California Plans’ Lowered Discount Rates Will Increase Pension Costs

In a report from S&P Global Ratings, the agency notes that the two largest public pension systems in the U.S.—California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS)—both have committed to lowering their discount rates without changing their funds’ asset allocations.

The CalPERS’ board voted on December 21, 2016, to lower the discount rate to 7.375% from 7.5% in the upcoming actuarial valuation for June 30, 2016; 7.25% in the 2017 valuation; and 7.0% in the 2018 valuation. Six weeks later, on February 1, 2017, the CalSTRS board decided to move slightly faster, reducing its discount rate to 7.25% in the 2016 valuation and 7.0% in 2017 from 7.5%.

The agency explains that CalPERS’ discount rate had an inflation assumption of 2.75% and a real rate of return of 4.75%. The real rate of return is scheduled to decrease 0.5% over the next three years while the inflation assumption is stable and will be looked at in 2018 in the experience study, which CalPERS conducts every four years. The impact on the cost of earning a year of service (the normal cost) will add 1% to 3% of pay for non-safety groups and 2% to 5% for most safety groups. S&P expects most unfunded liability payments to increase 30% to 40% over the next seven years as the costs are realized. For the state alone, that will ultimately mean contributing $2 billion a year more toward pension costs.

The substantial increases in current projections are primarily the result of poor investment returns over the past two years, the report says. Reducing the discount rate will accelerate the slope of cost increases, intensifying the pressure that state and municipalities will face as growing pension contributions account for larger portions of their budget, especially in this slow revenue growth environment.

Another recent analysis from S&P Global Ratings showed many plans across the country are lowering assumed long-term rates of return in light of global economic headwinds, which further contributes to declining funded ratios and puts a strain on cities’ credit ratings.

According to its current report, the CalSTRS board originally had a lower expected real rate of return but higher inflation assumption than CalPERS. Its plan lowers its inflation assumption to 2.75% in the first year from 3.0%, and its real rate of return to 4.25% in the second year from 4.5%, along with other assumption adjustments its 2016 experience study calls for.

Reducing the inflation assumption softens the discount rate reduction's impact. Pension benefits are calculated based on years of service and salary, so a lower inflation assumption implies that salaries are growing more slowly than before, lowering projected benefits and total liability. So although both systems ultimately end up with the same building blocks and an identical discount rate, the different paths taken to arrive there create a difference in the severity of impact to the liability and contribution rates.

Due to the different constructs of each system's funding rules, the cost from these increased contributions will not be borne equally by all plan participants, with the state carrying a greater share of the increased cost for CalSTRS. State legislation AB 1469 sets the contribution rate for schools through fiscal year 2021. This schedule more than doubles their contribution rates from fiscal years 2015 to 2021, so S&P anticipates significant strain on schools' budgets over the next several years. However, while their contributions will continue to increase due to the phase-in of AB 1469, the effect of the discount rate change has no impact on school contribution rates until fiscal 2022. Even after that window opens, school yearly contribution changes are capped at 1% and in total can only grow by 1.15% more than the bill's current schedule. So absent further statutory changes, the resulting contribution burden to schools is both delayed and limited to a minimal 1.15% of their payroll.

Because schools will shoulder a modest amount of the discount rate reduction cost, the majority of the burden will fall on the state's shoulders. AB 1469 allows state contributions to be adjusted 0.5% per year, so CalSTRS anticipates that the state's contribution will increase by 0.5% per year for at least 10 years to compensate for the impact of the assumption changes. While 0.5% of payroll (currently about $150 million) is not a significant burden to California, the cumulative significance is quite strong. S&P estimates that at the end of 10 years, the state will be contributing $2 billion a year more into the system. So the ultimate annual cost on the state between CalSTRS and CalPERS is comparable despite their differences in funding scheme and size.

Generally, costs from changes in assumptions are borne entirely by the state, municipalities, and schools, but under the Public Employee's Pension Reform Act (PEPRA), most employees hired during or after 2013 will share approximately half of the normal cost increases, relieving 1% to 2% of pay for the increased contribution burden. Roughly 20% of CalPERS' and CalSTRS' active membership are classified under PEPRA, the report says.