Why Our Public Pensions Need Stress Tests

In the wake of the 2008 financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which among many oversight-strengthening provisions requires large financial institutions to conduct stress tests. The purpose of the testing is to make sure these banks can absorb losses and pay their creditors without a bailout from taxpayers.

But the risks associated with a severe economic downturn that came to light because of the Great Recession aren’t limited to the financial industry. State and local legislators and budget managers face a similar challenge: how to ensure that their public-employee pension systems can pay future obligations without sacrificing fiscal discipline or cutting core services. Stress testing their pension plans is an important way to deal with that challenge.

There’s no disputing the dimensions of the challenge. State and local governments today are grappling with a cumulative unfunded pension liability of $1.6 trillion—a larger deficit in both absolute terms and as a percentage of GDP than at any time before the bottom fell out of the economy 10 years ago. And because of consistent underfunding, volatile investment returns and rising benefit costs, the financial health of most state plans is now vulnerable to even a mild recession. In some cases these systems face a real risk of insolvency.

In 2016, the most recent year for which full data are available, state pension plans paid out $214 billion in benefits while taking in only $130 billion from employee and employer contributions, continuing a trend that has worsened since 2000. As the difference between payments to beneficiaries and contributions to the plans grows, states become more dependent on pensions’ investment income to pay for anticipated benefits. And when investment performance falls short of expectations, many states are likely to see a drop in plan assets.

Stress testing can help policymakers prepare their pension plans for the next economic downturn. Stress testing is a rigorous analysis showing likely outcomes under various scenarios of tax collection, market performance and fiscal health, and provides an underpinning for policymakers to understand and respond to the impact of economic volatility on pension plans.

The Pew Charitable Trusts, in collaboration with the Harvard Kennedy School’s Mossavar-Rahmani Center for Business & Government, has developed a model to help policymakers make decisions to strengthen the long-term sustainability of their pension plans. The model relies heavily on existing reporting practices and data that state and local governments already collect. That’s good news for officials looking to limit the administrative burden and costs of stress testing, especially when those costs are weighed against the benefit to taxpayers and retirees of a well-managed pension system.

Colorado, Connecticut, Hawaii, New Jersey, and Virginia have moved since last year to require pension plan stress testing. Each state passed legislation requiring that a stress test capture a complete picture of the solvency and durability of the pension system, including revenue forecasts, the state’s record of making required contributions, and the ability of legislators and managers to maintain a balanced budget while ensuring the solvency of a multibillion-dollar pension plan.

Colorado lawmakers approved a package of reforms in 2010 that were intended to fully fund the state’s public employee pension fund by 2041. Four years later, to eliminate uncertainty about the system’s future financial health, the state decided to stress test the plan and found that the 2010 reforms did not go far enough—and that the system had a 1 in 4 chance of becoming insolvent within three decades. Last year, Pew ran a separate stress test in Colorado, factoring in revenue forecasts and the overall budget picture, and came to a similar conclusion. Colorado’s governor and lawmakers responded with new legislation, signed in June, that includes measures that other state and local governments could also consider: suspending cost-of-living adjustments, adding tax dollars to the fund and setting contribution levels that enhance long-term sustainability.

Pew’s research, based on an analysis of pension plans in 10 states, shows that those with low pension funding levels and minimal contribution rates could face insolvency. If New Jersey’s investments earn only 5 percent a year, for example, the state’s pension fund could be depleted by 2030 unless it follows through on its plan to substantially increase its contributions. The research also shows that policies calling for cost sharing between government and employees reduces risk and makes pension costs more predictable. This strategy has helped Wisconsin’s pension plan become one of the best-funded in the country, thanks to policies that automatically adjust contribution levels and benefit increases based on investment performance and fiscal health.

Public pension systems with large unfunded liabilities pose a significant risk to the long-term fiscal health of states. But with a nonpartisan, data-driven approach to stress testing, states can go a long way toward making sure that their pension funds will weather all cycles of the economy. This will enable them to adopt funding and benefit policies that are fair, affordable and fiscally sustainable while also putting employees on the path to a secure retirement.

Reposted with permission of e.Republic.