The California State Teachers Retirement Fund (CalSTRS) has
lowered the expected rate of return on its $188.7 billion fund by 50 basis
points by the summer of 2018.
The fund had averaged
returns of 7.8% over the past three years, 7.7% over five years, 5.6% over
10 years and 7% over 20 years. The impact of this decision will be borne by
taxpayers, school districts and many teachers who may each have to make larger
contributions to the fund or enact higher taxes to help the fund meet its
The lower rate of return is reflected in the fund’s pension
shortfall. An earlier report from May 2014 found that CalSTRS’ pension
shortfall was nearly $74 billion to meet its pension obligations to public
school teachers and community college instructors, and “the gap is growing by
$22 million daily. If the state does nothing, the fund is projected to be
cleaned out in 33 years,” the Los Angeles Times reported.
that time, Governor Jerry Brown asked the state legislature to approve a plan whereby
teachers and beneficiaries would raise their contributions from 8% of their pay
to 10.25% over a three-year period. At the same time, the state would increase
its contribution by more than 5.5% of payroll to 8.8%, also over three years. Then,
school districts would increase their contributions over the next seven years
from 8.25% of payroll to 19.1%. “In other words, school boards would have to
put more than twice as much into pension benefits seven years from now as they
do today,” according to the
Los Angeles Times
CalSTRS had previously assumed a 7.5% rate of return on its
$196 billion portfolio, but now that assumed rate will be reduced in two
stages. The first reduction will be to 7.25%, followed by a more conservative
7% assumption in 2018, the Los
Angeles Times reported.
In December 2017, the state’s largest pension fund, California
Public Employees' RetirementSystem
(CalPERS), with assets under management of $303 billion (as of December
2016), reduced its
investment projection last December.
Accompanying these changes, CalSTRS also announced on
February 1 that it had voted to adopt new actuarial assumptions that more
closely reflect its members’ longer life expectancies and “current economic
trends.” The fund made the changes after its actuarial consultant, Milliman,
studied different economic and demographic factors affecting its covered
members and then made recommendations to changes in the fund’s actuarial
methods and assumptions.
As a result of this actuarial study, the fund reduced its investment
return assumption over a two-year period:
Specifically, the fund:
- Decreased from 7.50% to 7.25% for the June 30,
2016, actuarial valuation to be presented at the April 2017 board meeting.
- Decreased from 7.25% to 7.00% for the June 30, 2017, actuarial valuation to be presented
at the April/May 2018 board meeting.
- Decreased some economic-related assumptions to
reflect ongoing trends. Specifically, the wage-growth assumption dropped to
3.50% from 3.75%, while the price inflation factor was reduced to 2.75% from 3%.
“The price inflation assumption was a factor in the lowering of expected
investment returns as it reflects the diminishing observed and expected yield
of U.S. Treasury bonds,” CalSTRS
These changes reflect the less than 50% probability that
current return assumptions will be met over the long term. CalSTRS last changed
the investment return assumption, also known as the discount rate, from 7.75%
to 7.50% in 2012.
Origins of the Underfunding
What CalSTRS is encountering is now is part of an ongoing,
national problem for state and municipal funds. One estimate found that if
state pension funding numbers were recalculated using more realistic discount
rates, the national unfunded liability would be close to $4 trillion.
A few factors
contributing to the underfunding problem are using unrealistic discount rates
to measure liabilities, political management of the funds, and assuming
unrealistic rates of returns, according to Olivia S. Mitchell, executive director,
Pension Research Council at the Wharton School.
“State and municipal plans are not covered by ERISA, so they
can use whatever discount rate they want,” Mitchell said, “so, in the past, CalSTRS
was using rates of 8% to 9% and we are seeing a decline now of down to around
7%. My perception is that CalSTRS is slowly getting on the bandwagon, but like
most state-defined benefit plans, they should be using lower rates than they
are using now.”
For example, Moody’s, the municipal bond rating company,
assumes a 5% discount rate and so
instead of CalSTRS reporting underfunding of about $80 billion, the reported
rate used by the Moody’s calculation would be an underfunding of about $300
billion, “so this slight decrease over the past few years from 7.5% to 7.27% to
7% in 2018 has been way too slow, in my opinion,” she continued.
“In my view, and in the view of financial economists, public
pension plans should be using the rate close to the cost of borrowing public
money at 4% to 5%, so they should be using a more realistic discounting rate,
rather than coming up with an assumed rate of return,” Mitchell said.
This would also mean less portfolio volatility. In 2016, CalSTRS
had about 55% of assets in stocks and the rest in fixed income and cash, “but
if over half of your portfolio is in stocks, you have to be able to sustain a
big downturn when the markets crash, so using a discount rate of 7%-7.5% is
simply unrealistic. And that is partly what happened,” according to Mitchell.
Another common problem is that state and municipal funds
fail to receive the required contributions, which creates a larger funding
In the CalSTRS case, one estimate Mitchell saw found that at
a 5% discount rate, contributions would have to double or be the equivalent of
35% of teacher’s pay. “This is significant and it gives you an idea of how big
that black hole is,” she said. Unfortunately,
there are few viable options for state funds. “What many of the state funds
must do is cut benefits or raise contributions or both,” she said.
Not An Uncommon
The funding problems at CalSTRS and CalPERS are happening
nationwide due to what some have called a “perfect storm” in pension funding. First,
as interest rates began falling, pension funds could either have stayed heavily
invested in bonds, which would force governments to either increase their cash
reserves or cut pensions. As an alternative, pension funds began to adopt
riskier investments (such as hedge funds) that could potentially produce larger
Academics have also noted that investing in hedge funds, a
favorite investing strategy, have fallen short of expectations. A 2016
study of state pension performance by Cliffwater, an alternative investment
consulting firm, found that state pension funds that invested in hedge funds
over the past decade experienced both lower returns and lower overall portfolio
risk than if they not invested in them.
This made hedge funds essentially a zero-sum game when it
came to risk-adjusted returns. Further, state pension fund allocations to hedge
funds have been constant in recent years at 4% of total assets, even though
more state funds are investing in hedge fund directly, as opposed through funds
of funds, Cliffwater found.
However, in many cases, returns from riskier investments did
not compensate for the underfunding problem.