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CalPERS gets candid about ‘critical’ decade ahead

The CalPERS headquarters in Sacramento. (Photo: Kit Leong, via Shutterstock)

Once CalPERS could shrug off low funding and rising employer costs as just another downturn, staying the course in the long-term strategy of getting most of its money from market investments that go up and down.

This time is different.

CalPERS is still only about 70 percent funded after a record decade-long bull market. State and local government CalPERS costs are at an all-time high and growing, amid warnings some cities may face bankruptcy.

“The benefits of the changes we’ve made are taking hold, but the next decade is critical.” — Marcie Frost

And as recession looms after years of growth, the failure of funding to recover to the traditional 80 percent or better leaves CalPERS more vulnerable to a big investment loss that drops funding below 50 percent, a red line experts say makes recovery unlikely.

CalPERS is hearing from workers worried about whether their pensions are secure, Marcie Frost, CalPERS chief executive, told the board last week, and a frequent question from employees and employers is: “Why does the fund remain at 70 percent?”

letter from Frost posted on the CalPERS website last month, “Our Plan to Protect Our Members’ Retirement Security,” is a response to the concern among CalPERS members about whether their promised pensions will be there when they need them.

After a look back at what caused the shortfall, the letter outlines some of the steps that raised employer rates to put more money into the system, after funding fell to 61 percent a decade ago, and a new focus on increasing investment returns.

“The benefits of the changes we’ve made are taking hold, but the next decade is critical,” the three-page letter said in the conclusion. “Pension costs are rising, and we must do all we can to control them.”

A critic could find things to pan in the letter. The opening refers to “changes in retirement benefits and lower contributions” when CalPERS was 128 percent funded 20 years ago during a high-tech boom.

Wilshire has been forecasting that the CalPERS portfolio, valued at $378.7 billion last week, will earn 6.2 percent during the next decade

Not mentioned is CalPERS dropping employer contributions to near zero for two years and sponsoring a state worker pension increase, SB 400 in 1999. Its generous Highway Patrol formula, adopted by local police and firefighters, is said by some to be unsustainable.

A CalPERS pamphlet told legislators SB 400 would not cost “a dime of additional taxpayer money.” State contributions expected to remain for a decade below the fiscal 1998-99 level, $766 million, actually turned out to be $3.9 billion in 2009 for various reasons.

The letter said CalPERS has lowered its expected annual investment return, used to discount debt, from 7.75 percent to 7 percent. Critics say the return target is still too high and conceals the need for a massive employer rate increase.

A CalPERS consultant, Wilshire, has been forecasting that the CalPERS portfolio, valued at $378.7 billion last week, will earn 6.2 percent during the next decade. Last week a new Wilshire report lowered the forecast to 5.9 percent.

Still, CalPERS members may be reassured by the prompter payment of new debt, a drive for higher investment returns led by a new chief investment officer, Ben Meng, with new private equity models, other examples of action, and a new attitude.

By last year, the employer contribution had soared to $19.9 billion, while the member contribution only increased to $4.4 billion.

“The financial world is changing, and we must change with it,” said the letter. “What we’ve done over the last 20 years won’t take us where we need to go in the future. New thinking and innovation are in order.”

The CalPERS Pension Buck

If hitting the 7 percent investment target will be difficult and rising employer rates are taking too much of government budgets, what about the other source of CalPERS funding — the employee or member share of pension costs?

The “CalPERS Pension Buck” on the CalPERS website main page, based on income during the last 20 years, understates the growing gap between contributions to CalPERS from employers and members since the huge investment loss a decade ago.

Over the last 20 years, the Buck shows members contributed nearly half as much as employers. But last year, member contributions were less than a quarter of the rapidly growing employer contribution, according to the CalPERS annual financial report. (see below)

In 2009 the employer contribution to CalPERS was $6.9 billion and the member contribution $3.9 billion. By last year, the employer contribution had soared to $19.9 billion, while the member contribution only increased to $4.4 billion.

An explanation of the Buck on the CalPERS website said some believe taxpayers fund the total pension cost, when in fact “72 cents out of every public employee pension dollar is funded by CalPERS’ own investment earnings and member contributions.”

Member contributions to CalPERS are usually set by union contract bargaining and statute.

A critic might argue that the Buck, by looking back two decades, obscures the fact that the annual cost government employers pay for CalPERS pensions has nearly tripled during the last decade, making it a larger part of the pension buck income.

As for any worry that CalPERS may soon run out of money, the chart below shows total employer and member contributions last year, $24.3 billion, exceeded pension payments, $22.7 billion, thanks to the big employer contribution increase.

The positive cash flow means CalPERS at this point does not, as it has in the past, need to dip into its giant investment portfolio to make annual pension payments, reducing the holdings that can yield earnings.

Member contributions to CalPERS are usually set by union contract bargaining and statute. Current rates paid by employees can be as high as 15.5 percent of their pay. But most rates are about 8 to 10 percent of pay.

Importantly, only employers are required to pay off pension debt or the “unfunded liability,” which for CalPERS was $139 billion last year. Paying off the debt is the reason that employer contributions soared during the last decade and member contributions did not.

Debt can result from several things, such as expecting longer average life spans that increase total pension costs. But the big one is changes in the investment earnings expected to pay most of the pension costs.

A series of state court rulings known as the California Rule prevent cuts in the pension offered at hire unless offset by a new benefit.

Lowering the investment target or discount rate, as CalPERS did from 7.75 to 7 percent, resulted in debt paid off by higher employer rates. Even investment returns slightly below target, like CalPERS earning 6.7 percent last fiscal year, produced new debt.

Most large corporations have switched employees to 401(k) individual investment plans, making an annual “defined contribution” that unlike a “defined benefit” pension produces no debt. In a time when equality is a political issue, public pensions fear the trend.

“We told the CalPERS story across the state,” Frost said in the letter, “fiercely defending defined benefit plans and highlighting their economic impact on local communities large and small.”

Some reformers who think 401(k)s provide inadequate retirement, while shifting investment risk to employees, advocate giving public pensions the flexibility to cut the pension amounts workers earn in the future — notably a Little Hoover Commission report in 2011.

But a series of state court rulings known as the California Rule prevent cuts in the pension offered at hire unless offset by a new benefit. The state Supreme Court, avoiding the issue in a ruling earlier this year, may address the California Rule in a pending case.

Even if the California Rule is modified, it’s not clear any local governments will rush to cut pensions. Stockton and San Bernardino did not try to cut pensions in bankruptcy, saying they are needed to be competitive in the job market, particularly for police.

Meanwhile, a line in Frost’s letter is a reminder that CalPERS remains at the mercy of the market, as when the stock market crash and recession struck a decade ago: “The value of the CalPERS fund fell 24 percent in a single fiscal year, to about $180 billion.”

Editor’s Note: Reporter Ed Mendel, the founder and editor of Calpensions.com, covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com

 


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