A key committee yesterday approved a drop in the often-criticized CalPERS investment earnings forecast, gradually raising record rates already being paid by state and local governments, if approved as expected by the full board today.
The earnings forecast would drop from 7.5 percent to 7 percent, giving the nation’s largest public pension fund one of the most conservative forecasts, possibly setting a nationwide trend in the view of some.
But the painful and costly drop in the forecast used to “discount” or offset future pension obligations is still well above the 6.2 percent earnings forecast expected by CalPERS consultants during the next decade, which drove the action to drop the forecast.
Acting this month, rather than in February as some expected, seemed to reflect a general agreement and sense of urgency among employers and employees. As of last June, the CalPERS funding level fell to 68 percent of the projected assets needed to pay future pensions.
“It’s a little bit of pain for everyone,” said CalPERS President Rob Feckner, noting that five groups had come together on the action: labor, employers, the Brown administration, CalPERS staff, and the CalPERS board.
The committee approved a plan that would lower the earnings forecast or discount rate over three years, beginning with the state next year. Schools were split from the state and would begin in 2018 along with local governments.
The rate increase from a lower discount rate is phased in over five years. Some employee rates will go up, particularly for those hired after a pension reform in 2013 requiring them to pay half the “normal” cost, excluding debt from previous years.
When fully phased in the lower discount rate will cost the state an additional $2 billion, Eric Stern of Brown’s Finance department told the committee, half from the general fund that contributes $5.4 billion to CalPERS this year and the other half from special funds.
The rate increase comes in the middle of the usual four-year cycle for setting a discount rate. Wilshire and other consultants think that for several reasons global economic conditions have deteriorated since the current discount rate was reaffirmed at 7.5 percent two years ago.
Another sign of how seriously CalPERS regards the market change was the announcement Monday that, in a closed September session, the asset allocation of the $303 billion portfolio had been changed to reduce growth investments and the risk of losses.
Global equity investments were reduced from 51 percent to 46 percent of the portfolio, private equity dropped from 10 percent to 8 percent. Inflation assets increased from 6 to 9 percent, cash from 1 percent to 4 percent, and real estate from 12 to 13 percent.
Ted Eliopoulos, CalPERS chief investment officer, said the announcement was delayed to allow time for CalPERS to make some of the fund transfers. CalPERS investment changes often are not announced until later to avoid moving the markets.
At the Finance committee yesterday, board member J.J. Jelincic said the new asset allocation dropped the earnings forecast to 6.25 percent. His motion to drop the discount rate to 6.25 percent died without a second.
Staff told the committee that Jelincic’s assumption that the new allocation is expected to yield 6.25 percent is correct for the next decade. But the 7 percent discount rate is supported by the long-term yield over three decades.
At the Investment committee on Monday, Jelincic said CalPERS members need to know what’s being done with their money. His request for the public release of part of the transcript of the closed session, along with the agenda item, was referred to legal counsel.
Part of the urgency for action is that the underfunded California Public Employees Retirement System is unusually vulnerable to a major investment loss, unlike 2007 when it went into the deep recession and stock market crash with a funding level of 101 percent.
Two years ago, when the current 7.5 percent discount rate was reaffirmed, the funding level was estimated to be 77 percent, up from a low of 61 percent in 2009 after the CalPERS investment fund dropped from about $260 billion to $160 billion.
But since 2014, the economic outlook has declined and CalPERS investment earnings were well below the 7.5 percent target (0.6 percent last fiscal year and 2.4 percent the previous year), dropping the funding level to 68 percent as of June 30 this year.
“In all the data that (staff and consultants) have presented to us and that I’ve read, you drop to a level of 50 percent and it’s a point of no return as we know a pension system today,” board member Henry Jones said. “You may return, but it won’t be the same.”
Some think raising rates and the discount rate high enough to project 100 percent funding would become impractical. CalPERS is a mature system with the number of retirees soon expected to outnumber active workers.
Investment funds must be sold to pay pensions now, about $5 billion this year to add to $14 billion from employer-employee contributions to pay $19 billion for the pensions of the retirees. Reducing this growing “negative cash flow” is one of the reasons for raising rates.
Critics contend that an overly optimistic discount rate hides massive national state and local government pension debt. They argue that a risk-free discount rate should be used to aid “intergenerational equity” and reduce debt passed to future generations.
But the cost of using a risk-free rate to discount risk-free pension debt, following a basic finance principle, also would be massive. The yield on a 20-year Treasury bond early this month was about 3 percent.
Since the recession, CalPERS employer rates have increased roughly 50 percent. The discount rate was dropped from 7.75 to 7.5 percent in 2012. An actuarial method that no longer annually refinances debt was adopted in 2013.
The rate increase from a longer average life expectancy for retirees adopted in 2014 is still being phased in over a five-year period.
Some board members, perhaps referring to advance coverage of their meeting in the national media, said that a widely watched lowering of the discount rate by CalPERS would set a good example for other public pension funds.
“The recommendation before us gives us a chance to be a leader in the nation in responsible pension funding, and I think from a reputational perspective that is something it’s time for this system to take the lead on,” said board member Richard Gilliahan, Brown’s Human Resources director.
Board members also expect criticism that the discount rate was not dropped far enough. But state Controller Betty Yee and other board members said they will continue to work on the issue during the process leading to the scheduled rate review in 2018.
“This is all about the long-term sustainability of the fund,” said Richard Costigan, the Finance committee chair. “We are going to continue to have a robust discussion. This is just the start.”
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com. Posted 21 Dec 16