CalPERS is speeding up payment of new pension debt, a step toward reforming a policy that pushes current worker pension costs to future generations and helped delay a recovery from a huge investment loss a decade ago.
The adoption of a new actuarial policy last week, which shortens the payment of new debt from 30 to 20 years, shows how CalPERS has a built-in conflict between the need to quickly repay debt while keeping an eye on the ability of governments to pay pension costs.
A large rate increase that suddenly takes a big bite out of government budgets could create a funding crisis, fueling a drive for pension reform. Delaying debt payment allows time for the normalization of high pension costs that once might have been shocking.
But delaying debt payment, as happened after the CalPERS investment fund lost $100 billion a decade ago, costs more in the long run. It also can fail to raise the funding level to the traditional 80 percent or more, high enough to provide some protection against a crippling investment loss.
Despite a lengthy bull market, CalPERS only has about 70 percent of the projected assets needed to pay promised pensions. The fear now is that another market plunge could drop funding below 50 percent, a red line experts say makes recovery difficult if not impossible.
CalPERS has taken some small protective steps — a temporary shift toward bonds, less risky but lower yielding, and a longer-term “risk mitigation” shift that could, over two decades, lower the current investment earnings forecast from 7 percent to 6 percent.
The conflict facing CalPERS as it applies a one-size-fits-all rate increase to its 3,000 government employers, half of them school districts, was on display last week when the board shortened the payment period for new debt from 30 to 20 years.
“What we are trying to avoid is a situation where we have a city that is already on the brink, and applying a 20-year amortization schedule would put them over the edge,” Dane Hutchings of the League of California Cities told the CalPERS board.
On the other hand, some counties have expressed “a strong desire to start earlier (than June 30, 2019) to take advantage of possible strong market returns,” said Dorothy Johnson of the California State Association of Counties.
The CalPERS finance chairwoman, Theresa Taylor, asked if the staff could work with some employers on a “hardship” exemption, presumably avoiding a rate increase by delaying payments, and with others on an “opt-in” beginning 20-year payments earlier than 2019.
“We will try to work with employers as they contact us,” said Scott Terando, CalPERS chief actuary.
The rate increase, which could be avoided if investment returns remain strong, is the fifth and likely smallest of five rate increases since 2012. The fourth and largest increase dropped the earnings forecast from 7.5 to 7 percent and won’t be fully phased in until 2024.
“Our members have expressed frustration that you keep coming to them asking for more while at the same time not providing a lot of other options and assistance for them,” Dillon Gibbons of the California Special Districts Association told the board.
Last September the CalPERS board rejected a city-backed request to analyze the cost savings of cost-of-living adjustments and of switching all employees to the lower pension given those hired after a reform took effect on Jan. 1, 2013.
Last week the board agreed, as urged by the city and special districts representatives, to take another look at legislation for an optional low-cost CalPERS trust for local governments that want to set aside money to help manage future rate increases.
New York state retirement systems are an example of pension funds that, when required by law to pay down debt quickly, rebounded quickly from heavy losses during the financial crisis and stock market crash a decade ago.
The California Public Employees Retirement System, with sole control of the power to set employer rates and pay down debt, is an example of the failure to recover quickly from losses that dropped funding from 100 percent in 2007 to 61 percent in 2009.
The first CalPERS rate increase after the investment fund plunged from $260 billion to $160 billion was in 2012 when the earnings forecast used to discount future pension costs was lowered from 7.5 to 7 percent. The fund is now up to $353 billion but not keeping up with debt growth.
Critics contend the earnings forecast is still too optimistic and conceals massive debt. Consultants expect the CalPERS investment portfolio to earn 6.1 percent next decade, offset by higher earnings in following decades that bring the average to 7 percent.
Last December the CalPERS board, as urged by local governments, adopted a new investment allocation that kept the earnings forecast at 7 percent, avoiding the rate increase from options expected to earn 6.75 or 6.5 percent.
The second post-crash rate increase was a major actuarial reform in 2013. CalPERS had been “smoothing” rate changes, and delaying debt payment, by spreading investment gains and losses over 15 years, far beyond the 3 to 5 years used by most pension systems.
CalPERS also had been using what actuaries call “open” or “rolling” amortization that refinances pension debt or “unfunded liability” every year — debt payment delay on steroids that theoretically may never pay off the debt.
The reform switched payment of investment gains and losses to 30 years and payment of actuarial assumption changes to 20 years, like a rate increase in 2014 for the longer expected life spans of retirees.
Both payment periods for debt “bases” calculated annually began with five years of a step-by-step increase or “ramp up” to the full rate, smoothing the impact on employer budgets but delaying debt payment, and ended with a five-year ramp down also delaying debt payment.
The reform adopted by CalPERS last week, as requested by local governments, retains the five-year ramp up for the new 20-year payment of debts and losses but not for new assumption changes. There is no ramp down for either payment period.
Under the old 30-year payment policy, the debt continues to grow for the first nine years. The payment is not large enough to cover the “interest,” the amount that could have been earned if the debt were invested and yielded the earnings forecast.
Actuaries call that “negative amortization.” The 30-year payment policy did not begin reducing the original debt amount until year 18, more than halfway through the period.
“So, you make 18 years of worth of payments and you are right where you started from,” Terando told the CalPERS board last November. “That’s kind of the reason our funding status has remained flat while our assets have grown.”
The new reform ends “negative amortization” for new debt. The debt payment is a fixed or “level dollar” amount that doesn’t change, replacing a “level percentage” of pay that began too low to cover the interest and slowly grew with the payroll.
Speeding up debt payment also moves CalPERS closer to its goal of “intergenerational equity,” the fairness principle that each generation should pay for the services it receives, rather than force the unborn and the young to pay for its golden years.