Archive for February, 2013

As economy recovers, CalPERS may lift rate lid

February 25, 2013

CalPERS last week gave some 1,575 local governments a small increase in their annual pension costs, one of the last rates kept low by unusual actuarial policies adopted after a $100 billion investment loss five years ago.

As a slowly improving economy bolsters government budgets, CalPERS is considering changes in investment and actuarial policies that could “turn on the spigot” over the next few years, requiring employers to put more money into the pension fund.

CalPERS funding levels are low, around 70 percent. Officials fear another big investment loss could require unworkable rate hikes to get to 100 percent funding. So a risk-based investment policy is being considered to cut losses in future downturns.

The level of the big CalPERS state worker fund is projected to drop to 60 percent in 50 years, even if earnings average 7.5 percent. Proposed actuarial changes would boost funding levels, avoid conflicting debt reports and make employer rates more predictable.

Did keeping a lid on rates put the system in jeopardy to avoid a rate shock that could trigger sweeping reform? Or were government budget cuts prudently eased during a financial crisis by a flexible pension system with a long recovery time?

Whatever the case, twin processes that could result in CalPERS board approval of major policy changes later this year are being led by Joe Dear, the chief investment officer, and Alan Milligan, the chief actuary.

The board is scheduled to consider “capital market assumptions” in May and a risk-based “decision framework” for investments in July. The goal is to adopt a new asset allocation while the economy is relatively good.

“We face higher rates if we do reduce the portfolio return,” Dear told the board last week. “As the charts indicate, this draw-down risk is absolutely associated with the portfolio risk we run with the exposure to growth in the portfolio, and when growth is good the portfolio does well.”

“But what we can’t withstand is another big loss,” he said. “Because in that circumstance we will not be able to grow our way out. Then the only recourse is contribution rates, and those increases would be punishingly high.”

Milligan wants to end the current actuarial clutter: a radical 15-year period for “smoothing” investment gains and losses, a “corridor” to limit smoothed values, rolling “amortization” that refinances debt each year, and two sometimes sharply different estimates of debt or “unfunded liability” based on the smoothed or market value of assets.

The chief actuary is proposing a conservative “direct” smoothing policy that would determine the rate increase needed to reach a funding level of 100 percent in 30 or 35 years, then phase in the rate increase over five years.

An example given the board last week: Under current policy, the employer contribution for most state workers, 20 percent of pay, is expected to increase to 23 or 24 percent of pay over the next two decades before dropping sharply to 12 or 13 percent.

Direct smoothing for full funding in 30 years would increase the employer contribution to a peak of 28 percent of pay in five years, decline over the following 15 years to 23 percent, fall sharply to 15 percent and fall again to 5 percent after 30 years.

These comparisons assume that investment earnings average 7.5 percent. But CalPERS expects to get about two-thirds of its revenue from investment earnings, which are unpredictable and have gained or lost 20 percent or more in a single year.

It’s a giant unknown or X factor, which makes running a California public retirement system a little like placing a bet in a big casino, where the taxpayers pick up the tab if you crap out.

CalPERS 10-year returns: actual (blue), target (gray), benchmark (red)

CalPERS 10-year returns: target (gray), actual (blue), policy benchmark (red)

The CalPERS board was shown several examples from 1,500 random simulations of the next 50 years, comparing current policy with proposed alternatives. One takeaway: a small rate increase can make a big difference in later funding and rate levels.

There is a better than 50-50 chance that CalPERS will fall below 50 percent funding at some point. The probability is 59 percent under current policy and 52 to 56 percent under four alternative methods.

The probability of the employer rate going above 40 percent of pay is 13 percent under current policy, 31 percent under the proposal to reach full funding in 30 years. The big difference is in rate shock, a single-year rate increase of more than 5 percent of pay.

The probability of that kind of rate shock is 59 percent under the current policy, but only 8 percent under the direct smoothing proposal aimed at reaching full funding in 30 years.

The board is scheduled to hear the proposed actuarial changes in March, followed by adoption in April. The changes would not affect rates until fiscal 2014-15 for state workers and non-teaching school employees and fiscal 2015-16 for local governments.

But Milligan said projections of the rates resulting from the new actuarial methods will be given to employers in their annual valuations before then, if the board adopts the proposed changes.

“This is along the lines of giving the employers that extra predictability they have been asking for,” Milligan said, referring to a common request at annual meetings, “and I think we should try our darnedest to get that extra predictability for them.”

Another factor likely to raise rates (in addition to changes in investment and actuarial policy): People are expected to live longer.

An insurance executive on the CalPERS board, Dan Dunmoyer, raised the mortality issue last week. He said the average female under 30 is expected to live to be 100.

For CalPERS, that means the average young female state worker could retire after 30 years of service at age 55, then for the following 45 years collect a pension equal to 60 percent of final pay that adjusts for inflation.

Milligan said employers and the board have been told that when a scheduled experience study is completed, probably next February, he will recommend that a mortality projection be included in the actuarial assumptions.

“That will result in an increase in employer contributions,” he said.

The CalPERS investment fund peaked at $260 billion in the fall of 2007, fell to $160 billion in March 2009 and was $253 billion last week. CalPERS had put a lid on rates in 2005 by adopting a 15-year smoothing period, well beyond the usual 3 to 5 years.

But after the big loss in 2008, most employers were still facing a rate increase of 5 to 10 percent of pay. So as part of three-year phase in of the rates, CalPERS temporarily widened the corridor limit on smoothing valuations.

When CalPERS lowered its earnings forecast from 7.75 percent a year to 7.5 percent last March, the resulting rate increase of 1 to 2 percent of pay was phased in over two years, cutting the first-year impact by half.

Under the local government rates set last week for fiscal 2013-14, the average employer contribution for miscellaneous workers increases 0.4 percent of pay to 15.3 percent of pay and for average safety workers 0.8 percent of pay to 32 percent of pay.

Three years ago, the fiscal 2010-11 local government rates averaged 13 percent of pay for miscellaneous and 25.1 percent of pay for safety workers, mainly police and firefighters.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Posted 25 Feb 13

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