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A new pension reform requires CalPERS to report the risk of investment earnings shortfalls when raising employer rates, but there is a problem.
The CalPERS chief actuary, Alan Milligan, says he lacks the staff needed to make multiple calculations for each of the 2,200 plans in the giant system.

The reform is a response to criticism that CalPERS estimates of future investment earnings are too optimistic.

Big returns were erroneously expected to pay for a major pension increase a decade ago, say the critics, and long-term pension debt facing taxpayers is understated.

Requiring CalPERS to report how employer costs and debt could balloon, if earnings fall short, is part of a pension reform obtained by Gov. Arnold Schwarzenegger in a new state budget, finally enacted this month after a record 100-day deadlock.


The reform also gives state workers hired after Jan. 15 lower pensions, rolling back a major increase enacted in 1999 by a CalPERS-sponsored bill, SB 400. The pensions will be based on a three-year salary average, curbing the “spiking” or boosting of benefits by manipulating final-year pay.

Milligan told the CalPERS board last week that the reporting reform applies to all 2,200 plans, not just state workers. The board met in the Hotel Maya in Long Beach, one of two “off-site” meetings held away from Sacramento headquarters each year.

The 1.6 million persons covered by the California Public Employees Retirement System are in three groups of roughly similar size: state workers, non-teaching school employees, and 1,568 local governments.

“So that’s going to be logistically a problem,” Milligan said. “I don’t have the staff to do that work. We are going to have to work on this to try to figure out how we deal with this particular provision.”

Milligan, with a staff of 40 actuaries, said options include requesting additional funding from the state. He said as the bill was presented, some legislators understood the workload problem and seemed willing to consider corrections after the budget passed.

“Hopefully, that would be attended to in a way that actually makes sense,” he said.

The “transparency” provision requires CalPERS, when setting the annual rate paid by employers, to include a forecast of how much higher the rates would be if investment earnings fell short.

CalPERS currently assumes investments will earn an average of 7.75 percent in the decades ahead. The additional calculation required by the reform is a forecast based on 6 percent or 1 percent below the assumed earnings, whichever is lowest.

Schwarzenegger and others have criticized CalPERS for telling legislators that the SB 400 pension increase in 1999 would be paid for by investment earnings, leaving state costs little changed for a decade.

“There were people that pulled wool over their eyes,” Schwarzenegger said after the budget passed. “They never really knew all the facts and the risks that were involved, (sic) Now this will be eliminated, this problem. We will have full transparency moving forward.”

A 17-page CalPERS brochure told legislators that enactment of the SB 400 benefit increase would keep the state contribution below the fiscal 1998-99 level, $766 million, for “at least the next decade.”

The legislative analyses of SB 400 said the same thing. What legislators were not told is that CalPERS actuaries had made a startlingly accurate forecast of how state costs would soar if earnings fell short.

The shortfall forecast of actuaries in 1999 nearly nailed the state payment to CalPERS this fiscal year, about $3.9 billion. The state also is paying $1.4 billion for retiree health care and $1.2 billion to the California State Teachers Retirement System.

As a result, 7.5 percent of the state general fund is being spent on retirement costs, $6.5 billion of the $86.5 billion budget. For the first time, Schwarzenegger said, the state budget spends more on retirement costs than on higher education.

CalPERS has already begun to respond to the criticism of overly optimistic earnings forecasts. A new “investment return sensitivity analysis” announced in August will give employers five short-term scenarios with their annual valuation report.

In addition to the usual forecast, two scenarios will show what happens to the employer’s cost if the earnings are a little or a lot below the target of 7.75 percent. Two more scenarios will show what happens if earnings are above the target.

Another “transparency” reform in the new state budget requires an additional CalPERS report that would show a much larger long-term debt.

Critics contend that overly optimistic earning estimates conceal massive public pension debt, guaranteed by taxpayers without a vote of the people. Some economists argue that a risk-free debt should only be offset with risk-free government bonds.

So instead of using the assumed earnings rate, 7.75 percent, to offset or “discount” the cost of paying for obligations to current workers and retirees in the decades ahead, the new report will use the 10-year U.S. Treasury bond rate, currently 2.5 percent.

The issue of how to properly report long-term public pension debt moved into the spotlight in April. Stanford graduate students used a 4.1 percent risk-free government bond rate to calculate the debt of the three state pension funds.

The Stanford students said CalPERS, CalSTRS and UC Retirement have a combined shortfall of $500 billion, nearly 10 times greater than the $55 billion unfunded liability reported by the three retirement systems.

The pension funds argue that using the assumed earnings rate is a time-tested actuarial method. It’s said to be appropriate for retirement systems sponsored by governments, which unlike corporate pension sponsors cannot go out of business.

CalPERS average earnings hit the target over the last two decades, but fell short during the last decade. Now CalPERS is considering lowering its assumed earnings rate, perhaps by about half of one percent as a panel of experts suggested earlier this year.

But even a relatively small drop in the assumed earnings would trigger an increase in contributions from employers, who already face rising pension costs to cover investment losses in the historic stock market crash two years ago.

Meanwhile, the use of a risk-free discount rate may be gaining traction. A report by Alicia Munnell and others at the Center for Retirement Research at Boston College said a risk-free discount rate should be used for public pension liabilities.

An editorial accompanying a report on state pension funds in the Oct. 16 issue of The Economist magazine said a change in accounting rules is needed to make taxpayers aware of the pension promises they have underwritten.

“Following rules set down (rather shamefully) by the Governmental Accounting Standards Board, the individual states discount their pension liability by the assumed rate of return on the assets, in most cases around 8 percent,” said The Economist.

GASB held a hearing in San Francisco earlier this month on proposed rule changes
 that include a “blended” discount rate – assumed earnings for liability covered by assets, and a risk-free rate for any remainder.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune.