A Nationwide Public Pension Trend Is Emerging

PHOENIX - Budget pressure from pension costs is growing for states and municipalities as many large pension systems across the country lower their discount rates to reflect lower investment return expectations.

Moody's Investors Service dissected the situation in a report Thursday, authored by analysts Thomas Aaron and Timothy Blake. The piece comes shortly after the nation's two of the nation's largest public pension funds, the California Public Employees' Retirement System and the California State Teachers' Retirement System decided to lower their assumed annual rates of return on investment, known as the discount rate. CalPERS' board voted in December to reduce the rate from 7.5% to 7% over three years, and CalSTRS decided this month to hit the same target over the next two years.

From a long-term market interest rate perspective, lower return assumptions are overdue, the Moody's analysts wrote.

"The gap between market interest rates and the reported discount rates of US public pension plans has been widening for over two decades and remains substantial," said the report. "For example, CalPERS' 8.55% assumed rate of return in 1990 was within five basis points of the annual rate for 10-year, constant maturity U.S. Treasuries. In 2016, that gap exceeded 550 basis points, even after incorporating the 7.375% rate that will be used as part of CalPERS' 3-year phased reduction to 7.0%."

Instead of reducing their discount rates, Moody's notes, pension plans reached for yield by making riskier investments.

And late 2016 interest rate increases did little to improve the gap between public pension discount rates and market interest rates, the rating agency said. But with lower returns expected for the next decade, many U.S. public pension funds are decreasing their discount rates and requiring higher contribution levels from their participants. Besides the big California plans, the New York State and Local Employee's Retirement System, Dallas Police and Fire Pension Fund, and the Chicago Firemen's Pension and Annuity Fund are among those to lower expectations.

Those adjustments mean challenges at the local level. While Moody's believes the impact will vary widely depending on the specific situation, some issuers could see their costs rise enough to amplify existing challenges. And even with the discount rate changes, pension costs are still understated by government funding and accounting assumptions, warned Moody's. Keeping pension costs manageable will require continued growth in government revenues and strong pension investment returns, especially for those governments with already large pension obligations, the agency said.

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