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 https://calpensions.com/ Posted 10 Mar 11