CalPERS agencies still reeling from the increase in employer contribution rates beginning 2013/2014 may very well experience yet another increase in the next couple of years due to a further reduction in the “discount rate” or rate of return.  Simply put, the discount rate or rate of return is the percentage of expected returns on investments made by CalPERS.  Generally, the higher expected return, the lower employer contributions will likely be. The problem arises, though, that if CalPERS’ investments do not meet the expected return rate, this creates risk and greater unfunded liabilities because the employer contribution rates were based on that expected return. This further results in volatile employer contribution rates.

In 2012, CalPERS reduced the discount rate from 7.75% to 7.5% which resulted in a considerable increase in employer contribution rates.  Now, CalPERS seems poised to potentially decrease that discount rate even further.  CalPERS’ Finance and Administration Committee undertook a study of decreasing the discount rate.  As a part of this, the Committee surveyed and received information from over 600 contracting agencies, as well as public school districts, in addition to receiving feedback from employee, employer and retiree organizations. Of those surveyed, 76% of contracting agencies, and 52% of school districts, are following CalPERS’ return on investments.  29%  are prefunding pension liabilities while 61% are planning for a reduction in the discount rate through budget forecasting out three and five years.  Employers were also asked what would be the level of impact to the agency if there was another drop in the discount rate.  72% indicated that the impact will be high to extremely high.

On December 20, 2016, the CalPERS Board of Administration will hear the Committee’s findings and recommendations.  The Committee’s Agenda Report indicates that “achieving the current 7.5% expected rate of return over the next 10 years will be a significant challenge.”  The Committee estimates that with a reduction in the rate of return to 7.25%, most employers could expect up to a 2% increase in the normal cost for miscellaneous plans, and up to 3% for safety plans.  Should the rate of return be reduced to 7%, employers could expect an increase in the normal cost of up to 3% for miscellaneous, and up to 5% for safety plans.  Bottom line: employer contributions toward their unfunded accrued liability payment and as a percentage of payroll will increase.

The Committee recommends that any reduction in the rate of return (and increase in employer contributions) begin with the 2017-2018 fiscal year for public school districts, and 2018-2019 for contracting agencies. The Committee indicated that the reduction in the rate of return is critical for the long-term health of the pension system. The Board of Administration will decide if, when and how any reduction in the rate of return will be implemented.

Employers should prepare now for a likely further reduction in the rate of return and higher employer contributions by including this prospect in budget forecasting.  Employers may also want to consider pre-funding trusts.