Commentary: Pension stress testing can help states plan for the next recession

Despite nine years of economic recovery, state and local public pension systems are more vulnerable to an economic downturn than they've ever been. State pension funds reported a cumulative $1.6 trillion deficit between assets and liabilities in fiscal 2017, larger than at any point before the Great Recession. At the same time, the outlook for investment returns is lower than it has been historically. And funds are heavily invested in assets that generally track the ups and downs of the economy — stocks and alternatives comprise 75% of portfolios — exposing pension funds to greater market volatility than in the past.

When the next recession hits, many states might find it difficult to afford their retirement obligations without new policies to better steward their pension funds. And some plans face the real prospect of insolvency. But if plans apply stress testing, which is an emerging trend among public pension systems, it could help policymakers understand how pension balance sheets and government budgets will fare under various adverse economic scenarios. And if state officials require stress testing, which is an emerging trend among public pension systems, it can help policymakers understand how pension balance sheets and government budgets will fare under various adverse economic scenarios.

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.

For example, New Jersey's state pension assets could be depleted within 15 years if investment returns are materially lower than its expected annual 7.5%, and if the state doesn't follow through on recently adopted legislation to increase plan funding.

Even in the absence of fiscal distress, lower-than-projected investment returns will have long-term cost implications for state retirement systems because pension plans rely on these earnings to pay for a substantial portion of benefits.

That's the case in Connecticut, where funding for the Teachers' Retirement System is governed by the terms of a $2 billion pension obligation bond. Pew's stress test analysis shows that meeting the bond's funding requirements could force the state to more than double its contributions by 2032 if investment returns fail to exceed 5%. Last October the state passed a law requiring annual stress-test reporting of all public employee pension plans, the results of which are expected to inform a forthcoming report exploring funding strategies and policy options to stabilize finances of the teachers' plan.

Recent developments in Colorado further demonstrate that stress tests are not merely an academic exercise. In 2015, five years after Colorado implemented reforms to its Public Employees' Retirement Association, a stress test analysis on the reform's effectiveness found a 1-in-4 chance that, without policy intervention, the state's pension assets would be depleted within 20 to 30 years. Pew's analysis yielded similar results, and Colorado lawmakers recently enacted additional reforms to further shore up the fund.

While there's no one-size-fits-all solution to every issue facing public pension systems, policymakers need tools that help them understand how inevitable market fluctuations and shifts in the economic landscape will affect their retirement plans and, in turn, their budgets. It's time for all states to follow expert recommendations and mandate stress-test reporting requirements that will help quantify the risks associated with current funding plans.

Greg Mennis is director of the public sector retirement systems project for The Pew Charitable Trusts, Philadelphia. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.