CalPERS is planning a two-year phase in of a rate increase resulting from a lower earnings forecast adopted yesterday, continuing a “smoothing” policy that softens the impact of rising pension costs on deficit-ridden state and local government budgets.

Lowering the investment earnings forecast from 7.75 to 7.5 percent is expected to increase the annual state payment to CalPERS by $303 million, pushing the total to $3.8 billion.

Critics contend CalPERS and other public pension funds use overly optimistic earnings forecasts to “discount” or reduce future pension debt, concealing a massive “unfunded liability” and the urgent need for cost-cutting reforms.

But CalPERS says its earnings averaged more than the 7.75 percent target over the last two decades. The new forecast stays the course and does not change the basic average investments are expected to earn, 4.75 percent.

What the board lowered is the forecast for 3 percent price inflation, which when added to the basic 4.75 percent return totaled 7.75 percent. The new inflation forecast of 2.75 percent drops the total earnings forecast to 7.5 percent.

“Your proposal is driven by an inflation assumption that I just don’t buy,” board member J.J. Jelincic told chief actuary Alan Milligan at a committee hearing. “I do admire your courage for bringing it forward.”

Jelincic, the apparent lone “no” in a board voice vote, argued that the U.S. Federal Reserve and central banks in other countries have “flooded” their economies with money, a stimulus likely to lead to inflation.

Milligan said a hired consulting firm, GRS of Texas, recommended loweringthe inflation forecast to 2.75 percent. The board rejected Milligan’s recommendation to drop the total forecast to 7.25 percent to provide a cushion or “margin for adverse deviation.”

One of the 1,573 local governments who have 2,044 separate California Public Employees Retirement System plans urged the CalPERS board to pick the high end of the GRS inflation forecast range, 2.5 to 3 percent, and avoid a rate increase.

The Santa Clara County benefits director, Peter Ng, said that after 10 years of county deficits, and closing a $220 million gap this year, the proposed rate hike would create a roughly $34 million shortfall just as county finances seem to be stabilizing.

The Sacramento Metropolitan Fire chief, Kurt Henke, told the board his agency closed six of 42 fire stations, cut the budget from $159 million to $132 million and obtained $28 million in labor concessions.

Henke said the proposed rate increase would cost his agency $2 million to $2.5 million, adding to an expected loss of $6 million in revenue as Sacramento area property values continue to drop. He made a passionate plea for a two-year phase in.

“You have a lot of local agencies that are on the verge of economic hardship and or bankruptcy, and to implement this in one fell swoop would push a lot of those entities over the edge,” Henke said.

Because personnel is a big part of most local government budgets, sometimes 80 percent or more, the pension rate hike has a big impact. Local pension costs for miscellaneous workers go up 1 to 2 percent of payroll, safety workers 2 to 3 percent.

For the state, pensions are a smaller part of the budget. Of the $303 million CalPERS increase for state workers, $167 million is from the deficit-ridden general fund that spends on schools, prisons, higher education, health, welfare and other programs.

Gov. Brown proposed a $92.6 billion general fund for the new fiscal year beginning in July, with an estimated $9.2 billion deficit that includes a shortfall carried over from the current year.

The proposal has a $1.8 billion general fund payment to CalPERS. The rest of the $3.5 billion CalPERS payment ($400 million would be shifted to CSU for the first time) is from special funds such as transportation that have a total budget of $39.8 billion.

With the $303 million CalPERS rate hike, state retirement costs would be roughly $7.5 billion next fiscal year:

CalPERS $3.8 billion, California State Teachers Retirement System $1.3 billion, retiree health $1.7 billion, and (2010-11 data) Social Security $500 million and Medicare $240 million.

Usually, the $303 million CalPERS state increase and a $137 million hike for non-teaching school employees would begin next July. The local government increase would not begin until a year later due to calculation time needed for 2,044 separate plans.

But as part of a motion by board member George Diehr supported during public comment by three representatives of the Service Employees International Union, Milligan was directed to prepare plans to phase in the increases over two years.

CalPERS previously adopted several polices that helped “smooth” the rate impact from massive investment losses. The CalPERS investment fund peaked at $260 billion in the fall of 2007, fell to $160 billion in March 2009 and is now about $236 billion.

In 2005, the rate impact of investment gains and losses were spread over a 15-year period, well beyond the typical three to five years. As a limit, the actuarial value of assets were not to exceed a “corridor” of 20 percent above or below their market value.

In 2009, the heaviest losses were isolated and amortized over 30 years with a rate increase phased in over three years. The corridor was expanded to 40 percent one year, 30 percent the next before dropping back to 20 percent from market value.

The smoothing policies are part of the reason the state CalPERS payment, $3 billion in fiscal 2008-09, had only increased to $3.5 billion this year. Another reason is union contracts that increased most worker CalPERS contributions by 3 percent of pay.

But delaying employer rate hikes has helped lower the CalPERS funding level. As of June of last year, the average CalPERS plan had roughly 74 percent of the projected assets needed to pay pensions promised in future decades to current workers and retirees.

Delaying rate hikes also uses up smoothing possibilities, making it more difficult to avoid a sharp rate increase if a sagging economy or stock market crash punches another big hole in investment funds expected to pay for two-thirds of future pensions.

A delay in rate hikes can increase future costs. Some unfunded liability payments are said to be less than the interest on the debt. And there is a moral issue, if a rate delay forces future generations to pay for pensions earned for services to the current generation.

As CalPERS considered the smoothing policy in June 2009, former Gov. Arnold Schwarzenegger complained that delaying a major rate hike was “using our kids’ money” to gamble that investment earnings will grow faster than pension obligations.

“Our pension system needs reform,” Schwarzenegger said, “and without meaningful and sustainable pension reforms that reduce future costs, the state should decline to participate in any effort to shift more costs to our children.”

His administration sought a $1.2 billion rate increase, pushing the state CalPERS payment to $4.2 billion and a funding level of 80 percent. As pensions faded among other state budget pressures, CalPERS adopted a $200 million increase for 60 percent funding.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Posted 15 Mar 12