The recent debate at the California Public Employees’ Retirement System over expected future investment earnings missed the forest for the trees.
The nation’s largest pension plan, and most government retirement programs across the state and nation, set contribution rates based on how much portfolio profit they expect in the future.
The higher the anticipated return, the less money public employers and employees must kick in now to cover future pension payouts. But if investment projections prove overly optimistic, future taxpayers must cover the shortfall.
At CalPERS, the argument this month was over whether to continue forecasting a 7.75 percent annual return, or lower the assumption to 7.5 percent or, as the system’s actuary recommended, 7.25 percent.
The pension board chose the midpoint. But the entire debate begs the bigger question many economists are raising: Why should pension systems base contribution rates on guesstimates of anticipated future earnings from often-volatile investments such as stocks and real estate?
Think about it: If you knew you had a large upcoming mortgage or property tax payment that absolutely had to be made, would you put money in the stock market and hope that it would earn enough interest to meet the obligation? Or, would you set aside sufficient funds in a safe investment so that you knew you could cover the payment when it came due?
Public-sector pension plans gamble much of their money on the stock and real estate markets. They then assume they’ll earn strong future investment returns. The CalPERS board members were told by their staff that they had only a 50 percent chance of hitting or surpassing the 7.5 percent target, yet they adopted that assumption. Others say the odds are even worse than that.
If CalPERS loses the bet, as it is likely to, the next generation will pay the shortfall, probably from funds that would otherwise go to public services. We’re already experiencing that phenomenon as California state and local governments divert money to pay pension debt racked up by CalPERS and other retirement systems that exceeds $200 billion.
The private sector operates under more rational rules. Provisions of a 2006 federal law require company plans to set contribution rates as if their assets were invested in lower-yielding, and safer, bonds.
The exact rate depends on when workers in the pension plans are likely to retire, but today the rate usually ranges from 5 percent to 6 percent. That means larger upfront contributions by employers and employees and less risk of future shortfalls. These private pension plans can still invest in riskier stocks and real estate, but they can’t factor in those hoped-for extra profits until they actually attain them. Only then can they lower the amounts employers and employees must contribute.
That’s the key difference. In the public sector, the actuaries come up with lower contribution rates today by assuming high returns from riskier investments will be earned.
In the private sector, contributions can’t be lowered until those profits materialize. A key concern driving passage of the private-sector rules was that if earnings fell short and companies went under, the federal Pension Benefit Guaranty Corp. and eventually taxpayers would have to pay the pension benefits.
As for public-sector plans, ” well ” if the earnings fall short, taxpayers will be left to pay the pension benefits.
Those who argue for the public-sector accounting system point out the difference between companies and government employers. The latter, they argue, won’t go away so there will always be funds available to tap in case of shortfall.
That ignores the growing prospect of municipal bankruptcies and, moreover, the intergenerational transfer of debt that leaves future taxpayers to cover our current bills. We’re gambling with our children’s money.
Also, if CalPERS or any other public-pension system banks on higher-investment returns, it must take greater risks to meet the target. As Joe Dear, Cal-PERS chief investment officer, told Pensions and Investments newspaper last year, his system has “a reasonably ambitious return target” and “needs to have a portfolio with a lot of growth exposure.”
As we’ve seen in the past decade, that also means a greater risk of falling short.
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