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California’s Pension Systems Lower Discount Rates

Reducing discount rates seen as painful in the short term, but set the stage for heftier employer contributions.

Faced with tepid returns and a challenging outlook, the nation’s two largest pension funds have lowered their discount rates. It’s a move that could put California taxpayers on the hook for billions more in pension contributions, but the shift also leaves the two big pension funds in better health, according to a new analysis by S&P Global Ratings.

The California Public Employees’ Retirement System (CalPERS) voted in late December to gradually lower its discount rate to 7% by 2018 from 7.5% in 2015. In February, the California State Teachers’ Retirement System (CalSTRS) decided to follow suit, although it’s moving slightly faster. CalSTRS will cut its discount rate from 7.5% to 7% by 2017.

“It’s quite a big deal,” said Todd Tauzer, a credit analyst at S&P Global Ratings and lead author of a new report about the challenges facing the California systems.

Tauzer sees the plans’ moves to cut their discount rates as painful in the short run but healthy in the longer term. By lowering assumptions about discount rates, the pension funds are setting the stage for heftier employer contributions.

Tauzer projects that lower discount rates mean a decade from now, the state of California will be required to boost annual contributions to CalPERS and CalSTRS by $2 billion each. 

“We believe that notwithstanding the near-term budget pressure that the reduced discount rates imply, they are constructive for stabilizing these pension systems in the long term,” Tauzer wrote in his report.

CalPERS had a market value of nearly $310 billion as of March 14. CalSTRS held $202 billion as of Feb. 28. 

Their assumptions about returns had been “arguably unrealistic,” Tauzer wrote.

Tauzer sees a variety of challenges for the California pension systems. One is low inflation, a generally desirable economic condition but one that hampers pension funds’ returns. While US inflation averaged 4% from 1970 to 2016, the inflation rate hasn’t topped 4% since the early 1990s.

Low interest rates are a related challenge. While the Federal Reserve on March 15 raised rates and is expected to do so twice more in 2017, rates remain so low that even a continued rise is unlikely to significantly boost pension fund returns, Tauzer said. 

A stock market correction would pose another challenge to the big California funds.And there’s also the one-two punch of a dwindling ratio of active workers to retirees and an aging beneficiary population.

“Plans with more retirees have more assets relative to their active payroll, leaving them vulnerable in that a single market downturn could push unfunded liabilities into a very painful or virtually unrecoverable state,” Tauzer wrote.

The CalPERS board of administration also terminated its contract with the East San Gabriel Valley Human Services consortium after it failed to pay $406,345 to fund its pension plan. As a result, pension benefits will be reduced by approximately 63% for 191 members, and by 24% for six members hired after pension reform went into effect in 2013. The cuts are effective July 1.

"The Board was forced to make this painful decision after East San Gabriel Valley failed to stand by its contractual obligations despite repeated and numerous attempts by CalPERS to avoid this terrible situation," said Rob Feckner, president of the CalPERS Board. "Cutting benefits to retirees is truly the last step we want to take, but our employers must uphold their obligations and keep the promises that they made to their employees. We have a fiduciary responsibility to protect the long-term future of all beneficiaries and the fund."

East San Gabriel Valley is a Joint Powers Authority consortium formed in 1979 by the cities of West Covina, Covina, Azusa, and Glendora to primarily provide employment and training services to local residents and inmates incarcerated by the Los Angeles County Sheriff’s Department.

By Jeff Ostrowski and Michael Katz