Risk Measurements

The Office of the State Actuary uses the assessment of risk methods noted in the prior section, and in some cases, combines these methods. Below are two examples.

Using our Interactive Reports, a user can assess how the plan’s present value of future benefits, funded status, and contribution rates change when the user selects an assumed rate of investment return or asset valuation method that varies from the best estimates used for the measurement.

These reports provide users with (1) a sense for how a plan’s financial condition or funding requirements may change if our assumptions prove inaccurate, and (2) an understanding of how our actuarial measurements would change if we applied different assumptions or methods at that same measurement date. For example, if we replaced the Actuarial Value of Assets (or smoothed value) with the Market Value of Assets (MVA), then how much would a plan’s funded status or contribution rates increase or decrease from current actuarial measurements? As another example, the interactive reports test the impact if we assume a lower or higher long-term assumed rate of investment return than our current best estimate. See our Interactive Reports to access these sensitivity tests.

We highlight the impact of the long-term rate of investment return assumption due to the significant impact of that assumption on plan funding. Over the past 20 years across all plans, investment returns have comprised approximately 70 percent of the pension fund’s total income, with the remaining 30 percent coming from employer contributions and employee contributions (split approximately 20 percent and 10 percent, respectively).

Our current best estimate measurements assume that future investment returns will continue to cover a significant share of future pension costs. However, past investment performance does not guarantee similar, future performance and our assumptions, in the long term, may prove to be inaccurate. As an example, if future returns are expected to be lower, the employee/employer contributions would need to account for a bigger piece of the pension fund income.

As required under the Actuarial Standards of Practice, we assess all assumptions (economic or demographic) each year for reasonability. Consistent with the Revised Code of Washington, we recommend economic assumptions every two years as part of our Economic Experience Study. We also analyze demographic experience approximately every six years as part of our Demographic Experience Study.

In 2010, we created a custom stochastic model to perform Risk Assessments periodically on our largest state pension plans. Every five to six years, we review the assumptions and methods used in those assessments as part of our Risk Assessment Assumptions Study.

Stochastic modeling is the most complex and time-consuming method for assessing risk. Unlike sensitivity analysis where you replace a single expected outcome with a different individual outcome under an alternative assumption or method, stochastic modeling provides a distribution of outcomes under numerous alternative assumptions or methods. This type of modeling provides the user with a better sense of the range of potential outcomes and the potential likelihood of those outcomes based on the assumptions and methods from the stochastic model. Because this modeling also includes very pessimistic outcomes, it represents a form of stress testing as well.

In Washington State, we combine scenario testing with stochastic analysis to assess two key risks for our state pension plans: (1) Contribution Risk – defined in this context as the potential for contributing entities to contribute less than the full actuarially required amount, and (2) Benefit Enhancement Risk – the potential for the Legislature to enact future enhancements to current benefit provisions.

Why are these risks to the systems? Significant and persistent underfunding weakens a plan’s financial condition and leads to significantly higher future contribution requirements. This can create a cycle of funding shortfalls as demonstrated in the graphic below.

Significant one-time benefit enhancements or the practice of regularly enacting smaller benefit enhancements over time can also weaken a plan’s financial condition and lead to unsustainable contribution requirements.

To assess these risks, we perform stochastic modeling under the following risk profiles.

• Current Law – Where we assume all plans receive the full, actuarially required contribution amount (subject to certain assumed maximums) and benefit provisions remain unchanged over time, and
• Past Practices – Where we assume all plans receive a percentage (less than 100 percent) of the actuarially required contribution and the Legislature enhances benefit provisions in the future consistent with past practices.

By comparing the stochastic measurements from these two risk profiles, users can see how the plan’s solvency and affordability risks change when the plans receive full funding and benefit provisions remain unchanged or when past practices continue in these areas.

For each case, we display select risk measurements and graphs generally, for the plans as a whole. The purpose of this information is to help users understand how much certain outcomes can vary from our best estimates and the likelihood of those outcomes based on the assumptions and methods from our stochastic modeling.

See our Risk Assessment webpage to access the results of our latest stochastic analysis.

Using this same risk assessment model, we also project employee and employer contribution rates for the next two biennia under the current law case. We then summarize the output of our modeling and compare the expected outcome with both pessimistic and optimistic outcomes. This information can be found on our Contribution Rates Projections webpage.