Pension funds should get real on rate of returns

When the taxpayer is backing up the entire liability for the pensions received by members of the California Public Employees Retirement System, then CalPERS officials are exuberant about the stock market. They insist that a predicted rate of return of 7.75 percent is perfectly realistic.

When their own funds are on the line, however, CalPERS can be extremely conservative as it embraces one of the lowest annual return rates imaginable: 3.8 percent.

In essence, the state’s largest pension system has admitted – through its actions, though not its words – that the most vociferous pension critics have been right all along. Yes, the pension debt is much higher than CalPERS has declared, and its assumed rate of return on its investments is much more optimistic than it should be. CalPERS quietly conceded this reality when it changed the way it handles local governments that want to exit the CalPERS fund. Some localities want to leave as CalPERS wallows in unfunded liabilities and faces scrutiny over allegations of corruption and cronyism.

“Now that a swarm of local governments wants to abandon the floundering retirement trusts, the state plans are willing to credit only a 3.8 percent expected return,” former Orange County Treasurer Chriss Street explains. If CalPERS used that 3.8 percent number rather than the rosy 7.75 percent figure for calculating its overall pension liability, he argues, the state retirement plans’ “published $288 billion in pension shortfall would metastasize into an $884 billion California state insolvency.”

This is blockbuster news, although the unions and CalPERS officials are doing their best to obscure what it means. As pension writer Ed Mendel explains the CalPERS rationale for the change, “[a]fter a plan terminates, there is no way to get more money from the employer. The worry is that ending just one big plan could ‘dramatically’ erode a pool currently responsible for the pensions of 4,700 members of 118 terminated plans. The new safeguard increases the money an employer must set aside to offset or ‘discount’ future obligations.”

Exactly. CalPERS must pay the locality that exits its plan the true value of the benefit; so, CalPERS can no longer grab money from future taxpayers or spread out its debt endlessly into the future through a dubious practice known as smoothing. So it must assume a rate of return that assures CalPERS gets its money back. That is the same argument that pension critics have been making with regard to taxpayer dollars. We want the government to make only promises that it can afford – not foist an uncertain amount of debt on future taxpayers.

With government defined-benefit retirement plans, where the retiree gets a guaranteed payment, the higher the predicted rate of return, the better-funded the retirement plans appear to be and the less political pressure the funds get for their pension debt. If CalPERS predicts a high rate of return on the money it has invested on behalf of employees, then there’s lots of money to go around and nothing to worry about. (“That huge debt to pay for your retirement will be covered because we’re making so much money in stock-market returns!”) Likewise, if it predicts a low rate of return, then the funds are deeply in the hole, and taxpayers must backfill the difference between what the fund has promised in benefits and what it can pay.

Ironically, as Street pointed out, the rate of return estimate CalPERS adopts for its own money is even lower than the suggested number that Stanford University provided in a pension-debt study that CalPERS maligned last year.

Aptly called “Going for Broke,” the study pinned the unfunded pension liability, or debt, for California’s three main public-employee pension funds at up to more than $500 billion. Few can criticize the credibility of Stanford, or of the former Democratic legislator who led the researchers, but CalPERS and the unions slammed the results, claiming that it was absurd for Stanford to calculate the pension debt based on a piddling rate of return of 4.1 percent.

Government is promising millionaire’s pensions (when you consider the aggregate value of payments over the retiree’s lifetime) to its employees based on the assumption that the markets – which the same unions routinely deplore, by the way – will make it up in the future. Stanford figured that using a “risk-free” rate would expose the real taxpayer liability and eliminate the games played by the unions to hide the debt. CalPERS argued in a statement that it “does not believe that using a risk-free rate as suggested in the study is appropriate since the fund can earn a premium over the risk-free rate with high certainty by investing in a diversified portfolio with an acceptable level of risk.”

In May, CalPERS announced record earnings – 18.6 percent over the trailing nine months. Union spokesman Steve Maviglio gloated: “The impressive gains made this year take the air out of the political arguments that we need to take drastic action.” Union officials were strangely quiet as the fund sustained massive losses in subsequent the following months. But we see that the foundation of these unsustainable pensions is the predicted rate of return, which is why so much debate is focused on this point.

If any business promised its employees oftentimes six-figure, cost-of-living-adjusted pensions that were guaranteed regardless of how the stock market or the economy performed, investors would be running for the hills. Of course, the government does exactly this with its employees. Officials, who benefit from the plans themselves or receive the campaign contributions from those who do, were able to hide the disastrous results of this massive wealth transfer as long as the economy was booming, given the bizarre way that taxpayer-backed pension debt is calculated. Now they are still trying to hide the debt by manipulating the numbers.

But instead of listening to well-pensioned union apologists, we should look at how CalPERS handles its own dollars, as it provides only a risk-free guaranteed return to localities that exit its plan.

Better yet, why don’t we just remove all the risk and institute defined-contribution – 401(k)-style – plans for government employees. Let them live the way the rest of us do – and assume the risk for their own retirement portfolios?

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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