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On Tuesday, April 16, the Pension and Health Benefits Committee of the California Public Employees' Retirement System (CalPERS) board is scheduled to consider a proposal by its actuarial staff to change actuarial amortization and smoothing policies that are central to the system's setting of required employer contribution rates each year. The proposal likely would result in additional contribution increases—above those already likely to occur under existing CalPERS actuarial policies—mainly to address the system's considerable investment shortfalls in some recent years.

This is an informational item addressing the possible near-term and long-term budgetary ramifications of the actuarial proposal. The proposal would affect state and school district (classified employee) contributions to CalPERS beginning in 2014-15 and the contributions of other local governments in CalPERS beginning in 2015-16.

CalPERS Board Has Sole Authority Over Its Actuarial Policies. Under the State Constitution and longstanding case law, the CalPERS board—not the Legislature or the Governor—has the sole responsibility to establish actuarial policies that result in sufficient mandatory employer payments to ensure the actuarial soundness of the system's key pension plans.

Background

The principal aim of the proposal is to modify how CalPERS considers asset value changes and unfunded liabilities in its annual actuarial rate-setting process.

What Are Unfunded Liabilities? Typically, the state and other CalPERS employers pay at least their normal cost each year: the amount of money that needs to be deposited annually—coupled with assumed future investment earnings—to fund all benefits earned by employees in that year under existing benefit policies. Unfunded liabilities materialize from shortfalls in investment returns (compared to prior actuarial assumptions), unanticipated changes in system demographics, or certain changes in benefits. The system's unfunded liabilities essentially represent the amount of additional money that would need to deposited to the system today--coupled with assumed future investment earnings--to pay all benefits estimated to have been earned up until now by current workers and retirees.

CalPERS' Estimates of Its Unfunded Liabilities. Each CalPERS employer—the state and the various local governments in CalPERS—is accounted for separately, and the state is not obligated to pay for liabilities of local employers. As of June 30, 2011, CalPERS calculated that unfunded liabilities attributable to the state's plans were $38.5 billion and that assets totaled 70 percent of the plans' liabilities (meaning these liabilities were estimated to be 70 percent "funded"). School district classified employee plans had estimated unfunded liabilities of $12.5 billion (79 percent funded). Local agency plans had an average funded ratio of 74 percent. For all state and local plans in the system's main Public Employees' Retirement Fund (PERF), unfunded liabilities equaled $87 billion (74 percent funded status). These estimates rely, among other things, on CalPERS' assumption of annual investment returns for the PERF that average 7.5 percent over the long term.

CalPERS' Existing Rate Stabilization Policies. Following increases in public employee pension benefits during the dot-com boom, CalPERS--like other pension systems--suffered significant investment shortfalls (relative to assumed investment returns) during the stock market downturn at the beginning of the last decade. Employer contributions to CalPERS had been allowed to fall dramatically during the dot-com boom, and the combined effects of stock market losses and higher benefits were resulting in large increases in employer contributions during the early and middle part of the last decade. In response, CalPERS initiated a series of actions to stabilize employer contribution rates. In general, these actions resulted in delays—compared to prior actuarial policies—in increasing employer payments to make up for the significant actuarial losses resulting from market downturns and benefit increases. Investment losses were reflected in required contribution rates more gradually, and unfunded liabilities were to be retired over a longer period of time.

Current Policies Do Not Effectively Amortize Unfunded Liabilities. In the agenda item for last month's Pension and Health Benefits Committee meeting, CalPERS staff noted that the existing rate stabilization policies of the system do not fully fund "gains and losses" (an actuarial term encompassing lower-than-expected investment returns and changed demographics) even over a 45-year period. In other words, existing actuarial policies would tend to leave CalPERS with unfunded liabilities over the next 45 or more years. As we understand it, recent guidance of the California Actuarial Advisory Panel (CAAP)—a panel of the state's top actuaries established by the Legislature in 2008—classifies such a policy as a "non-recommended practice." As the American Academy of Actuaries made clear in a July 2012 statement entitled The 80 Percent Pension Funding Standard Myth, pension plans generally "should have a strategy in place to attain or maintain a funded status of 100 percent or greater over a reasonable period of time." The CAAP identified actuarial policies that aim to retire actuarial gains and losses over a 15 to 20 year period as a "model practice." Retiring such gains and losses over an up to 25-year period was identified as an “acceptable practice, with conditions.”

What is the proposal being considered?

Shortens Period for Retiring Liabilities, Reduces Chances of Large, Sudden Contribution Hikes. The proposals, involving various changes to CalPERS' actuarial policies, are understandably quite complex. In summary, the proposals aim to significantly shorten the intended time period for recognizing asset gains and losses and fully retiring existing and future unfunded liabilities in CalPERS' pension plans. The proposal also aims to lower the prospect of very large, year-over-year increases in employer contribution rates after extreme investment losses. To accomplish these goals, the proposal would phase in beginning in 2014-15 an increase--above that already likely under existing CalPERS actuarial policies--in employer contribution rates. (For detail on the proposals, refer to Agenda Item 9 and its attachments that are linked to the agenda notice for the committee meeting on CalPERS' website.)

Proposal Aims to Retire Unfunded Liabilities Over Fixed 30-Year Period. The proposal, as described in this month's committee agenda, significantly reduces the existing 15-year rolling period for "asset smoothing" to five years and aims to amortize system gains and losses over a fixed 30-year period (faster than the current rolling 30-year period). For the state's main pension plan (State Miscellaneous), for example, CalPERS staff used statistical analysis techniques to test whether the proposal would meet their goals of improving system funding and reducing the chances of sudden, large employer contribution increases. These statistical models estimated that while the current actuarial policies would tend to produce a plan that was only 79 percent funded after 30 years, the proposed method would tend to result in a fully-funded plan in 30 years. Moreover, while current actuarial policies were estimated to have a 59 percent likelihood of producing at least one year-over-year state miscellaneous contribution rate increase of over 5 percentage points during the next 30 years, the proposed method is expected to reduce this likelihood to only 8 percent.

What would be the budgetary impact of the proposal?

State and Local Contributions Already Poised to Increase Under Existing Policies. Under existing actuarial policies of CalPERS, employer contributions already are set to increase, as CalPERS has disclosed in its employer actuarial valuations and other materials in recent years. This is a direct result of the system's decisions to delay contribution increases needed to address its 2008-09 investment loss and to phase in the effect of reducing the system’s discount rate (assumed investment return rate) last year.

The Governor's January budget proposal, for example, assumes that the state employer contribution rates for State Miscellaneous Tier 1 and Correctional Officer/Firefighter plans (the state's two largest pension plans) will equal 21.2 percent and 30.7 percent of payroll, respectively, in 2013-14. In total, the budget plan estimates that the state's General Fund contributions to CalPERS—including those related to California State University employees—will total $2.3 billion in 2013-14. (The General Fund currently pays about 57 percent of the state's total contributions. The state's hundreds of special funds and other accounts support costs for many state employees and pay the remainder of the state's CalPERS contributions each year.)

Under existing CalPERS actuarial policies and reflecting the system’s expected average level and volatility of investment returns and also assuming that other actuarial assumptions prove accurate, the state's Miscellaneous Tier 1 and Correctional Officer/Firefighter contribution rates already may climb to 25.3 percent and 32.3 percent of payroll, respectively, by 2018-19. Assuming a 2.5 percent annual increase in state payrolls, a rough estimate is that these contribution rate increases under existing CalPERS actuarial policies would cause the state's General Fund contributions to CalPERS to climb from $2.3 billion in 2013-14 to about $2.9 billion in 2018-19. Under existing policies, further contribution rate increases are quite possible after 2018-19, as shown in CalPERS' statistical estimates.

Other state and local employer contributions would see similar increases in contribution rates under the "Current Method," as indicated in Attachment 6 to CalPERS' April committee agenda item.

Proposal Likely Would Result in Additional Contribution Increases. Given the system’s assumptions about the average level and volatility of its annual investment return targets and its other actuarial assumptions, CalPERS' statistical estimates show that, under the proposed new actuarial policies, it is likely that the state's Miscellaneous Tier 1 and Correctional Officer/Firefighter contribution rates would climb further. Specifically, Attachment 6 to this month's agenda item indicates that these two employer contribution rates may rise to an estimated 29.2 percent and 37.5 percent of payroll, respectively, in 2018-19 ("Year 5" for state plans) under the proposed actuarial changes. Assuming a 2.5 percent annual increase in state payrolls, a rough estimate is that the state's General Fund contributions to CalPERS would climb from $2.3 billion in 2013-14 to about $3.4 billion in 2018-19 under the proposed actuarial policies. As noted above, however, roughly one-half of this increase would occur anyway under existing actuarial policies.

As under the existing actuarial policies, further contribution rate increases are quite possible under the proposal, even after 2018-19. Attachment 6 estimates that by 2023-24 ("Year 10" for state plans), state Miscellaneous Tier 1 and Correctional Officer/Firefighter employer contribution rates could be 30.9 percent and 39.4 percent of payroll, respectively, under the proposal. After Year 5, however, contribution rates tend to grow more slowly under the proposed actuarial methods, as compared to existing actuarial policies of the system.

This month's agenda item and its attachments show that similar results are likely for other state and local plans in CalPERS under the proposed actuarial changes.

LAO Comments

CalPERS Staff Proposal Attempts to Address Major System Funding Risks. Since we analyzed CalPERS' rate stabilization policies in 2006, the system opted to delay certain employer contributions further following the economic crash of 2008, and system staff have completed significant, new statistical research concerning the system's funding risks. The system's latest research—culminating in development of the detailed statistical model projecting future trends in CalPERS' assets and liabilities referenced in this month's agenda items—was summarized in a report released last month by the system, entitled Annual Review of Funding Levels and Risks as of June 30, 2012. While noting the effects of last year's statewide pension legislation (which reduced benefits, particularly for public employees hired beginning this year), the report concluded that CalPERS' major state, school, and local plans generally have a 50 percent or greater chance of falling below 50 percent funding status at some point in the next 30 years. Such shortfalls, if they were to occur, would result in much larger shifts of costs to future generations to cover benefits earned by past public employees. Potential investment volatility or shortfalls would be among the key reasons that this funding weakness could materialize.

The report also indicated that many CalPERS plans have a very high risk of seeing contribution levels go to extremely high levels--sometimes very suddenly--under existing actuarial policies. Local public safety members' plans, for example, were collectively estimated to have a 30 percent chance of seeing their contribution rates exceed 50 percent of payroll at some point over the next 30 years.

CalPERS' staff proposals attempt to address many of the risks identified in this research, especially the risk that funding levels will decline to very weak levels in the coming decades. Unfortunately, the only way that CalPERS can address risks of funding shortfalls is to institute gradual, additional increases in employer contributions over time.

CalPERS Report Describes System Funding As Having "Considerable Risk." According to the CalPERS report, the data shows "that there is considerable risk in the funding of the system." "Unless changes are made," the CalPERS report continues, "it is likely that there will be some point over the next 30 years where the funded status of many plans will fall below 50 percent" and a "not insignificant probability that we will see funded statuses below 40 percent." "If these risk levels are not acceptable," the report says, "some change would be needed in the actuarial assumptions, actuarial methods, or the investment policies." If periods of low funded status or high employer rates occur "before we recover from the current funding shortfall, the consequences," the report adds, "could be very difficult to bear."

Funding Risks and the Contractual Right to Actuarial Soundness. The risks discussed in the CalPERS report are similar to those of which an appellate court warned in 1997 in a landmark opinion that described the actuarially sound pension plan to which most CalPERS members are contractually entitled. In Board of Administration v. Wilson (1997), 52 Cal.App.4th 1109, the court ruled in favor of CalPERS (declaring unconstitutional an attempt by the state to avoid paying its required contributions). The court's opinion indicated that an "orderly schedule" of employer contributions was necessary for an actuarially sound system in order to assure "benefit security for retirees" and to maintain "intergenerational taxpayer equity." Insufficient contributions, actuaries told the court, can impair benefit security and shift costs to the future: a "shift of costs [that] can accurately be characterized as a loan to cover the current employee costs that must be repaid by future generations of taxpayers."

Citing another actuary, the Wilson court noted that the "most important general financial objective for any public employee retirement system is to practice intergenerational equity" via contributions that, "expressed as percents of active member payroll, will remain approximately level from the present generation of citizens to future generations."

CalPERS Board Faces Difficult Decision. Under case law and Proposition 162, the CalPERS board alone has the responsibility to set required employer rates in order to ensure that most CalPERS plans remain actuarially sound. Under Proposition 162, the board's fiduciary and other duties to CalPERS members take precedence over any other duties. (These other duties include "minimizing employer contributions," which, therefore, must remain a secondary consideration.)

We read the recent analyses by CalPERS staff to indicate that the funding of the system may not prove to be sound under existing actuarial policies. Increasing required employer contributions further will strain state and local budgets in the coming years, thereby making it more difficult for public employers in CalPERS to either restore funding to programs cut in recent fiscal years or to stabilize (and increase) public employee pay and benefits. Given its constitutional and fiduciary responsibilities, the CalPERS board may find this to be a necessary decision in order to address the significant funding risks identified by the system's staff analyses.