This is just scary.
As those of you who follow the CalPERS soap opera may recall, California Governor Jerry Brown pushed for the giant pension fund CalPERS to lower its assumed investment return from 7.5% to 6.5%. Given that the world is headed towards deflation and that CalPERS earned only 2.4% for the fiscal year ended June 30, 2015, Brown’s request seemed entirely reasonable. Instead, the board approved a staff proposal to move to the 6.5% target over 10 years.
One of the things that is perverse about pension accounting is that the convention is that the liabilities, that is, what the pension fund expects to pay out over time, are discounted at the same rate as the assumed returns. However, for a government pension plan, where taxpayers are on the hook for any shortfalls, the risk of CalPERS beneficiaries getting their money is not the risk measured in terms of what CalPERS projects in terms of future employee contributions, expected returns, and expected payouts; it’s ultimately California state risk, which means the liabilities should be discounted at California’s long term borrowing rate. With California rated S&P AA3, Moody’s Aa-, and 20 year AA muni yields 2.75% and A at 3%, no matter how you look at it, the discount rate on the liability side is indefensibly high.
This matters on the estimation of liabilities because the lower the discount rate, the larger the amount (in current terms) that has to be paid out. Remember, this is the mirror image of “inflation can help bail out underwater borrowers” scenario. High discount rates erode the value of future commitments; low ones increase them. This is why we have been warning that ZIP and QE, which explicitly sets out to lower long-term interest rates, is a death sentence to long-term investors like life insurers and pension funds. And investors like CalPERS are trying to finesse that problem by continuing to pretend that they can earn a higher rate of return than is attainable without taking batshit crazy risks.
But even worse is the incomprehension about what is going on, as reflected in a statement by the president of CalPERS’ board, Robert Feckner. From the CalPERS website, State of the System 2016: Our Progress Toward a Sustainable Pension Fund:
The fact that our members are living longer is a sobering reminder that we have a growing obligation to provide for their pensions. Just a decade ago the ratio of active workers to retirees was over 2 to 1. That ratio is now 1.3 workers to every retiree, and we pay out more in benefits than we receive in contributions.
In response, our Board approved a policy designed to reduce the discount rate, our 7.5 percent assumed rate of return on investments, over time. The result will help pay down the pension fund’s unfunded liability and reduce risk and volatility in the fund.
Huh? This is utterly backwards. What will reduce CalPERS’ unfunded liability is higher contributions or higher earnings. A lower discount rate, while a reflection of current reality, exposes that it will be harder, not easier, to meet this objective.
The worst is that given the level of finance acumen I’ve seen after watching hours of Investment Committee hearings is that the odds are high that this is not an obfuscation misfire but evidence of an utter lack of understanding of finance basics. And worse is that CalPERS staff, which had to have reviewed this text, didn’t see fit to correct this glaring error. Do they also not get it or did they assume that beneficiaries were too clueless to catch it?
And what is even worse about CalPERS’ refusal to implement a more realistic discount rate is that Brown, who was pushing for the change, was also prepared to make a contribution from the state’s coffers to offset the apparent impact of more realistic accounting. From the Los Angeles Times last November:
For years, CalPERS critics have warned that the pension fund was using overly optimistic projections for its investment portfolio, projections that would leave taxpayers picking up an ever larger share of the obligations made to state and local government workers…
The decision will increase amounts paid to CalPERS for state government workers’ future retirement. As the employer, the state’s general fund already pays CalPERS $5 billion a year. And for a governor who preaches lower spending, it seems jarring to think Brown would actually push to increase the size of the state’s annual pension costs.
Jarring, that is, until one considers Brown’s real strategy: to help pay down the pension obligation now, when funds are available, rather than face the question in an economic downturn. It also would take revenues off the table for other budget fights in Sacramento in 2016.
The Times story has more on the politics of this perverse standoff. At least one board member, Richard Gillihan (who is a direct report to Brown) supported moving to a lower return target now.
But again, I find the evidence of financial incompetence of influential members of the board to be more troubling than the substance of this action, which we’ve commented on in passing before. No wonder CalPERS staff can lead the board by the nose.
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Barbers, cosmetologists and manicurists all must be licensed in California:
http://www.barbercosmo.ca.gov/licensees/
Evidently, though, one can serve on the board or staff of one of the world’s largest pension funds without knowing the difference between the financial analog of a hair cut versus a trim
Or the difference between a haircut verses hair plugs. Yikes
[rimshot. hollow laughter]
By CALPERS’ logic, they could just reduce their discount rate to zero and solve all their problems!
I took it more like the government will be forced to fund the resulting deficit instead of the plan jumping into riskier investments to meet the higher return expectations.
Same here. Feckner might have meant that reducing the assumed return will force higher contributions from workers or the state general fund to make up the increased deficit.
Cutting the discount rate from 7.5% to 6.5% over ten years is too little, too late. It’s like handing out rain ponchos as a tsunami approaches: no effect on the result.
There’s just no way to excuse this:
“The result will help pay down the pension fund’s unfunded liability….”
And he also does not understand the idea of target returns versus the risk-free rate. a 7.5% return target when the 30 year Treasury is at 4.5% is a completely different beast than a 7.5% return target going super slowly to 6.5% when the 30 year Treasury yield is 2.6%. CalPERS is assuming a much more aggressive risk posture now, when Feckner states the reverse.
Because of the recent Illinois Supreme Court ruling it is a clear contract with the state not the fund and that includes retiree health care which has no fund. The court said it’s nice to have a fund but ….it doesn’t matter. I am not sure this is the case in all states. We have a bunch of GTCR stuff in our fund and sadly I’m the govoners office.
In California, the pensions are clearly a state obligation.
Yes. However, county and municipal employees are not similarly esconced. These political subdivisions are not sovereign and can elect bankruptcy. (Ouch!)
Not in CA. San Bernardino, which declared bankruptcy and decided to pay its CalPERS obligations in full, beat a challenge by two other creditors that wanted CalPERS to take a haircut:
http://www.sacbee.com/news/business/article20770341.html
Thanks for keeping us up to date on the latest idiocy by the CalPers Board. I’m a certainly no economics genius, but even I can see how ridiculous this decision is.
Why not just say: we’re using smoke ‘n mirrors, folks. Enjoy the show!
I currently contribute to CalPers and some day will be an annuitant. I have put off retirement for a good while bc I am saving, saving, saving my own money (where to invest that is another good question these days… maybe under my mattress). Who can count on CalPers in the long run?? I do not. I’ve advised the people I work with not to count on CalPers, but like most US citizens, they prefer to live with their heads in the sand.
Good luck to us all.
As for where to invest, I’d call Cutting Edge Capital (based in SF, I think) and see what DPOs are available from small businesses and co-ops in your area. Invest locally, if you can – Cutting Edge and others are working to make that easier to do.
You may want to take a Winter trip to Central America. There seems to be a large contingent of California expats who have found a way to extend their pensions.
Here you go again, Yves, spouting off from the hip. If you read their risk mitigation policy you would know he’s correct. In years of superior returns (4+7.5 and up) part of that return, of course, allows for an incremental lowering of the return rate. But the other part, with employer/employee contributions, also goes toward lowering the unfunded liability. The end result is the fund getting to 6.5 return rate, with a zero balance on the unfunded liability. Calpers actuaries and financial folks have modeled the policy and likleyhood that there would be enough good return years to make that happen. They say over a 20-30 year period there will be. But that is another topic for debate altogether. Bottom line, the policy as written does lower the rate of return and pay down the unfunded liability.
For someone who claims to know what they are talking about, your comment goes from a personal attack to being incoherent. You make it clear you don’t understand the very basic point made in this post: that lowering the assumed return rate increases the unfunded liabilities. As a result, employees would be required to contribute more.
And no one takes seriously the idea that CalPERS is getting to a zero balance on unfunded liability on its own. This is why it is so indefensible that CalPERS rejected the Brown offer of a large contribution from the state to the fund in return for going to more realistic return assumptions now.
CalPERS average return over the last decade was 5.2%. I’d like know what its actuaries are smoking to think that CalPERS will have many, much the less any years, when it beats the 7.5% target, which are the only times CalPERS will then lower its return target going forward. CalPERS has already stated, repeatedly, that the only asset class it expects to be able to exceed its return target on a gross basis is private equity which is only targeted for 12% of its portfolio. And we’ve stressed repeatedly that private equity does not provide enough in the way of returns to justify its greater risk, so that hoped-for higher return is a very risky wager.
CalPERs is engaged in an elaborate kick-the-can-down-the-road strategy. And you understand finance so little that you act as if CalPERS machinations to hide that fact are reasonable.
Any employer in the CalPERS system can make additional contributions to the fund. I have consistently encouraged employers to do so. I have even offered to pick up the check if the state wishes to make a larger contribution,
What Brown wanted was for the CalPERS Board to mandate higher contributions for all 3000 or so employers (and employees hired under the recent pension reform law). What the governor wanted was to take the legislature out of the process. Why negotiate? Get CalPERS to be the heavy. When the governor introduced his budget I didn’t notice that he even suggested the state make higher contributions.
Wrong again. Read. The. Policy. Part of the excess return also offsets the increase in employer contribution rate that would normally occur from a lowering of the discount rate. To be clear, some rate increase is inevitable. But this policy does pay down the unfunded liability, and lower the discount rate with minimal impact to employer rates
The poster above emphatically did read the policy: he is a current CalPERS Board member, who is also an employee of CalPERS with a background in finance.
You are reading the policy correctly, Bruce, except that in an environment where interest rates are effectively negative the assumed rate of return forces staff to chase returns by engaging in risky investment strategies that do not “reduce risk and volatility in the fund” as claimed by Feckner. The assumptions made in the policy about beating return assumptions are wrong-headed and dangerous. Brown didn’t simply want to raise contributions by employers and employees in a vacuum — he wanted the fund to reduce risky investing strategies by lowering assumptions about returns.
Risk is not an abstraction — in particular the exposure of the fund to Private Equity firms that have been looting their portfolios in order to compensate their executives handsomely is likely to increase employer rates in the not too distant future when those investments wind-up and fully account for expenses and fees.
Enjoy. The. Kool. Aid.
Based on their track record, CalPERS actuaries are hardly to be considered reliable forecasters of pension costs. In the 20-year period between 1993 and 2013, CalPERS investments yielded 7.8%. Yet over that time CalPERS went from fully funded to a shortfall of $113B. The problem is not that investments did worse than expected — it’s that the actuaries underestimated how much the promised benefits actually cost. See, e.g., http://sagedrive.com/calpers/16_01_11.htm.
It’s all well and good to be concerned about investment return going forward. But it doesn’t explain the hole that CalPERS currently finds itself in. The blame for that lies with the actuaries.
The Board’s “reasoning” is ‘Alice in Wonderland’ upside down. yikes!
How to account for that? Delusion? A strange Cargo-Cult mindset ? The belief that past (20 years) performance does indicate future returns?
Thanks so much for your continued reporting on CalPERS and PE.
CalPERS leadership’s incompetence is staggering — but you just aren’t going to be able to find competent finance and legal minds willing to live and work in Sacramento. It’s hot, it’s dull, and it’s a snake-pit of political corruption.
I’ve found in the preponderance of finance jobs where the public interest is at stake, the norm for abilities or job performance is on the continuum from incompetence-to capture-to perhaps outright corruption. I’ve seen this on nonprofit investment boards, heard it from union pension leaders, and seen it in both official regulators (e.g. the SEC) and quasi-official regulators (e.g. FINRA). While it is easy to blame the plutocrats for everything wrong with finance, we should also blame a culture of credulity and enabling by those that are supposed to protect us. CalPERS, it seems, is rife with these weaknesses. These CalPERS staff jobs and board gigs are steady bread for anyone who fits the mold and stays sufficiently boring and impotent, the sooner their scams get blown the better.
I am in deep admiration of yves’ work on private equity but have to quibble with you on the discount rate stuff here. Unfortunately lowering discount rates tends to lead to more financialization, because it diverts general fund revenue into the pension funds, which in turn leads to more wall st grifting.
The model of prefunding benefits originates with life insurers who have no guaranteed revenue streams in the future. The state of California is radically different in this regard—they will have revenue steams for the next 100 years. Pay go systems like social security are far superior if we want to reduce financialization and provide benefits.
*Sigh*
California is not in the position of the Federal government, which can alway create the money it needs to make payments. There are years of budget stress, like right after the crisis, when the budget as a whole is under pressure. Remember that California had to resort to IOUs to fund itself for a while?
Having a pay as you go system in the current political environment would guarantee that public pensions would have been greatly reduced years ago to correspond to the way private employers have eroded them. The legislature could demolish them as part of its annual budgetary process, since the payments go only to a segment of the voters, unlike Social Security which has broad based participation and hence voter support.
This is just postponing the inevitable, receivorship. Hopefully the (mis)managers there will be held accountable
Complexity and fee reduction, feel good ESG initiatives, tantamount to throwing deck chairs off the Titanic.
CalPERS has reciprocity agreements with many of these California public retirement systems that allow retirees with service credit and contributions in two systems to receive payments from both systems.