New CalPERS earnings forecast would raise rates

UPDATE: A key CalPERS committee unanimously voted today (March 15) to leave the earnings forecast unchanged at 7.75 percent. The full board is expected to adopt the action tomorrow.

CalPERS actuaries are recommending a small decrease in the investment earnings forecast used to offset or “discount” future pension obligations, from 7.75 to 7.5 percent, but it would be another rate increase for struggling state and local governments.

The change would erase most of the $200 million CalPERS rate reduction received by the state after labor unions agreed last year to increase worker payments into the pension fund and give new hires lower pensions.

Many of the more than 1,500 local governments in CalPERS, who spend a much larger part of their budgets on personnel than the state, would be even harder hit by a lower discount rate.

Acknowledging that government budgets are being cut in a difficult economy, the actuaries’ report tells the CalPERS board, which may act next week, that making no change in the current discount rate would be “reasonably” prudent.

“Both assumptions would be able to provide for an actuarially sound system over time with a 7.50 percent assumption providing slightly more security than remaining at 7.75 percent,” said a report by actuaries Alan Milligan and David Lamoureux.

Discount rates, not a hot topic in the past, have moved into the spotlight as government pension costs go up to replace investment losses during the recession and stock market crash, while other programs are cut.

An attachment to the report by the California Public Employees Retirement System actuaries responds to a study by Stanford graduate students last year that said overly optimistic earnings forecasts were concealing a massive pension debt.

The Stanford report followed the view of some economists that a “risk-free” government bond rate should be used to report debt (but not necessarily for discount rates that determine rates) because public pensions are risk free, guaranteed by the taxpayer.

Using a government bond rate, 4.1 percent, the Stanford students calculated that the shortfall or “unfunded liability” of the three state retirement systems was not $55 billion as reported, but instead about $500 billion.

Former Gov. Arnold Schwarzenegger, who requested the Stanford study, obtained budget legislation last year requiring CalPERS, when setting annual rates, to include a forecast of how much higher rates would be if assumed earnings fell short.

Similarly, U.S. Rep. Devin Nunes, R-Visalia, has introduced a bill in Congress that would require public pension funds to report debt using a risk-free discount rate, or lose their ability to issue tax-exempt bonds if they do not comply.

The CalPERS actuaries say that public pensions can take on some risk because their debt is spread over decades, stocks and other investments have yielded more than bonds in the past, and a low earnings forecast could result in pension fund surpluses.

The actuaries also mention situations in which a risk-free rate could be useful. For example: when a plan is being phased out or comparisons are being made with other funds.

The report said the Governmental Accounting Standards Board “is currently considering changes to pension reporting along the lines of risk-adjusted accounting. Changes appear to be forthcoming.”

Although lowering the CalPERS discount rate from 7.75 to 7.5 percent is only a small change compared to several full percentage points in the debt-reporting dispute, the impact on state and local governments would be costly.

After a union representing most state workers classified as “miscellaneous” agreed to increase their pension contributions from 5 to 8 percent of pay last fall, the CalPERS rate paid by the state dropped from about 20 to 17 percent of pay.

That change along with increased worker contributions from other union agreements allowed CalPERS to drop the current state payment to about $3.8 billion, saving the state $200 million.

Now the actuaries estimate that dropping the discount rate to 7.5 percent would result in an increase in the state “miscellaneous” payment of 2.3 percent of pay, erasing much of the state gain from the 3 percent increase under the new labor contract.

The lower discount rate is estimated to increase the state payment for the Highway Patrol by 3.8 percent of pay, nearly twice as much as the increase in pension contributions from officers under their new contract, up 2 percent to 10 percent of pay.

For the more than 1,500 local governments in CalPERS, the actuaries estimate that lowering the discount rate would increase the rate for miscellaneous workers from 1.5 to 3 percent of pay and for police and firefighters 3 to 5 percent.

How soaring pension costs are already eating up some local government budgets was described yesterday by the mayor of the largest city in CalPERS, Bob Foster of Long Beach, who spoke in San Francisco at a Bay Area Council panel on pension debt.

Foster said that Long Beach, which spends more than 85 percent of its budget on personnel, may lay off 500 employees this year. He said pensions are the city’s largest cost driver.

“It clearly is an unsustainable path,” said Foster. “If we continue on the path, we are going to have to probably double the portion of our budget that goes to pensions, which already is about 20 percent.”

The mayor said that for every $1 that Long Beach spends on police and firefighters 28 cents has to be contributed to pensions — 2 cents of the total coming from the employees and the rest from the city.

“In three years that 28 cents will be 45 cents,” Foster said, “and beyond that it will climb up. It could easily get to the 60 or 65 or 70 cents level. And if we intend to fund police and fire by 2022 or 2023, that’s all we will have in the city of Long Beach.”

The CalPERS actuaries said that, “contrary to what some believe,” the earnings forecast used to set the discount rate is not an arbitrary target. It’s based on a new CalPERS asset allocation adopted in December after a year-long process.

“There appears to be a consensus that returns are expected to be lower than historical returns over the next 10 years,” the actuaries said of financial experts who expect slower economic growth.

The new CalPERS allocation of stocks, bonds and other assets is expected to earn 7.38 percent over the next decade after 0.15 percent for administrative expenses. Four years ago, a similar portfolio would have been expected to earn more than 8 percent.

The actuaries said the main result of leaving the discount rate at 7.75 percent, instead of lowering it to 7.5 percent, is that CalPERS would lose the cushion, the “margin for adverse deviation,” previously built into the discount rate.

When the current discount rate was adopted, the earnings forecast for the next decade was 8.04 percent. But economic times were better then and CalPERS adopted a lower rate, 7.75 percent, as a conservative margin for error.

The “real” earnings assumption in the current rate is 4.75 percent. The other 3 percent of the assumption is from inflation.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/ Posted 10 Mar 11

11 Responses to “New CalPERS earnings forecast would raise rates”

  1. Keen Observer Says:

    An awful lot of authority is being granted to a group of graduate students, even if they are from one of America’s top universities. Couldn’t the anti-pension forces have found any Stanford professors to provide a study to advance their crusade?

  2. IT Pro Says:

    Keen,

    The Stanford study has repeatedly been debunked for the garbage it is. But it’s just the drum that keeps getting beaten by the anti-pension crowd. I mean, they heard it on the internets so it must be true, right?

  3. jskdn Says:

    This is the implicit moral hazard of defined benefit pensions. The principle decision makers are playing with other people’s money with high discount rates. The lower the rate the more the costs are experienced in the present. By betting high, costs are avoided in the present and the risk is shifted to the future. We need defined contribution systems where all the costs occur in the present and so are properly accounted for and can therefore be subject to negotiation between the interested parties. By the way this moral hazard with defined benefits systems is not exclusive to the government sector. Corporations do it too.

  4. Charles Sainte Claire Says:

    There is much to actuarial accounting that is difficult to understand. From what I read about the Stanford study it appears that they admit that their study shows the maximum State debt possible. Also, they do not suggest that Calpers base their planning on a 4.14% rate.

  5. john moore Says:

    Here in Pacific Grove,Calpers lost 51 of our 100 million dollar pension plan. We have 19 million in pension bonds(plus interest) and 31 million dollars of deficit. The 31 million grows at 7.75% per yr.. Because of the pension losses,Pacific Grove will only provide minimum services for century after century. Reality is ,well,Reality. Agreed,PG had some of the most incredibly incompetent management and professional advice to get in this condition. But forever is a long time to pay for acts of greed.

  6. Rex The Wonder Dog! Says:

    The Stanford study has repeatedly been debunked for the garbage it is.
    ===============

    LOL…another trough feeder whopper.

    The Stanford study has never been “debunked” much less “repeatedly”.

    It is in fact a study proven up NUMEROUS times by other top flight universities-like Northwestern. Why you clowns think you can get away with such a whopper when the facts are from the top university on the west coast is very strange……….

    Why do public employee trough feeders think they can get away with posting such whoppers?????? Oh, I forgot, they are not the sharpest tool in the shed :)

  7. jskdn Says:

    As I understand it, actuarial accounting requires looking at the predicted life expectancies of existing and future pensioners, the pensions benefits those people have been promised as the result of employment already completed and then comparing the value of the assets in the pension fund to what is necessary to meet those obligations, discounted for a chosen rate of return. And reflecting John Moore’s comment, any shortfall in amount of money in the pension fund required to meet those obligations compounds at the same discount rate function of the chosen rate of return.

    If I got anything wrong or am missing some important consideration. I’d appreciate it if Ed Mendel would write about it. This blog is an invaluable resource. Thanks Ed.

  8. roger Says:

    Look how much cops cost the people of Kali. Time to issue CCWs & let people protect themselves!!!

  9. Keen Observer Says:

    Rex, you amaze me with your half-informed, arrogant vitriol. You’d cite an undergraduate’s term paper if it supported your bias.

    In fact, I am an alumnus of that great west coast university. Where did you go to school, doggy?

  10. Ambidxtrous Says:

    The discount rate should have been approved at 7.50%. The reason the board is pushing 7.75% is because of their internal relationships with Hedge Funds. There fees and costs have increased and so Calpers must adjust to these higher costs. You will not find this in their balance sheet but Under 8% Calpers investments is being heavily invested in derivative markets. Yet they do not release such information to the Public about these so called “volatility management” or “Hedging risk” strategies.

  11. Sam Says:

    NOTE: The name of Calpers devoted Hedge fund is Och-Ziff Capital Management

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