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Feb. 27, 2021, 9:04 a.m. EST

With lower returns on the horizon, public pensions will turn to riskier assets, Moody’s says

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Andrea Riquier

State and local government pension systems are increasingly dependent on investment returns, and at risk of increasingly volatile results, as funding levels remain depressed and systems increasingly start to pay out more than they take in, according to a new report from Moody’s.

The credit-ratings agency anticipates higher volatility and lower returns across asset classes in 2021 compared to 2020, even as many pension sponsors have spent the past few years lowering their assumed returns from previous loftier targets that they rarely hit.

“With persistently low interest rates for high-grade fixed-income securities, public pension systems continue to rely on highly volatile equities and alternatives to meet return targets, posing a material credit risk for some governments,” the Moody’s analysts wrote.

They call exposure to equities and alternatives “generally heavy across state and local government pension systems,” but note that individual systems vary greatly.

“Despite their gradually falling return targets, most public pension systems’ long-term return expectations still remain far above prevailing market interest rates,” Moody’s adds.

That means that systems using more conservative metrics may still be at risk. Meanwhile, those that continue to rely on much more aggressive return assumptions “are even more susceptible to higher-than-assumed future pension costs if return performance above market interest rates does not materialize.”

Moody’s mentions the Kansas Public Employees’ Retirement System, which is counting on a 7.75% rate of return, and the Ohio Police and Fire Retirement System, which assumes 8%.

While interest rates /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.51% have spiked in recent weeks, they remain historically very low, Moody’s points out, and notes that their own calculations show “relatively high risk is required to generate returns of around 7%.”

“The asset classes carrying return expectations above 7%, such as emerging market equities and private equity, also carry the highest risk,” meaning volatility risk is at historically high levels.

What exactly does volatility risk mean in practice? Moody’s gives two examples, both illustrated by the Teacher Retirement System of Texas. If the system hits its 7.25% return target in 2021, participating governments would have to contribute 11% of their payroll to “tread water” – keep the funded level steady. But if the system lost about that amount, returning -7.5%, local governments would have to kick in 14%. But participating governments are on track to contribute only 8.57% of payroll.

Investment volatility also keeps assets from growing over time. If Texas Teachers hits its 7.25% target annually over the next decade, assets would reach about $275 billion, Moody’s reckons. But if the system were to hit its 7.25% investment return target on a compound average annual basis, but with greater than 14% volatility, its assets would amount to just $257 billion by August 2031.

Read next: Chuck Reed warned of city services ‘insolvency’ after the Great Recession. He thinks the corona-crisis may be worse.

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