This blog post was authored by Michael Youril.
Employers contracting with the California Public Employees’ Retirement System (“CalPERS”) are still grappling with rate increases initiated in 2013 which continue to build for the foreseeable future. Now, CalPERS has signaled a possible additional increase as it considers moving towards the adoption of a risk mitigation strategy. While the strategy will hopefully stabilize contribution rates over the long run and ensure the long-term sustainability of the fund, it will definitely send employer contribution rates even higher for years to come.
Employer rates have increased dramatically in recent years as a result of three actuarial changes by CalPERS. First, CalPERS reduced the “discount rate” from 7.75% to 7.5% which increased employer contribution rates beginning in 2013. The “discount rate” is an actuarial assumption of the average projected market return on investments. Generally, the higher the discount rate the lower the employer contribution rate because the employer receives a “discount” on their contributions based on a projection of market investment returns. Second, CalPERS made changes to its smoothing and amortization policies. This resulted in yet another rate hike starting 2015. Third, CalPERS made changes to actuarial assumptions based on mortality (i.e., people, men in particular, are living longer). The rate increase for this initiates in 2016. At this time, some employer plans already have employer contribution rates that are in excess of 40 percent, or even 50 percent, of payroll.
Here comes a possible fourth rate increase. An agenda item prepared for the CalPERS Board of Administration’s August 18, 2015 meeting states, “[w]e are in a period of negative cash flow with a rapidly maturing public employee workforce.” The item further states that CalPERS “expect[s] employer contribution rate volatility to continue to increase over the next 20 to 30 years.” CalPERS staff has indicated that a mitigation strategy is necessary to reduce these risks. In other words, CalPERS needs to address the fact that market investment returns are not meeting expectations and that a large number of baby boomers are retiring.
Under the plan, CalPERS will reduce its “discount rate” again when its investment returns exceed certain goals in a given year. CalPERS will then move to safer assets and more conservative investments, which will likely have a lower rate of return, but will be less risky and volatile. One of the primary concerns facing the fund is the risk of another recession, such as the one which began in 2008 and caused the fund to have a return on investment of negative 24 percent for the year. Another dramatic drop of that magnitude could damage the sustainability of the fund and further increase contribution rates.
Unfortunately, the strategy of reducing the discount rate and moving to more conservative investments will send employer contribution rates even higher.