The nation's largest public pension fund could make a small accounting change that would carry a large price tag for taxpayers when board members meet this week.
Staff of the California Public Employees' Retirement System have recommended that the board reduce its estimate about how much money the fund's investments will make in future years, dropping the so-called "discount rate assumption" from 7.75 percent to 7.5 percent.
While it's a relatively small change, the reduction could force the state and other employers with workers covered by CalPERS to increase the amount they pay into the pension fund, probably by $200 million or more. The pension fund could take all or part of that from California's general fund, the part of the state budget that pays for day-to-day operations but is facing a $26.6 billion deficit.
Gov. Jerry Brown's budget proposal, now pending in the Legislature, was based on the assumption that the giant pension fund would lower the rate. A committee of the pension fund's board is scheduled to consider the change on Tuesday.
"If the assumed rate of investment return is lowered, it has the effect of increasing contributions by employers," said Edd Fong, a spokesman for the pension fund.
In this case, the employers are government agencies that typically pay their bills with tax dollars. That puts the CalPERS accounting decision in the middle of a national debate about public pension reform.
As of February, the pension fund estimated a shortfall of about $75 billion between its accrued liabilities and the market value of its assets. The state's second largest public pension fund, the California State Teachers' Retirement System, had an estimated shortfall of $40.5 billion as of June 2009 and is expected to update that figure this spring.
Assemblyman Allan Mansoor, R-Costa Mesa, welcomed the recommendation to lower CalPERS' expected rate of investment return.
"It brings us closer to reality in what we're facing," said Mansoor, who has introduced a bill to ban collective bargaining over pension benefits by public employees. "Any time there's a shortfall, the taxpayers have to make up the difference because there is a guaranteed benefit. What we have is not sustainable."
Some economists say pension funds should adopt even more conservative assumptions about their annual rates of return -- in the range of 4 percent to 5 percent. CalPERS, which serves 1.6 million current and former government employees and their families, says it has averaged a 7.9 percent return on its investments over the past 20 years.
The fund had assets valued at $230 billion in February. It was valued at $251 billion in mid-2007, before the recession hit, and fell as low as $165 billion in early 2009.
The defined benefit plans enjoyed by many government employees across the nation, where retirees are guaranteed a benefit for the rest of their lives, are rapidly disappearing from the private sector. Republican lawmakers, taxpayer groups and certain business interests say the current public pension systems provide an unsustainable level of benefits and are pushing for reforms.
A recent report by an independent state auditing agency, the Little Hoover Commission, estimated a $240 billion shortfall for the 10 largest public employee pension plans in California. The report said some cities will have to devote from one-third to one half of their budgets to support retiree benefits in the near future.
Defenders of the system say most pensions are reasonable and justified, and can be sustainable over the long term with small changes. They argue that the large gap between their assets and liabilities can be blamed mostly on the recession and its effect on investment portfolios.
In California and elsewhere, public pension fund managers say the financial problems will ease as the national economy recovers.
The staff recommendation to lower expectations for investment returns is based on a general consensus that investment returns are likely to be lower than historical levels over the next 10 years. It also reflects recent changes in CalPERS' mix of investments, including shifting money from fixed-income securities to inflation-linked bonds and Treasury instruments.
The investment mix approved by the board is expected to produce a compounded return of 7.38 percent over the next 10 years, but the same portfolio in 2007 would have been expected to generate more than 8 percent.
Cutting the discount rate would require an increase in employer contributions to the pension fund, with increases of anywhere from 1.5 percent of total payroll to 5 percent for various groups of workers with different retirement benefits.
Fong, the fund spokesman, said the financial impact on the state likely would be $200 million or more, but more precise figures were not immediately available.
If the board approves the change, it would be the second year in a row the fund needed a cash infusion. Last year, it demanded as much as $600 million more from the state but reduced that amount to about $400 million after state labor unions agreed to increase worker contributions to their pensions.
CalPERS can act on its own to increase the state's contribution. The fund representing teachers, which has a portfolio valued at $147.6 billion and serves 852,000 California public school educators and their families, can do so only with legislative approval.
Because the state faces a massive budget deficit, pension fund staff also said the board could choose to leave the discount rate assumption unchanged and thus eliminate the need to take bring in more money in the coming fiscal year. Doing so would still meet accepted guidelines for government accounting, according to the report prepared for the board.
aiCIO also reports, CalPERS May Lower Investment Target, Raising Rates:
The $230.1 billion California Public Employees' Retirement System (CalPERS) may make a small accounting change that would reduce its investment target.
CalPERS staff has suggested that the board lower its estimate about the amount of money the fund will make in the future, reducing its discount rate assumption from 7.75% to 7.5%. The decrease in the investment earnings forecast could put greater pressure on the state and municipalities, forcing them to increase the amount they pay into the pension fund, probably by $200 million or more. If approved, the contribution increases would reportedly be effective July 1 for the state and July 1, 2012, for municipal agencies.
“There appears to be a consensus that returns are expected to be lower than historical returns over the next 10 years,” Alan Milligan, CalPERS' chief actuary, said in a report. "Given that the median investment return net of administrative expenses is 7.80%, we recommend that the discount rate assumption be lowered to 7.50% per year to have a margin for adverse deviation similar to that currently used. Given that the state of the economy has put severe pressure on employers’ budgets, we recognize that it may be appropriate to reconsider the level of margin for adverse deviation," the report noted.
As of February, CalPERS, the nation's largest public pension, estimated a shortfall of about $75 billion between its accrued liabilities and the market value of its assets.
Last year, a report released by the Stanford institute for Economic policy Research (SIEPR) showed that the shortfall or unfunded liability of the three state retirement systems was not $55 billion as reported, but instead about $500 billion. The calculations from the SIEPR study, conducted by Stanford University graduate students, revealed that California’s three main public employee pension funds -- CalPERS along with the California State Teachers' Retirement System (CalSTRS) and University of California Retirement System (UCRS) -- are in more serious financial difficulties than previously believed, resulting in more pressure on the state’s budget and a shortage of pension funds in the future. According to the report, titled “Going For Broke: Reforming California’s Public Employee Pension Systems,” the state of California's real unfunded pension debt had so far been understated due to the accounting rules used. The Stanford report confirmed a recent report with similar, alarming findings from Northwestern University and the University of Chicago.
In response, CalPERS Chief Investment Officer Joe Dear wrote an article published in The San Francisco Chronicle, opposing the validity of the findings. “The study is fundamentally flawed because it is based on a what-if scenario that does not reflect how most public pension funds invest their assets,“ he wrote.
According to Dear, the “purely hypothetical” study uses a controversial method of calculating government pension liabilities, which he said doesn’t match with governmental accounting standards. “The Stanford study used an artificially low investment return assumption that's about half of our historical average,” he asserted.
Dropping the so-called "discount rate assumption" from 7.75% to 7.5% isn't dramatic but it's a step in the right direction. Should the discount rate be closer to 5%? I don't think so but 7.5% is still too high. Mr. Dear is right to point out that the Stanford study used an "artificially low" investment return assumption that was about half CalPERS' historical average but there is nothing to suggest that the next ten years will look anything like the last ten years. The problem is that if the new investment assumption doesn't pan out over the long-term, then at some point drastic measures will be taken to address their pension deficit.