The board of the California Public Employees Retirement System sent shockwaves through the state last month when it lowered its investment returns assumption, a move that revealed the pension plan is billions more in debt than was previously recognized.
In the short-term, this change is going to mean increased pension contributions for the state and most local governments, which could potentially impact taxpayers through service cuts or tax increases. But there is a definite silver lining for taxpayers in the long term.
It is a recognition that CalPERS’ previous assumption was overly optimistic. The system’s own chief investment officer started warning last summer that after two consecutive years of very poor returns, CalPERS’ long-term historical returns had fallen below its 7.5 percent target at the time. And CalPERS’ investment adviser, Wilshire Associates, recently advised that it should not expect more than a 6.2 percent average investment return over the coming decade.
Thus, while a strong argument can be made that CalPERS’ decision to lower its investment return assumption to 7 percent by 2020 still isn’t enough, the system is now moving closer to a more realistic pricing of public worker pensions, which benefits taxpayers in the long term.
Here’s why: The higher the returns that California assumes the pension system will earn on its assets in the future, the lower the government’s (read: taxpayers’) contributions that are needed today.
Maintaining an unrealistically high investment return assumption has some problematic long-term effects on taxpayers. It artificially lowers the pension contributions made today by the government and its employees, effectively pretending the pension promises made are lower than they actually are. But if a pension plan consistently earns less than its assumed rate of return on average—which CalPERS has been doing—then it accumulates unfunded liabilities (or pension debt) that simply get passed on to taxpayers down the road. And like most debt that accrues interest, paying the piper later is always more expensive than paying it now.
Keeping CalPERS’ assumed rate of return unreasonably high has benefited governments and unions at the expense of taxpayers left holding the bag for pension promises that have not been sufficiently saved for. Thus, the decision to lower the assumed rate of return from 7.5 percent to 7 percent will lower the long-run costs to taxpayers relative to what would have been expected under the previous rate.
The bad news is that, in the short term, taxpayers are still going to have to pay higher costs for the benefits that have been promised to the state and local employees working on their behalf, past and present.
It is also worrying that the reduced earnings assumption still probably isn’t low enough to stop CalPERS from accumulating additional pension debt. It won’t stop the debt financing of today’s pension costs; it will merely lessen it.
Still, the near-term pain may have a beneficial side effect in that taxpayers and politicians will be forced to confront the implications of a massive jump in pension costs that had already been on a slow and steady uptick for years and, by extension, the financial risks inherent in offering guaranteed retirement benefits. Hopefully, this accelerates the push for additional reforms designed to make the state’s pension systems solvent and offer less costly and risky benefits to future government employees.
Leonard Gilroy is senior managing director of Reason Foundation’s Pension Integrity Project (reason.org). This article was originally published in the Orange County Register on January 7, 2017.