Experts tell CalSTRS earnings may fall short

The CalSTRS board was told this month that financial experts are forecasting investment earnings of 7 percent a year or less during the next decade, below the 7.5 percent assumed by the pension fund.

If the new forecast turns out to be correct, long-sought legislation in June that phases in a $5 billion CalSTRS rate increase over the next seven years could fall short of the goal of projecting full funding in three decades.

It’s even possible that with new power granted by the legislation the California StateTeachers Retirement System board could, in three to seven years, add another rate increase for the state and school districts to get full funding back on track.

The new forecast from eight consultants and five asset managers also casts a shadow on the 7.5 percent earnings assumptions of the California Public Employees Retirement System and the UC Retirement Plan.

“Consensus assumptions likely lead to expected compound long-term returns of 7 percent or less for typical institutional portfolio over a 10-year period,” said a Pension Consulting Alliance presentation of the forecasts from the 13 experts.

Whether public pension systems have overly optimistic earnings forecasts, which conceal massive debt, is one of the major issues raised by critics, who advocate lower bond-based earnings forecasts like those used for private-sector pensions.

It’s an old issue for CalSTRS. An investment banker, David Crane, was removed from the CalSTRS board in 2006 (denied confirmation by the state Senate) after repeatedly arguing that investment earnings forecasts were too optimistic.

The new “capital markets forecast” by the experts is an early step in a routine four-year CalSTRS process that will lead to a review of the 7.5 percent earnings assumption in 2016.

“Nothing has changed for CalSTRS since the enactment of full funding legislation in June, and no gap in funding has developed,” Chris Ailman, CalSTRS chief investment officer, said via e-mail. “In fact, AB 1469 achieves the right balance of funding and timing, and we are confident our fund is on a sustainable course as a result of the legislation.”



In the earnings review, CalSTRS will look at other factors such as a 30-year investment horizon, what could happen during market booms and busts, and the possibility that inflation might offset a lower earnings forecast.

“It is premature to speculate on the impact until all the assumptions are evaluated,” said Ailman. “If there was a net impact, it could affect the state’s contribution rate in 2017, and the employer’s contribution rate seven years from now, as provisions of the new funding legislation give our board the authority to adjust employer and state contribution rates.

“However, this year’s investment earnings of 18.66 percent already gives us a jump start on the funding and positions us well as we move into the future with a diverse asset allocation in place.”

After the last earnings review in 2012, the CalSTRS board made a small change, dropping the forecast from 7.75 to 7.5 percent, that added an estimated $500 million to the $4 billion-a-year rate increase needed to project full funding in 30 years.

Before the rate hike last June CalSTRS was on a path to run out of money in about 30 years, emptying a $184 billion investment fund even if earnings averaged 7.5 percent. Spending totaled $11.3 billion a year, rate revenue only $5.8 billion.

Now as legislation will nearly double current rates, most of the $5 billion annual increase will come from school districts and community colleges. Their current rate of 8.25 percent of pay will gradually increase to 19.1 percent of pay by July 2020.

Teachers get the smallest rate increase, going from 8 percent of pay to 10.25 percent for most and 9.2 percent for new hires. The state contribution to two CalSTRS funds will increase from 5.5 percent of pay to 8.8 percent.

CalSTRS had been pleading for a rate increase for years, arguing that delay drives up the total cost: pay now or pay more later. Unlike most California public pension systems, CalSTRS lacked the power to raise employer rates, needing legislation instead.

The non-partisan Legislative Analyst’s Office has suggested that CalSTRS be given the power to set employer rates, like other public pension funds. The new legislation does give CalSTRS some rate-setting power, but it’s tightly limited.

CalSTRS can increase the employer rate after 2020 if needed for full funding by 2046, but only by a little more than 1 percent of pay. CalSTRS can increase the state rate after 2016, but only to eliminate debt for benefits in effect prior to 1990.

Last year a leading critic of pension earning forecasts, Moody’s, a credit-rating agency, began calculating pension debt by using lower earning forecasts and the market value of assets, rather than actuarially “smoothing” gains and losses over several years.

A Moody’s analysis last month of the 25 largest U.S. public pension systems found that investments earned an average of 7.45 percent from 2004 to 2013, a period that included the recession and stock market crash.

But the average debt or “unfunded liability” reported by the big pension funds grew during the decade — dramatically if calculated using Moody’s methodology, which drew a rebuttal from the National Association of State Retirement Administrators.

For example, Moody’s said CalSTRS earnings during the decade averaged 7.52 percent (CalPERS 6.99 percent). In one measure of debt growth, CalSTRS reported a funding level of more than 80 percent in 2004, which had dropped to 67 percent last year.

Part of the reason debt increased during the decade, even though average earnings were near the target, is that heavy losses, particularly during the stock market crash in 2008, sharply lowered the value of investments on which earnings were made.

In addition, said Moody’s, the growth of the debt is “due to inadequate pension contributions, stemming from a variety of actuarial and funding practices, as well as the sheer growth of pension liabilities as benefit accruals accelerate with the passage of time, salary increases and additional years of service.”

Only one of the 25 big pension plans, the Wisconsin Retirement System, uses a lower earnings forecast similar to those required for private-sector pensions. WRS uses 7.2 percent for active employees and 5 percent for retirees, the equivalent of 5.5 percent.

“At 5.5 percent, WRS’s valuation of its pension liabilities is mathematically closer to Moody’s valuation using our adjusted approach than are other plans, given current market conditions,” said the Moody’s analysis.

“The approach also makes WRS less dependent on investment returns and thus less exposed to investment underperformance than its peers, reducing risk.”

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 27 Oct 14

9 Responses to “Experts tell CalSTRS earnings may fall short”

  1. larrylittlefield Says:

    Asset prices are inflated, and returns will be low from those inflated values. Either stocks will crash and interest rate increases will crash the value of existing long term bonds. Or investors will be stock with rock bottom interest rates and a 2.0% dividend yield.

    Your stock market gain is inflation, currently expected at 1.5% a year over the next decade based on the TIPS/Treasuries spread, dividends, currently at 2.0%, and the capital gain on stocks in excess of inflation, generally 0.5% to 1.0% long term but perhaps less in the near future due to current bubble valuations.

    I wouldn’t be on more than 4.5%. Bonds? Perhaps about the same. Save the day with hedge funds and private equity? Get raped for fees to wipe out a big chunk of that return more likely.

  2. Bring Back the WPA Says:

    “…financial experts are forecasting investment earnings of 7 percent a year or less during the next decade, below the 7.5 percent assumed by the pension fund.”

    No one can predict market returns in advance — no one!
    Did these experts tell the pension funds to go short in 2007 because stocks were going to lose half their value? No.
    Did these experts tell the pension funds to go 100% long in 2009 because the market was going to double in 4 years? No.

    CalSTRS 10-year and 20-year rates of return met or beat the 7.5% assumption. There’s no objective reason to change the assumed rate of return.

  3. Bring Back the WPA Says:

    A lot of nerve by Moody’s to tell pension funds what to do when Moody’s had Lehman rated AAA right before Lehman went bankrupt

  4. larrylittlefield Says:

    “There’s no objective reason to change the assumed rate of return.”

    Here is the main reason: every asset is overvalued, and the most important factor in the rate of return on an asset it what it cost to acquire it.

    The plunge in interest rates as a result of Federal Reserve policy has caused the value of previously bought bonds paying high interest rates to go to the moon. Has CalTRS included those increases in its rate of return? Then it can’t also count the nominal interest rate from those inflated values. The same is true for stocks.

  5. Bring Back the WPA Says:

    @larrylittlefield “Here is the main reason: every asset is overvalued…”

    Value opinions are irrelevant to market returns. A lot of people in the late 1990’s bought overvalued assets and made large profits when they became even more overvalued.

    CalPERS and CalSTRS have annual independent audits by private sector auditors that certify the asset values and cash flows are accurate and meet US accounting standards. I haven’t seen any reason to question the integrity of their results.

  6. Captain Says:

    “Value opinions are irrelevant to market returns. A lot of people in the late 1990’s bought overvalued assets and made large profits when they became even more overvalued.

    CalPERS and CalSTRS have annual independent audits by private sector auditors that certify the asset values and cash flows are accurate and meet US accounting standards. I haven’t seen any reason to question the integrity of their results.”

    – Surely you jest. Audited Valuations – in the public sector? How are CalPERS & CalSTRS doing 1/3 into their fiscal year? That’s right, not only have they not earned a penny but they also haven’t even earned a penny toward covering their management costs For these organizations to meet their 7.5% (net) rate of return requires a return of probably 8.5%. The probability tables say they can’t do it; their own consultants say they can’t do it.

    Actually, both CalPERS & CalSTRS are well behind the eight-ball for 2014-15. That means extra costs, beyond the already ridiculous extra costs, taxpayers will be asked to pay to insure pension payouts for public employee union members.

    The dollar amounts taxpayer are paying to cover these ridiculous PENSION/HEALTHCARE benefits has officially become insane. CalPERS continued failures have led to increased demands on the taxpayer purse in many different forms, and that includes Parcel Taxes, Safety Taxes, Bonds for just about everything, and even SODA TAXES.

    CalPERS is CORRUPTION IN MOTION, and is a microcosim of everything that is wrong with California Politics.


  7. Captain Says:

    “Experts tell CalSTRS earnings may fall short”

    When you’re working with about a 70% funding level the 7.5% return means nothing. Actually it means, based on 7.5% rate of return, that the hole, that taxpayers will have to fill, is being dug deeper.

  8. Borty s Says:

    Dog bites man
    Another non story
    Doomera loves this red meat
    But all of this is premature
    The 30ohi and the 18.45 carries us forward

  9. Borty s Says:

    Moody’s has become a joke

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