Financial ‘Stress Test’ of Colorado Pension System Spurs Reform

The pension reforms recently enacted in Colorado demonstrate how states can benefit from a tool called stress testing to shore up financially troubled retirement systems.

The legislation signed June 4 by Governor John Hickenlooper (D) includes steps similar to those taken by other states coping with significantly underfunded public pension systems, including raising the retirement age for new workers and increasing employee contributions. But Colorado’s approach also reflects the state’s leading role in using stress testing to more precisely assess the government’s ability to fulfill benefit promises made to workers.

Nationwide, pension plans have been struggling to cope with investment losses stemming from volatile financial markets as well as the impact of the Great Recession of 2007-09. When considering reforms, a growing number of states are turning first to stress testing to assess how adverse economic scenarios could affect retirement system investments as well as state budgets.

Colorado lawmakers embarked on that process four years ago, voting in 2014 to conduct what is known as a sensitivity analysis to examine the pension system’s current and future financial position under various investment return scenarios. Lawmakers specifically asked consultants to assess the impact of reforms adopted in 2010 that were intended to ensure that the Colorado Public Employees’ Retirement Association (PERA) system was fully funded by 2041. The system’s health is critically important. Ten percent of state residents are PERA members.

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. Using the colors of traffic signal lights—green for positive, yellow for warning, dark red for danger—the study confirmed that the 2010 reforms would not resolve the underfunding crisis.

In fact, the total pension obligation had increased by $10 billion since those reforms were adopted—from an unfunded liability of $23 billion in 2013 to $33 billion in 2018. State contributions, investment returns, and benefit cuts had proved insufficient to raise fund balances, and assets had declined slightly; more money was being paid out than was coming in.

Largely because of the decline in assets, the traffic signal color had gone from yellow in 2015 to orange by 2017—a step closer to the red of pending insolvency—for most of PERA’s employee divisions. In response, policymakers worked on a package of reforms that led to this year’s legislation.

Lawmakers decided to raise the retirement age for newly hired employees and require increased contributions from current and future workers who do not receive Social Security benefits. The law suspends the annual cost-of-living adjustment for current retirees for two years and then resumes the COLA at a lower percentage. The state is also providing additional taxpayer dollars to the PERA-managed pension fund.

Funding was at 58 percent before the legislation was approved, according to the most recent financial statements. That is among the lowest levels in the country; the program has not been 100 percent funded since 2001. State officials predict the changes will bring PERA to 100 percent funding within 30 years.

The Pew Charitable Trusts conducted a separate stress test, released in May 2018, that reached nearly identical conclusions about the future of Colorado’s pension fund. The Pew model uses a variety of scenarios, depending on economic performance and other factors such as revenue forecasts and the overall state budget picture.

Assuming a 5 percent return, which is the estimated rate at the 25th percentile, Pew concluded that PERA would run out of money by 2044 if state officials did not act immediately. Legislators relied in part on Pew’s independent analysis when considering options for reform and assessing whether the proposed changes were sufficient to reduce the risk of insolvency.

Like many states, Colorado had approved several rounds of changes to pension benefits and contributions only to learn that the reforms did not go far enough to put the system’s long-term funding on a secure footing. The 2018 legislation marks the third time in 13 years that Colorado attempted to address pension underfunding.

Interest in stress testing is picking up as states seek to avoid an endless cycle of pension reforms. Eight—California, Colorado, Connecticut, Hawaii, New Jersey, Vermont, Virginia, and Washington—currently require such analyses, with six of those implementing the requirement within the last year.

Colorado’s pension fund still faces challenges. The path to the program’s financial security will require decades of discipline from policymakers. Even a mild economic downturn could leave pension assets vulnerable to market volatility. Additionally, the PERA fund is constrained by a state constitutional amendment, the Taxpayers’ Bill of Rights, that limits lawmakers’ ability to increase contributions to the pension fund without corresponding cuts elsewhere in the state budget.

Still, as Colorado has demonstrated, turning to stress tests can help policymakers create funding policies that manage volatility and allow them to set contribution levels and benefits that enhance the long-term sustainability of the pension plans.

Greg Mennis is the director of The Pew Charitable Trusts’ public sector retirement systems project and Tim Dawson is an officer with the project.  Stephen C. Fehr is a senior officer with Pew’s state and local fiscal health project.