January 21, 2016 / 10:01 PM / in 3 years

U.S. public pensions may need to hike contribution rates as markets tumble

NEW YORK, Jan 21 (Reuters) - The erosion of assets at U.S. public pension funds since last summer is raising concerns state and local governments will have to increase their contributions to the funds to make up for shortfalls, leaving less for public services.

U.S. public pension funds count on returns of 7 percent to 8 percent a year to meet their liabilities, an ambitious target in a low interest rate environment.

“The contributions have gone up very substantially and we are headed toward them going up more again, creating really politically difficult choices,” said Donald Boyd, a state and local government expert at the Nelson A. Rockefeller Institute in Albany.

Two heavy bouts of selling in the last six months have hit assets. State and local pension funds saw their unfunded liabilities jump by $268 billion to a staggering $1.7 trillion from June to September, according to the latest data from the Federal Reserve. That unfunded liability amounts to 9.5 percent of the U.S. economy, according to Boyd.

Pension funds would have made some, but not all, of that back when markets rallied in the last quarter of 2015. Now, with the S&P 500 down nearly 8 percent this year, those funds could end the first quarter lower than they were in September.

Government employers will have to amortize those losses, paying them down over the life of the fund, potentially pushing up the amount they have to pay into the pension funds.

Contribution rates have been edging lower since they skyrocketed after the financial crisis. Any reversal of that trend would be a blow for local finances.

The Employees Retirement System, the largest fund in the overall New York State retirement fund, saw contributions leap from under 1 percent of payroll in 2000 to 20.1 percent in 2014. The current rate is 15.5 percent.

“It’s a big and continuing long-term problem that puts more strain on state and local government finances,” said Boyd.

The hit to pension funds is just one channel where market volatility can hurt local government budgets. A collapse in oil prices is already creating a headache for U.S. oil producing states and stock market losses cause havoc in states that rely heavily on capital gains tax revenues.

Pension fund administrators like to see themselves as above the fray when it comes to market volatility, pointing to their long-term horizons and diversified portfolios.

“We don’t let short-term trends in the market dictate our strategy. However, we do make tactical course adjustments when the markets are less than stable and we are undertaking such action. I cannot get into the details of those actions,” said California State Teachers’ Retirement System spokesman, Ricardo Duran.

But the sheer size of pension funds’ asset base - $4 trillion, according to the Federal Reserve - means that swings in the unfunded liabilities generated by market volatility are huge compared to the fixed tax bases that support the funds.

In a quest for higher returns in a zero interest rate environment, money managers moved out of fixed-income toward equity and other risky assets. Hedge fund, private equity fund and real estate investing has left the pensions more exposed to market gyrations. More than 70 percent of their assets are in equities and other higher-risk investments, according to Toronto-based research firm CEM Benchmarking.

Most funds do not publish quarterly data, but New York’s Common Retirement Fund does, giving a small window into losses suffered across the sector. By the end of September the fund lost $11 billion, bringing its asset base to $173.5 billion after including the $5 billion paid out in benefits.

Because pension funds are long-term investors they smooth returns over a five-year period. That means a few bad quarters will not necessarily translate into high contribution rates. But sustained weakness and slow recovery will. They can also amortize losses over 30 years, reducing the short-term impact to budgets.

“In terms of how volatility affects contributions from governments it’s really slow moving,” said Jean-Pierre Aubry, a pension expert at the Center for Retirement Research at Boston College. “Volatility is fine as long as it goes both ways.” (Reporting by Edward Krudy in New York; Additional reporting Rory Carroll in San Francisco; Editing by Daniel Bases and Tom Brown)

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