Moody’s says governments are in a worse position to smooth costs than during financial crises.

US public pension investment losses are approaching $1 trillion as a result of the stock market crash caused by the COVID-19 pandemic, which will “severely compound” the pension liability difficulties many governments are already dealing with, according to a report from Moody’s Investors Service. 

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Moody’s said US public pension systems are on pace to see investment losses of approximately 21% for the fiscal year ending June 30, adding that the recent volatility of the equity markets could lead to either a significant improvement of those returns in the coming months or a further decline.

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“Without a dramatic bounceback of investment markets,” the report said, “2020 pension investment losses will mark a significant turning point where the downside exposure of some state and local governments’ credit quality to pension risk comes to fruition because of already heightened liabilities and lower capacity to defer costs.”

Based on Moody’s estimates, the adjusted net pension liabilities (ANPLs) for public pensions are expected to surge by nearly 50% to a record high of $3.6 trillion for fiscal year 2020 from $2.4 trillion at the end of June. The firm derives its estimates from a representative sample of 56 large US public pension systems, which covers roughly half of all liabilities and assets.

“If governments’ revenue performance also deteriorates,” the report said, “pension affordability ratios will worsen significantly for some because of the combination of cost hikes and revenue stagnation or decline.”

To make matters worse, Moody’s said many governments have less capacity to “smooth” or defer pension cost hikes without “severe pension funding repercussions” than they did in the years following the financial crisis of 2007-2009.

“Significantly deferring costs to make up for 2020 investment losses would carry potentially severe long-term pension funding consequences for some governments,” the report said. “Many systems today have significantly negative non-investment cash flow relative to assets, attributable to their underfunded positions and rising benefit outflows due to rising numbers of retirees.”

Moody’s said the asset/benefit coverage, which indicates the rising risk of pension asset depletion without contribution increases, is lower for many US public pension systems than it was before the financial crisis.

The report compares a large US public pension system before the last recession with one today. It said participating governments in the system are currently contributing around 17% of payroll, compared to 12% in 2008. Despite the higher contribution rate, the system had more negative non-investment cash flow relative to its assets before any 2020 investment losses, and only slightly higher asset/benefit coverage compared to the 2007-2009 recession.

“If 2020 investment losses are as substantial as current market conditions suggest, the system’s asset/benefit coverage will fall to 6.8 years and its non-investment cash flow will fall below -6% of assets, both historic lows,” the report said. “Without increases to government contribution rates, we project that the system’s asset base is now on a far worse trajectory, and will continue to fall closer to insolvency.”

Moody’s said the ability to reduce government contributions is more difficult today than during the financial crisis because of the negative repercussions to the resulting condition of the pension system.

“Other options for governments facing rising pension affordability challenges and limited ability to increase revenues could include reductions to service levels, pension benefit cuts, or in the most severe cases, restructuring of long-term balance sheet liabilities through bankruptcy,” according to the report.

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