As states begin to respond to the economic impact of the pandemic and the subsequent recession, public pension funding will likely be among the issues at the forefront of budget discussions. Although plan assets largely recovered from the financial market drop at the start of the crisis in March 2020, an estimated 6% to 11% decline in state revenues nationwide has, in some cases, limited states’ ability to make full annual contributions to their pension plans.
With careful planning and comprehensive data, however, policymakers can better maintain the fiscal health of their retirement systems in such uncertain times. In fact, these are precisely the conditions that the simulation technique known as stress testing is designed to address.
Stress tests examine a range of potential scenarios and have been adopted by 12 states. Such testing can help policymakers prepare for the impact of adverse economic conditions on pension balance sheets and government budgets. To reflect current circumstances, The Pew Charitable Trusts has updated earlier guidelines for these analyses in a document known as the “Foundation for Public Pensions Risk Reporting.”
The foundation spells out a framework for measuring investment risk — the potential that market returns will be lower than expected — as well as contribution risk, meaning the possibility that future contributions will fall short of the rate required to meet funding objectives.
First released in November 2018 by the Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government, the foundation builds on government accounting and actuarial standards and provides a comprehensive starting point for pension stress test and risk analysis for government plan sponsors and budget decision-makers.
Using the original framework, Pew updated the foundation to better reflect the dynamic nature of stress testing analysis today. Reporting standards and practices evolve over time, and the swings of the national economy prompt the need to routinely adjust baseline assumptions and projections.
For example, Pew’s update reflects recently proposed changes to actuarial standards and proven practices in states that have adopted pension risk reporting requirements. As a result, the document explicitly identifies the need to account for workforce reductions in a downturn when measuring contribution risk. It also includes further information on risk tolerance measures as critical budget management tools to help officials actively monitor and manage key risks during all cycles of the economy — but especially during an economic downturn and expected recovery.
The supporting notes detail how Pew’s baseline economic assumptions and state revenue projection methods have been updated to reflect the impact of the COVID-19 pandemic using the latest Congressional Budget Office (CBO) forecasts, as well as state-specific estimates of near-term revenue changes and long-term economic growth. In addition, long-term investment return assumptions for most asset classes have been revised downward to reflect the long-term impact of the pandemic on gross domestic product and interest rates. As a result, the typical pension fund investment portfolio is now expected to return about 6% annually, down from 6.5% previously.
The updated downside scenario reflects the most recent federal Bureau of Economic Analysis data, which shows that although a recovery is underway, the risk of a slowdown remains. The result is a scenario that includes a double-dip recession, with real gross domestic product contracting once more in 2021 and a moderate asset shock. This possibility is based on the “Alternative Severe” scenario included in the Federal Reserve’s second round of bank stress tests published in September 2020. That scenario was designed specifically with the pandemic in mind.
Stress tests are not an academic exercise. The states that have adopted legislation requiring such testing and risk reporting have proved how useful these analyses can be in supporting budget decisions. For example, New Jersey, which has one of the most fiscally challenged retirement systems in the nation, used stress test analysis in 2020 to determine how to avoid further erosion of its pension fiscal health during the pandemic.
Legislative leaders requested the assessment, which revealed that the state’s failure to make planned contribution increases would lead to a significant risk of system insolvency. Because of the analysis, policymakers agreed to maintain planned contribution increases despite pandemic-related revenue declines.
On the other side of the spectrum, North Carolina, one of the nation’s best funded state retirement systems, has used stress test analysis to examine ways to navigate market downturns and to plan reductions to the target rate of return on investments while sustaining the state’s budget.
Stress testing alone will not solve the unprecedented near-term challenges many states may face, but it can provide a clearer understanding of the economic landscape. More importantly, it can help policymakers evaluate proposals and serve as an early warning sign for problems that may arise.
Susan Banta is a director and Fatima Yousofi is an officer with The Pew Charitable Trusts’ public sector retirement systems project.