Dan Carrigg, interim executive director for the League of California Cities, said he has had sobering conversations with city managers over CalPERS’ plans to lower its rate-of-return expectations.

LOS ANGELES — Lower-than-expected returns are spurring the California Public Employees' Retirement System to further lower its rate-of-return expectations, adding pressure on the budgets of California cities.

The board of the nation's largest pension fund could decide as soon as Tuesday on the best method of reducing its rate-of-return expectations.

Last year, the board voted to use gradual smoothing over a 20-year period to reduce the rate of return expectations. But lower-than-expected returns since then have the $303.6 billion pension fund speeding up plans to lower the rate, which will mean higher contributions for its member cities.

A conference call with the state's city managers on the topic resulted in a "sobering conversation," said Dan Carrigg, interim executive director for the League of California Cities.

The city managers were concerned they would not be able to hire more people and might have to lay people off, Carrigg said.

The pension fund's board began evaluating taking a different tack after the year-end report from consultant Wilshire Associates in July showed a 0.61% return compared to a 2.4% return in fiscal 2015. CalPERS officials say the returns are in line with other pension funds.

"One thing that struck me is when you look at the funded status of CalPERS since 2009, when the stock market hit rock bottom, and then began to go back up," Carrigg said. "Even after one of the most robust stock markets in memory, the overall status of the CalPERS fund is somewhat flat."

CalPERS investment consultants advised against increasing risk in the portfolio during a Nov. 15 board meeting.

Being more aggressive, having a reasonable amount of volatility and being wrong could lead to an unrecoverable loss, Andrew Junkin, president of Wilshire Consulting, the system's general investment consultant, told board members.

The pension fund expects an average return of 6.21%, which is 90 basis points, or 0.9% lower, than the 10-year return that was expected two years ago, CalPERS chief investment officer Ted Eliopoulos at the board meeting. The forecast was produced by Wilshire.

The board is considering lowering the discount rate for state and local agencies effective January 2018 from 7.5% to 7.25% and then to 7% in 2019. This proposal arose out of recommendations in a September report from now retired CalPERS Chief Actuary Alan Milligan.

CalPERS has since told the League that it could just lower the rate to 7% all at once, rather than over a two-year period, Carrigg said.

"They should have had a lower investment return assumption for a long time," said David Crane, a lecturer on public policy at Stanford University and former special advisor to former Republican Gov. Arnold Schwarzenegger.

If the pension fund had lowered the target to 6.2% a decade ago, it would be in a dramatically different situation, Crane said.

He supports the move to lower the rate, but said 7% is still too high. He has long advised that 6% would be a more sustainable number and pointed out that is the rate billionaire investor Warren Buffet supports for pension funds.

Some municipalities could see their contributions more than double if the rate of return was lowered to 6%, according to CalPERS documents.

CalPERS, currently 68% funded, is cash-flow negative, and has been forced to sell investments to cover a $5 billion gap because The pension fund received $14 billion in contributions in the fiscal year ended June 30, but paid out $19 billion in benefits.

"If the incoming revenue from employers and employers is not enough, then you have to make it up by selling assets," Carrigg said. "That means a portion of the portfolio has to be much more liquid and it is earning less interest than it otherwise would."

The current trajectory doesn't look hopeful even if CalPERS lowers the discount rate. The ratio of employed pension fund members to retirees has also moved down from its former two-to-one level and is on track to be one-to-one as the fund matures, Carrigg said.

Absent public reforms, Crane said in a recent blog post, pension costs will crowd out more than $1 trillion of California public services over the next 30 years.

Using Los Angeles as an example, Crane said a decade ago pension costs were 3% of the budget, and now they are 20%.

"That is 20 cents of each dollar that cannot be used to provide city services," Crane said.

The CalPERS board could vote as early as Dec. 20, but it might not take action until its February meeting.

The board has invited all stakeholders to its December meeting, which will involve a workshop to evaluate all the options and allow for additional public comment.

CalPERS has been meeting with the California League of Cities and other agencies and conducted an online survey of the League's members to get a sense of the preferred approach of its member employers.

CalPERS got responses of the 240 of California's 482 cities, and 82% of respondents preferred an approach that phases in the return expectations over time.

Some 26% of the respondents said lowering the discount rate would have an "extremely high" impact on their city and 42% responded it would have a "high" impact.

Respondents also said the most important aspect of lowering the discount rate for cities is that it would decrease the volatility of employer contributions.

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