North Carolina recently enacted legislation that mandates regular stress testing of the state’s largest pension system—the Teachers’ and State Employees’ Retirement System (TSERS)—based on a framework developed by The Pew Charitable Trusts and aligned with the reporting schedule for the plans’ actuarial experience review.
Policymakers designed the state’s approach to ensure that the stress test analysis is informative to a broad range of stakeholders, including plan sponsors and state finance officials. Stress testing is a simulation technique that can help policymakers prepare for the impact of adverse economic conditions on pension balance sheets and government budgets.
The new law, signed by Governor Roy Cooper (D) on June 26, had broad support, passing 117-2 in the House of Representatives and unanimously in the Senate. North Carolina is the 11th state to require comprehensive pension stress testing or risk reporting. (See Figure 1.)
The measure formalizes a practice that began in 2019 when the state treasurer’s office asked Pew to provide a stress test analysis of TSRES to help put policymakers in a position to navigate an economic downturn.
Those drafting the legislation based the proposal on Pew-developed guidance known as the Foundation for Public Pensions Risk Reporting. Developed in collaboration with industry experts, the framework is designed to boost officials’ understanding of how pension investment risk could strain government budgets, and to help states evaluate the impact of contribution risk on system solvency.
Pew has updated its economic scenarios to reflect the impact of the COIVD-19 pandemic and will publish a revised version of the framework soon. Because of the quick spread of the novel coronavirus and the start of a new recession, many states are tracking fluctuating returns on plan investments while confronting losses in expected tax revenue and increased costs. To effectively navigate what is likely to be a period of great uncertainty, policymakers need to understand how pension funds would perform under different economic scenarios.
Pew’s analysis for North Carolina, completed last year before the pandemic and presented to the TSERS Board of Trustees in October, found that the state’s high contribution levels and funded ratio—assets as a percentage of pension liability—would protect the system from significant cost increases in the event of a market downturn. Additionally, the state could continue to transition from a discount rate now set at 7% to one as low as 6% without significant impact on cost or funding. Lowering return assumptions is one of the key adjustments that states can make to reduce risk, and experts now expect long-term returns to be closer to 6% for pension systems.
North Carolina illustrates that stress testing should be an important component of risk management for even the best-run systems. In good times, the analysis can aid in assessment of contribution policies and provide early warnings of potential problems. And in times of economic downturn, routine stress testing can help states improve budgetary planning, allow better assessment of proposed pension changes, and avoid costly mistakes.
David Draine is a senior officer and Michael Lowenthal is a manager with Pew’s public sector retirement systems project.