$TRE$$ED: To gauge their resiliency, public pensions are being put through their paces.

• Author: Petrini, Anna
• Position: PENSIONS

A mid market volatility and fiscal uncertainties, the number of states requiring their public retirement systems to undergo standard financial stress tests is on the rise. The tests help officials and plan members assess how their plans would fare under different economic and investment-return scenarios.

Stress testing aims to refine, enhance and formalize the work states are already doing to evaluate their pensions' exposure to risk. Making the results public, and more transparent to policymakers and plan members, supporters say, will provide important context for discussions about how the plans are designed and funded.

There are several simulation techniques that can help measure the soundness of pension plans. Sensitivity analysis looks at the liability side of the equation, quantifying risk by asking how much liabilities would rise if plans assume, for example, a return of 6 percent rather than 7 percent. Stress testing evaluates the health of plans against several economic factors, like market volatility, contribution policies and state revenue forecasts. Scenario testing looks at how economic shocks like recessions can affect a plan's financial condition.

A conversation about the mechanics of stress testing gets very technical, very fast. But essentially, these measures all tell a story about risk, because risks to the market create risks for pension funds. What happens if things don't go as expected? How much risk is a pension plan taking on, and who bears it?

The Great Recession's Legacy

The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in response to the financial crisis of 2008, requires large financial institutions to conduct annual stress tests and report the results to the Federal Reserve. Recent jolts to the market have led some financial experts to encourage more widespread use of these tests, and the enthusiasm has spilled over to public retirement systems. Legislation to require these tests has really gained traction in the last couple years.

The Pew Charitable Trusts reports that state and local governments are facing $1.7 trillion in unfunded pension liabilities as of fiscal year 2017. "When you talk about billions of dollars of unfunded liabilities, it can be overwhelming," said Susan Banta, director of research for Pew's Public Sector Retirement Project. She told lawmakers and legislative staff at an NCSL meeting in Chicago this spring that, to help manage these liabilities, state pension plans increasingly have relied on riskier, more complex investments that track market volatility. They are more vulnerable to economic...