The Office of the State Actuary (OSA) has curated this content in order to help interested parties understand how COVID-19 may impact Washington State retirement systems. Also see the
Inside Olympia interview with the State Actuary, Matt Smith.
Content will be updated as this situation evolves and as we complete up-to-date analysis, such as when 2020 Fiscal Year investment returns are known in the fall. It is important to note that actuarial work takes time and the full scale of the impacts will not be known until many months in the future.
|EXECUTIVE SUMMARY |
This webpage provides education on the following topics:
- How the Pandemic Impacts Pensions
- Pension Plan Health Prior to COVID-19
- Investment Returns and Asset Smoothing
- Timeline on COVID-19 Impacts to Pension Systems
- General Policy and Risk Considerations; and
- Stress Tests
In summary, COVID-19 will most likely impact our state pension systems by reducing investment returns below expectations and reducing the revenue available to meet contribution requirements. Fortunately, our state has many factors working in our favor as we respond to COVID-19. Our state pension plans entered 2020 in a relatively good position with a forecasted decline in contribution rates prior to COVID-19 and with $4.4 billion of deferred asset gains, in total, at June 30, 2019. In addition to these deferred asset gains that will dampen future contribution rate increases, we also have time lags built into our standard funding cycle that will delay the initial contribution rate impacts of COVID-19 until the start of the 2023 25 Biennium under current law.
Despite all these positive factors, required contributions for our state pension systems may come at a time when employers’ financial resources are limited. If required contributions are deemed unaffordable, the Legislature may provide short-term funding relief. The basic policy decision (or tradeoff) rests with the choice of paying for pensions now or paying more for pensions later.
If the choice is to pay more later, the ultimate costs will depend on the duration and magnitude of the funding relief (underfunding) along with any additional funding requirements due to a market downturn from COVID-19. In the stress testing we performed in this area, we found that our systems appear to be in a good position to weather a certain level of short-term underfunding in absence of a market downturn. However, we observe that poor investment experience, especially when coupled with underfunding, does markedly decrease plan solvency and markedly increase future funding requirements. We recommend additional actuarial analysis for any policy option that addresses the short-term affordability of the retirement systems in response to COVID-19.
See the following sections for more details on these topics.
|HOW THE PANDEMIC IMPACTS PENSIONS |
Generally, the word “pandemic” doesn’t stir up thoughts of pensions but, like most other sectors, the downstream impacts will certainly be felt here too.
Pensions are funded through investment returns and contributions. As outlined in
Commentary on Risk, pension funding is significantly influenced by investment returns which historically have comprised approximately 70 percent of plan funding in our state. The other 30 percent of funding has come from annual contributions from plan members and their employers.
Investment returns that do not meet long-term expectations have financial impacts on the retirement systems. The extent of the financial impacts are dependent on how far the actual investment returns deviate from expectations. The financial impacts due to COVID-19 have been significant and are still evolving. Poor market performance is expected in Fiscal Year 2020 and could extend to future years. The negative investment experience will noticeably impact the amount of funds available to pay out future benefits, funded statuses of plans, and raise contribution requirements.
Furthermore, the ability to pay the contribution requirements is dependent on state and local government revenue. Due to the lockdown put in place to mitigate the spread of COVID-19, and the potential for a significant drop in consumer confidence, the amount of revenue collected is expected to fall significantly short of the revenue forecasts published before the pandemic. This may create a situation where more contributions are required during a time when they are least affordable.
It is hard to say today just how far reaching the COVID-19 impacts will be on pension funding including the more subtle changes to factors such as retirement behavior, salary growth, Cost Of Living Adjustment (COLA)s, and life expectancy. Fortunately, pension plans are funded over a very long time period and engineered to be less reactive to current climates. This funding design gives contributing members and employers time to prepare for any increases in funding requirements and legislators and local government leaders time to prepare for the impacts in budget planning.
|PENSION PLAN HEALTH PRIOR TO COVID-19 |
The Washington State retirement systems entered 2020 in a relatively good position due to two main factors.
- The Legislature recently made a commitment to reach full funding by adopting historically high contribution rates over the past few biennia. Over the short-term this led to lower affordability (as defined in our
2019 Report on Financial Condition However, it allowed for a phase-in of new assumptions that more closely match expectations for the future, including lower assumed investment returns and longer assumed lifespans. In addition, it assisted the lower funded plans to recover from past periods of funding shortfalls.
- High investment returns experienced over the past few years helped. Not all assets are recognized immediately under the current funding policy, so some asset gains were deferred to future years. As of the preliminary 2019 valuation, there were 4.4 billion dollars, or 4 percent of total assets, in deferred investment gains.
The combination of these factors led to a forecasted decline in contribution rates prior to COVID-19 impacts. These factors will still be present going into the pandemic and will help partially offset increases in contributions rates and reduce the impacts on plan solvency.
As of the
2019 preliminary Actuarial Valuation Report (AVR), with a June 30, 2019, measurement date, all open plans are more than 90 percent funded. The closed PERS and TRS Plans 1 are between 60-70 percent funded with a plan in place to reach full funding by 2030 if all assumptions are realized and all required future contributions are made.
INVESTMENT RETURNS AND ASSET SMOOTHING |
The current asset smoothing method helps limit immediate contribution increases due to the lower than expected investment returns caused by COVID-19 impacts in two ways: deferred gains prior to the pandemic and distributing any losses that follow over time.
- Leading into the current market decline, the CTF had consistent positive experience since the great recession. As of the June 30, 2019, AVR,
preliminary assets for all plans had investment gains being deferred, totaling 4.4 billion dollars or 4 percent of total assets. As discussed in the
PENSION PLAN HEALTH PRIOR TO COVID-19 section, future contribution rates were expected to decline under our assumptions before the pandemic due in part to these deferred investment gains.
- Any investment losses that follow will be deferred for up to an eight-year period when determining future contribution rates and funded status. As a result of this asset smoothing method, the plans will recognize a minimum of 1/8 of the loss in any single year.
To put the current amount of deferred asset gains prior to the pandemic in perspective, we can compare two funded status measures: one using the Actuarial Value of Assets (AVA) and one using the Market Value of Assets (MVA).
We can rely on the preliminary
June 30, 2019, funded statuses of the plans to make this comparison. Based on that preliminary measurement, the total funded status of all plans under the AVA, or smoothed assets, is 92 percent. The same metric increases to 96 percent using the MVA.
|TIMELINE ON COVID-19 IMPACTS TO PENSION SYSTEMS |
Predictable and stable contribution rates are one of the funding goals for the Washington State pension systems. This means, by design, the systems are not as reactive to current economic conditions with deliberate and natural time lags in the funding cycle. To understand when COVID-19 may start to impact contribution rates, one can look at the typical rate setting process over three biennia.
As illustrated above, under the standard rate-setting process, the impacts from COVID-19 will not start to be incorporated in employer and Plan 2 member contribution rates until the 2023-25 Biennium subject to any changes made by the Legislature. Additionally, the more subtle changes that impact funding, such as long-term changes in salary growth or retirement behavior that may emerge, may not be fully captured until well beyond the 2023-25 Biennium.
This delay in increased funding requirements due to COVID-19 combined with the asset smoothing described above gives stakeholders time to prepare and makes it more likely that any increased funding requirements will begin during a recovery period rather than the downturn.
Additionally, not all members will be impacted by changes to the calculated contribution rates. For instance, members of Plan 1 have a fixed 6 percent contribution rate and members of Plan 3 make defined contributions to their personal retirement accounts.
|GENERAL POLICY AND RISK CONSIDERATIONS |
As illustrated in prior sections, the Washington State retirement systems have many factors to help counteract the negative impacts of COVID-19. The pension systems were in relatively good health entering the pandemic, the asset smoothing method in place will help mitigate contribution rate swings due to poor market experience, and there are time lags in the typical rate setting process that allows time to prepare. Despite these factors, required contributions may come at a time when employers’ available financial resources are limited. If required contributions are deemed unaffordable, the Legislature may provide funding relief. Typically, this results in lower pension contributions than required for full funding. Lowering pension contributions today will help with short-term affordability but it comes with long-term costs.
At the most basic level, decision makers must ask themselves if they would like to pay for pensions today or pay more for pensions later. If the choice is made to pay more later, the ultimate costs will be determined by the duration and magnitude of the underfunding along with any additional funding requirements due to a market downturn from COVID-19. Under a best-case scenario, short-term underfunding can lead to manageable increases in future pension costs and a modest short-term decline in the overall health of the pension systems. Under a worst-case scenario, chronic and significant underfunding can lead to unaffordable and ultimately insolvent pension systems. Risk management supported by actuarial analysis can support informed decisions in this area.
|STRESS TESTS |
There are several methods for measuring or assessing risk. One such method, a stress test, assesses the impact of an adverse change in one or relatively few factors affecting a plan’s financial condition. A stress test can be used to determine how reactive key measurements of the retirement systems are to adverse changes in areas likely impacted by COVID-19. They are not predictive and should not be used to determine future plan costs or health. We recommend additional actuarial analysis for any policy option that addresses the short-term affordability of the retirement systems in response to COVID-19.
For this section, we selected four tests in increasing severity for illustration. In these tests, we evaluated the change in long-term contributions (affordability) and change in funded status (solvency) from the baseline case. Please note that these tests are not our prediction for what will take place in the future.
- A short-term period of underfunding (i.e., adopting contribution rates below those determined for full funding).
- A short-term market downturn (i.e., lower-than-expected investment returns).
- The combination of short-term underfunding and market downturn.
- A prolonged period of poor investment returns and underfunding without an adjustment to the assumed long-term rate of return.
In summary, each stress test above will lead to an increase in plan cost, but we found that Test 1, in isolation, can largely be counteracted by current deferred asset gains to prevent a decline in pension plan health metrics. However, this would only happen if the assumed rate of return is realized all years in the future. Those mitigating factors [see the
Investment Returns and Asset Smoothing section] are overcome when we introduce a short-term market downturn in Test 2. Poor short-term investment returns, especially when coupled with underfunding, leads to notable increases in required contribution rates and decreases in funded ratios in Test 3. We observe the highest negative impacts to contribution rates and funded ratios when there is a prolonged period of poor investment returns, underfunding, and no change to the assumed long-term rate of return in Test 4.
The above stress tests are for illustrative purposes and do not consider a “bounce back period” that typically occurs following a period of negative market returns. Under a bounce back period, we would see a period of higher-than-expected investment returns following the lower-than-expected returns we modeled in Tests 2-4 above.
|ADDITIONAL RESOURCES |
Plan members looking for more information related to their retirement benefits should visit the
Department of Retirement Systems.
More information regarding Commingled Trust Fund returns and the most recent investment reports is available through the
Washington State Investment Board.
Washington State Economic and Revenue Forecast Council provides information on the latest revenue forecasts.
Additional educational resources and actuarial measurements for Washington State pensions of interest may include: