When an investment strategy is adopted, the discount rate is set, which is key in estimating how much future benefits are expected to cost.
By Michael Cohen, Special to CalMatters
Michael Cohen is the chief financial officer of CalPERS, Michael.Cohen@calpers.ca.gov.
Managing pension liabilities has become increasingly challenging for governments across the country. Rising costs are due to a variety of factors, including longer lifespans, financial market uncertainty and low inflation. Without a regular review of investment strategies and actuarial assumptions, pension systems run the risk of liabilities not being matched with assets.
At CalPERS, we do this review every four years, through what we call our Asset Liability Management process. The goal is to have solid analytical assumptions underlying our pension system so that we can meet our commitment to workers who spent their careers serving the people of California.
Key decisions on the horizon
Pension systems invest money and use the earnings to pay for future costs. For instance, 55 cents of every dollar CalPERS pays today in benefits comes from investment earnings. The remainder comes from employees and governments – school districts, cities, counties, special districts and the state.
The decisions made through the Asset Liability Management process are critically important to the governments in our system. They will determine how billions of dollars are invested, how much risk is taken and how much required contributions are likely to vary from year to year.
By the end of the Asset Liability Management process in November, the CalPERS board will decide on its investment strategy and discount rate assumption. Before then, we’re asking our stakeholders, including government agencies, employees and retirees, for their thoughts and priorities. In addition to regular public board meetings, we’re also holding webinars and posting to a dedicated ALM webpage to give everyone an opportunity to stay informed.
While no one can accurately pinpoint how different types of investments will perform over the next couple of decades, the Asset Liability Management process uses experts’ best projections in building the CalPERS investment strategy. We do, however, already know two things. First, for the same types of investments, expected performance is lower than it was four years ago. Second, over the long term, riskier types of investments tend to yield higher returns than safer ones.
These factors both lead to a similar conclusion – CalPERS can’t keep counting on a 7% return target without taking on more risk. Whether we can even achieve 7% return without taking on excessive risk will be the major question in this year’s Asset Liability Management process.
Planning for future costs
Once an investment strategy is adopted, our actuaries determine the appropriate discount rate – a key in estimating how much future benefits are expected to cost.
In 2016, the CalPERS board gradually lowered the discount rate from 7.5% to 7%, leading to higher annual contributions for governments. No one was happy with these higher costs, but the likely alternative was that, without the lower discount rate, CalPERS would not be able to reach its investment target over the long term. If CalPERS doesn’t consistently meet its expected investment return, governments will see sharp increases in their annual payments through the creation of unfunded liabilities. Pushing costs into the future makes the system even more expensive.
Before joining CalPERS, I ran the Department of Finance under Gov. Jerry Brown and saw first-hand how increasing pension contributions affected the budget of the state and local agencies. Balancing a budget constantly involves trade-offs. It’s even more challenging when projected costs change significantly from their original estimates. Our goal is to provide agencies with as clear a view as possible of future pension costs so they can plan ahead.
Any decision to lower the discount rate is by no means an easy one. It puts a greater burden on governments and employees to pay higher contributions – at a time when many government and family budgets are strained from the weight of the pandemic and its economic turmoil.
Our mission is clear – ensure our members will retire with the benefits they’ve earned while minimizing any strain on government budgets. The Asset Liability Management process is designed to weigh all of these factors in a collaborative manner.