Unlike current projections, which narrowly look at long-term pension funding based on investment performance, stress testing applies multiple economic scenarios and evaluates plan health against market volatility, contribution policies and state revenue forecasts. This rigorous analysis is a better way to inform policymakers hoping to navigate economic uncertainty and reduce long-term costs.
Comprehensive stress testing also has the benefit of assessing state pension funding against the overall state economy. In many states, the contributions needed from the government to pay retirement benefits are consuming a larger share of the state budget than in previous years, forcing the pension fund to compete with money spent on other essential services and programs. Analysis that is tailored to the economic conditions in each state can aid policymakers in developing policies to make costs more predictable throughout the economic cycle.
Large financial institutions are required to conduct annual stress tests under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, but stress testing wasn't recommended for pension plans until a 2014 blue-ribbon panel report commissioned by the Society of Actuaries. The Actuarial Standards Board has followed suit and recently adopted new guidelines for pension plan risk reporting that are closely aligned with recommendations in the blue-ribbon panel report.
Before the SOA report, only California and Washington state regularly conducted a formal stress test analysis on their pension funds. Since then, Connecticut, Colorado, Hawaii, New Jersey and Virginia have all adopted the practice. In all five cases, legislation has emerged as the vehicle to establish stress test reporting. This approach will help to ensure that the information is available to lawmakers responsible for the overall state budget picture. In Pennsylvania, the state's Independent Fiscal Office used stress testing to evaluate its 2017 pension reforms, and legislators are considering including the testing as part of regular reporting.
States can't afford to ignore the essential information a comprehensive stress test can provide, even as questions on cost and administrative burden emerge. The good news is that public pension stress-testing models build on existing reporting practices, including annual actuarial reports and asset/liability studies. That means states aren't burdened with collecting new data and can affordably conduct the analysis even when government budgets are tight.
The Pew Charitable Trusts recently published the results of stress tests conducted on the largest government pension plans in 10 states. The report showed that plans with both low funding levels and low annual contribution rates face the real prospect of insolvency without substantial improvement to state policies and behavior.