This is just scary.
As those of you who follow the CalPERS soap opera may recall, California Governor Jerry Brown pushed for the giant pension fund CalPERS to lower its assumed investment return from 7.5% to 6.5%. Given that the world is headed towards deflation and that CalPERS earned only 2.4% for the fiscal year ended June 30, 2015, Brown’s request seemed entirely reasonable. Instead, the board approved a staff proposal to move to the 6.5% target over 10 years.
One of the things that is perverse about pension accounting is that the convention is that the liabilities, that is, what the pension fund expects to pay out over time, are discounted at the same rate as the assumed returns. However, for a government pension plan, where taxpayers are on the hook for any shortfalls, the risk of CalPERS beneficiaries getting their money is not the risk measured in terms of what CalPERS projects in terms of future employee contributions, expected returns, and expected payouts; it’s ultimately California state risk, which means the liabilities should be discounted at California’s long term borrowing rate. With California rated S&P AA3, Moody’s Aa-, and 20 year AA muni yields 2.75% and A at 3%, no matter how you look at it, the discount rate on the liability side is indefensibly high.
This matters on the estimation of liabilities because the lower the discount rate, the larger the amount (in current terms) that has to be paid out. Remember, this is the mirror image of “inflation can help bail out underwater borrowers” scenario. High discount rates erode the value of future commitments; low ones increase them. This is why we have been warning that ZIP and QE, which explicitly sets out to lower long-term interest rates, is a death sentence to long-term investors like life insurers and pension funds. And investors like CalPERS are trying to finesse that problem by continuing to pretend that they can earn a higher rate of return than is attainable without taking batshit crazy risks.
But even worse is the incomprehension about what is going on, as reflected in a statement by the president of CalPERS’ board, Robert Feckner. From the CalPERS website, State of the System 2016: Our Progress Toward a Sustainable Pension Fund:
The fact that our members are living longer is a sobering reminder that we have a growing obligation to provide for their pensions. Just a decade ago the ratio of active workers to retirees was over 2 to 1. That ratio is now 1.3 workers to every retiree, and we pay out more in benefits than we receive in contributions.
In response, our Board approved a policy designed to reduce the discount rate, our 7.5 percent assumed rate of return on investments, over time. The result will help pay down the pension fund’s unfunded liability and reduce risk and volatility in the fund.
Huh? This is utterly backwards. What will reduce CalPERS’ unfunded liability is higher contributions or higher earnings. A lower discount rate, while a reflection of current reality, exposes that it will be harder, not easier, to meet this objective.
The worst is that given the level of finance acumen I’ve seen after watching hours of Investment Committee hearings is that the odds are high that this is not an obfuscation misfire but evidence of an utter lack of understanding of finance basics. And worse is that CalPERS staff, which had to have reviewed this text, didn’t see fit to correct this glaring error. Do they also not get it or did they assume that beneficiaries were too clueless to catch it?
And what is even worse about CalPERS’ refusal to implement a more realistic discount rate is that Brown, who was pushing for the change, was also prepared to make a contribution from the state’s coffers to offset the apparent impact of more realistic accounting. From the Los Angeles Times last November:
For years, CalPERS critics have warned that the pension fund was using overly optimistic projections for its investment portfolio, projections that would leave taxpayers picking up an ever larger share of the obligations made to state and local government workers…
The decision will increase amounts paid to CalPERS for state government workers’ future retirement. As the employer, the state’s general fund already pays CalPERS $5 billion a year. And for a governor who preaches lower spending, it seems jarring to think Brown would actually push to increase the size of the state’s annual pension costs.
Jarring, that is, until one considers Brown’s real strategy: to help pay down the pension obligation now, when funds are available, rather than face the question in an economic downturn. It also would take revenues off the table for other budget fights in Sacramento in 2016.
The Times story has more on the politics of this perverse standoff. At least one board member, Richard Gillihan (who is a direct report to Brown) supported moving to a lower return target now.
But again, I find the evidence of financial incompetence of influential members of the board to be more troubling than the substance of this action, which we’ve commented on in passing before. No wonder CalPERS staff can lead the board by the nose.