Faced with financial uncertainties and unpredictable markets, an increasing number of states are mandating stress testing for their public pension systems. Public pension stress testing is the process of evaluating how pension systems would respond to a variety of potential scenarios, allowing states to gauge the effects of hypothetical adverse market conditions on their retirement systems.
Fundamentally, stress testing is about risk assessment. It aims to supply information about key risk factors in order to improve the planning and decision-making of pension plan fiduciaries, policymakers and budget officials.
While state-level legislative mandates to stress test public pensions are recent developments, the concept of stress testing is nothing new. The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010 in response to the Great Recession, requires large financial institutions to conduct annual stress tests and disclose the results to the Federal Reserve.
The results of these stress tests help determine how much capital these institutions must maintain, in hopes of achieving greater financial stability during future downturns. Though recent years have seen several changes to the Fed’s stress testing regime for big banks, the same rationale informs public pension stress testing in the states – stress testing can help policymakers understand risk and guide institutions through economic shocks.
State and local government pension systems collectively hold vast amounts of assets—$4.99 trillion as of Sept. 30, 2022 according to the Federal Reserve—meaning even small variations in projected and actual circumstances can have multi-billion dollar impacts. The most consequential variable is the rate of return of a pension system’s investments, but other factors such as inflation, demographic change, and retirement rates also have significant effects. If a plan’s baseline projection turns out to be incorrect and actual assets fall short of required payouts, states must increase contributions to the plan or cut benefits to make up the difference.
Stress testing models enable states to evaluate the effects of a specified set of circumstances and conduct simulations to ascertain a pension plan’s overall risk in the long term. This allows states to assess both the impacts of a hypothetical scenario and the rough likelihood of that scenario occurring, and then make policy changes if deemed appropriate.
Thirteen states have enacted stress testing requirements of their public retirement systems: Arizona, California, Colorado, Connecticut, Hawaii, Indiana, Maryland, Montana, New Jersey, North Carolina, Pennsylvania, Vermont, Virginia and Washington. At least two more states—Arkansas and Minnesota —considered bills in 2019 that would do the same. In 2017, Pennsylvania created a commission to study the financial health of the state’s public retirement systems. The commission’s findings included a recommendation to enact formalized, mandatory stress testing, which the legislature adopted in 2020.
Pension stress testing is gaining momentum outside of statehouses, as well. In 2018, the American Actuaries’ Actuarial Standards Board (ASB) adopted a new actuarial standard, ASOP 51, which expands the risk assessment responsibilities of pension actuaries. Though most actuaries already conducted such assessments, all actuaries, including those reviewing public pensions, now will be required to analyze factors that pose potential risks to a plan’s future financial condition. In the context of public pensions, ASOP 51 requires actuaries to identify risks that might significantly impact a plan’s financial condition in the future. Importantly, the ASOP does not compel actuaries to evaluate the ability or willingness of the plan sponsor to make on-time contributions to the plan.
The ASOP elaborates various types of risk an actuary may wish to assess. Examples include investment risk, interest rate risk, longevity and other demographic risk, and contribution risk. For public plans, investment risk is likely to be the most significant. Though actuaries retain discretion in choosing what risk assessment methods to use, ASOP 51 lays out various methods for actuaries to consider, such as scenario testing, stochastic modeling and stress testing (See Stress Testing Methodology below). The emerging standards also build upon new pension accounting reporting rules approved by the Governmental Accounting Standards Board after the last recession.
With ASOP 51 now obligating public pension actuaries to conduct regular stress tests, some contend that passing statutory stress test requirements is redundant. However, proponents of these laws counter that they formalize the process, make the results more accessible to state legislatures, and standardize the type of stress tests conducted, ensuring that the stress tests are helpful to lawmakers hoping to use them to inform policy decisions.
Supporters also say that with modern technology, stress testing is easy, cost-effective, and well-worth the effort given the information it equips policymakers with. Some states that have codified mandatory stress testing have also implemented public pension reforms.
On the map below, click on any blue state to see details about legislative stress testing mandates.