CalPERS is considering once again to reducing its investment forecast. It attempted to do so last year when CalPERS senior actuary, Allen Milligan recommended to CalPERS that they lower their annual investment return forecast by a half point from 7.75% to 7.25%. The annual return forecast, also known as investment forecast or “discount rate,” is an estimate or assumption of future investment earnings. CalPERS and other pension systems rely heavily on assumed investment earnings to pay for their promised benefits. Currently, CalPERS’ investment forecast is 7.75% and it has not adjusted its investment forecast since 2003. Simply put, CalPERS assumed it will earn at least 7.75% on its investments and factors that into its accounting. If CalPERS doesn’t earn that much, it will come up significantly short on its ability to payoff promised benefits. In recent years, CalPERS, CalSTRS and other public sector pension systems have fallen far short of their assumed investment earnings. In 2011, CalPERS earned just 1.1% on its investments.
SO WHAT’S THE PROBLEM? WHY NOT SET THE INVESTMENT FORECAST AT A REASONABLE LEVEL THAT IS LIKELY TO BE MET?
Well, part of the answer lies in the effects of reducing the investment forecast. If CalPERS reduces its investment forecast to 7.25%, the State’s contribution to CalPERS would be increased by over $770 million dollars. The school districts that belong to CalPERS would have to kick in almost an additional $340 million dollars, with the impact on cities and counties being equally significant. Of course those increase costs to the state, cities and counties make politicians unhappy. They would then be required to get more money from the state, cities and counties and probably also require employees to pay more. This of course makes the labor unions unhappy. So the easiest thing to do, which CalPERS has routinely done, is to kick the can down the road and not reduce the investment forecast. However, this time around it looks like they may have no choice.
SO WHAT IS A REASONABLE AND FAIR INVESTMENT FORECAST?
Many experts believe a safe investment forecast would be 4% or less. After all, investments in public sector pensions should be conservative insuring the pension benefit is available when the retiree needs it. The treasury yields, considered by most to be the safest form of investment yield barely 2% on a 10 year note. It is enlightening to look at how the private sector deals with this problem. There are still a few major corporations that maintain traditional defined-pension programs that are similar to California public sector pension plans. By law, corporations are required to adjust their investment forecast based on their corporate bond interest rates. Interest rates are historically low therefore requiring U.S. corporations to reduce their investment forecast correspondingly. This requires U.S. corporations to pay a lot more money into their pension funds. The Wall Street Journal reported that General Electric had to contribute $7.4 billion dollars in its pension fund in 2011 in order to keep up with the reduced investment forecast. Ironically, the private sector unions want a low investment forecast and insist that corporations adequately fund their pension plans.
So the obvious question is why doesn’t CalPERS and other public sector pension plans do what GE did? Unlike GE, CalPERS is not required by law to adjust its investment forecast. CalPERS’s Board is a political entity. No politician wants the party to end. There is no politician that wants to make California municipalities and their employees pay more money. So historically, CalPERS and other public sector pensions kick the can down the road and force the hard decisions on somebody else.
SO WHAT IS GOOD FOR THE EMPLOYEE? STABILITY AND CONFIDENCE
Employees first want to be confident. The pension plan will exist and will be able to pay out the benefits that were promised when their time is due. Employees also want stability. While it may be tempting to roll the dice on high and unrealistic investment forecasts, emergency measures have to be taken when those investment forecasts are not met. CalPERS demands more money from the municipalities and municipalities in turn, immediately demand more money from employees, sometimes a lot more money. CalPERS needs to get real about what the market can deliver and adjust what its investment forecast should really be.