in December, the result of its large equity holdings. The end result was a bigger hole for a fund already in deep trouble.
On the other hand, avoiding stock market risk comes with problems of its own. Rates on U.S. Treasury bonds have collapsed in recent years, meaning safe but meaningful investment returns have all but disappeared. The police fund invests a fifth of its assets in fixed income bonds, including Treasuries.
Pension funds nationwide used to rely on U.S. Treasuries to help reach their yearly investment targets. In the early 2000s, 10-year bonds paid as much as 6 percent annually and 30 years ago they paid more than 8 percent.
But recently, those 10-year bond rates have collapsed to record-low rates of 0.38 percent.
The collapse in both stocks and bond yields is a real problem considering the police fund still assumes it will make average annual returns of 7.25 percent over the next three decades.
The results of 2018 provide a good example of what happens when poorly-funded plans don’t achieve their assumed returns.
In 2018, the police fund received employer and employee contributions of $695 million, but lost $128 million on its investments. In all, the fund’s inflows totaled $568 million. But because the fund had to pay $784 million to its pensioners, the plan’s assets shrunk by more than $200 million that year.
For a well-funded plan, losing assets in one year is not a big deal. But for a plan that’s less than 25 percent funded, it makes insolvency all the more likely.
Nobody is certain about the duration of the market impact of the Coronavirus or the subsequent impact on Illinois’ pension plans. What’s clear, however, is that ordinary Illinoisans are on the hook for whatever the losses turn out to be. They’re the ones who’ll bear the cost of plunging returns on the pensions’ fixed income investments for as long as they persist, as well as any lasting damage the virus inflicts on stock valuations.
Read more about Illinois’ pension crisis:
- Chicagoans, pensioners: Beware a stock market shock
- Collapsing interest rates are devastating for Illinois’ troubled pensions
- US stock markets up 200%, yet Illinois pension hole deepens 75%
- Illinoisans overwhelmed by a ‘shadow mortgage’ of pension debts
- Illinois’ financial decay spreads to cities across the state
- Illinois state pensions: Overpromised, not underfunded
Cover image credit: Christoph Scholz