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Stress tests help policymakers plan for the next recession.
Eager to strengthen the long-term financial health of their public-sector pension systems, officials in several states have embraced a nonpartisan, data-driven approach to more precisely assess their ability to fulfill the benefit promises made to public employees.
Called stress test reporting, this new practice can show policymakers how adverse economic scenarios could affect retirement system investments and state budgets. Because earnings on investments typically make up the largest share of pension fund revenue, lower returns or losses need to be offset by higher contributions from the state government and workers. The stress testing model created by The Pew Charitable Trusts also allows states to account for the condition of their economy and tax collections, offering a broad look at the impact of pensions on their overall fiscal health.
A forthcoming report by the John F. Kennedy School of Government at Harvard University looks at initial results using the Pew approach in 10 states.
The ability to consider the impact of a range of economic conditions on pension balance sheets and government budgets helps policymakers evaluate whether current policies are sufficient to withstand the impact of the next recession. Over the past decade, many state officials learned that overly optimistic investment return assumptions caused gaps in pension funding that had to be covered by increasing contributions and reducing benefits, often several times.
Stress testing provides the information needed to evaluate policies and adjust investment assumptions over time to ensure retirement plans are affordable and fully funded under a range of economic scenarios. Pew’s analysis of plans in New Jersey and Colorado, for example, demonstrates that without significant policy intervention, pension systems in both states risk insolvency—full depletion of plan assets—if faced with a recession and investment returns lower than expected for an extended period of time.
The increasing use of stress test reporting comes at a crucial period in state government finance. Since the Great Recession that ran from 2007 to 2009, state tax revenues have been slower to rebound than after the three previous downturns. In addition, revenues have been more volatile than in the past. States are finding that spending on Medicaid and retirement liabilities is outpacing revenue growth, siphoning off dollars that might otherwise be spent on education, public safety, and infrastructure.
State Systems Remain Vulnerable
Looking ahead, state retirement systems are more vulnerable than ever to the next downturn, even one less severe than 2007-09. According to the most recent statistics, the gap between retirement fund assets and liabilities grew each year from fiscal year 2000 through 2016, despite increased pension contributions, benefit cuts, and stock market gains. Pew’s latest analysis of state financial reports shows the cumulative divide hit $1.4 trillion in fiscal 2016.
Although most state pension systems have lowered the assumed rates of return on stocks, private equity, and other assets in recent years, Pew found that the level of portfolio risk that states are taking on to meet their investment targets has never been higher. The median return assumption was 7.5 percent in fiscal 2016 for public pension plans, at a time when many analysts expect investment performance to be a full percentage point lower, with a 1 in 4 chance that returns may not top 5 percent over the next 20 years.
Against this backdrop, more states are looking at stress testing to give policymakers a better sense of potential funding scenarios. Eight states—California, Colorado, Connecticut, Hawaii, New Jersey, Vermont, Virginia, and Washington—now require their public pension systems to analyze the impact of downturns on pension costs and liabilities, financial market volatility, and contributions.
The analyses can also be used to explore the impact of pension system reforms. For example, officials in Colorado and Pennsylvania recently examined the budget impact of proposed reforms, in part to determine whether the states could maintain benefits if confronted by another recession.
States benefit from comprehensive stress testing. Every public pension system projects investment returns based on past results and future assumptions about how the portfolio may perform. But analysts typically use a single rate of return to simulate outcomes to determine what level of contributions would be needed to fully fund the system.
Pew’s model differs because it uses multiple rates and evaluates results based on a state’s economic outlook. Most pension plans periodically perform sensitivity analysis on a range of returns, but these studies are typically designed to assess investment policies and are not explicitly intended to inform long-term policy and budget development. The Pew approach offers policymakers a range of economic assumptions to help them determine how the state will make its required contributions.
Need for States to Take Long-term View
Experts who analyze the consequences of financial risk say stress testing allows states to sync the long-term sustainability of their retirement systems with their overall fiscal health. That’s why industry experts have set new standards that embrace such testing.
For example, as of Nov. 1, actuaries measuring pension system obligations and contributions will follow risk reporting guidelines adopted by the Actuarial Standards Board. The emerging standards also build upon new pension accounting reporting rules approved by the Governmental Accounting Standards Board after the last recession. The next economic downturn is inevitable, but many states are not prepared for how it could affect the costs of their retirement systems. Unless legislators adopt policies to address the pension risks they face, those costs are going up. Stress testing can help states manage the pension fund through the cycles of the economy.
Greg Mennis is the director of The Pew Charitable Trusts’ project on public sector retirement systems, and Stephen C. Fehr is a senior officer with Pew’s project on states’ fiscal health and economic growth.