Public Pension Stress Testing in the States

1/15/2021

By Tatiana Follett, Noah Harrison and Anna Petrini

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.

calcuator and checkbookFundamentally, 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—$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.

Twelve states have enacted stress testing requirements of their public retirement systems: 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.

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Public Pension Stress Testing

Click on any green state to see details about legislative stress testing mandates.

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 California

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  • 2010 and 2011 legislation codified in CA Govt Code § 20229 requires the CalPERS Board to provide an annual report, which includes certain information for state employees, such as:
    • Liabilities and contribution rates using an investment return assumption that is 2% higher and 2% lower than the board’s current discount rate assumption.
    • Contribution rates calculated by paying down unfunded liability over the average remaining service period of state employees.
  • This requirement is fulfilled by the State Actuarial Valuations, which set forth a detailed risk analysis and illustrate the sensitivity of employer contribution rates to a change in the discount rate assumption.
  • CalPERS publishes an additional report to assist the Board in assessing the soundness and sustainability of the system.
    • Its Annual Review of Funding Levels and Risks (2019) noted that the methods used to determine the alternate investment scenarios for the report’s stochastic modeling have been modified somewhat in recent years. For the 2019 probability results, the model was modified to produce slightly less favorable investment results over the next 10 years.
    • CalPERS’ 2020 Annual Review noted that required employer contributions are projected to increase over the next few years, and with the economic slowdown due to coronavirus, this could pose considerable problems for some employers.
  • CalSTRS also performs an annual Review of Funding Levels and Risk (2020 report), which includes various stress tests and stochastic simulations.
  • CalSTRS is also required by statute to provide a report to the legislature every five years on the progress of the funding plan. The first progress report was completed and provided to the legislature in June 2019.

 Colorado

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  • Senate Bill 14-214 (2014) requires the state auditor to retain a nationally recognized and enrolled actuarial firm to conduct a one-time sensitivity analysis on PERA to be completed by December 2015. Requirements for the test were codified in CRS §24-51-614.
    • Passed the House and Senate unanimously.
    • Costs: $500,000 appropriated for contracting an actuarial firm, other costs.
    • Released in 2015, the analysis concluded that the chances were 1 in 4 that the assets in PERA’s main funds would be depleted within 25 to 30 years.
  • C.R.S. § 24-51-204: SB 200 (2018) makes plan design changes to Colorado’s Public Employees Retirement Association (PERA) plans for state workers and teachers and codifies routine stress testing reporting requirements as part of the reforms. The legislation requires PERA’s Board of Trustees to conduct an annual sensitivity analysis in accordance with actuarial standards and report the results to the office of the governor, the Joint Budget Committee, the Legislative Audit Committee, and the Finance Committees of the Senate and the House of Representatives.
    • Statute authorizes the board to hire a contractor to perform the stress testing.
    • Fiscal note for SB 18-200 cites rate of $200,000 every three years for the conduct of an independent review of the assumptions used to model PERA's financial condition.
    • SB 18-200 passed with bipartisan, but not overwhelming support.
    • The 2018 legislation marked the third time in 13 years that Colorado attempted to address pension underfunding.

 Virginia

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  • HB 1768 (2017) required the Virginia Retirement System (VRS) to formally adopt stress testing and report the results online. Stress tests must include projections of benefit levels, pension costs, liabilities, and debt reduction under various economic and investment scenarios. Reports focus primarily on negative scenarios, as they help to identify areas of risk and generally provide the most challenges to plan sponsors. The legislation also required reporting on investment policies, performance and associated expenses.
    • Legislation passed both chambers unanimously.
    • Stress tests were estimated to have no fiscal impacts, as the board already performed many of the required assessments according to industry standard or existing board policy.
  • The bill was codified in § 51.1-124.30:1. The statute requires regular stress testing and sensitivity analysis covering one, three, five, 10, 20 and 25 years in the future. A sample of the 2019 stress test results can be found here.

 Connecticut

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  • Sec. 109 of SB 1502 (the 2018-2019 state budget bill) required the Office of Policy and Management to develop and annually report to the General Assembly on sensitivity and stress test analyses for the teachers' retirement system and the state employees’ retirement system. The legislation provides that the stress test should include projections of benefit levels, pension costs, liabilities, and debt reduction under various economic and investment scenarios. Stress test results are also to be posted to the OPM’s website.
    • The fiscal note estimates each annual stress test may cost up to $50,000 and states that the cost may be borne by either OPM, the Teachers' Retirement Board, or the State Employees' Retirement Fund.
    • Passed with broad and bipartisan support.
  • The Pew Charitable Trusts performed the inaugural report in 2018. Then-Governor Dannel P. Malloy (D) released the results of the state’s first stress test that December. The analysis found that although reforms to SERS had improved the system’s fiscal health, additional changes to the teachers’ system could help avoid substantial cost increases.

 Indiana

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  • SB 545 (2019) 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 the interim study committee on pension management oversight.
    • Des not actually codify any requirements to conduct stress tests.
    • Fiscal note estimates minimal monetary costs associated with reporting the results of stress testing.
    • Passed both houses unanimously (with some abstentions).

 New Jersey

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  • A4704 (2017) requires the boards of trustees for the Teachers’ Pension and Annuity Fund, the Judicial Retirement System, the Public Employees’ Retirement System, the Police and Firemen’s Retirement System, and the State Police Retirement System to conduct and report regular stress test analyses of their state-administered retirement systems. The legislation is modeled on Virginia’s stress testing requirement and passed both legislative chambers unanimously.
    • It also requires the State Investment Council to report the fees charged by external managers for the investment of pension funds under their supervision.
  • Actuarial consulting firm Cheiron’s July 1, 2019 Actuarial Valuation of the state’s Public Employees Retirement system fulfills the statutory stress testing mandate, providing baseline projections and additional stress testing based on varying return assumptions.
  • Though revenue declines related to the pandemic created new spending pressures in 2020, the governor and legislative leaders relied on stress testing data when they committed to make the largest pension contribution in state history ($4.7 billion) to move the system toward solvency.
  • The Pew Charitable Trusts provided an independent stress test to Senate President Stephen Sweeney and state policymakers in response to decreased revenues due to COVID-19.

 Hawaii

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  • HB 1182 (2017) requires the Employees’ Retirement System actuary to conduct an annual stress test and report the results to the legislature.
    • The legislation specifies scenarios to be tested:
      • A 30-year projection of assets, liabilities, pension debt, service costs, employee contributions, employer contributions, net amortization, benefit payments, payroll, and funded ratio assuming current assumptions are met.
      • Two estimates of the items listed above, assuming the actual investment performance is 2% less than the assumed rate of return, but with two different contribution policies.
      • Two 30-year projections of the items listed above, assuming investment performance in the first year is negative 20%, followed by a 20-year period where the investment performance is 2% less than the assumed rate of return (also with two different contribution policies).
    • The requirement passed both houses unanimously and is now codified at §88-105.5.
    • The 2019 stress test report is available here. It concludes that the system is sustainable in return environments much lower than currently assumed.
  • The Pew Charitable Trusts independently examined Hawaii’s 2018 report. Its analysis showed how increased pension contributions required by the 2017 legislation were an important change to keep the system solvent.

 Pennsylvania

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  • SB 1 (2017) represented one of the more comprehensive reform efforts in recent years, establishing a risk-managed hybrid plan for new employees and addressing funding issues. It also formed the Public Pension Management and Asset Investment Review Commission to study the financial health of the Pennsylvania Public School Employees' Retirement System and the Pennsylvania State Employees' Retirement System, and to evaluate the merits of formalized, mandatory stress testing.
  • Commission released its findings in 2018 and made several recommendations, including passing legislation to mandate stress testing.
  • In response to the results of the initial stress test through the Public Pension Management and Asset Investment Review Commission, the Pennsylvania legislature introduced HB 1962 during the 2019-2020 session.
    • The enacted legislation calls for annual stress testing to be reported to the governor, General Assembly, and Independent Fiscal Office. The stress test will include sensitivity, scenario, and simulation analyses. The Independent Fiscal Office must release a report based the results of the test.
    • The fiscal note indicates that the actuary's contract costs may increase over time to cover the new analyses.

 Montana

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  • HB 715 (2019) instructed the legislative finance committee to conduct a financial modernization and risk analysis study and a budget stabilization study. The latter provides for stress testing of Montana’s two largest pension plans, PERS and TRS.
  • In 2020, The Pew Charitable Trusts prepared an analysis intended to supplement a more detailed assessment by the plans’ actuarial consultant in accordance with HB 715’s calls for a long-term budget stabilization study.
    • Pew’s analysis found that the financial position of the plans would improve over time if current assumptions were met, but that under a low return or asset shock scenario, the two systems would face a risk of fiscal distress.

 Washington

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  • Select Committee on Pension Policy instructed the Office of the State Actuary to conduct a risk assessment report in 2010.
  • OSA now conducts annual risk assessment reports annually.
  • Washington combines scenario testing with stochastic analysis to assess two key risks for its state pension plans: (1) contribution risk—the potential for contributing entities to contribute less than the full actuarially required amount, and (2) benefit enhancement risk—the potential for the legislature to enact future enhancements to current benefit provisions.
  • In 2020, the Office of the State Actuary released a report on the effects of COVID-19, including the results of a stress test, which indicates the system is strong enough to weather some short-term losses.

 North Carolina

NC flag

  • S 719 passed in 2020 and mandates regular stress testing of the state’s largest pension system for teachers and public employees, TSERS. The legislation draws on a framework developed by The Pew Charitable Trusts and conforms to the reporting schedule for the plans’ actuarial experience review.
    • The legislation requires an array of projections assuming that investment returns are 2 and 4 percentage points lower than the assumed rate of return across several contribution rate scenarios.
    • The bill had wide bipartisan support and passed the House 117-2 and the Senate 47-0, with two excused absences.
    • Pew completed a separate analysis for North Carolina before the pandemic and presented it to the TSERS Board of Trustees in October. Pew’s analysis fund that the state’s high contribution levels and funded ratio would protect the system from significant cost increases in the event of a market downturn.

 Maryland

MD flag

  • Maryland HB 993 (2018) calls for an annual risk assessment and publicly reporting of the results on the state pension system’s website. Part of the assessment focuses on the growing investment risk associated with climate change.
    • The bill passed the Senate unanimously (44-0, with absences) and passed the House 92-44.
    • Fiscal note indicates that expenditures may increase by up to $400,00 per year.
    • The bill requires the state to conduct a risk assessment testing multiple scenarios for long-term effects on separate asset classes as well as on the total portfolio performance of different systems.
  • A copy of the 2019 risk assessment is available here. And the 2020 risk assessment is available here. It focuses on the risks associated with the Maryland State Retirement and Pension System’s investment program, especially its asset allocation strategy.

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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. 2010 and 2011 legislation codified in CA Govt Code § 20229 requires the CalPERS Board to provide an annual report, which includes certain information related to state employees. This includes liabilities and contribution rate calculations using an investment return assumption that is 2% higher and 2% lower than the board’s current discount rate assumption. These statutory requirements are fulfilled by the State Actuarial Valuations, which set forth a detailed risk analysis and illustrate the sensitivity of employer contribution rates to a change in the discount rate assumption. CalSTRS is also required by statute to provide a report to the legislature every five years on the progress of the funding plan. The first progress report was completed and provided to the legislature in June 2019.

Pennsylvania’s comprehensive reform effort in 2017 established the Public Pension Management and Asset Investment Review Commission to study the financial health of the Pennsylvania Public School Employees' Retirement System and the Pennsylvania State Employees' Retirement System, and to evaluate the merits of formalized, mandatory stress testing. The commission released its findings in 2018 and made several recommendations, including passing legislation to mandate future stress testing. In response, the Pennsylvania legislature introduced HB 1962 during the 2019-2020 session. The legislation was signed into law in November 2020 and calls for annual stress testing to be reported to the governor, General Assembly, and Independent Fiscal Office.

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

Public Pension Management Tools in Action, Part 1: Economic Scenario Modeling and Stress Testing in the Time of COVID-19 | NCSL Webinar, October 2020

Putting Data to Action: Stress Testing as a Tool for State Budgets and Public Pensions | 2020 NCSL Atlantic States Fiscal Leaders Meeting Session, February 2020

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.