School districts, already bracing for record pension contributions for school employees, will face additional costs they hadn’t expected as a result of a decision Wednesday by the California Public Employees’ Retirement System.
The CalPERS board voted to lower the expected rate of return on its investments from 7.5 to 7 percent. That action will force local governments, school districts and the state to make up the difference by annually paying billions of dollars more into CalPERS to keep the nation’s largest public employee pension fund afloat.
The board acted because the pension fund remains underfunded and vulnerable to further erosion without more money. Since investments aren’t generating what the board had counted on and the board isn’t planning to revise its investment strategy for two years, it’s turning to employers and, to an extent, employees for larger contributions.
The decision puts the earnings forecast closer to what financial advisers say CalPERS can realistically expect over the next three decades. It will also put pressure on the board of the California State Teachers’ Retirement System to follow the lead and consider reducing its identical 7.5 percent earnings forecast on investments when its board of directors meets this spring.
CalPERS serves hourly school employees, including bus drivers and clerks, while CalSTRS serves teachers, administrators and other school employees who have a teaching credential. Since CalPERS members make up a smaller portion of school staff and generally get smaller pensions, potential changes to CalSTRS contributions rates would have bigger repercussions. However, only the Legislature has the authority to set CalSTRS district and employee contribution levels, and it’s too soon to say what, if anything, might happen in 2017. Legislators would look to Gov. Jerry Brown for a signal.**
The CalPERS board accepted a board committee’s recommendation to phase in the lower rate of return over three years, starting next year for the state and in 2018-19 for school districts and local governments. CalPERS projected that a drop of 0.5 percent in the rate of return would increase pension contributions by school districts and local governments by 20 percent.
Dennis Meyers, an assistant executive director of the California School Boards Association, estimated that the lower investment forecast would add $400 million to $600 million to school districts’ costs. Combined with already scheduled cost increases to CalPERS and CalSTRS, higher pension costs will consume every dollar of projected revenue increases for 150 to 200 school districts in coming years, he told the CalPERS board committee during a hearing Tuesday. Those are districts get little supplemental money for English learners and low-income students under the Local Control Funding Formula.
School employees hired since the Legislature passed the Public Employees’ Pension Reform Act four years ago will share a portion of the higher CalPERS contributions, but school employees hired before then won’t pay more. Districts will bear the increase.
The Legislative Analyst’s Office in November wrote that the 2012 pension reform act would add $6 billion in combined annual CalSTRS and CalPERS pension expenses for K-12 and community colleges by 2020-21, when the costs are fully phased in. CalSTRS pension contributions will increase about 2 percentage points of payroll annually between now and then. For CalPERS, the increase will be closer to 1.5 percentage points each year. The impact of CalPERS’ assumed lower investment return will gradually add another 2 percentage points to payroll costs, according to School Services of California, a school consulting firm.
Meyers and representatives of other government organizations didn’t oppose the CalPERS board’s decision in testimony Tuesday. They acknowledged that higher contributions would be needed in the mix of options to sustain the system long-term.
During the recession, the value of CalPERS’ investments fell $100 billion to about $160 billion, and the fund has not fully recovered. CalPERS’ assets are at only 68 percent of what’s needed to fully fund future obligations.
The Dow Jones Industrial stock average neared 20,000 this week and other indexes were at record highs, adding irony to the timing of the board’s vote. But Ted Eliopoulos, CalPERS chief investment officer, said the board should expect less than a 7.5 percent return and more market volatility in coming years. Investment earnings for the past two years – 0.6 percent during the last fiscal year and 2.4 percent the year before – were far below the 7.5 percent goal, known as the “discount rate.”
CalPERS’ other challenge is that it is selling $5 billion more from its investment portfolio than it is taking in from contributions from employers and employees, and that amount is increasing about $1 billion annually. Larger contributions will reduce that gap, advisers said.
The CalPERS board reaffirmed the 30-year, 7.5 percent earnings target two years ago, but its financial advisers concluded market conditions have changed since then. They’re now forecasting annual earnings averaging 6.2 percent over the next decade, followed by better than average returns for the following 20 years. The odds of hitting the revised 7 percent target would be 50-50, they said. Lowering the rate more would require even higher contributions from employers and the state; board members indicated that, for now, a half-percent reduction is an acceptable compromise.
For years, critics have called for CalPERS and CalSTRS to assume a lower investment return – or face financial shortfalls that will force higher costs on the next generation of Californians. Joe Nation, a former state legislator and a public policy professor at Stanford University, said that the board’s action didn’t go far enough. The discount rate should be closer to 6.25 percent, he said.
“If CalPERS only takes baby steps, its problems will never be solved,” he said. “I understand the political pressure, but this guarantees pain in the long run will be higher.”
An assumed 7 percent forecast will make CalPERS among the most conservative of the nation’s large pension funds. But several board members acknowledged that further, unspecified actions would be needed.
“This is not the end of the conversation,” said state Controller Betty Yee, a board member. “We have an opportunity to stabilize the system.”
No one said which of the available options – dicier investments with higher returns, even higher employee or employer contributions, or lower employee benefits – would be the most palatable and realistic.
** Updated note: In 2014, the Legislature did give the CalSTRS board the authority to raise employer rates to a maximum of 20.25 percent of payroll after 2020-21.