By Ed Mendel
Monday, October 27, 2014

The CalSTRS board was told this month that financial experts are forecasting investment earnings of 7 percent a year or less during the next decade, below the 7.5 percent assumed by the pension fund.

If the new forecast turns out to be correct, long-sought legislation in June that phases in a $5 billion CalSTRS rate increase over the next seven years could fall short of the goal of projecting full funding in three decades.

It’s even possible that with new power granted by the legislation the California StateTeachers Retirement System board could, in three to seven years, add another rate increase for the state and school districts to get full funding back on track.

The new forecast from eight consultants and five asset managers also casts a shadow on the 7.5 percent earnings assumptions of the California Public Employees Retirement System and the UC Retirement Plan.

“Consensus assumptions likely lead to expected compound long-term returns of 7 percent or less for typical institutional portfolio over a 10-year period,” said a Pension Consulting Alliance presentation of the forecasts from the 13 experts.

Whether public pension systems have overly optimistic earnings forecasts, which conceal massive debt, is one of the major issues raised by critics, who advocate lower bond-based earnings forecasts like those used for private-sector pensions.

It’s an old issue for CalSTRS. An investment banker, David Crane, was removed from the CalSTRS board in 2006 (denied confirmation by the state Senate) after repeatedly arguing that investment earnings forecasts were too optimistic.

The new “capital markets forecast” by the experts is an early step in a routine four-year CalSTRS process that will lead to a review of the 7.5 percent earnings assumption in 2016.

“Nothing has changed for CalSTRS since the enactment of full funding legislation in June, and no gap in funding has developed,” Chris Ailman, CalSTRS chief investment officer, said via e-mail. “In fact, AB 1469 achieves the right balance of funding and timing, and we are confident our fund is on a sustainable course as a result of the legislation.”

In the earnings review, CalSTRS will look at other factors such as a 30-year investment horizon, what could happen during market booms and busts, and the possibility that inflation might offset a lower earnings forecast.

“It is premature to speculate on the impact until all the assumptions are evaluated,” said Ailman. “If there was a net impact, it could affect the state’s contribution rate in 2017, and the employer’s contribution rate seven years from now, as provisions of the new funding legislation give our board the authority to adjust employer and state contribution rates.

“However, this year’s investment earnings of 18.66 percent already gives us a jump start on the funding and positions us well as we move into the future with a diverse asset allocation in place.”

After the last earnings review in 2012, the CalSTRS board made a small change, dropping the forecast from 7.75 to 7.5 percent, that added an estimated $500 million to the $4 billion-a-year rate increase needed to project full funding in 30 years.

Before the rate hike last June CalSTRS was on a path to run out of money in about 30 years, emptying a $184 billion investment fund even if earnings averaged 7.5 percent. Spending totaled $11.3 billion a year, rate revenue only $5.8 billion.

Now as legislation will nearly double current rates, most of the $5 billion annual increase will come from school districts and community colleges. Their current rate of 8.25 percent of pay will gradually increase to 19.1 percent of pay by July 2020.

Teachers get the smallest rate increase, going from 8 percent of pay to 10.25 percent for most and 9.2 percent for new hires. The state contribution to two CalSTRS funds will increase from 5.5 percent of pay to 8.8 percent.

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