The California Public Employees' Retirement System (CalPERS) manages the largest public pension fund in the US, with more than $469 billion in assets as of June 30, 2021. CalPERS is funded by a combination of employee contributions set by statute and employer contributions that fluctuate year to year depending on how much is needed to finance the costs of employee benefits earned during the year.
CalPERS invests these contributions in assets to generate additional income, which is essential for employers (such as city governments) to meet their pension obligations. Its target return on assets - aka “discount rate” - was recently lowered from 7.5% to 7.0% per year, to better align investment income expectations with reality. This is important, because local governments and policymakers can’t do their job without a budget and you can’t develop a budget without a pretty good idea of future income. Plus, if future income is less than expected, then the employer is on the hook to finance any “unfunded liability”. To do so, they may need to cut other budget items, such as road repair.
Unfortunately, the CalPERS 7% discount rate is still too optimistic, given that its return on assets has averaged around 5% for over a decade. So why not lower the discount rate even further? After all, pension funds in Finland, Iceland and Luxembourg have discount rates of 3%, 3.5% and 5%, respectively. However, these countries may invest in lower-risk assets than CalPERS, so their expected returns would be lower as well. Then again, there’s no question the CalPERS discount rate is too high given past performance of its assets, so the question remains: why not provide a realistic expectation of future asset income?
The answer: politics. Policymakers and bureaucrats would have to recalculate their budgets if CalPERS used a realistic discount rate. Making it official means public servants would have to get serious about raising revenue in other ways (e.g., higher taxes) and/or cutting spending (e.g., eliminating popular but inessential services). Either way, the people won’t like it. The easiest thing to do is kick the can down the road. Pretend it will all work out.
But we Californians are already living the consequences of overpromising and underfunding pension benefits. To illustrate, some excerpts from the Biennial Report of Current City of Berkeley Liabilities and Projections of Future Liabilities:
The City has a significant pension liability that is anticipated to grow due to recent financial losses experienced by CalPERS… The City’s retiree health plans are significantly underfunded… The City’s ability to borrow is negatively impacted by its unfunded liabilities… the City’s unfunded liabilities tied to benefits total $751 million, and the City’s unfunded infrastructure needs total $1.1 billion.
The City has not adequately planned for expected pension and [Other Postemployment Benefits/OPEB] cost increases. The more these pension and OPEB costs increase, the more strain there will be on the City’s budgets and operations. Failure to address this could result in:
a. Reduction in the number of employees
b. Reduction in pension benefits
c. Reduction in services provided to citizens and businesses
d. Possible future tax increases
e. A combination of these possible outcomes
The solution to this mess? I don’t know. Politicians can’t push pension reform and win elections. At least not in California - and especially not in Berkeley.