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CalSTRS Lowers Return Expectations and Revises Actuarial Expectations

The first reduction will be to 7.25%, followed by 7% in 2018.

By Chuck Epstein

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 pension obligations.

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.

At 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.

Changing Actuarial Assumptions

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 said.

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 Problem

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 shortfall. 

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 Problem

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 returns.  

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.