Stress Testing for Municipal Pension Plans
Stress testing for public sector retirement plans is gaining attention following the adoption of new standardized guidelines, as well as support from The Pew Charitable Trusts. The practice of stress testing started with banks and financial institutions following the 2008 economic crisis, pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
While economic conditions in recent years have been relatively favorable, there is growing concern among pension industry participants that a potential future economic downturn will put further pressure on public pension plan funding levels that are already inadequate.
An expected benefit of stress testing, when conducted using standardized evaluation techniques, is the generation of data analytics that might help plan participants and plan managers better understand the potential impact of an economic downturn. Stress test results might help municipal plan sponsors and managers take corrective actions to support future liquidity needs and minimize the risk of potential insolvency.
According to Pew research reports, state pension funds cumulatively face a $1.4 trillion deficit as of 2016. Viewed from a different perspective, states have only $2.6 trillion of assets set aside to cover $4 trillion in pension plan liabilities.
On average, state pension plans are only 66 percent funded according to Pew. Funding levels vary greatly across states, with a low of 31 percent in New Jersey to funding levels above 90 percent in New York, South Dakota, Tennessee, and Wisconsin.
The Actuarial Standards Board (ASB), which sets U.S. standards used by actuaries, adopted Actuarial Standard of Practice (ASOP) No. 51 in September 2017. Titled, “Assessment and Disclosure of Risk Associated with Measuring Pension Obligations and Determining Pension Plan Contributions,” the new standard provides guidance regarding the assessment and disclosure of pension risk.
ASOP 51 (also referred to as the “Pension Risk” ASOP) defines a stress test as “a process for assessing the impact of adverse changes in one or relatively few factors affecting a plan’s financial condition.” The standard takes effect for any actuarial work product with a measurement date on or after November 1, 2018.
Risks that a public pension plan actuary might commonly evaluate when assessing a pension plan’s future financial condition are identified in ASOP 51 as follows:
-- Investment risk (i.e., the potential that investment returns will be different than expected);
-- Asset/liability mismatch risk (i.e., the potential that changes in asset values are not matched by changes in the value of liabilities);
-- Interest rate risk (i.e., the potential that interest rates will be different than expected);
-- Longevity and other demographic risks (i.e., the potential that mortality or other demographic experience will be different than expected); and
-- Contribution risk.
According to the Pew Charitable Trusts, California, Colorado, Connecticut, Hawaii, Virginia, New Jersey, and Washington either currently or will in the future disclose the results of pension plan stress tests to inform interested parties of how future pension plan performance may differ from expectations.
Stress testing for public sector retirement systems was recently recommended by the Pew Charitable Trusts. With stress testing, states may be able to assess the sustainability of their pension funding plans while factoring in fluctuations in the economy.
According to a spokesperson of the Pew Charitable Trusts’ project on public sector retirement systems, states can utilize stress testing to determine if their fund can:
-- Absorb any losses from adverse changes in the economy; and
-- Continue to maintain payments and benefits to their beneficiaries under current pension plan investment policies.
By assessing both questions using stress testing, states may be able to more effectively analyze how adverse economic situations might affect the fund in terms of the benefits promised to participants and their beneficiaries.
In a September 2018 report released by Pew Charitable Trusts, Pew cautions that “plans with both low funding levels and low annual contribution rates face the real prospect of insolvency without substantial improvement to state policies and behavior.”Altogether, states may be able to predict if a plan faces insolvency and what specific polices act as contributory factors to such a risk by using stress testing.
We recently wrote on the risk of insolvency in an article titled, "Pension Benefit Reductions Approved for Two Pension Funds." In the article we reported that the U.S. Treasury Department recently approved pension benefit reductions for two pension funds, the Western States Office and Professional Employees Pension Fund of Portland, Ore., and the Ironworkers Local 16 Pension Fund of Towson, Md. Both benefit reduction plans were meant to avoid insolvency.
By identifying weaknesses in current municipal pension plan funding policies, stress testing may prompt plan sponsors to evaluate actions that could narrow funding deficits.
Stress testing might also enable states to analyze how any loss in revenue might potentially be offset not just by higher beneficiary and employer contributions but by also lowering the promised benefit levels.
ERISA Benefits Consulting, Inc. by Mark Johnson provides benefit consulting and advisory services and does not engage in the practice of law.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.