CalPERS may soon report investment earnings for the fiscal year ending June 30 that are near or even above its long-term target of 7 percent, up from a return of 0.61 percent the previous year.

But the nation’s largest public pension system will still be seriously underfunded.

Like most public pension funds nationwide, CalPERS has not recovered from huge investment losses a decade ago. Going into the financial crisis in 2007, CalPERS had 101 percent of the projected assets needed to pay future pension costs.

Despite a lengthy bull market that followed a stock market crash in 2008, CalPERS recently was only 65 percent funded. Now CalPERS is worried about a downturn that might drop funding below 50 percent, a red line actuaries think makes recovery very difficult.

Two causes of the shortfall are often mentioned: overly optimistic forecasts of investment earnings, expected to pay nearly two-thirds of CalPERS future pension costs, and generous retroactive pension boosts at the turn of the century.

Last month, the Society of Actuaries issued a study reflecting a new focus on a traditional but lesser-known cause of debt — not promptly paying down debt, the “unfunded liability” from below-target investment earnings, longer life spans, or other factors.

The unfunded liability continues to grow if annual contributions to the pension fund only cover the normal cost of a pension earned during the year, but are not large enough to also pay the interest (currently 7 percent for CalPERS) on the debt from previous years.

It’s called “negative amortization.” The Society of Actuaries study, looking at 160 public pension systems nationwide from 2006 to 2014, found that most set an annual contribution target that allowed debt to continue to grow.

“Many plans with negative amortization contributed at least as much as their target contribution,” said the study. “However, at the peak in 2010, 76% of target contributions entailed negative amorization. By 2014, the percentage fell to 67%, roughly the same level as 2006.”

The study looked at two traditional methods of paying debt over a 30-year period that allow negative amortization in the early years, even though the debt is expected to be paid off by the end of the period.

“If plan assets earn less than the assumed rate of return during the negative amortization period, the unfunded liability will grow because of two factors: negative amortization and less-than-expected investment returns,” said the study.

As in the Society of Actuaries study, reports from the Pew Charitable Trusts in April and Moody’s rating service last year developed their own methods for measuring negative amortization in public pension funds.

Moody’s “tread water” indicator tracks the amount of the annual government contribution needed to prevent pension debt from increasing, if investment earnings hit the target and other assumptions are met.

“A contribution below the “tread water” level in effect suppresses expenditures by leaving implied interest on net pension liabilities unpaid, akin to borrowing at the assumed rate of investment return for operations,” said a Moody’s explanation of the measurement.

In a three-year forecast last month based on a sample of 56 public pension plans, Moody’s projects that government contributions generally will continue to be short of “tread water” due to factors such as “backloading” amortization and “smoothing” investment returns.

Under the most optimistic Moody’s scenario, in which cumulative investment returns over the next three years are 25 percent, the net pension liability reported under government accounting rules would be little changed, down 1 percent.

The government contribution needed to “tread water” would increase 17 percent under the same Moody’s optimistic scenario.

CalPERS Comprehensive Annual Financial Report June 30, 2016, p. 116

CalPERS unfunded liability soared after a huge loss during the financial crisis and stock market crash in 2008, when the investment fund plunged from about $260 billion in 2007 to $160 billion in 2009.

The latest CalPERS annual financial report (see chart) shows an unfunded liability of $111.3 billion as of June 30, 2015, up from $31.7 billion in 2007. The CalPERS investment fund was valued at $323.6 billion last week.

Until a change four years ago, CalPERS paid off some debt with what actuaries call “rolling” or “open” amortization. The debt is refinanced each year and theoretically might never be paid off, unless booming markets produce a period of full funding.

CalPERS debt payment also had been slowed by an unusual, if not unique, “smoothing” period that spread gains and losses over a 15-year period, well beyond the standard smoothing period of three to seven years.

The first of four increases that will double many government employer rates did not begin until 2012, four years after the stock market crash. The investment earnings forecast was dropped from 7.75 percent to 7.5 percent, then dropped again last year to 7 percent.

The switch to a more conservative “direct” debt payment method in 2013 was a significant reform. But it does not pay down debt promptly to keep the pension system near full funding as, for example, is required for New York state pensions.

CalPERS still phases in rate increases, as urged by employers wanting to avoid sudden and unpredictable budget shocks and, on occasion, unions wanting to leave money on the bargaining table for rate increases.

The recent drop in the earnings forecast used to discount future pension obligations will be phased in over three years, starting with the fiscal year that began this month. Rate increases are phased in over five years, beginning with 20 percent of the new base rate.

A rate increase for a change in actuarial “assumptions,” like those for the lower earnings forecast last year or longer expected life spans in 2014, is paid off over 20 years. The negative amortization stops in year five, said Amy Morgan, a CalPERS spokeswoman.

Investment losses are paid off over 30 years, and the negative amortization stops in year nine. The 20-year and 30-year debt payments are both phased out over the final five years, beginning with 80 percent of the base rate.

In addition to increasing cost, long amortization periods push debt to future generations. Advocates of “intergenerational equity” say the cost of pensions, regarded as deferred compensation, should be paid by the generation that receives the services of the pensioner.

The Governmental Accounting Standards Board recommends that investment losses be paid off over five years and actuarial assumption changes be paid off over the average time employees will remain on the job.

The “average remaining service life” calculated by the California Public Employees Retirement System for the employees in its more than 2,000 state and local government pension plans is four years.

CalPERS encourages local governments to pay down debt more quickly by including 10-year and 15-year amortization schedules in annual valuations to show the potential savings. Newport Beach is among several cities planning to make extra pension payments.

Gov. Brown’s proposal to borrow $6 billion from a state cash-flow fund to make an extra payment for state worker pensions, saving an estimated $11 billion over two decades, emerged from the Legislature with no significant changes and is expected to be signed soon.

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Originally posted at Cal Pensions.