As CalPERS puts a new focus on risk, a funding level that drops to 40 percent is emerging as the red line.
The worry is that if the funding level of the big pension fund drops too far, it may not be practical to raise annual employer payments enough to regain proper funding.
The rough estimate (final figures are not in yet) is that CalPERS funding as of last June averaged 74 percent, up from 65 percent the previous year. A spokesman said the average level has never fallen below 55 percent.
But CalPERS wants some cushion in case the economy slides back into a major recession, punching another big hole in investment earnings expected to provide about two-thirds of pension revenue.
Board member Henry Jones, the new CalPERS investment committee chairman, said last week the nation’s largest public pension fund has the dual task of respecting the employer’s financial situation as well as the “fiduciary” duty to protect pensions.
“If you dig a hole so deep, as Mr. (board member Dan) Dunmoyer said, you could find institutions going into bankruptcy,” he said, “and we have been provided with a chart which shows that if your funding drops to 40 percent you probably can’t survive.”
Jones was explaining why he voted with all but one of the other board members to lower the CalPERS earning forecast from 7.75 to 7.5 percent, raising the annual payments to CalPERS from state and local governments struggling with deep budget cuts.
Dropping to 40 percent of the projected assets (employer-employee contributions and investment earnings) needed to pay pensions promised in the decades ahead would probably not be literally fatal to the California Public Employees Retirement System.
But some recent board reports have charts showing that funding levels would enter a “warning track” (see investment roadmap, p. 15) if they were to drop to 40 percent or below due to big losses during another deep economic recession.
The chief investment officer, Joe Dear, and the chief actuary, Alan Milligan, are trying to understand what might happen if there is another sharp “drawdown” of the pension fund, valued at $237 billion this week.
“I’m quite confident of our ability to achieve a long-term target rate of return,” Dear told the board last week. “I’m more concerned about the risk we have in the portfolio with respect to drawdown.”
At a January workshop, said Dear, the board went through a preliminary exercise showing under what conditions the funding level could drop below 40 percent if a deep recession resulted in investment losses of 20 percent.
“Alan Milligan and I will be bringing a report to you at the end of June and expect, with your agreement, to spend some time at the July off-site (board meeting) on this topic,” Dear said.
Milligan said theoretical work on this type of risk has been done by an actuary, Bill Hallmark, who uses the term “pension event horizon” for the point at which an employer cannot sustain the payments needed to pay off pension debt in a given period.
CalPERS began a new focus on risk after huge losses during the recession, when the investment fund plunged from a peak of $260 billion in the fall of 2007 to a bottom of $160 billion in March 2009.
In addition to developing a risk-based framework for investments, CalPERS also has begun giving the 1,573 government agencies in the system a five-year analysis showing how rates go up if investment earnings are below the target, now 7.5 percent.
CalPERS has been criticized for telling legislators investment earnings would pay for a major trendsetting state pension increase, SB 400 in 1999, even though its actuaries had accurately forecast how rates could soar if earnings fell below the target.
This month CalPERS began making more information public through its website. Board meetings are now being webcast and archived, actuarial reports for 2,043 separate retirement plans posted, and Public Records Act requests listed and summarized.
“We are committed to be an honest broker of information, especially as we discuss the future of pensions in our state,” Anne Stausboll, CalPERS chief executive officer said in a news release.
This month the board also was given the first “Annual Review of Funding Levels and Risks,” a report on “overall pension soundness and sustainability” resulting from a governance project that restructured some of the board committees.
The new report that monitors five “key measures” said, among other things, that CalPERS had “negative cash flow” last fiscal year, paying out $2.7 billion more in benefits than received in employer-employee contributions.
In most years a funding gap of that size seems easily closed by earnings from a $237 billion investment portfolio. But CalPERS finances are based on actuarial projections of costs and revenue that go decades into the future.
What CalPERS watches in its 2,044 separate plans is whether negative cash flow is preventing “adequate progress” toward reaching full funding. The board adopted a policy two years ago that can trigger a rate increase in two ways:
“If in 30 years, 1) a plan’s funded status is not projected to improve by 15 percent or 2) a funded status of 75 percent is not projected,” the report said.
CalPERS critics point to the massive “unfunded liability.” But that debt (which balloons with a lower earnings forecast said by critics to be more realistic) is based on the additional money needed to reach 100 percent funding, usually after 30 years.
Under the CalPERS policy a projected 30-year funding level of 75 percent is acceptable. The report said plans can be “behind schedule” and “do not necessarily have to be fully funded at all times.”
Investment gains and losses are amortized over a “rolling” 30-year period. The actuarial view is that over time gains and losses will offset each other, but the balance can change quickly and is rarely even for any length of time.
On the other hand, an increase in pension benefits or a change in the earnings forecast that “discounts” future pension obligations is amortized over a 20-year period because there is no offset for the cost.
Critics argue that the failure to fully fund pensions passes the debt to future generations, forcing them to pay for services received by the current generation. But any CalPERS “intergenerational transfer” of debt is likely dwarfed by retiree health costs.
With some new and small exceptions, no money has been set aside to earn interest and pay for retiree health care promised state workers. It’s one of the fastest-growing state budget costs, about $1.7 billion next fiscal year.
Two decades ago legislation by former Assemblyman Dave Elder, D-Long Beach, created a retiree health care fund, but it received no money. Now state Controller John Chiang estimates the state owes $62 billion for retiree health care promised current state workers over the next 30 years.
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