What could future events like the COVID-19 pandemic mean for pension balance sheets and state budgets? To help government finance officials and budget decision-makers gain a more transparent view into a hazy future, The Pew Charitable Trusts has fine-tuned its guidance for stress testing state pensions.
Stress testing is about assessing risk so states can think through a range of possible scenarios. It’s a simulation technique that projects important actuarial and financial data for pension funds. Thirteen states have now adopted legislation mandating the practice.
Following the Great Recession, the Dodd-Frank Wall Street reform legislation required big banks to conduct annual stress tests and disclose the results to the Federal Reserve. The practice can help policymakers understand risks and guide institutions through economic turmoil. The same rationale informs public pension stress testing in the states.
Stress testing gives policymakers a glimpse of what happens if everything goes as planned, and what happens in various adverse tax collection, market performance and fiscal health scenarios. Last year’s market volatility and state revenue declines underscore the importance of gathering and reporting forward-looking data.
Pew’s Updated Framework
To reflect swings in the national economy and state budget dynamics, The Pew Charitable Trusts has updated earlier guidelines for stress test analyses in its document “Foundation for Public Pensions Risk Reporting.”
Public pension funds continually grapple with various risks related to investment performance, contributions and changing demographics. The document offers advice for measuring and reporting investment risk (the potential for market returns to fall short of expectations) and contribution risk (the potential for contributions to fall short of what’s required to meet funding objectives).
As it turns out, the public finance gyrations of the COVID era tie into both types of risk factors. Against this backdrop, Pew updated its methodology to help policymakers break down recent economic data to manage short- and long-term budget challenges. Pew worked with researchers at the Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government and other stakeholders to develop the first round of guidance in 2018.
Stress testing gives policymakers a glimpse of what happens if everything goes as planned, and what happens in various adverse scenarios.
Pew’s updated document builds on government accounting and actuarial standards. But risk reporting standards and practices evolve constantly. For example, COVID-19 triggered dramatic economic ups and downs, which prompted Pew to revisit the baseline assumptions and projections set out in its framework.
For example, the document identifies a need to account for workforce reductions in a downturn when measuring pension contribution risk. Furloughs, layoffs and early retirements can have real implications for the employer and employee contributions flowing into pension funds.
Similarly, the revised framework’s baseline and negative scenarios reflect the current economic climate. The early months of the pandemic saw the biggest state revenue plunge in decades, but now several states are running a surplus. In updating its stress-testing guidance, Pew drew on Congressional Budget Office, Federal Reserve Board and Moody’s Analytics data, along with state estimates. These suggest that although recovery is underway, risks remain; when economic output will approach its pre-pandemic trajectory is uncertain.
The updated stress-testing materials also revisit investment return assumptions, reflecting historically low interest rates and COVID-driven volatility. Some states have seen seemingly stratospheric pension fund investment returns since the depths of the pandemic selloff last spring. But according to the CBO, short-run expectations for interest rates have shifted from the outlook just two years ago. This helped prompt Pew’s downward revision to long-term investment return assumptions for most asset classes in pension portfolios.
Stress Testing in the States
Stress testing is not an academic exercise. States that require it use the analysis in their budget decision-making. For example, New Jersey, which has a chronically under-funded retirement system, utilized stress testing as part of its pension fiscal health calculus during 2020. The state was not alone in considering skipping or reducing planned payments amid revenue shortfalls and extreme budget uncertainty. However, in light of their analysis, New Jersey policymakers agreed to maintain planned contribution increases despite pandemic-driven revenue declines.
North Carolina, Montana and Pennsylvania are among the states that have passed legislative stress-testing mandates in recent years, and Nebraska and Arizona took up legislation in their 2021 sessions. Stress testing can help states identify problems before they emerge, suggest methods for addressing issues as they arise, and inform the budget process in times of turmoil and uncertainty.
Anna Petrini is a senior policy specialist in NCSL’s Employment, Labor and Retirement Program.