Despite rising funded levels, US public retirement systems are “more vulnerable than ever” to the next economic downturn, according to a report from The Pew Charitable Trusts.
In preparation for the next time the economy heads south, and to strengthen their long-term financial health, several states have undertaken stress test reporting, the report said. Pew said the practice “can show policymakers how adverse economic scenarios could affect retirement system investments and state budgets.”
Pew said eight states—California, Colorado, Connecticut, Hawaii, New Jersey, Vermont, Virginia, and Washington—now require their public pension systems to analyze the impact of downturns on pension costs and liabilities, financial market volatility, and contributions. Pew also said that stress testing allows states to account for the condition of their economy and tax collections, and offer a broad view of how pensions impact their overall fiscal health.
“The ability to consider the impact of a range of economic conditions on pension balance sheets and government budgets helps policymakers evaluate whether current policies are sufficient to withstand the impact of the next recession,” said the report. “Over the past decade, many state officials learned that overly optimistic investment return assumptions caused gaps in pension funding that had to be covered by increasing contributions and reducing benefits, often several times.”
Pew said the testing provides the information needed to evaluate policies and adjust investment assumptions over time, which can help ensure retirement plans are affordable and fully funded during various economic scenarios.
For example, Pew said its analysis of plans in New Jersey and Colorado found that without “significant policy intervention,” the pension systems in both states risk insolvency if a recession hits, and investment returns are lower than expected over an extended period.
The report said that since the Great Recession of 2007 to 2009, state tax revenues have been slower to rebound than after the three previous downturns, and that revenues have been more volatile than in the past. It also said the gap between retirement fund assets and liabilities had grown each year from fiscal year 2000 through 2016, despite increased pension contributions, benefit cuts, and stock market gains.
Pew also found that although most state pension systems have lowered their assumed rates of return, the level of portfolio risk that states are taking on to meet their investment targets “has never been higher.”
It said the median return assumption in fiscal 2016 was 7.5% for public pension plans, despite the fact many analysts expect investment performance to be a full percentage point lower, with a one in four chance that returns may not top 5% over the next 20 years.
“Against this backdrop, more states are looking at stress testing to give policymakers a better sense of potential funding scenarios,” said the report.