In a sign of the uncertain times, the CalPERS board last week approved a sharp increase in the cost of terminating pension plans, a rare action said to be taken each year by only one or two of the more than 2,000 retirement plans in the giant system.
After a plan terminates, there is no way to get more money from the employer. The worry is that ending just one big plan could “dramatically” erode a pool currently responsible for the pensions of 4,700 members of 118 terminated plans.
The new safeguard increases the money an employer must set aside to offset or “discount” future obligations. A much lower bond-based earnings rate will be assumed, currently 3.8 percent, rather than the CalPERS earnings forecast, 7.75 percent.
The change touches a hot-button issue. Critics contend that the California Public Employees Retirement System earnings forecast, 7.75 percent, is overly optimistic and conceals massive debt.
“I don’t want it to be reprinted somewhere else where CalPERS has all of a sudden decided to lower our assumed rate of return,” said board member Tony Oliveira. “This is a different animal here.”
Last March the CalPERS board, on a 10-to-3 vote, rejected a recommendation from actuaries to lower the earnings forecast from 7.75 to 7.5 percent. Dropping the forecast would have raised annual payments by employers.
A widely publicized report by Stanford graduate students last year estimated that the combined unfunded liability of CalPERS, the California State Teachers Retirement system and UC Retirement is $500 billion, not $55 billion as the funds reported.
The students used a bond rate, 4.1 percent, rather than the 7.5 to 8 percent the funds assume for their diversified portfolios. Some economists say a risk-free bond rate should be used because pensions are risk free, guaranteed by taxpayers.
“That’s one of the concerns I have,” said board member J.J. Jelincic, getting a laugh by referring to the Stanford report by describing the location of the university, as if uttering its name would sully his lips. “I think that some of these numbers will be quoted as, ‘Aha!’”
Jelincic said the critics may not understand “that there is a difference between pools where the system has a call on the employer and a pool where the system does not have a call on the employer.”
Unique among CalPERS funds, the Terminated Agency Pool lacks the key part of the modern public pension plan: the ability to get more money from employers and taxpayers if investments, expected to cover roughly two-thirds of pension costs, fall short.
“For all of the other funds at CalPERS we can ask the employers to make up any shortfall,” the CalPERS chief actuary, Alan Milligan, told the board. “That’s what allows us to invest the way we do.”
CalPERS investments, currently worth $224 billion, are in a diversified stock-based portfolio that is riskier than government bonds. Some of the money is in even riskier private equity and real estate expected to outperform the stock market.
“And as a result of investing the way we do, employers get a significantly lower cost in the long term,” Milligan continued.
A history of investment returns presumably would show that a diversified portfolio can pay for higher pensions than bonds, given the same level of contributions from employers and employees.
That was the theory behind a legislative ballot measure in 1984, Proposition 21, that allowed public pension funds to shift most of their investments from bonds to stocks and other riskier investments.
But arguably, diversified investments also led to the mismanagement of the state pension funds: lowering employer contributions and raising pensions when the stock market boomed.
A decade ago the Legislature was told, erroneously, that earnings from diversified investments would pay for increases in CalPERS pensions and a new CalSTRS benefit supplement. (See Calpensions 10 Jan 11: “State pension funds: what went wrong”)
Now the new bond-based discount rate for terminated plans is likely to result in a bond-based investment of the pool. The goal is to generate cash flow from the investments that matches cash needed to pay the pensions.
“This is really what insurance companies do, and for the same reasons,” said Milligan. “They have no ability to change the contributions, the premiums, so they have to fund like this.”
Milligan said the plan is to “immunize” the terminated pool against risk to better ensure pensions. Two years ago the CalPERS board rejected a proposal by actuaries to “immunize” a small survivor benefit program as a potential model for other funds.
Some of the dwindling number of private-sector pension plans, as well as a few European public pensions, are said to be moving toward bond-based investment strategies such as “immunization” and “liability-driven investing.”
As of June 2009, the terminated pool had assets worth $144 million, liabilities $60 million, and $5.4 million in annual pension payments. The pool was 240 percent funded, far better than CalPERS total funding of nearly 70 percent earlier this year.
A report given to the board by actuaries last week said the new 3.8 percent rate (an annual calculation based on 10-year and 30-year Treasury bond yields) would increase the liabilities from $60 million to nearly $92 million.
“For active agencies that wish to terminate in the future, a similar percentage increase in liabilities can be expected if rates remain unchanged,” said the report.
Even with a 7.75 percent rate, terminating a CalPERS plan could be prohibitively expensive. A study commissioned by the city of Pacific Grove last year found that leaving CalPERS would cost $30 million to $34 million.
Pacific Grove owed an additional $19 million on an ill-advised pension obligation bond. CalPERS does not require terminated plans to make a lump sum payment, instead allowing installment payments over time.
But the scenic Monterey Peninsula city with 15,000 residents had a general fund budget of about $15 million last fiscal year. The city has made deep spending cuts, reportedly reducing its police force from 30 to 20 members.
A local initiative approved by 74 percent of Pacific voters last fall, Measure R, would limit city pension contributions to 10 percent of pay. The police union filed a lawsuit in Monterey County Superior Court to block the cap.
The measure is one of the first attempts to reduce the pension benefits promised current workers. It’s a cost-cutting move some think is needed to make pensions “sustainable,” but which also is widely believed to be prohibited by court rulings.
A leader of the citizen group that wrote the measure, Dan Davis, said the legal argument that Pacific Grove employees do not have a “vested right” to promised pension benefits is based on what may be a unique provision in the city charter.
“I’m not sure it’s going to help anybody else,” Davis said last week, if the courts uphold the measure.
CalPERS will include a hypothetical termination liability in the annual actuarial reports sent to plans, starting in October of next year. With a lower 3.8 percent rate, the termination liability will be much higher than ongoing liability with a 7.75 percent rate.
“CalPERS will need to proactively communicate with stakeholders, including employers, members, and the general public about this change and why it was necessary to protect our members,” said the report to the board.
If there is an initiative on the November ballot next year that would switch new state and local government hires to a 401(k)-style retirement plan, the goal of a group led by Dan Pellissier, the higher cost of leaving CalPERS could be a campaign issue.