New focus on showing risk as CalPERS rates go up

A new CalPERS projection shows employer rates for the largest group of state workers increasing 27 percent over the next six years — but the focus is on the risk of how much things can change.

As the giant pension fund begins to take a bigger bite of state and local government budgets, employers will get more information about rates and a kind of mixed message.

The goal is make rates more predictable for employers, avoiding shocks and allowing time to adjust budgets, while also encouraging employers to think about risks that could change the rates.

A new annual “actuarial valuation” for state and schools plans has added a “risk analysis” section. How rates can change is shown with several examples of different annual investment earnings and long-term earnings forecasts.

CalPERS also is holding a two-day asset liability management workshop next month. It’s open to the public, and representatives from the 1,576 state and local government agencies in CalPERS are encouraged to attend.

“They need to think not just about their current risk levels, but also how that risk level can change over time,” Alan Milligan, CalPERS chief actuary, said last week. “If they are uncomfortable with the risk level now, and we know that is likely to increase, then that’s something they should be aware of and thinking about.”

As pension systems move toward full funding (the goal of new higher CalPERS rates) year-to-year jumps in employer rates are more likely. “Volatility” grows with increasing assets. If there is an investment loss, a bigger rate increase is needed to fill a bigger gap.

Milligan previously has said that a rate increase is likely to result from a review early next year of economic and demographic forecasts, including new projections that people on average are living longer.

Another rate increase could result from a California Public Employees Retirement System board review of asset allocations later this year. Milligan said he is likely to recommend lowering risk levels.

In the past, CalPERS has adopted a “discount rate” to offset future obligations based on a slightly lower earnings forecast than actually expected, providing some cushion to reduce risk.

“I am not sure I will be recommending including a margin for adverse deviation (cushion) in the future,” Milligan said. “I may instead recommend that they consider adopting a less volatile asset mix, because that may be actually a better way to control risk.”

Milligan said the November workshop will consider “flexible derisking.” In a year with outstanding investment returns, for example, the board could think about lowering the discount rate, changing the asset allocation mix or doing both.

New CalPERS projection of state and school rates over next six years       (Rates are  percentage of pay)

New CalPERS projection of state and school rates over next six years (Rates are percentage of pay)

At the core of CalPERS risk is the need to get about two-thirds of the money to pay future pensions from market-based investment earnings, which are difficult if not impossible to predict with precision.

Public pensions in California originally were limited to more predictable investments: bonds. But Proposition 1 in 1966 allowed 25 percent of investments in blue-chip stocks. Proposition 21 in 1984 removed the lid, allowing anything “prudent.”

When a booming stock market in the late 1990s gave CalPERS a surplus, pushing the funding level past 100 percent, the pension system followed the common practice of spending the “windfall” rather than keeping the money to offset future downturns.

Employers were given a contribution “holiday,” dropping the annual state payment from $1.2 billion to $159 million in fiscal 1999-00 and to $157 million the following fiscal year. Pension reform legislation last year bans contribution holidays.

CalPERS sponsored a large retroactive pension increase for state workers, SB 400 in 1999, telling legislators “superior” market-based investment returns would cover the cost.

The SB 400 benefit increase accounted for 27 percent of the increase in the annual state CalPERS payment by fiscal 2009-10, a chart on the CalPERS Responds website said several years ago. The pension reform rolled back the SB 400 increase for new hires.

A provision in SB 400 allowed local police to bargain for the trendsetting 50 percent pension increase given the Highway Patrol. Critics say big police and firefighter pensions, matching the Highway Patrol increase, are straining local government budgets.

As state payments to CalPERS soared, reaching $2.5 billion in fiscal 2004-05, former Gov. Arnold Schwarzenegger briefly backed a proposal to switch state and local government new hires to 401(k)-style individual investment plans.

CalPERS announced a new actuarial method in 2005 aimed at preventing future rate shocks. A radical “smoothing” plan spread investment gains and losses over 15 years, well beyond the three to five years used by most public pensions.

When a deep recession hit, the CalPERS investment fund plunged from about $260 billion in the fall of 2007 to $160 billion in March 2009. The CalPERS fund, which did not reach $260 billion again until this year, was valued at $270.5 billion last week.

The big loss revealed shortcomings in the 2005 actuarial method that kept rates low. CalPERS in 2009 temporarily lifted actuarial limits for a three-year phase in of the biggest one-year loss, $24 billion.

Other problems are described in an annual risk report this year. For example, most funds pay less than the annual interest on their debt or “unfunded liability” and state funding levels have a better than even chance of dropping below 50 percent.

CalPERS took one step to raise employer rates in March last year by lowering the discount rate from 7.75 to 7.5 percent. Critics say the earnings forecast is still too optimistic.

Another step raising rates came last April when CalPERS adopted a new actuarial method aimed at getting to full funding. The estimate then was that rates could go up roughly 50 percent over the next seven years.

Now the next step could be a change in investment policy as the board looks at asset allocations later this year.

CalPERS has about 70 percent of the projected assets needed to pay future pension obligations. The prospect of another economic downturn, and more heavy investment losses, is worrisome.

“There is a substantial risk that, at some point over the foreseeable future, there will be periods of low funded status and high employer contribution rates,” said the risk report issued this year before the new actuarial methods were adopted.

“Should this coincide with a period of financial weakness for employers or if such a period occurs before we recover from the current funding shortfall, the consequences could be very difficult to bear.”

History of state and school CalPERS payments

History of state and school CalPERS payments

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 7 Oct 13

8 Responses to “New focus on showing risk as CalPERS rates go up”

  1. Mike Genest Says:

    Another excellent job of reportage, Ed. A couple of points:
    I think you must have made a typo in referring to Prop 1 as having been enacted in 1996.
    You refer to those who note the fiscal strain on local governments of high safety/fire pension costs as “critics”. They’re just observers of the facts.
    On the other hand, saying that “critics” assert that 7.5% is too optimistic is fair enough since that is a matter of opinion, although it’s starting to look like CalPERS may share that opinion.

    Finally, a point for some of your readers who seem to misunderstand who bears the risk. As you know, the normal costs of pension plans are very often shared between the employer and employee. But, if the assumptions that go into calculating those costs go wrong (disappointments in returns, overly optimistic benefit increases, employer holidays that skim off peak returns, higher wage growth or increased longevity), currently the employer (i.e., tax payer) bears 100 percent of those costs. It seems to me that we retirees and employees should share some of that risk, but to accomplish that we would need a constitutional amendment or voluntary agreements in new MOU’s.

  2. SeeSaw Says:

    MG, the employee is also a taxpayer. Why don’t you just spell it out! What are you, as a retiree, offering to take on, in the way of having your own retirement reduced?

  3. Bill Says:

    27% on top of the already estimated 50% increase?

  4. John Moore Says:

    Excellent Analysis. The only thing missing is the size of the total pension liability, with, and without 15 year smoothing. The point that there is but a 50% chance of avoiding a 50% deficit is sobering. Here in PG we are already past 50%(65 million dollar deficit and POB principal in plans with a 120 million liability) Soon PERS will own all of the city assets. It is just a matter of a few years.

  5. RSpringbok Says:

    Agree with Seesaw, employees and retirees bear a double risk because they pay taxes too. And Mr. Genest’s idea of having retirees share in the cost of unfunded liabilities makes no sense under a defined benefit plan. The benefit is either defined or it isn’t.

  6. JJ Jelincic Says:

    Mike Genest is right that the employer absorbs the costs of low investment returns. He ignores that the employer keeps all of the returns above the discount rate.

  7. Tough Love Says:

    CalPERS will fail as assuredly as there will eventually be another great CA earthquake.

    The former is well deserved, The latter, not.

  8. Bille Says:

    If CalPERS fails, it will only be after another round of Wall Street bailouts. But then again, there won’t be any taxpayers left to bail out CalPERS so there is really nothing to worry about.

    71 million boomers are heading into retirement.
    46 million Gen-Xers are following. Not enough to pay for the boomers.

    The good news?

    76 million Gen Y have been entering the work force for years now…
    and of course we love to hate immigration to help bridge this gap.

    From a macroeconomic perspective, we have a bubble but we are using illegal immigrants to help manage it. As generations live longer actuarial assumptions will have to be adjusted, but it is not the doom and gloom end of the world Genest and Toughlove might have you believe. It is a simple math problem.

    Oh, and taxes have been cut while all this is going on. Talk about a payment holiday. That is delusional to cut taxes and demand more services.

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