Risky Choices: Simulating Public Pension Funding Stress with Realistic Shocks

Abstract

State and local government pension funds in the United States collectively manage a very large and diverse pool of assets to meet the even large sum of accrued liabilities. Recent research has emphasized that widely-used accounting practices, like matching discount rates to expected asset returns, understate the market value of these liabilities. Less work has explored the risks inherent in existing diverse set asset allocations, and the accounting practices used by most state and local pensions do not capture or report this risk at all. To explore the effect of asset market risk, we build and simulate a dynamic model of pension funding using a realistic return generating process. We find that the range of potential outcomes is very large, meaning that state and local governments need to prepare for an extremely wide range of possible funding shocks in the next few decades. Moreover, this wide range of outcomes makes the ultimate impact of policy choices – such as changing the discount rate or failing to sufficiently contribute to the fund – nonlinear and difficult to anticipate. Together, these findings suggest the need for more attention and reporting of these risks and the attendant range of possible outcomes by public plans.