Wednesday, March 14, 2012

CalPERS Cuts Assumed Rate of Return to 7.5%

Marc Lifsher of the Los Angeles Times reports, CalPERS cuts assumed rate of return to 7.5%:

Taxpayers probably are going to be paying more for state government and school district employee pensions beginning in July.

A committee of the California Public Employees' Retirement System board voted 6 to 2 on Tuesday to cut the assumed annual rate of return on investments that it uses to calculate the contributions that need to be collected from the state and some 2,000 other public agencies.

The committee set the new benchmark at 7.5%, down from a two-decade-old rate of 7.75% but higher than the 7.25% recommended by its own chief actuary, Alan Milligan.

The change, if approved Wednesday by a majority of the 13-member board, would cost the state general fund an additional $167million a year, boosting the total bill for the fiscal year beginning July 1 to about $3.7 billion.

School districts would be tapped for $137million more a year to cover the retirement costs of non-teaching personnel. Cities, counties and special service districts that participate in the CalPERS program would get higher, still-to-be-determined bills July 1, 2014.

Returns have fluctuated greatly over the years, and the fund lost nearly a quarter of its value during the recession. But over 20 years, the fund's returns have averaged 8.8%.

The benchmark reduction comes as cities and counties across the state struggle with escalating pension costs.

One Northern California city, Vallejo, filed for bankruptcy protection in 2008 after being hit hard by the collapsing housing market. Another, Stockton in San Joaquin County, is threatening to do the same thing.

Gov. Jerry Brown's administration has sent the Legislature a 12-point plan to overhaul the state's increasingly expensive and under-funded public pensions systems.

Howard Schwartz, Brown's representative on CalPERS' board, voted for the less-drastic reduction, even though it would add to a projected $9.2-billion deficit in next year's state budget.

Schwartz, chief deputy director of the Department of Personnel Administration, and other members of the CalPERS Finance and Administration Committee struggled over the financial hit on its member agencies. They had to balance that with their legal duty to keep CalPERS strong enough to meet future obligations.

But critics said they acted irresponsibly by failing to heed Milligan's advice.

"They're obviously using funny numbers," said Marcia Fritz, a Sacramento-area certified public accountant and an advocate for pension reform. "The truth hurts, but it was the truth."

CalPERS is the largest public pension fund in the nation, with investments valued at $236 billion. Its various retirement funds have 55% to 75% of the money needed for future retirees. Pension experts consider 80% to be a minimum safe funding level.

Milligan's plan would have forced the state to pay an extra $425million next year and the schools to pay $339million more.

The panel adopted another Milligan recommendation, agreeing to adjust its long-term, assumed inflation rate to 2.75% from 3%.

In voting to reduce the benchmark by a quarter of a percentage point, board members took into consideration testimony from local government officials and labor union representatives.

Peter Ng, the employee benefits director of Santa Clara County, urged the panel not to raise retirement costs. The bigger reduction, he said, would cost his county $68million as it is "just starting to see our financial situation stabilize."

Board member George Diehr, a Cal State University professor, proposed a middle position between no reduction and a half-point cut. "This is a … true rock-and-a-hard-place situation," he said. "But, continuing to assume something that probably is not realistic is kicking the can down the road."

But a colleague called that position imprudent.

"We're still kicking the can," said board member Dan Dunmoyer, an executive of Farmers Insurance Group. He is not a finance committee member, so he will be voting Wednesday when the measure comes before the full board.

"If this hole gets bigger and deeper," Dunmoyer said, "the impact on the counties won't be bigger numbers: It will be bankruptcy."

This move is hardly surprising. California's other large pension behemoth, CalSTRS, is also is thinking of cutting its investment forecast for the second time in barely a year.

Was the chief actuary right to ask for the target to be cut to 7.25%? I think so as the assumed rate of return remains too high, especially when compared to Canadian pension plans whose actuarial rate of return hovers around 6%.

Bernard Dussault, Canada's former chief actuary, shared his thoughts on CalPERS' assumed rate of return:
They are actually assuming a real rate of return of 4.5%, i.e. 7.5% for the yield on invested assets minus 3% for inflation. Based on the attached long term data (1923+) on returns on various types of investments (bonds, equities, Treasury Bills), my view is that any assumed real rate of return in excess of 4% is too optimistic and inappropriate for pension valuation purposes.
I agree. With 10-year bond yields at 2.2%, CalPERS will need significant added value from risk assets and alternative investments to meet their investment projections. Sure, bond yields might rise significantly in the next decade, but there are still significant risks of debt deflation, which means yields can go lower from here.

But the risks of stagflation (low growth, high inflation) are rising. Interestingly,the panel adopted the recommendation from CalPERS' chief actuary to adjust its long-term, assumed inflation rate to 2.75% from 3%. If stagflation takes hold, they'll have to adjust it once again.

Below, will leave you with an interesting interview with Nassim Taleb, author of The Black Swan (h/t, Zero Hedge). I completely disagree with Taleb on many issues but he does raise interesting points that merit consideration.

Importantly, listen to his comments on growth of government and how the system is broken. Also, listen to how he's positioning his personal portfolio. He's afraid of hyperinflation, so he owns stocks, real estate and euros because "they're addressing their budget problems".