The Pew Charitable Trusts has evaluated how state public pension plans would perform if the economy enters a recession or their fund investments return less than expected.
This is the kind of stress test that the federal Dodd-Frank law requires for major financial firms. Pew looked at what would happen to pension funds if their investment return is 5 percent (instead of the median assumption of 7.5 percent) or if the fund lost 20 percent in a market downturn and had low returns for years afterward.
The 5 percent test delivered a shock. “The pension system for state workers in New Jersey is so underfunded that it could run out of money in 12 years,” Pew analysts wrote in a June 6 report. “Future retiree benefits would have to be paid out of the state budget and from increased employee contributions.”
With the U.S. economy growing strongly, such a scenario may seem unlikely. But in fact, the value of investments by U.S. public pension funds declined a quarter of a percent in the first three months this year. Over the past two decades, they have averaged a 6.5 percent return, according to Wilshire Trust Universe Comparison Service. Some analysts told Pew there is a 1-in-4 chance returns will be 5 percent or less over the next two decades.
Such a modest rate of return would devastate New Jersey finances, says Pew. Unfunded pension liabilities would rise to $101 billion from the current $56 billion, and once fund assets ran out by the end of 2029, the state budget contribution would jump from $5 billion to $7 billion the following year.
The good news is that New Jersey has pledged to take steps to reduce what Pew concludes is a “high risk of insolvency.”
In January, former Gov. Chris Christie signed a bill requiring comprehensive annual stress testing of the state’s five largest pension funds. New Jersey became one of seven states to require such testing, which Pew recommends to reveal vulnerabilities and help administrators and policymakers plan.
Last year, New Jersey also adopted a plan to increase pension contributions over the following five years (some of it from dedicated lottery sales revenue). Annual contributions are supposed to reach financially recommended levels by 2023.
Pew expects this will be a challenge. “New Jersey’s track record for making annual required contributions is weak — our research places it last among the 50 states in making actuarial required contributions since fiscal year 2000.”
New Jersey has only funded about 30 percent of its public pensions — the lowest level in the nation — so the most important indicator of its fiscal health in this month’s budget agreement and during the next few years will be how it addresses its pension shortfall.
State officials might look at some of the approaches taken by their peers in Wisconsin, where public pensions are fully funded and costs are controlled by better-designed plans.
Wisconsin’s “unique risk-managed defined benefit plan mitigates most of taxpayers’ exposure to market fluctuations,” Pew said. Public employees benefit more when investments outperform and their contributions adjust if costs are greater than expected. Investment performance determines the size of cost-of-living increases for retirees.
For the next 10 days or so, state officials and residents will be preoccupied with what new taxes and spending will be included in the budget agreement by the Legislature and governor.
But pay attention to the budget’s pension funding level. That and additional reforms to the pension system will do more than anything to determine the fiscal health of New Jersey government and its ability to deliver essential services.