This post was authored by Stephanie J. Lowe and Frances Rogers.

The California Public Employees’ Retirement System (CalPERS) recently decided to change its Actuarial Amortization Policy (“Amortization Policy”), which will impact employer contribution rates for contracting agencies. The revised Amortization Policy will go into effect for public agencies in the 2021-2022 fiscal year, which will be based on the June 30, 2019 actuarial valuations.  The policy changes include:

• Shorter amortization periods from 30 years to 20 years.
• Level dollar amortization payments for unfunded accrued liability (“UAL”) bases
• Elimination of 5-year ramp-up and ramp-down on UAL bases attributed to assumption changes and non-investment gains and losses that occur on or after the effective date of the policy change.
• Elimination of 5-year ramp-down on investment gains and losses occurring on or after the effective date of the policy change.
• A 15-year maximum amortization period for inactive employers (this provision is effective for the June 30, 2017 actuarial valuations).

In layman’s terms, an amortization period broadly refers to the length of time which a borrower pays off a debt. CalPERS amortizes gains and losses in investments over a standard amortization period which is currently 30 years.  Longer amortization periods generally provide lower annual contributions but greater cumulative contributions due to interest costs.  Further, to control rate volatility, the current policy uses “direct rate smoothing” that phases in certain costs associated with actuarial assumptions over a 5-year period and phases them out again during the last 5 years of the amortization period (i.e., the ramp-up and ramp-down).

According to CalPERS, the combination of the current amortization schedule, “direct rate smoothing,” and the payment escalators have contributed to more “negative amortization” in the earlier years of the amortization schedule.  Negative amortization means the payments on the debt are not sufficient to cover the interest accrued on that debt.  Thus, reducing an amortization period, as well as eliminating direct rate smoothing for most sources of unfunded liability, can provide faster recovery of funded status following market downturns and decrease expected cumulative contributions, according to a CalPERS Finance and Administration Committee report.

While contracting agencies had the voluntary option to contribute based on a 20 or 15 – year amortization period, most contribute on the 30-year schedule because employer contribution rates remain lower. Thus, agencies on the 30-year schedule will experience higher employer contributions once the revised amortization policy goes into effect.  The change to the amortization base established prior to the effective date of this new policy will continue according to the employer’s current schedule.

Level Dollar Amortization for UAL Payments

Under the current policy, payments on changes that adversely impact an employer’s UAL base begins with a lower initial payment that increases each year by the payroll growth assumption (“escalator” approach). The revised Amortization Policy will require agencies to pay a higher initial amortization payment for changes in the UAL base established on or after the effective date of the new policy, and thereafter the employer will a level dollar amount throughout the remainder of the amortization period, assuming no changes to the discount rate or amortization methods occur.  This will result in higher initial payments, but is expected to reduce interest costs and eliminate negative amortization.

Elimination of Direct Rate Smoothing for Non-Investment Impacts

The current Amortization Policy utilizes direct rate smoothing, or a “ramp-up” and “ramp-down” approach, for phasing-in contribution increases resulting from changes in actuarial assumptions and non-investment gains and losses. This allows for gradual contribution increases in the first five years of the amortization period and gradual lower payments in the last five years.  The policy now eliminates this direct rate smoothing due to a change in actuarial assumptions or experience and non-investment gains and losses.  The policy will keep ramp-ups for investment gains and losses.

Elimination of Ramp-Downs for Investment Gains and Losses

Under the current policy, CalPERS allows a “ramp-down” in base payments for investment gains and losses at the end of the amortization period. For example, under a 30 year amortization period, agencies would pay a reduced percentage of the base payment in the final four years for investment gains and losses (80% of the base payment in Year 27, 60% in Year 28, 40% in Year 29, and 20% in Year 30).  The policy changes completely eliminate all ramp-downs, which includes ramp downs for investment gains and losses, UAL due to a change in actuarial assumptions, and non-investment gains and losses.

Amortization Periods for Inactive Employers

Public agencies without active CalPERS members are subject to a closed amortization period of no more than 15 years. This change will begin with the June 30, 2017 actuarial valuations.

Effect on CalPERS Agencies

Annual actuarial valuation reports published by CalPERS for each contracting agency already contain information regarding the 20-year amortization schedule as an alternative to the 30-year schedule. An agency can refer to these reports to see what the agency’s balance and payment structure would be like under a 20-year amortization schedule, although they do not necessarily reflect all impacts of the changes in the Amortization Policy.

Under the revised policy, employers will experience additional contribution rate increases over the next few years. Employers may also see higher year-to-year contribution increases due to actuarial losses than would otherwise be expected under the current policy.  Agencies should prepare for these increased costs as they prepare for future negotiations and long-term budgeting.

Changes to Projections Due to Reduction in Discount Rate

According to the CalPERS Finance and Administration Committee report, the policy changes will also affect amortization projections and payments related to the scheduled discount rate change from 7.25 percent to 7 percent. The discount rate, or rate of return, is the percentage of expected returns on investments CalPERS makes.  In December 2016, the CalPERS Board voted to adopt an incremental reduction in discount rate over a three-year period beginning with the 2018/2019 fiscal year for contracting agencies.  Each one of the three reductions to the discount rate have a five-year ramp up.  The result is a long-term payment of interest-only.  Projections on the impact to employer contribution rates as a result of the lowered discount rate did not take into consideration a reduced amortization period that goes into effect with the 2021-2022 fiscal year.  The new changes to the Amortization Policy could result in unanticipated increases to employer contributions.

Tied into the changes in the Amortization Policy, the CalPERS Board of Administration recently approved new actuarial assumptions based on a study of CalPERS membership. CalPERS released Circular Letter 200-014-18 (February 8, 2018) to inform agencies that the assumption changes will impact employer contribution requirements by increasing the percentage of payroll costs and the employer UAL contribution. CalPERS will implement the new actuarial assumptions with the June 30, 2017 actuarial valuations, which will set the employer contribution requirements effective July 1, 2019.

For more information on these changes, please contact one of our offices. The issues presented here are not exhaustive so please consult with legal counsel for further information.