Enron's Effect on U.S. Public Pension Funds

Publication date: 25-Feb-2002
Reprinted from RatingsDirect

Enron's Effect on U.S. Public Pension Funds

Analyst: Parry Young, New York (1) 212-438-2120; Steven J Murphy, New York (1) 212-438-2066

The Role of Public Pension Funds

Enron Was A Small Piece of the Pie

The recent bankruptcy of Enron Corp. has sent shock waves through many sectors of the nation's investment community including its public pension funds. The media have reported losses to public funds from Enron approximating $1.5 billion. While no small event in itself, to evaluate the real impact of Enron on public pension funds we need to take a step back and put it in perspective. By looking at the background of public funds, where they came from and where they are going, we can get a clearer picture. To accomplish this, we will review:

The objectives of public pension funds and the strategies for achieving such;
The progress retirement systems have made in improving funding levels; and
The relative asset positions of the funds.

The Role of Public Pension Funds

Public pension funds fulfill a very important role in the United States by providing for the retirement security of government workers. The vast majority of public funds are defined-benefit plans whose main goal is to provide a specific level of retirement benefits to their 13 million members, which include general government employees, teachers, police, and firefighters. While in most cases members make some contributions to the plans, the sponsors of such plans -- states, cities and other governmental units -- ultimately have assumed the investment risk for providing such benefits. In defined-contribution retirement plans this role is reversed with the individual members assuming the investment risk.

Each defined-benefit pension fund develops an asset allocation strategy, the objective of which is to generate sufficient assets to meet benefit obligations as required. Each plan's individual strategy, developed within guidelines that as a rule mandate attention to prudence, attains a diversification of investments that is consistent with the plan's individual risk tolerance level. Without taking some investment risk, pension funds would not receive returns sufficient to generate the assets required to pay promised benefits, which, in turn, would necessitate much higher contribution levels from sponsors (from higher taxes and fees) or members to meet the pension obligations.

In the last decade, public pension funds accelerated the shift in asset allocation toward equity investments at the expense of fixed income. The domestic equity allocation, under 40% at the beginning of the 1990s, was approaching 50% by the end of the decade. This greater emphasis on equities coupled with the bull market for stocks during the 1990s led to significant increases in the average funding ratio (actuarial assets divided by actuarial liabilities). Funding improvements were enhanced not only by the accelerated growth in assets but also by relatively low inflation,which constrained growth pressures on liabilities. The average funding level was about 80% at the beginning of the decade and boomed to 95% by the end, a stellar rise. Driven by the increase in investment income, public pension fund assets topped $2.3 trillion near the end of the decade, compared to only about $800 billion at the beginning.

Enron Was A Small Piece of the Pie

While Enron was a company with a very large capitalization, it was one of thousands of equity investments owned by public funds and it alone could not seriously damage their financial integrity. If total losses were in fact $1.5 billion, that is less than seven one-hundredths of a percent (0.07%) of the $2.3 trillion in total fund assets. The daily swing in asset value of a fund might have been several times its Enron exposure. Any such loss, of course, stings, but the effect of Enron must be looked at in relation to the fiscal strength garnered by public funds over the years and their future prospects.

As mentioned above, public funds experienced an extended period of above-average portfolio returns through 1999. In the fiscal year ended June 30, 2000 (most public funds have June fiscal years), the S&P 500 index, a measure of domestic equities, gained only 6.0% after four years of increases exceeding 20% and at least 17 years of averaging double-digit increases. In fiscal 2001, the S&P 500 fell 15.8%. This decrease, if applied to total public pension fund domestic equity assets ($2.3 trillion times the approximate 50% allocation to domestic equities) would represent a decline in market value for that asset class of about $172.5 billion, dwarfing the Enron loss.

Even with the significant fiscal 2001 equity reversal, public funds on average will still be fiscally sound for a number of reasons:

Investment performance has exceeded the average investment return assumptions for an extended period of time (results cannot be above-average every year);
Assets are valued on an actuarial basis, which usually smoothes gains and losses over a number of years (the Enron and fiscal 2001 losses will be offset to some extent by gains from prior, and possibly future, years); and
Equity losses may be balanced by gains from other, better-performing assets in that pension funds have diversified investment portfolios.

Thus, average funding levels will still be above earlier expectations, even if their rate of increase slows or they experience small declines. Further, due to the self-balancing nature of actuarially funded pension schemes, any deficiencies caused by underperformance is eventually corrected by an adjustment in contribution rates.

While the Enron loss adversely affected all of its investors, its long term effect on the nation's public pension funds will be relatively small given their size, structure, and diversification. The experience in the domestic equity market as a whole during the prior fiscal year had a much greater effect. Public pension funds were able to deal with both episodes from a position of strength built up over decades.

Going forward, public funds will be challenged to maintain the pace of funding improvements experienced in the 1990s from both the asset and liability perspectives. The expectation is for lower investment returns and accelerating growth pressues on benefit liabilities due to the inexorable fact of the population's increasing longevity.

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