Tuesday, March 15, 2011

CalPERS Holds Assumed Return Rate at 7.75%

Jeannette Neumann of the WSJ reports, Calpers Committee Holds Assumed Return Rate at 7.75%:

A committee at Calpers on Tuesday decided to maintain the pension fund giant's annual assumed rate of return on investments, despite an actuary's recommendation to switch to a lower rate.

The committee of the California Public Employees' Retirement System decided to recommend maintaining the rate at 7.75%, instead of adopting the recommendation by Calpers's chief actuary to lower the rate to 7.5%.

The committee's recommendation still has to be approved by the fund's board.

The board is scheduled to meet Wednesday.

A Calpers spokeswoman said a main factor behind the vote was a push by local governments to maintain the status quo. A decrease, the spokeswoman said, could have bumped up the amount of money public employers pay toward government workers' pensions.

The vote by the committee at Calpers, the biggest public pension fund in the U.S., with nearly $230 billion in assets, comes as public retirement plans across the country are facing pressure from academics and policy makers to lower their annual assumed rates of return on investments.

Critics blame too-rosy rates for contributing to state pension shortfalls, estimated at more than $1 trillion nationwide.

A decrease in the Calpers rate of return to 7.5% would have bumped up what local California governments pay on behalf of government workers by 1.5% to 3% of payroll costs each year and 3% to 5% of what they pay on behalf of police officers, firefighters and other public-safety officers, a Calpers spokeswoman said.

Also, a decrease in the rate, also referred to by public pension plans as the discount rate, drives down the funded status of a pension plan, or the difference between its assets and long-term liabilities. Calpers is about 70% funded, it says.

Despite his recommendation, Calpers's chief actuary, Alan Milligan, said keeping the discount rate at 7.75% is "reasonable and achievable and appropriate for funding the promised benefits," according to a statement on the Calpers website.

Public pension plans have a median annual assumed rate of return of 8%, according to a recent report by Wilshire Associates, an investment consulting firm. Calpers lowered its rate to 7.75% from 8% in 2004.

Pension plans are typically funded by investment returns as well as contributions from public employers and government workers. Pension plans considering the adoption of a more-conservative annual rate of return are faced with having to shift a greater financial burden on to public employers, since typically contributions from employees legally can't be changed.

That is a tough sell to state and local governments, faced with steep budget shortfalls and sluggish tax revenue.

About ten public employers attended Calpers' committee meeting Tuesday, and the fund also received several letters urging officials to maintain the discount rate, a spokesman said.

I already stated that an assumed return rate of 7.75% is too high and so is 7.5%. US ten-year bonds are yielding 3.3%, which means in order to achieve that 7.75% over the long-term, CalPERS will have to take risks in both public and private markets. It's not impossible but taking on more risk means the fund is vulnerable to another big drawdown similar to the one it experienced in 2008. With each sizable drawdown comes the risk that the fund's deficit will grow even wider. That's the problem with assuming a rate of return that's not easy to achieve.


David Reilly of the WSJ reports, California Still Dreamin' on Pensions:

Pass out the rose-colored glasses.

The California Public Employees' Retirement System chose Wednesday to leave its assumed rate of investment return unchanged at 7.75%. That was against its own actuary's recommendation to lower it to 7.5%.

The move will please strapped local governments. A cut would have caused the system's liabilities to rise, deepening its funding hole and requiring increased contributions from states and municipalities with staff covered by the system. For the state of California alone, this could have meant $400 million a year more in contributions.

But that may be little solace to taxpayers, who could be left holding the bag years from now if the hoped-for returns don't pan out.

It also shows how pension funds still hope the long-term investment outlook hasn't undergone a lasting change. Instead, funds are betting they can replicate past performance.

On average, public pension funds expect to generate an 8% average annual return. This despite the fact stock markets have essentially flat-lined over the past decade, bond yields are at historic lows, and prior gains were in many cases because of the Internet, housing and credit bubbles.

Should Calpers—the biggest public pension fund in the U.S., with assets of about $228 billion—fall short of its expectations, it could find itself in an even deeper hole. The system's main retirement pool is only about 70% funded. That is up from about 60% as of June 30, 2009, but it has only been fully funded in three out of the past 10 years.

In leaving its rate unchanged, Calpers cited the fact that, over 20 years, it has posted an average annual return of 7.9%, before administrative and investment expenses. And the system said it based its future outlook on an analysis of 10,000 investment scenarios over 60 years. These resulted in an expected average annual return of 7.95%.

As the financial crisis showed, though, unexpected events can easily make such models irrelevant. Calpers itself said there is a "50-50 chance that returns will be either higher or lower" than the scenario analysis projected.

For taxpayers, those aren't great odds.

50-50 chance that returns will be either higher or lower? I think it's safe to assume that without taking considerable risk in public and private markets, it's going to be next to impossible to achieve 7.75% over the long-run. And more risk leaves the fund exposed to more downside risk. Again, if CalPERS was fully funded, this wouldn't be as much of a concern, but now that it's only 70% funded, it's margin of error has been reduced. If those investment assumptions don't pan out, taxpayers are on the hook.

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