Hawaii is the latest state to require regular analysis of the potential impact of future economic swings on its public pension funds. Known as stress testing, such calculations can help states monitor the fiscal strength and sustainability of these funds.
This spring, the Legislature unanimously approved a bill requiring the analyses, and Governor David Ige (D) signed it into law July 5. California, Virginia, and Washington already require extensive and routine sensitivity analyses on their public pension plans. Typically, these tests provide estimates of the future financial position of these funds under various economic and investment return scenarios. Interest among other states appears to be growing as well.
This type of analysis has become more important because of state pension funds’ increasingly complex mix of investments in recent decades, a shift that brought greater exposure to financial market volatility. For example, many state funds lost at least 20 percent of their portfolio value at the start of the Great Recession in late 2007. Overall, state pension investment returns over the past five years have ranged widely, from 1 to 17 percent.
Policymakers benefit from tools that help them understand the variability and uncertainty in state pension plans. Rules promulgated by the Government Accounting Standards Board (GASB) after the Great Recession went into effect in 2014 and require state and local plans to estimate and disclose liabilities based on projected returns that are 1 percentage point above and below their assumed rate of return. In 2014, the Society of Actuaries’ Blue Ribbon Panel on Public Pension Plan Funding also recommended this kind of stress testing. The information can show how a plan’s funding levels are shaped by its investment returns and other economic factors.
Many public pension funds across the country face mounting unfunded liabilities and limited budgets. At the same time, many pension plans are taking on increased risk in part to counter lower investment returns on fixed-income assets. Policymakers need to make sure they have the tools that help them understand the potential impact of these risks.
Hawaii has implemented a system that goes beyond the GASB requirements to make sure leaders have a feel for how well they can meet their pension obligations under different scenarios. Stress testing represents just one approach, but this type of analysis is critical in an uncertain economic landscape.
Greg Mennis and Tim Dawson are with The Pew Charitable Trusts’ public sector retirement systems project.