CalPERS considering pension hikes for workers, agencies as investment outlook dims

CalPERS is considering an investment policy change that would raise costs for local governments and some public employees as part of an effort to help stabilize the retirement system.

Long-running financial trends are making it harder for the system, recently valued at $459 billion, to earn enough money on its investments to keep up with its growing liabilities. As a result, CalPERS must either raise rates or put more money into riskier investments, CalPERS officials said in a recent meeting with The Sacramento Bee editorial board.

The 13-member CalPERS Board of Administration is scheduled to decide in November how to balance the rates with the risks.

Cities, counties, schools and the state — already paying bigger bills under a 2016 change to payment schedules — would pay more if the system raises rates. Local government employees hired after 2013 could be required to chip in, too, depending on the size of the increase. State employees likely would face pressure in labor contract negotiations to pay more toward their pensions.

Local government representatives, while acknowledging the market pressures on the underfunded system, are preparing to urge CalPERS to hold off on new rate increases.

“At this time, in May 2021, our membership is more concerned about immediate increased cost than it is about decreasing the volatility over the long run,” said Bijan Mehryar, a lobbyist with the League of California Cities.

To pay their pension bills, some cities have raised sales taxes, deferred spending and hiring and set up new pension trust funds, city managers said in interviews. And they’re still sorting out the financial consequences of the coronavirus.

“Coming out of a pandemic, when cities have just had their revenues completely diminished, is the wrong time to consider an adjustment” to what cities pay, said Jim Lewis, city manager of Pismo Beach.

CalPERS actuaries in the last two years have acknowledged the growing burden on local governments. Yet the retirement system still relies on assumptions about investment returns that remain unrealistically high, according to projections from consultants.

“The whole value of a defined benefit system is making sure that the benefits we promise can actually be paid,” CalPERS Chief Financial Officer Michael Cohen said. “That’s underlying all that we do. There is a balance of looking at employers and ability to pay, but we want to set reasonable targets for our investment office. Those two things do come into conflict a little bit.”

CalPERS’ earnings target

At the center of the debate is the “discount rate” that serves as a target for CalPERS’ investment office. The rate is currently 7%, meaning CalPERS aims to make a 7% return on its investments each fiscal year.

Lowering the discount rate would align it more closely with market predictions, but would automatically force government agencies to contribute more toward employees’ pensions. And since local government employees must split pension contributions with their employers under a 2013 state law, workers hired since then would also have to pay more, unless the increase amounts to less than 1% of payroll.

The CalPERS board voted in 2016 to reduce the discount rate to 7% from 7.5%, introducing the change gradually over eight years starting in 2017.

That change, along with others aimed at improving the fund’s long-term health, is already increasing pension costs in a way the League of California Cities has called “unsustainable.”

A 2018 survey published by the organization showed 170 cities expected their pension costs to increase 50% by 2024, to an average of 15.8% of general fund budgets.

In Lodi, the city’s pension bill has already increased by 39% since 2017, according to data provided by City Manager Steve Scwhabauer.

Schwabauer said city voters in 2018 approved raising the local sales tax to 8.25%, up from 7.75%, which allowed the local government to avoid cutting $6 million worth of services. But he doesn’t know how many more increases voters will support.

“I don’t know where the tipping point is, but it’s somewhere,” he said.

Yet the 7% rate the board chose in 2016 was still higher, by nearly a percentage point, than the annual returns consultants told the board they should expect.

Advisers from Wilshire Consulting told the board they should expect a 6.2% return. In the years since, the system has averaged 6.3%.

The CalPERS board will receive fresh estimates in June, but the system’s analysts have said they expect the downward trends in investment returns to persist.

Long-term debts

Groups representing public employees also are preparing to urge CalPERS to hold off on lowering the discount rate for now.

Terry Brennand, a lobbyist for SEIU California, said the system should aim high and then make adjustments if returns fall short, rather than raising costs upfront. Lower targets are bound to result in lower returns, Brennand said.

“You just have to decide where you want to put the pressure on,” he said. “The investment teams and the strategies and that process or the employers and the employees.”

But holding the discount rate steady carries its own risks for government agencies.

CalPERS sends them two bills. One is for the “normal costs” of their employees’ pensions. The second is for long-term debts.

The retirement system has about 71% of the assets it would need to cover all of its long-term liabilities, leaving it with an unfunded liability of about $167 billion.

The system is trying to pay off that debt by the mid-2040s, and the second bill it sends government agencies goes toward the debt.

When CalPERS misses its annual investment return target, as it did in the fiscal year that ended June 30, 2020, governments’ bills for the debt go up.

With an unrealistically high discount rate, that will happen more often and “ultimately cost even more,” CalPERS analysts wrote in a November 2020 report.

In the worst case, unpayable pension obligations could drive local agencies into bankruptcy or agencies could terminate their pension plans, according to the report.

No safe investments

CalPERS has been gradually reducing the discount rate since 1987, when it stood at 8.5%.

That year, the average yield on 10-year US Treasury bonds was 8.39%. The pension fund could park its money in long-term bonds and meet its obligations.

Last year’s average yield on the bonds was 0.89%, and the figure hasn’t been above 7% since 1994. The changes have forced the pension system to greatly expand its holdings in the more volatile stock market, and more recently, to push money into private equity and direct lending.

CalPERS is evaluating its long-term situation even as it enjoys a short-term bounty from a booming stock market.

At the end of March, the system’s year-to-date investment return stood at 15%. Absent a big drop in markets in the next month and a half, the system will record an annual return well above its target at the end of June.

But one good year only goes so far for CalPERS, the largest state-run pension system in the country.

And the high prices of stocks, real estate and other assets leave less room for more on-target returns, said Dan Bienvenue, the system’s interim chief investment officer.

“Everything is expensive, and when things are expensive, the forward-looking returns just aren’t as high,” Bienvenue said.

Any change the board makes this year likely would be phased in over several years. But Lewis, the city manager of Pismo Beach, said those prospective changes affect city decision-making immediately.

“Can you hire a new police officer? Probably not,” he said. “Because you know you have this cost coming at you.”

This story was originally published May 19, 2021 at 5:00 AM with the headline "CalPERS considering pension hikes for workers, agencies as investment outlook dims."