Monday, June 27, 2011
By Ed Mendel

While not complying with an apparently flawed state law, CalPERS is opposing a similar federal bill calling for a report showing how pension debt could soar if long-term investment earnings are well below average.

How public pension funds report their long-term debt, and its impact on future payments needed from government employers, has become an issue in the politically charged debate over pension reform.

Do overly optimistic earning forecasts conceal massive debt owed by taxpayers and shift costs to future generations?

Or do pessimistic forecasts needlessly alarm the public and aid those who want to switch government workers to 401(k)-style plans?

The debate centers on the fact that public pension funds, once limited to bonds, now expect to get two-thirds or more of their revenue from stocks and other risky investments — a funding source that can only be estimated, not predicted with precision.

Critics contend that overly optimistic earning forecasts keep employer-employee contributions artificially low, force future generations to pay for the cost of current workers, and can be abused to claim pension increases won’t cost taxpayers.

For example, bill analyses show legislators were told that earnings and surpluses would pay for a major pension increase for state workers, SB 400 in 1999, and a contribution cut and new retirement supplement for teachers, AB 1509 in 2000.

Public pension earnings forecasts, often 7.5 to 8 percent, are well above the forecast used by private-sector pension funds, now 5 to 6 percent. The rationale is that companies, unlike governments, can go out of business and need more caution.

Last year, the debate moved to a new level when Stanford graduate students issued a report arguing that the unfunded liability of the three state pension funds is $500 billion, not $55 billon as the funds were reporting.

The students, following the view of some economists, used an earnings forecast based on a risk-free bond rate, 4.1 percent, rather than the forecasts based on a diverse portfolio, 7.5 to 8 percent.

The economists argue that because the pensions are risk free, guaranteed by taxpayers, the assets should be valued the same way, with a risk-free government bond rate. It’s said to be how insurers would charge to take over pension obligations.

The Stanford study used data prior to the stock market crash in fiscal 2008-09, when the state funds were underfunded, but not as much as now. The study dropped the earnings forecast by nearly half, causing the debt or “unfunded liability” to soar.

The California Public Employees Retirement System unfunded liability jumped from $39 billion to $240 billion, the California State Teachers Retirement System from $16 billion to $157 billion and UC from $600 million to $29 billion.

The study estimated that when market-crash investment losses are added to the total $426 billion risk-free debt calculation, the unfunded liability of the three state funds is more than $500 billion.

“Unfortunately, I think most people would give this a letter grade of ‘F’ for quality,” Jack Ehnes, the CalSTRS chief executive, told his board in April of last year when the Stanford study was issued.

CalPERS said, among other things, that its investments earned 7.9 percent during the last 20 years and, with “high certainty,” can earn more than the risk-free rate in the future, continuing to save tax dollars by providing billions to finance pensions.

Both pension boards recently rejected slightly lower earning forecasts recommended by their actuaries.

CalPERS left its forecast at 7.75 percent in March, instead of dropping to 7.5 percent as advised. The actuaries said no change would still be “reasonably” prudent, noting that a lower forecast would raise costs during a time of deep government cuts.

CalSTRS dropped its forecast from 8 to 7.75 percent in December, not to 7.5 percent as advised. Teacher groups said a lower forecast could reduce member benefits by raising the cost of annuities and service credits purchased to boost pensions.

A lower CalPERS forecast would have quickly raised employer rates, erasing savings from new labor contracts that cut pension costs. The CalSTRS board lacks the power to raise employer rates, needing legislation not expected any time soon.

How missing the earnings target, even by a relatively small amount, can increase pension costs was the aim of a “transparency” bill in a state budget package enacted last October.

“There were people that pulled wool over their eyes,” former Gov. Arnold Schwarzenegger said, referring to CalPERS telling legislators that the SB 400 pension increase in 1999, now said by critics to be “unsustainable,” would not increase state costs.

“They never really knew all the facts and the risks that were involved,” Schwarzenegger said. “Now this will be eliminated, this problem. We will have full transparency moving forward.”

When CalPERS sets new employer rates, the transparency bill, SB 867, requires a report showing how the rate would increase if earnings fell below the target — either 6 percent or one percentage point below the target, whichever is lower.

Among several other things called for by the transparency bill is a calculation of CalPERS liabilities based on a risk-free earnings forecast or discount rate: the 10-year U.S. Treasury note.

Since the transparency bill was enacted, CalPERS has set state rates twice, lowering them in December and again in May to reflect more than $400 million in savings under new labor contracts.

But CalPERS has not made reports required by the transparency bill “any time” rates are set.

A Senate bill analysis said CalPERS compliance would be “discretionary” because Proposition 162 in 1992 gives CalPERS sole power over actuarial services. In addition, the nonpartisan Legislative Analyst said the new law has drafting flaws.

The bill could require additional actuarial calculations and reports to the Legislature each time the giant CalPERS sets rates for 2,200 state and local plans. The analyst said the risk-free rate calculation may be more “alarmist” than useful.

A new transparency bill, AB 1247, requires a report showing employer rates if the earnings forecast is 2 percentage points below or above the CalPERS forecast, currently 7.75 percent, but does not call for a risk-free rate calculation of CalPERS debt.

The new bill, approved 75-to-0 by the Assembly, is scheduled to be heard by a Senate committee today. CalPERS supports the bill but suggests the report be based on earnings one percentage point below or above the target, not two points.

In Congress, high on the agenda of lobbyists for CalPERS and CalSTRS is opposition to HR 567 by U.S. Rep. Devin Nunes, R-Visalia, which requires public pension funds to report debt with an earnings forecast based on risk-free U.S. Treasury bonds.

Nunes and a CalSTRS lobbyist have both talked about the potential impact of the bill on the drive by some to switch public pension funds to the 401(k)-style individual investment plans now common in the private sector.

Reporting pension debt with a risk-free bond rate received nonpartisan support last year from Alicia Munnell at the Center for Retirement Research at Boston College and last month from the Congressional Budget Office.

But a new front could open in pension-debt reporting under a proposal mentioned last week by Robert Attmore, chairman of the influential Governmental Accounting Standards Board.

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