California Pension Board Lowering Estimate of Pension Investment Returns Causes Higher State and Local Pension Contributions—but a Credit Positive for One Rating Agency

Last month, the California Public Employees Employment Retirement System (CalPERS), the nation’s largest public pension fund, with over $300 billion in assets, decreased the assumed rate of return on its investments from 7.5% to 7.0%. The impact of CalPERS lowering its earnings estimate will be felt by the state of California and local government participants, as they will be forced to increase their annual contributions to the pension plan. Employee contributions will also increase, primarily for those state and local government employees who were hired after January 1, 2013, the effective date of California’s pension reform legislation.   

There appears to have been a consensus among CalPERS, state officials and public employee leaders that the rate should be dropped given changes in global economic conditions and investment outlooks. The CalPERS decision also reflects an increasing sense of urgency among officials, as the action was taken in the middle of a four-year cycle for rate setting, after two years of low investment returns. The plan currently has a negative cash flow, where investment holdings are being sold to help pay for benefits. CalPERS has also taken steps to reduce risk in its portfolio by reducing its equity holdings from 51% to 46%, private equity from 10% to 8% and increasing cash from 1% to 4%.    

Increased pension contributions from the state and from local governments are expected to put pressure on budgets. In CalPERS board hearings, for example, state officials estimated that the impact to the state of California will be $2 billion annually. To mitigate its impact, the rate decrease will be phased in over five years, beginning with the 2017-18 fiscal year for the state, and one year later for local governments.

In response to the discount rate decrease, Moody’s indicated in a report on January 4 that the decision was a credit positive, despite the near-term impact on budgets. Moody’s favors increased contributions from the state and from local governments into the pension plan, and less dependence on potentially volatile investment returns. Moody’s concern has been that higher discount rates force pension plans into riskier assets, increasing the possibility of unanticipated contribution increases due to investment losses.

The CalPERS action is evidence of the need for municipal bond investors to be judicious in selecting California bonds for their portfolios. We look for California bonds that have relative protection from pension impacts, such as local general obligation and dedicated tax bonds. While the state of California’s GO and lease bonds have exposure to pensions, the state has more revenue and expenditure flexibility than local governments, voters have extended “temporary” increases to state income tax revenues, and for now economic and financial market conditions still support state revenue growth. We are more concerned about appropriation debt issued by California local governments, as there will be competition for dollars needed both for debt service and for higher pension contributions. Both are liabilities of local government general funds, but without the benefit of a dedicated revenue source.

Source:  CalPERS, calpensions, Moody’s