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Confronted with diminishing contributions from government sponsors, public pensions must balance their pursuit of yield with their need for liquidity
July 2020, Boston—Public pensions’ experience in prior market downturns lends some insight into what can be expected following the COVID-19 fallout, according the latest Cerulli Edge—U.S. Institutional Edition. It is likely that public pensions will face hurdles similar to those seen in the previous two recessions—the early 2000s recession and the 2008 global financial crisis—both of which resulted in a decrease in funded status for pension plans, and a corresponding strain on sponsoring governments.
The prior two recessions brought about an increase in public plans’ unfunded actuarial liabilities, causing funded statuses for public plans to diminish in the years following each recession. The primary drivers of a public plan’s funded status are its investment returns and employer (government) contributions. In the absence of investment returns, plan sponsors (or government sponsors) must boost contributions. “The problem with a recession is that a government’s ability to raise revenue via taxes is impaired just as the pension requires additional contributions,” says James Tamposi, senior analyst at Cerulli. “During the 2002 and 2008 recessions, state governments were not able to collect nearly as much revenue because taxable income evaporated.”
The impending shortfall of government contributions will result in an increased dependency on investment returns. Combined with the Federal Reserve’s rate cut, many plan sponsors will consider alternative sources of yield. A survey conducted by Preqin found that 63% of investors intend to maintain course, while 29% plan to increase allocations to alternatives in the long term. Within the alternatives space, investors are wary of certain sub-asset classes that are prone to the COVID-19 fallout, such as retail-focused private market real estate. Other sectors, such as private equity healthcare, will be closely monitored. Infrastructure funds, which may offer higher yields, are expected to attract attention as well.
Private equity managers stand to benefit in the long term, but accelerated asset gathering may not happen in the immediate future. Asked about the near term, most investors (59%) state that they plan to reduce the number of commitments they make this year. As markets remain volatile and uncertainty rampant, these investors are hesitant to lock up capital. “With government contributions expected to decline, pensions will lose one source of liquidity,” Tamposi adds. “Many, particularly smaller pensions, will need to make up for this lack of liquidity somewhere else, perhaps by holding more cash or short-term securities,” he concludes.
NOTES TO EDITORS:
These findings and more are from The Cerulli Edge—U.S. Institutional Edition, 3Q 2020 issue.
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