LOS ANGELES — Changes in the discount rate by California's two largest pension funds will fiscally stress the state and cities, but are needed to make the pension funds sustainable, according to an S&P Global Ratings report.
The California Public Employees' Retirement System and California State Teachers' Retirement System both have committed to lowering their discount rates without changing their funds' asset allocations.
The CalPERS board approved a plan Dec. 21 to lower its discount rate in a three-step process from 7.5% to 7% in 2018. CalSTRS followed on Feb. 1 with plans to move faster, reducing its discount from 7.5% to 7.25% in the upcoming 2016 evaluation and then to 7% in 2017.
"These reductions have significant implications for state and local budgets, increasing both the unfunded liability and total contributions required while lowering the funded status for all fund participants," S&P analysts wrote in the report Wednesday.
But it also creates a sustainable and favorable environment for state and local government employers, analysts wrote.
Discount rates are calculated by merging an estimated real rate of return based on the fund's asset allocation with an expected general inflation value over the long term to determine the total discount rate, according to the report.
The changes mean near-term budget pressures, but "are constructive for stabilizing these pension systems in the long term," analysts wrote.
Mature funds like CalPERS and CalSTRS face pressure from aging workforces, analysts wrote, which can result in negative cash flow from paying out more in benefits than come in through contributions and then relying on investment returns to cover the difference.
This scenario can leave them "vulnerable in that a single market downturn could push unfunded liabilities into a very painful or virtually unrecoverable state," analysts wrote.
In S&P's "view, funded ratios that depend less on arguably unrealistic rates of investment return are more robust and dependable, creating a sustainable and favorable environment for state and local government employers."
