Policymakers Have Multiple Pathways to Stress Test Municipal Pension Plans

Funding levels for municipal pension plans have improved in recent years, Pew research shows, with the shortfall shrinking between assets on hand and liabilities for promised benefits. The aggregated funded ratio had risen slightly in 2017 to 68% from 66% in 2015. And the historic investment gains of the last year are estimated to bolster that percentage to at least 80% for 2021.

Despite the encouraging trend, public pension funding can be volatile. Even before the pandemic, many economists were forecasting lower long-term investment returns compared with past business cycles and the first months of 2022 have highlighted the potential for dramatic market swings.

Returns that come in significantly lower than predicted could force local governments to raise their pension fund contributions to make up the shortfall. Pension stress tests, which simulate funding levels and required contributions under a range of economic scenarios, can help plan sponsors prepare for these potential cost increases.

Local policymakers can incorporate stress testing and other tools into existing financial and actuarial reporting frameworks to understand how twists and turns in the economy might affect pension funds and government budgets. At the same time, states with strong oversight practices for local pension plans could incorporate simplified risk assessments into existing reporting frameworks to efficiently assess risk across jurisdictions.

How cities are implementing stress testing

Several cities are incorporating additional financial metrics and forward-looking risk indicators, including pension stress tests, into their annual plan financial reporting. These recent developments reflect recent changes to actuarial reporting standards that require pension plan valuations to disclose the risk that actual outcomes may differ from those expected under current assumptions.

In some cases—for example, in Detroit and Milwaukee—plans are implementing the new standards by incorporating financial cash flow measures that can help assess risks to plan assets and government budgets. Other jurisdictions, such as Baltimore, Los Angeles, Philadelphia, Santa Barbara County in California, and Wichita, Kansas, have begun including risk analyses projecting the effects of market shocks, swings in the stock market, and economic downturns, into their assessments.

These approaches are proving to be instructive to municipal policymakers in managing plan finances and informing budgetary decisions. For example, recently approved legislation in Philadelphia requires the city to incorporate estimates of the impact of changes in pension costs on the city’s budget into its pension plan stress tests. And in Milwaukee, where city pension contributions are scheduled to double in 2023 despite extreme revenue constraints, a task force recently urged policymakers to apply stress testing and monitor operating cash flows as they evaluate potential funding policy changes.

Increasing local plan risk reporting through state oversight

While more larger municipalities are taking steps to incorporate risk analysis into plan-specific reports, state policymakers may be able to boost risk assessments for local plans by building on existing reports that cover multiple jurisdictions. Over the past decade, several states—including Michigan, Rhode Island, and Tennessee—have adopted oversight models for pension plans sponsored by municipalities. These models generally include statutory requirements for local plan financial reporting, funding requirements, and, in some case, prescribed steps to correct underfunding.

These oversight models offer state and local policymakers a way to evaluate the health of local plans within a standardized framework and that also allows for comparison across municipalities. For example, Rhode Island’s annual report on municipal plans uses standardized actuarial and financial metrics—such as contributions as a share of tax revenues and net cash flow as a share of assets—to assess the financial health of each plan, identify financially distressed jurisdictions, and summarize local plan funding across the state. A similar report in Michigan also includes data on plan contributions as a share of tax revenues. Tennessee’s reporting framework, meanwhile, includes a measure to assess the adequacy of employer contributions.

States with local oversight models could expand these reporting frameworks to include simple measures of risk to demonstrate the impact of market shocks and downturns on the municipal plans they oversee. Key elements of pension risk reporting that might be incorporated into a comprehensive municipal framework include:

• Data on plan finances and government budgets, including assets and liabilities, contributions and benefit payments, the assumed rate of return on plan investments, and government tax revenues. 
• Key pension metrics, including plan funding levels, contributions as share of tax revenues, net amortization (which measures the adequacy of actual contributions to pay down unfunded liabilities if plan assumptions are met), and operating cash flow as a share of assets.
• Forward-looking risk indicators that assess changes to required contributions and assets if investment returns deviate from plan assumptions. Examples include analyses of alternative investment return scenarios, and an “asset shock” indicator from Moody’s credit rating methodology.

Although funding for many local plans has improved over the past decade, challenges remain for many municipalities. To ensure that future market swings do not jeopardize the progress that plans have already made, administrators should consider tools such as stress testing to identify and navigate potential risks. Policymakers at the state and local levels can build onto existing financial reporting frameworks to include simple risk analyses that can help local plan sponsors ensure the financial health of the plans that they oversee through future economic downturns.

Stephanie Connolly is a senior associate with The Pew Charitable Trusts’ public sector retirement systems project.