CalPERS Says 7.5% Returns Over the Next Decade Unlikely

Last year, CalPERS announced that it would begin systematically reducing its 7.5% assumed rate of return on pension assets over a 20-year period. Earlier this week, CalPERS signaled that they now might be looking to reduce the assumed return a bit faster.

For defined benefit plans the assumed rate of return is a critical part of how annual contributions are calculated. The assumed return — a function of how a pension plan’s assets are allocated and how much risk a pension board wants to take with taxpayer-backed money — is part of the calculation for what a public sector employer should be contributing this year to pay for all of the benefits earned this year. And since most public plans use the assumed return on assets as a proxy for determining the value of existing liabilities (a fundamentally flawed nationwide practice), the assumed return is also the basis for amortized payments on unfunded liabilities.

Most pension plans across America have been too slow to lower their assumed rates of return as the shifts in capital markets over the past 10 to 15 years have reshaped yields for institutional investors. The reasons for doing so can vary from plan to plan, and state to state, but an underlying reason pretty much anywhere for not lowering the assumed return of a pension plan is that the change winds up increasing contribution rates.

The less you expect to earn on your investments, the more you should be chipping in now to be able to fulfill all of the promised pension benefits.

Thus, it was a fairly important moment last year when CalPERS announced its intention to lower the assumed return. As one of the largest pension plans in the world, CalPERS is a benchmark for practices (good and bad). At the same time, the approach of taking 20 years to reduce the assumed return in steps of 5 to 25 basis points and only during strong investment return years was a very, very weak attempt at getting more responsible.

And it would seem that CalPERS itself is coming around to that reality. PI Online reports:

Andrew Junkin, president of Wilshire Consulting, the pension’s fund’s general investment consultant, told the committee its firm estimates the pension fund’s annualized investment return over the next decade will be 6.2%, down 90 basis points from the 10-year forecast Wilshire made a year ago of 7.1%…

CalPERS board member Richard Costigan, who chairs the finance and administration committee, asked CalPERS consultants and staff members at Tuesday’s meeting to come up with a specific rate-of-return recommendation for the committee’s Dec. 20 meeting.

Mr. Costigan expects a February vote by his committee and the full board.

“What has really changed over the last 12 months is the world has changed,” Mr. Costigan said in an interview after the meeting. “I am not even talking about what happened last Tuesday,” looking beyond the election of Donald J. Trump and focusing on what Mr. Costigan said was a slow-moving economy for years to come.

This stark and realistic outlook is exactly on point. And it echos the Government Pension Fund of Norway’s special commission report earlier this year that emphasized the challenge of changing expected returns on typically invested public pension plans. A PIOnline further reported:

…Theodore Eliopoulos, CalPERS’ CIO, said the low-interest-rate environment and the slowing of U.S. economic growth, the main driver of global growth, were all contributing to the diminished economic outlook. Mr. Junkin said the election of Mr. Trump would increase market volatility but would not change the base economic forecast.

CalPERS was scheduled to determine its rate of return in February 2018 after a review of asset allocation, scheduled for 2017, was complete. But Mr. Costigan insisted Tuesday that the two “don’t have to move in tandem” and the rate of return could be determined without a new asset allocation in place. Mr. Eliopoulos on Tuesday asked members of the finance and administration committee to move sooner rather than later so the pension fund could receive increased contributions.

As we’ve covered on this blog regularly, you can’t throw an assumption in any direction without hitting a capital markets forecast suggesting assumed rates of return over 7% are utterly insane. (Most recently, my colleague Anil Niraula discussed on this blog last week an S&P Global report last week that argued there is a need for revised investment strategy among pension plans.) Thus, it is very positive to see CalPERS looking to move sooner on its assumed return than a slow-played 20-year phased change. And more than just this being a potentially positive event for California taxpayers in the long-run, what CalPERS does going forward could have major ramifications for the nation as a whole, as other pension funds will look to the outlook of one of the largest global plans, and consider adjusting as well.