In the past few years, states have considered legislation that would require public pension plans to conduct financial stress testing. While we’ve mostly written about the Pew Research Center’s promotion of cash balance plans, Pew is also known for traveling to states and pushing for mandatory stress testing. The thing is, most public pension plans already conduct financial stress tests. Pew is campaigning for stress testing that biases the results against public pension plans, so they can push for changes that gut pensions.
Each year, actuaries for public pension plans determine what the actuarially required contribution (ARC) is for plans to maintain or achieve full funding. While contribution rates for employees and employers vary from plan to plan and are often fixed by law, this annual calculation of the ARC is itself a form of stress testing in which the plan looks at all of its financial variables and determines how much needs to be contributed to pay future benefits.
Financial stress testing is a fairly standard procedure conducted by the professionals who manage public pension funds. Stress testing examines a number of different possible scenarios in which investment returns are above or below the expected rate of return. This stress testing allows pension professionals to gauge the likelihood of achieving their expected rate of return and make the necessary adjustments. Pension plan managers use this assessment to adjust the expected rate of return, determine the actuarially required contributions, and set other policies.
Over the long term, investment returns typically revert to the mean; that is, if returns are really high for a few years, they are then likely to decline for a few years, and vice-versa. Long term investment results have much less variance than short term results. This is good for public pension plans, where the investments are made over the course of an employee’s career. The 20- or 30-year returns are what really matter for paying out pension benefits. When Pew comes to a state and pushes for mandatory financial stress testing, they fail to acknowledge that investments revert to the mean, thus creating biased results. Pew’s method of stress testing focuses on downside events only: times when the pension plan’s investment returns fall significantly below expectations. This effectively rigs the outcome because the plan is going to look bad if you are only considering worst case scenarios.
While Pew may talk about the importance of making contributions to the pension plan, they always couple that with talk of cutting benefits. The reality is that fully funding the plan every year is the best thing a state can do to ensure its pension plan is fully funded and can withstand financial stress.
Pew also betrays their intentions by the way they go about promoting stress testing. Rather than working with public pension plans themselves, they go directly to state legislatures and push for state-mandated stress testing, even though stress testing is something pension plans already do. The Pew-backed, state-mandated financial stress testing is rigid and set up to produce a certain outcome. It is not the flexible testing conducted by plans themselves that takes into account current real-world factors.
Pew should be honest about their reasons for promoting mandatory stress testing. Pew’s stress testing method is designed to make public pension plans appear unsustainable, so Pew can push state legislatures to cut benefits by switching new workers to cash balance or hybrid retirement plans. Stress testing is a tool and like any tool, it matters how you use it. In the wrong hands, any tool can be dangerous, and Pew has proven this with the way they use financial stress testing.