A better understanding of pension risk can lead to improved investment strategies and expected financial outcomes. This premise is one of Aon’s core beliefs and applies uniformly to all public sector pension plans. It stands in contrast to polarizing and divisive issues such as the level of investment return assumptions and the appropriateness of alternative assets— aiming instead to focus on desired outcomes and the paths to achieving them.
At their core, public pension plans represent a pool of assets that are dedicated to funding benefits promised to employees (both past and present). Understanding how the liability associated with these pension payments interacts with the asset level, the asset allocation, and the funding strategy is vitally important for public plan sponsors. The question then becomes: “What should plan sponsors do?”
The Actuarial Valuation Covers This… Right?
Annual actuarial valuations tell a version of the story about the interaction of assets, liabilities, and funding strategy; however, they are only a partial view of a snapshot date that focuses on an expected outcome. What these reports currently lack, but are working to supplement through new standards of practice, is a focus on the risks associated with a pension plan.
Additionally, actuarial valuation reports focus on only one plan year at a time, rather than handling forward-looking projections. More times than not, any future projections incorporated assume a smooth pattern of actual experience equaling plan assumptions or slight deviations. These projections attempt to focus on the expected outcomes over time. In reality, the path forward is generally much choppier than expected, producing a wide range of future outcomes. The range of outcomes, or risks to the pension plan, tells an important part of its story. The actuarial valuation report does not define what those risks are and how they evolve over time.
How About Stress Testing?
The term “stress testing” is in vogue within the public sector pension world. It refers to financial projections that aim to stress key variables (such as investment performance) in order to gauge their downstream impact (or risk) on other financial measures such as plan contributions, funded ratio, etc. The way stress testing is handled and the extent to which variables are stressed play an important role in the value of such analyses.
Current examples of stress testing can range from a handful of specific scenarios outlined by the Society of Actuaries’ Blue Ribbon Panel to modeling prescribed by The Pew Charitable Trusts, which have been advocating for states to enact stress testing legislation.
Any stress testing projections are beneficial because they aid in the understanding that for some risks, actual experience differs from expectations. However, stress tests paint an incomplete picture because they focus only on a handful of specific future environments.
A Solution-Oriented Approach
Ultimately, the common thread for any future planning is for plan sponsors to gain an understanding of how their pension plan will be impacted in a changing world. Given the limitations of deterministic stress testing, Aon recommends the robustness of stochastic projections to analyze a wide range of economic scenarios (e.g., 5,000 independent trials) over a long time period (up to 30 years), with each scenario exhibiting a non-uniform pattern of results.
Solution-oriented approaches allow plan sponsors to look at the risks within the pension plan and determine if the strategies in place allow them to meet their goals.
In our opinion, a key component of these projections is the period of time under consideration, since public pension funding has a long lifecycle (due to amortization practices). The wider the lens being used, the more the future patterns begin to take shape. Limiting the time horizon could potentially gloss over longer-term trends/risks that should be known to plan sponsors when making decisions on investment strategy.
Solution-oriented approaches allow plan sponsors to look at the risks within the pension plan and determine if the strategies in place allow them to meet their goals—or, alternatively, to determine whether adjustments to the investment strategy offer beneficial risk/reward trade-offs to the stated goals. Forward-looking projections alone will not necessarily solve a specific problem. They lay out the analysis that should aid in decisions and answer questions such as:
- How is the plan’s funded status projected to trend over time?
- How do different asset allocations impact both the time to expected full funding and the downside funded ratio?
- Is the contribution policy strong enough to take the plan to its desired position?
- Does today’s contribution policy work in the long run, or is there a risk of creating budgetary strain in the future?
- Does any potential pension reform have unintended future consequences?
Every public pension plan is different, and each story is unique. There is not one broad brush that can be painted over them as a whole. That is why we believe it is imperative that each plan sponsor consider its own version of solution-oriented analysis (such as an asset-liability study or some other means) to arm itself with the knowledge of how the plan is expected to behave in turbulent times.
Understanding the range of potential future outcomes is important in judging the viability of the investment strategy and funding policy currently in place. When viewed over a long time period, such as 30 years, these trends and ranges of possible outcomes tell the story of the pension plan’s future health. This should help focus today’s efforts on addressing potential future pain points. A better understanding of the risks associated with the pension plan—not merely of its expected performance—can lead to improved investment strategies that look to limit downside scenarios and improve expected outcomes.