LOS ANGELES — Analysts are still weighing the impact a decision by the California Public Employees’ Retirement System to lower its investment assumptions will have on local governments.
CalPERS’ board last Thursday voted 9 to 1 to reduce the expected average annual return on its investments to 7.5% from 7.75%.
That means CalPERS’ member governments, including the state and many local governments and agencies, will have to make up the difference by paying more into the system.
CalPERS’ chief actuary, Alan Milligan, had recommended a steeper reduction, to 7.25%.
“The cost to local governments hasn’t been quantified yet, but it will obviously be an additional budgetary cost,” said Karen Ribble, senior director in the San Francisco office of Fitch Ratings. “We will continue to look at budget costs and how the increased costs are pressuring budgets.”
In addition to lowering the assumed rate of return, the board ratified a reduction in CalPERS average annual inflation rate to 2.75% from 3%.
The changes, which take effect for the state and school districts on July 1, are expected to cost California $303 million yearly, including $167 million in higher pension contributions from the general fund. The annual hit to school districts for non-teaching staff is a $137 million increase. Teachers are in a separate pension plan.
The financial impact on hundreds of counties and cities, which will experience cost increases beginning July 1, 2013, has not been calculated.
“When we analyzed the credits, we already looked at a 7% investment assumption and how that would impact the ratios,” Ribble said. “We do try to look at what the vulnerability will be if they change the assumptions or have lower returns than assumed.”
Cities in which a higher proportion of the budget goes to pay CalPERS are going to be disproportionately affected, Ribble said.
“This was a difficult, but important, decision for the board to make. We understand the impact this will have on our employers in meeting contribution requirements,” said Rob Feckner, president of CalPERS’ board. “However, current economic conditions impelled us to make this change now, and our actuaries will continue to evaluate the discount rate in the coming years.”
CalPERS’ chief actuary had recommended a similar decrease in assumptions last year. That discussion was followed by the retirement system’s announcement in January that the investment portfolio had only earned a 1.1% return for the 12-month period ended Dec. 31, 2011.
The $233 billion CalPERS, the largest public pension fund in the country, has used the 7.75% assumed rate of return for more than a decade. The fund’s performance predictability has been hampered by losses, including the drop of nearly a quarter of the value at the height of the recession in 2007-2009.
CalPERS’ annual return averaged 5.1% for the 10 years that ended Dec. 31, 2012, and the five-year annual return was 0.4%, according to its website.
The retirement fund’s most recent overall actuarial funded ratio, for the period ended June 30, 2010, was 83.4%, according to a Standard & Poor’s report released Feb. 12. It was little changed from the 83.3% funded rate in 2009, in part due to long-term actuarial smoothing of asset values, the report said.
The fund’s long-term smoothing methodology includes partially delaying amortization of 2009 investment losses. CalPERS’ funded ratio using the market value of assets at fiscal year-end 2010 rose to 65.4% from 60.8% in 2009.
“We believe the market-value-funded ratio could improve when the 2011 actuarial report is released, as result of the 21.7% investment rate of return experienced in fiscal 2011,” S&P analysts said.
In fiscal 2011, the fund paid $14.2 billion to retirees, against employer contributions of $7.5 billion, member contributions of $3.6 billion, and investment income of $43.9 billion, which after other expenses left net assets of $241.8 billion, an increase of 19.9% in fiscal 2011.
David Hitchcock, senior director in Standard & Poor’s New York office, described the increased costs as within most governments’ ability to manage.
“I think it is a modest enough increase that they will be able to respond to it,” said Hitchcock, who follows CalPERS for Standard & Poor’s. “They will have to cut, but a lot of local governments are seeing revenue increases and they are on the upswing in the property and sales tax cycle.”
In general, pensions are a relatively small amount of overall costs, but you have to look at individual districts and cities, Hitchcock said, adding that it’s hard to make broad statements.
“There are literally thousands of local governments in California,” said Matthew Reining, a director in Standard & Poor’s San Francisco office who tracks local governments. “But we are generally seeing creditworthiness in state and local governments.”
In the larger scheme of things, Hitchcock said local governments and the state should be able to manage the additional costs.
Hitchcock suggested putting the $167 million cost to the state budget in the context of the $89 billion in resources Gov. Jerry Brown is projecting in this budget.
“It hurts,” Hitchcock said. “But it is not going to break the state even though the state has a lot of other issues going on. It is our lowest-rated state.”
Patrick Whitnall, general counsel for the League of California Cities, thinks the impact will be substantial. “Employer contribution rates are already high,” he said. “It will cause problems for the cities, particularly cities that are less financially healthy than others.”
Whitnall said he did not know if it might be enough to force some cities into insolvency.
“I hope not,” he said. “Cities choosing those kinds of options have probably been in trouble for quite some time.”
It’s an impossible task to guess who might be next, according to Whitenall. “Cities do not talk an awful lot about it, until it is about to happen,” he said.
Rod Gould, city manager of Santa Monica, said he estimates his city will have to chip in an additional $2.8 million in fiscal 2013. The city’s annual budget for 2011 was $286 million.
While triple-A-rated Santa Monica is far from being pushed over the brink by the additional cost, Gould said there are quite a few cities that are fiscally unstable, that have been cutting for years and have run their reserves down to nothing.
“Do I expect widespread bankruptcy? Absolutely not,” Gould said. “Most cities are nowhere near that, but there are quite a few cities hurting.”
Increased costs will likely result in more layoffs in the state’s cities, he said.
But he added that does not mean muni bond buyers should now be fearful and steer away from local government debt, which is generally backed by reliable property taxes.
“Cities are not going to default on their bonds, because it means they will have given up the ghost and the city is no longer functional,” Gould said. “Cities know how absolutely imperative it is to maintain their bond ratings.”
CalPERS’ investment assumption changes come against the backdrop of efforts by the governor and some state lawmakers to implement pension reforms, and as the city of Stockton, a CalPERS member, publicly struggles to avoid bankruptcy in a process that has already resulted in bond defaults by the city.
“The most important thing from our standpoint is to be able to get flexibility in current costs for current employees,” Whitnall said.
Brown’s proposals would primarily change benefits for future employees.
“Most of the governor’s proposals are prospective and don’t get at the cost for current employees,” Whitnall said. “We need flexibility to negotiate greater cost- sharing between employers and employees.”
At this point, he added, most of the improvements have been made when local governments have been able to negotiate agreements for their employees to contribute more to their pension and health plans.
Standard & Poor’s views attempts at pension reforms favorably.
Hitchcock adds the caveat, however, that new reforms would result in a lot of savings gradually over time, while the $167 million in additional annual contributions from the state’s general fund would be immediate and cumulative.
“Pension is a long-term liability similar to debt,” Hitchcock said. “So to the extent you can change pension costs from new employees and pull down costs, it will have a positive impact on future years.”