Last year was one of the best ever for the CalPERS investment fund, a gain of $47 billion that boosted the total to $350 billion. But pension funding only increased from 68 to 71 percent of the projected assets needed to pay future costs.

A CalPERS report last week said investments earned 15.7 percent last year, nearly double the 7 percent target. Now after a lengthy bull market experts predict CalPERS returns will average 6.2 percent next decade, then increase to average 7 percent in the long term.

That a $47 billion investment gain only makes a small change in pension funding shows the difficulty CalPERS still faces in recovering from a $100 billion investment loss a decade ago, when the funding level nosedived from 101 percent to 61 percent.

During the financial crisis and stock market crash, the California Public Employees Retirement System investment fund plunged from about $260 billion in 2007 to $160 billion in 2009. How debt outpaced funding since then is shown in a chart in the new report (see below).

The failure of CalPERS funding to recover to the traditional level of 80 percent or more leaves little cushion to absorb another big investment loss. Experts have told CalPERS that if funding drops below 50 percent, recovery becomes even more difficult if not impossible.

CalPERS is at the mercy of the market. Most of the money needed to pay future pensions, 61 percent, is expected to come from investments. Employers are expected to provide 26 percent of the funding, employees 13 percent.

Even if there is another major market crash, CalPERS would be far from danger of running out of money. It paid $21.4 billion in pension benefits last fiscal year, while employers contributed $12.3 billion and employees $4.2 billion.

The new report, “A Solid Foundation for the Future,” shows CalPERS no longer has “negative cash flow” requiring the sale of some investments to help pay pensions each year. For two decades, employer-employee contributions and investment income will cover the cost.

Three changes are expected to strengthen CalPERS funding. The investment earnings forecast used to discount pension debt was lowered from 7.5 to 7 percent, triggering a local government employer rate increase of about 50 percent for cities over the next seven years.

The 3,000 local governments in CalPERS (half are schools) have a range of funding from high to low. The new rates may force some service cuts, employee reductions, tax increases and test the “sustainability” of current pensions.

A new CalPERS investment allocation increased predictable bonds or fixed income from 19 percent to 28 percent of the portfolio. Riskier but higher-yielding stocks are 50 percent, private equity 8 percent, and real estate 13 percent.

California pension systems were originally limited to bond-like investments. Voters approved Proposition 1 in 1966 allowing 25 percent of investments in blue-chip stocks. Proposition 21 in 1984 allowed any “prudent” investment.

The third change is a cost-saving reform that shortens the payment period for new debt or “unfunded liability” from 30 to 20 years. The debt is usually from below-target investment earnings, the adoption of a lower discount rate, or longer expected life spans.

The new debt payment, possibly requiring a small employer rate increase, is a fixed dollar amount that doesn’t change. It replaced a fixed percentage of pay that began too low to cover the debt interest and slowly grew with the payroll.

The new policy ends “negative amortization” under the old 30-year payment that allowed the debt to grow for the first nine years and did not begin paying down the original debt until the 18th year.

As a maturing pension system, CalPERS faces another funding difficulty. The pension fund has become much larger than the payrolls on which rates are based. So a larger employer rate increase is needed to replace investment losses.

A California State Teachers Retirement System risk report two years ago gave an example. When the payroll and the pension fund were about equal in 1975, a loss of 10 percent below the investment target could be replaced by a 0.5 percent of pay increase over 30 years.

Now when the CalSTRS investment fund is about six times larger than the total member payroll, replacing a 10 percent loss would require a rate increase of about 3 percent of pay over 30 years.

An annual report on state pension funds issued by the Pew Charitable Trusts last week said the average nationwide funding level in 2016 was 66 percent, a little below the CalPERS 68 percent funding then.

“In 2016, the state pension funds in this study cumulatively reported a $1.4 trillion deficit—representing a $295 billion jump from 2015 and the 15th annual increase in pension debt since 2000,” said the Pew report.

The report listed five states with funding below the 50 percent CalPERS regards as a redline: Colorado, Connecticut, Illinois, Kentucky and New Jersey, which had the lowest funding level, 31 percent.

Pew listed four states that were at least 90 percent funded: New York, South Dakota, Tennessee and Wisconsin, which had the highest funding level, 99 percent. The Pew state pension fund report in 2010 called Wisconsin a “national leader.”

That year former Wisconsin Gov. Jim Doyle told a Milken Institute conference in Los Angeles that all of the Wisconsin state and local government pensions, except the city and county of Milwaukee, were consolidated in the 1970s.

An unusual dividend feature allows Wisconsin retiree payments to be cut in hard times and increased in good times. After strong returns last year, the Employee Trust Funds department said retirees will receive an increase of at least 2.4 percent beginning in May.

Doyle said Wisconsin tries to keep the system fully funded. When the funding level fell to 82 percent after the stock market crash in 2008, the state added a contribution of about $200 million to bring the funding level back up to near 100 percent.

“I would love to take credit for this,” said Doyle. “But this is something that’s built into our culture for a long period of time. I will take credit for, even in these very dire times, we have never deferred payments. We pay them in.”

The first of four CalPERS employer rate increases after the 2008 crash did not come until 2012, when the discount rate was lowered from 7.75 to 7.5 percent. The second rate increase was the adoption of the 30-year debt payment.

CalPERS had been using a rare 15-year period to “smooth” investment gains and losses, far beyond the typical three to five-year period, and a “rolling” or “open” debt payment that was refinanced every year and theoretically might never pay off the debt.

Gov. Brown put the spotlight on the need to more quickly pay pension debt with a $6 billion extra payment to CalPERS last year for state workers. This week the CalPERS board is expected to set employer state worker rates for the new fiscal year beginning July 1.

The staff recommendation, routinely approved by the board, is a $6.4 billion payment, up $424 million from the employer contribution for state workers in the current fiscal year. The payment was reduced $177 million by the extra $6 billion contribution.

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Originally posted at Calpensions.