US Retirement Systems ‘More Vulnerable Than Ever’

Despite rising funded levels, US public retirement systems are “more vulnerable than ever” to the next economic downturn, according to a report from The Pew Charitable Trusts.

In preparation for the next time the economy heads south, and to strengthen their long-term financial health, several states have undertaken stress test reporting, the report said. Pew said the practice “can show policymakers how adverse economic scenarios could affect retirement system investments and state budgets.”

Pew said eight states—California, Colorado, Connecticut, Hawaii, New Jersey, Vermont, Virginia, and Washington—now require their public pension systems to analyze the impact of downturns on pension costs and liabilities, financial market volatility, and contributions. Pew also said that stress testing allows states to account for the condition of their economy and tax collections, and offer a broad view of how pensions impact their overall fiscal health.

“The ability to consider the impact of a range of economic conditions on pension balance sheets and government budgets helps policymakers evaluate whether current policies are sufficient to withstand the impact of the next recession,” said the report. “Over the past decade, many state officials learned that overly optimistic investment return assumptions caused gaps in pension funding that had to be covered by increasing contributions and reducing benefits, often several times.”

For more stories like this, sign up for the CIO Alert newsletter. 

Pew said the testing provides the information needed to evaluate policies and adjust investment assumptions over time, which can help ensure retirement plans are affordable and fully funded during various economic scenarios.

For example, Pew said its analysis of plans in New Jersey and Colorado found that without “significant policy intervention,” the pension systems in both states risk insolvency if a recession hits, and investment returns are lower than expected over an extended period.

The report said that since the Great Recession of 2007 to 2009, state tax revenues have been slower to rebound than after the three previous downturns, and that revenues have been more volatile than in the past. It also said the gap between retirement fund assets and liabilities had grown each year from fiscal year 2000 through 2016, despite increased pension contributions, benefit cuts, and stock market gains.

Pew also found that although most state pension systems have lowered their assumed rates of return, the level of portfolio risk that states are taking on to meet their investment targets “has never been higher.”

It said the median return assumption in fiscal 2016 was 7.5% for public pension plans, despite the fact many analysts expect investment performance to be a full percentage point lower, with a one in four chance that returns may not top 5% over the next 20 years.

“Against this backdrop, more states are looking at stress testing to give policymakers a better sense of potential funding scenarios,” said the report.

Tags: Economic Downturn, Pension, PEW Charitable Trusts

Ever since Congress included a 1.4% excise tax on certain university endowments as part of the Tax Cuts and Jobs Act of 2017, colleges and universities that are potentially affected by the new tax have been lobbying for its removal.

In March, 49 college and university presidents wrote a letter to leaders of Congress, urging them to repeal the endowment tax, saying that it will impose an “unprecedented and damaging tax” on the charitable resources of American colleges and universities.

And the lobby efforts seem to be making some headway. Representatives John Delaney (D-MD) and Bradley Byrne (R-AL), introduced a bill in March to repeal the excise tax. And earlier this month, Rep. Tom Reed (R-NY) introduced a bill that would eliminate the tax for endowments that spend 25% of their annual investment earnings on reducing the cost of tuition for middle-income students.

But until those bills make their way to becoming law, colleges and universities with at least 500 students, and assets of more than $500,000 per student still have to deal with the 1.4% excise tax on net endowment income. However, “there are three things that we think an endowment can do to minimize the tax,” Kane Brenan, global head and co-CIO of Goldman Sachs Asset Management’s Global Portfolio Solutions (GPS) group, told CIO.

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

From a legislative standpoint, Kane said an endowment can continue to lobby Congress to change or minimize the tax, as any trade organization might do when certain legislation has a negative effect on its industry. Second, on the operational and administrative side, universities can run their school in such a way that it doesn’t fall within the excise tax’s parameters.

“It’s still vague in terms of how they’re defining the number of students,” Carolyn Tavares, vice president, global portfolio solutions, told CIO. “There is still some ambiguity which the IRS has yet to clarify.”

This ambiguity could allow universities some wiggle room when it comes to determining whether their enrollment or assets per student exceeds the threshold that would cause the excise tax to kick in. For example, colleges with enrollments near the limit may reduce their enrollment to less than 500, or change the way they measure it to reduce the assets per student below $500,000.

And the third thing they can do, according to Goldman Sachs, is manage the endowment’s investments to minimize the impact of the tax. This includes basic tax planning strategies, which was not relevant to endowments before the new tax law, such as offsetting gains with losses, and “all the typical things a tax-aware person can do,” said Kane.

And although Kane and Tavares said they were adamant that endowments should not materially change their portfolio to minimize the tax, they had four suggestions for endowments to help minimize the tax on the investment side:

Use incoming contributions to meet spending needs first. Build up a cash pool throughout the year funded by contributions to meet near-term spending to avoid realizing capital gains.
Instruct managers not to reinvest dividends and interest. Because they will be taxed regardless, leaving dividends and interest in cash allows it to be used to meet spending needs and any tax liability.
Offset realized gains with losses. If assets need to be sold, endowments should sell those with tax losses first. One possible strategy is to use a passive manager in a separate account that offsets gains taken in the total portfolio with losses in individual securities from the index account.
Invest more passively. Active managers tend to generate capital gains and trade more frequently than passive managers. And those with price targets that sell when those targets are reached are selling gain securities and holding loss securities, which is the opposite of standard tax management.

Tags: Endowments, Goldman Sachs, Tax