A record-setting run for U.S. stocks and an expanding economy aren’t solving one of the biggest challenges facing cities and states -- how to pay for retiree benefits.
This week’s move by California Public Employees’ Retirement System, the nation’s largest, to scrap a decade-long bet on hedge funds underscored that there’s no magic bullet to dealing with mounting costs. Halfway across the country, the plan for Texas counties is devoting more pension assets to hedge funds to boost returns. In New Jersey, Governor Chris Christie put off pension contributions to avert budget cuts.
While there are pockets of success, state plans last year had 75 percent of what they needed to meet retirement obligations, according to Wilshire Consulting. Nationwide, states and localities faced a funding gap of about $1.4 trillion as of March as officials struggle to make up for recession-era investment losses and years of shortchanging their pension plans, Federal Reserve data show.
“This is not a problem that you can fix very rapidly,” said Chris Mier, chief municipal market strategist for Loop Capital Markets, a Chicago bond underwriter. “The more severe the problem is, the more resources you have to throw at it.”
The $298 billion California plan, known as Calpers, said Sept. 15 that it would eliminate its $4 billion allocation to hedge funds. The Sacramento-based fund said the investment vehicles were too complex, costly and small to affect performance. It began the strategy in 2002.
The decision cut against a growing push among public pensions to pump money into alternative assets such as hedge funds and private equity. With the Fed keeping its benchmark overnight rate near zero since 2008, riskier investments are luring pensions, which typically need to earn more than 7 percent yearly to avoid falling behind.
The approach to financing pension promises helps dictate municipalities’ standing on Wall Street and how much money officials have to devote to services and infrastructure.
New Jersey this month suffered its eighth bond-rating cut since Christie took office in 2010. The second-term Republican backed out of a pledge this year to make $2.5 billion in extra pension payments after tax collections fell short of forecasts.
Only Illinois, led by Democratic Governor Pat Quinn, has lower ratings than New Jersey among U.S. states. Illinois also has the biggest pension shortfall of the group.
“Those that take action will have a bit better rating profile, all things equal, and those that don’t are going to be penalized,” said Peter Hayes, head of munis at New York-based BlackRock Inc. The world’s biggest money manager oversees $122 billion of state and local securities.
“Penalties mean lower ratings and higher borrowing costs,” Hayes said.
States and cities have been working to lower retirement costs since the recession ended in 2009 by cutting benefits and shifting new employees into less costly defined-contribution plans, as typically offered by businesses. Illinois has moved to reduce cost-of-living adjustments and raise the retirement age, steps that workers are challenging in court.
Alternative investments can lift returns or protect against setbacks should stocks or bonds stumble. The Standard & Poor’s 500 index set a record high this month and is on pace to gain a third straight year.
The Texas County & District Retirement System by the end of 2013 had $5.7 billion, or 25 percent of assets, in hedge funds, which delivered annual returns of 10.5 percent a year in the previous five years, according to its 2013 annual financial report. The plan was 89 percent funded as of year-end.
In Rhode Island, where the state in 2011 took steps such as raising the retirement age for workers and suspending cost-of- living increases, the system has put $1.2 billion, or 14 percent of its money, into hedge funds.
Andrew Roos, chief of staff for Treasurer Gina Raimondo, said the approach protects against volatility in financial markets and has generated annualized returns of 9 percent for the past three years.
“This strategy is working,” he said.
While the legacy of the financial crisis is still resonating around the country, some pensions have recovered.
In New York, Comptroller Thomas DiNapoli this month said local-government contributions to the state system are set to drop for a second straight year, with the state’s plan 92 percent funded.
Nationwide, the expense is rising: State and local governments put $95 billion into the 100 largest pension funds last year, up $23 billion from 2009, according to Census figures.
In Chicago, where retirement funds have just 37 percent of assets needed, taxpayer contributions to the plans are set to more than double to $1.1 billion next year, according to a report from the city.
Hayes at BlackRock said investors will reward states and cities that are tackling the challenge, while demanding higher interest-rates to lend to those who don’t.
“The not-dealing-with-it aspect is key,” he said.