A decade of consistent economic growth lifted the major stock market indices to all-time highs in 2018. But even before the recent dip, many state pension plans were struggling to get back to where they were before the last recession. Unfunded pension debt across the 50 states totals a staggering $1.6 trillion, even by the plans' own (often overly rosy) accounting.
If a decade of positive investment returns can't fix what's wrong with America's public pension systems, how much worse could things get in the event of another downturn? That's what Greg Mennis, Susan Banta, and David Draine, three researchers at the Harvard Kennedy School, set out to determine. They subjected state pension plans to a series of stress tests meant to simulate the consequences of a variety of adverse economic climates over the next two decades, including everything from another major recession to merely lower-than-expected investment growth.
What they found isn't pretty.
"Public pension systems may be more vulnerable to an economic downturn than they have ever been," the trio of researchers concluded in a paper published by the Pew Charitable Trusts in 2018. Deeply indebted pension plans in places such as Kentucky and New Jersey face insolvency if annual returns average 5 percent for the foreseeable future rather than the higher (usually around 7 percent) rates the plans assume. In other words, it won't take much to tip those systems into bankruptcy.
If a major downturn does come, states such as Colorado, Ohio, and Pennsylvania—which are closer to the national average in terms of how well-funded their pensions are—could require "contributions that may be unaffordable" to avoid insolvency.
One of the only states that seems ready to survive fiscal troubles is Wisconsin, where the combination of low existing debt and a 401(k)-style defined benefit plan means unexpected costs would be manageable and shared between employees and taxpayers.
Mennis, Banta, and Draine argue convincingly that stress tests provide a better snapshot of the health of a state pension system than more traditional methods, such as looking at aggregate unfunded liabilities or the funding ratio—that is, the percentage of future liabilities projected to be covered by a combination of future contributions, taxes, and investment earnings. Those metrics can be gamed by making unreasonable assumptions of future investment growth, but stress testing is a reminder that the good times won't keep rolling forever.
Connecticut, Hawaii, New Jersey, and Virginia have passed legislation or adopted policy changes mandating annual stress-testing of public pension plans, while California and Washington have created informal guidelines establishing similar processes. More states should do the same.
Comments