Puzzling PERS Decision on Assumed Rate of Return Looks to Push Off Tough Decisions into the Future

The vote followed the recommendation by the pension fund’s Benefits and Program Committee, which voted Tuesday to support the retention of this rate.  However, it overrules the judgment of their own chief actuary and deputy chief actuary, who released a report to the board last week, advising them that it would be “reasonably prudent” to to lower the rate to 7.50 percent.

CalPERS Chief Actuary Alan Milligan recommended that the pension fund adopt a lower discount rate  at 7.50 percent, but indicated that keeping the rate unchanged was also prudent.  Employers appeared before the pension fund’s Benefits and Program Administration Committee Tuesday, urging the fund to keep the rate unchanged due to their financial pressures.

The discount rate represents what a pension fund believes it can realistically earn from its investments on an annual basis, when averaged over the course of 20 years or more. In any given year, investment returns are likely to be higher or lower than the long-term assumed rate.

Over the past 20 years, including the two recent recession years, CalPERS has earned an average annual 7.9 percent rate of return before deducting administrative and investment expenses. For the fiscal year that ended June 30, 2010, CalPERS earned a 13.3 percent return.

Local governments are split on the move.  According to a release from the League of Cities, “Some city officials in attendance expressed concern about the devastating impact a one-quarter percent change in the discount rate would have on their operating budgets. However, not all city officials agree on this issue. In contrast, some city officials believe that keeping the current 7.75 percent rate only pushes pension obligations off into the future.”

Last week in a report to the board, the chief actuary wrote, “There appears to be a consensus that returns are expected to be lower than historical returns over the next 10 years and the expected returns that were presented to the Board reflected that.”

They continue in technical language, “Given that the median investment return net of administrative expenses is 7.80%, we recommend that the discount rate assumption be lowered to 7.50% per year to have a margin for adverse deviation similar to that currently used. Given that the state of the economy has put severe pressure on employers’ budgets, we recognize that it may be appropriate to reconsider the level of margin for adverse deviation.”

However they add, “We believe that either using a lower margin for adverse deviation and choosing a discount rate assumption of 7.75% or lowering this assumption to 7.50% would be a reasonably prudent assumption. Both assumptions would be able to provide for an actuarially sound system over time with a 7.50% assumption providing slightly more security than remaining at 7.75%.”

The concern that many officials have is that CalPERS operates with a 30-year time horizon.  That means that they are essentially pushing difficult decisions off into the future, as they have with their rate-smoothing apparatus.

Writes Ed Mendel, who covers CalPERS and other pension issues on his Calpensions site, “Actuaries got another rebuff this week when the labor-friendly CalPERS board voted to leave its earnings forecast unchanged, much like a CalSTRS [California State Teachers’ Retirement System] board action in December that did not lower its forecast as far as actuaries recommended.”

He also notes, “A lower earnings forecast raises pension costs for state and local governments struggling with budget cuts during a deep recession. But another rate increase also might fuel the drive for pension reforms that increase worker costs and cut their benefits.”

“I was afraid we were going to throw gasoline on the fire in the public pension debate,” Neal Johnson of the Service Employees International Union told a CalPERS committee after a key vote, according to Mr. Mendel.

One possibility that the City of Davis could consider is to operate as though there is a 7.5% ARR.  I had suggested that the city set aside their own fund, which they could use as a buffering mechanism to prevent unfunded liabilities and guard against the rising and falling of contributions.

However, the point was made and well taken that CalPERS is going to get far more return on any investment than the city could on its own, and therefore paying more into their fund would yield more return in the future while achieving the same ends ,which is to reduce unfunded liabilities for the city’s pensions.

This is a complex scenario, and one that will likely take legislative action and bargaining concessions by city employee groups to obtain.

It is not clear that there is complete buy-in for what needs to be done legislatively, which is to basically undo the enhanced 3% at 50 and 2.7% and 2.5% at 55 enhanced pensions.  That would obviously have to done done into the future, but it needs to be done for current employees, not just the creation of a second tier that could be undone in twenty years.

Moreover, there needs to be some insurance that future pension increases do not occur retroactively as the last round did.

There is no assurance that CalPERS will not change their mind on this point in six months, as legislative pressure will undoubtedly increase.  But for now, this may forestall the worst budgetary hits or at least push them off for future councils.

I believe there is sufficient council support, however, for getting the pension situation fixed and avoid what has happened in the past, which is an essential passing of the buck, not just on the issue of compensation and pensions, but a number of other issues like water rate hikes that are expected to begin this August.

—David M. Greenwald reporting