Bonds: a way to avoid pension cost shock?

CalPERS actuaries proposed a plan last week to “immunize” a small survivor benefit program against big cost increases in the future.

Bonds with a predictable yield would be used to cover the expected payouts in future death benefits, avoiding the risk of relying on the fickle stock market.

The actuaries said the plan for using part of the $63 million surplus in the survivor benefit program is a “unique opportunity to apply immunization principles” to a small part of the liabilities in the giant CalPERS system.

The survivor program “could then be used as a model for immunization possibilities in the future should surpluses ever arise in other programs.”

The board of the California Public Employees Retirement System rejected the immunization proposal last week.

But members of the benefits committee said they might take another look at immunization in several years, when some think bond yields will be much higher than they are now.

Meanwhile, the board voted to use some of the surplus to increase benefits in the program for the survivors of local government employees not covered by Social Security. A $2 a month employee contribution was eliminated.

What is now called immunization is in part a return to the early days of public employee retirement systems in California, when investments were limited to fixed-income bonds and mortgages.

A ballot measure in 1966 allowed the pension systems to put 25 percent of their funds into blue-chip stocks. Advocates said Proposition 1 would enable increased retirement benefits and lower employee and taxpayer contributions.

A measure to allow 60 percent of pension funds to be invested in stocks, Proposition 6, was rejected by voters in 1982. But two years later voters approved a far broader measure, Proposition 21, simply requiring that investments be “prudent.”

The ballot pamphlet argument said the measure, still in effect today, is similar to federal law covering private pension funds and is needed to prevent inflation from eroding the value of pension funds.

After the lid was lifted, public pension fund earnings went far beyond keeping pace with inflation. CalPERS had a decade or more in which 75 percent of its revenue came from investment earnings, dwarfing employer-employee contributions.

A stock market soaring during a high-tech boom a decade ago gave CalPERS a surplus — an investment fund worth more than the pension payments projected to be paid in the decades ahead.

The CalPERS board responded to the “overfunding” in two ways that, in retrospect, now have their critics.

The annual payment to CalPERS from state and local governments, but not their employees, was lowered in a contribution “holiday” that went all the way to zero in some cases.

In 1999 the CalPERS board sponsored a bill, SB 400, that increased pension payments and lowered retirement ages for state workers, setting an example widely followed by local government pension systems throughout the state.

When the stock market boom ended, the projected surplus vanished. The annual state payment to CalPERS, which dropped to $160 million in 2000 during the boom years, soared to $2.6 billion by 2005.

The nonpartisan Legislative Analyst estimated that about $600 million of the increase resulted from higher benefits under SB 400. Most of the increase was due to lower investment earnings.

Gov. Arnold Schwarzenegger cited the dramatic increase in state costs when, early in 2005, he briefly backed a proposal to switch new state and local government hires to a 401(k)-style individual investment plan to begin to control future pension costs.

Elected officials have little or no control over public employee pension costs, once the benefits are granted through a labor contract. Retirement system boards set the amount of the annual payments made to pension funds by state and local governments.

To help balance budgets, state and local governments can cut education, health care and nearly all other services. But generally the amount budgeted for annual payments to pension systems can only be cut by retirement boards.

And retirement board members have a legal “fiduciary” duty to ensure that future pension obligations are property funded. A key variable used by actuaries to calculate contribution rates is the amount investments are expected to earn in the future.

CalPERS assumes its investments will earn an annual average of 7.75 percent. Advisers to Schwarzenegger, who in June proposed lower pension benefits for new state hires, are among those who think 7.75 percent is overly optimistic.

The governor and others argue that current pension benefits are “unsustainable” and will require contributions that eat up too much of state and local government budgets. When investment earnings fall short, it’s employers not employees who must fill the gap.

The immunization plan proposed by CalPERS actuaries would substitute the predictable earnings of bonds for market-based earnings that can fluctuate, as the stock market crash last fall underscored.

“We can take surplus and purchase assets that actually mimic the payouts for liabilities,” Rick Santos, senior CalPERS actuary, told the benefits committee.

“These assets would be something like fixed income or bonds or whatever,” Santos said. “Essentially what that does is it would prevent you from ever falling below 100 percent funded.”

State Controller John Chiang’s representative on the board, Terry McGuire, said that even if CalPERS investments do not earn 7.75 percent as assumed, they will earn more than any fixed-income rate that could be locked in a this point.

“Frankly, with that level of surplus I would rather not do immunization and look toward future benefit increases and stay with full investment in the PERF (Public Employees Retirement Fund),” McGuire said.

Board member George Diehr agreed: “I don’t think we need to immunize. Even if there were some increase in premium, it would hardly be a large amount. I think we would see it coming, and there would be choices then.”

Is CalPERS missing a chance to start a trend, back to basics with bonds?

Not if you look at Texas, where a newspaper story says a “unique” large pension fund has been a last holdout with most of its investments in bonds.

The value of the Texas Municipal Retirement System was $14.6 billion at the end of last year, down only 1 percent while many stock-laden pension funds had losses of about 25 percent in the stock market crash.

But the Texas Legislature approved a plan earlier this year that will slowly shift investments in the municipal retirement fund, now about 84 percent in fixed income, to 35 percent fixed income in the next four years.

Eric Henry, the TMRS executive director, told the newspaper the all-bond strategy was risky, putting “all of our eggs in one basket.” The bonds were expected to earn 5 percent a year, while diversifying with stock is expected to earn 7 percent.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at https://calpensions.com/ Posted 21 Sep 09

2 Responses to “Bonds: a way to avoid pension cost shock?”

  1. Peter Says:

    You continue to promote this ludicrous notion that the state led local governments down the garden path to higher benefits. The state enacted SB400 because it was losing employees to local governments with more generous pension plans – most of them already had 2%@55 or better long before SB400 – do your homework, ED!

  2. Chad Says:

    First off, I can’t believe that any part of that fund has any surplus after the last 2 years. Second, if there is a surplus after such extraordinary losses, why would you want to invest in assets that pay such low interest rates? Wouldn’t now be a time to take some risk?

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