Public Pension Stress Testing

9/12/2019

Public Pension Stress Testing in the States

By Noah Harrison

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 assess the effects of hypothetical adverse market conditions on their retirement systems.

calcuator and checkbookWhile 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. The same rationale informs public pension stress testing, with the hope that stress testing will help state policymakers ensure their retirement systems can better withstand economic shocks.

State and local government pension systems collectively hold vast amounts of assets—$8.977 trillion as of Sept. 30, 2018 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.

Nine states have enacted or adopted stress testing requirements of their public retirement systems: California, Colorado, Connecticut, Hawaii, Indiana, Montana, New Jersey, Vermont, Virginia and Washington. Three more states—Arkansas, Minnesota and North Carolina—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, but, thus far, no action has been taken by the legislature.

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 consider scenarios that would raise a state’s required contributions. Though actuaries retain discretion in choosing what risk assessment methods to use, ASOP 51 essentially amounts to a required stress test.

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.

Highlighted States

Virginia was one of the earlier states to statutorily mandate stress testing of its public pension systems. In 2017, the state passed HB 1768, which required the Virginia Retirement System to formally adopt stress testing and report the results online. The bill passed both chambers of the legislature unanimously and was estimated to have no fiscal impacts.

Hawaii also statutorily mandated stress testing in 2017 for its Employees’ Retirement System, and explicitly specified scenarios to be included in the risk assessment. The state instructed actuaries to project a 30-year outlook for the system under two scenarios: if investment returns are 2% lower than assumed and if there is a one-year, 20% loss on planned investments followed by 20 years of investment returns two percentage points lower than assumed. The latter scenario is to be tested twice: once under the assumption that employer contributions are adjusted based on current policy and then under the assumption that employer contributions are held constant at baseline levels. The bill that codified these requirements, HB 1182, passed both houses unanimously.

In 2019, Indiana enacted SB 545, which requires the executive director of the Indiana Public Retirement System and the trustee of the Indiana State Police Pension Trust to report the results of any stress tests conducted to Indiana’s interim legislative study committee on pension management oversight. Though the measure did not codify any requirements to conduct stress tests, it standardizes the way stress test results are communicated to the legislature, with the hopes of improving legislators’ awareness of the fiscal stability of the systems.

California was one of the first states to regularly stress test its public pensions, but it has no statutory requirement to perform stress tests. Rather, the board of the California Public Employees Retirement System (CalPERS) has adopted internal stress testing regulations. These regulations, outlined in the Investment Performance committee’s Total Fund Investment Policy, require CalPERS administrators to conduct annual stress testing, scenario analysis, and liquidity risk assessment.

Stress Testing Methodology

Stress testing is an umbrella phrase that can encompass several methods of assessing a pension system’s risk, including sensitivity analyses, scenario testing and stochastic modeling. Fundamentally, stress testing analyzes the risk of not meeting goals.

Sensitivity analyses allow actuaries to isolate variables in a pension plan. They assess the impact of a change in an actuarial assumption on an actuarial measurement. A sensitivity analysis typically focuses on a small number of actuarial assumptions that have significant bearing on the condition of a pension plan. These assumptions often relate to investment returns, inflation, population growth, payroll growth and employer contributions. 

Scenario testing allows pension administrators to select a whole set of conditions and examine the outcomes, enabling policymakers to analyze the effects of hypothetical scenarios such as an unexpected recession or a prolonged period of sluggish investment returns.

Stochastic modeling is a more complex form of analysis in which actuaries run thousands of random simulations. The outcomes of all of these individual runs are compiled to forecast an “expected result” along with rough probabilities of various outcomes. Stochastic modeling is a useful tool since it allows pension administrators to understand which scenarios are most likely to occur as well as what range of outcomes has a reasonable chance of occurring.

Other Considerations

One expressed concern is the cost of conducting stress tests, which range from hundreds to hundreds of thousands of dollars, depending on the scope of the stress test and whether a state contracts an independent actuarial firm to perform it. Stress testing proponents counter that states often appropriate additional funds when an outside firm is contracted, and that, regardless of the source of funding, stress tests are well worth the costs considering the long-term instability they can help avoid.

Another concern is that the results of stress tests will be misinterpreted. Vermont Treasurer Beth Pearce has advocated for pension risk assessment to be conducted by a pension system’s trustees, out of concern that outside stress tests could present a slanted assessment that leads to problematic reforms. However, legislatures that have implemented stress testing appear confident in their ability to interpret the results.

Lastly, some argue that mandated stress tests are repetitive in light of the adoption of ASOP 51.

Since virtually every public pension plan is regularly reviewed by actuaries to determine required funding levels, these plans will now be regularly stress tested, even in the absence of any statutory mandates. Nonetheless, proponents say there are still benefits of codifying risk assessment procedures, namely that legislators can specify scenarios to be evaluated or standardize the way results are reported.

 

Additional Resources and Recent Developments in Pension Risk Reporting

NCSL Resources

Putting Public Pensions Through Their Paces |State Legislatures Magazine, June 2018

Don't Stress Out About Pension Stress Testing | NCSL Webinar, May 2018

Data Tools for Policymakers: Stress Testing Pension Plans | NCSL Webinar, July 2017

Other Resources

2019

Arkansas, Minnesota, Indiana, and North Carolina consider legislation.

2018

Using Virginia’s legislation as an example, New Jersey adopts its own stress testing and investment transparency requirements.

Colorado implements plan design reforms to its Public Employees Retirement Association plans for state workers and teachers and codifies routine stress testing reporting requirements as part of the reforms.  

Experts meet at Harvard Kennedy School of Government in a second conference discussing public pension plan funding focused on Better Measurements for Risk Reporting.

ASOP No. 51 goes into effect for all reporting on or after November 2018.

Connecticut publishes first stress testing report.

Virginia and Hawaii publish their second annual stress testing reports, respectively. 

Public Pension Management and Asset Investment Review Commission in Pennsylvania recommends annual stress testing of the state’s retirement plans for workers and teachers.

2017

Hawaii adopts annual stress testing requirements, publishes its first stress testing report.

Connecticut adopts annual stress testing requirements.