An increase in CalPERS employer rates from switching to a less risky but lower-yielding investment portfolio seemed unlikely after a two-day board workshop last week. A final decision may not be made until February.
In anonymous voting, the CalPERS board strongly preferred two portfolios that would leave the “discount rate” used to offset future pension costs at around the current 7.5 percent or higher. The discount rate is based on an investment earnings forecast.
The giant pension system, hit hard by a $100 billion investment loss during the recession, is nearing the end of a two-year plan aimed at getting to full funding in 30 years.
The first step lowered the discount rate from 7.75 to 7.5 percent in March last year, triggering an employer rate increase. A second rate increase was approved last April with the adoption of a new actuarial method.
The new direct actuarial rate “smoothing” raises employer rates over a five-year period, beginning in 2014 for the state and schools and 2015 for local government. The total increase is expected to be less than 50 percent above rates paid last fiscal year.
Now the next steps in the plan are the adoption of a new investment allocation and new economic and demographic assumptions. If adopted by the board, a new “mortality” improvement scale discussed last month could raise rates to cover longer life spans.
Action on a new investment allocation originally was scheduled for next month. But to “integrate” all of the remaining steps, a new allocation may be delayed until February for one big decision on the discount rate and a third employer rate increase.
“You have a portfolio which pretty much keeps us where we are,” Joe Dear, CalPERS chief investment officer, said after the board chose two of five suggested portfolios, “base case” and “higher return,” as a guide to develop a detailed proposal.
The board chose to keep the target for private equity, expected to yield above-market earnings, at the current 12 percent of the portfolio. In the staff view, more investments in the saturated asset class would likely be lower quality with lower yield.
The workshop leader, Eric Baggesen, senior investment officer, said in his opening remarks there is little CalPERS can do to avoid the risk of investment losses in another economic downturn.
“Liability-driven” investing based on bonds with predictable yields would be too expensive. The CalPERS investment portfolio, $276 billion last week, is too large to “hedge” with counter positions.
“So we are very much going to be creatures riding along with the ups and downs of the marketplace,” Baggesen said.
The CalPERS chief actuary, Alan Milligan, asked the board for guidance on developing a plan for “flexible de-risking.” A small reduction in the discount rate would be made after years with exceptional investment earnings, perhaps 14 to 18 percent.
Ideally, the discount rate could be slightly lowered without raising employer rates above previous projections. Investments would gradually change to reduce big swings in value, probably lowering earnings. A tentative de-risking schedule would be 15 years.
Milligan said the plan is intended to “reduce the funding risk when it is least painful for our stakeholders to do so. Understand that we cannot truly reduce risk without increasing the expected cost of the program.”
During a stakeholder panel at the workshop with representatives from labor and management, two from each, a remark that drew several responses came from a 10-year veteran on the CalPERS board, the elected representative of state members.
George Diehr, a CSU San Marcos business professor, said his retirement benefit including Social Security “gives me a pension of 120 percent of my salary. I think that kind of level is beyond what you would call retirement security.”
Like most state workers, Diehr has a “2 at 55” pension formula based on 2 percent of final pay for each year served at age 55. He has 36 years of service, some in another state. The “2 at 55” formula provides 100 percent of final pay after 40 years of service.
“In a word, I find us in a very untenable situation,” Diehr said. “The elephant in the room is liabilities . . . The discount rate change at the level we are talking about has a little impact but not much.”
Dave Low, California School Employees Association executive director, said non-teaching school members in his union often are part-time and do physical labor that “wears down bodies” and shortens careers, making 36 years of service difficult to attain.
In 1980 during Gov. Brown’s first term, Low said, CalPERS was 55 percent funded and the school employer contribution was 13 percent of pay. As CalPERS funding exceeded 100 percent two decades later, employer contributions dropped to near zero.
“I think it’s important we don’t look at the situation we are in today and, because of the people who are critical of pensions, that we allow them to sway the discussion so far to the other side that we react in ways that are not long-term responsible,” Low said.
Currently, CalPERS is more than 70 percent funded and the school contribution is 11.4 percent of pay. As Brown noted during his 2010 campaign, he unsuccessfully proposed lower pensions for new hires as his first term ended in 1982.
Brown said then it was possible for state workers to retire at age 62 and receive more than their final pay from CalPERS and Social Security. He said 70 percent of final pay is a “common standard” for maintaining a similar standard of living in retirement.
A former League of California Cities president on the panel, Ron Bates, Pico Rivera city manager, said the main driver of city costs is a “3 at 50” formula for police and firefighters, first given to the Highway Patrol by the CalPERS-sponsored SB 400 in 1999.
Bates said either some “cities go bankrupt,” like Detroit, “or we start dealing with the elephant in the room, which is we probably made some mistakes in 1999 when everybody jumped on that accelerated pension band wagon and we promised things that are difficult for us to keep.”
Ron Cottingham, president of the Peace Officers Research Association of California, said few police and firefighters reach 30 years of service and most do not receive Social Security.
When CalPERS raises employer rates, he said, employers try to cut their costs by bargaining an increase in employee contributions. He cited a several cases where police are contributing 20 to 26 percent of pay, well beyond their standard 9 percent share.
Cottingham urged the CalPERS board not to lower the current discount rate from 7.5 to 7.25 percent. He said the new cost sharing and Brown’s pension reform giving new hires lower pensions should be given time to ease local budget problems.
Critics say a discount rate based on investments averaging 7.5 percent a year is too optimistic, concealing massive pension debt. Low said a survey of public pension systems shows 86 have a discount rate above 7.5 percent, 16 are at 7.5 and eight are below 7.5 percent.
If pension costs are pushing some local governments toward bankruptcy, CalPERS itself is a long way from insolvency. As a chart at the workshop shows, CalPERS has been able to pay pensions with contributions and investment income.
Now the Public Employees Retirement Fund, valued at $276 billion last week, is moving into an era of “negative cash flow.” CalPERS presumably will begin dipping into investments to help pay pensions and other benefits.
That’s said to be an expected milestone as pension funds mature. A decade from now, the expected cash-flow shortfall is about $5 billion.