PHOENIX – The "gradual and contingent nature" of the California Public Employees' Retirement System's plan to revise its investment return assumptions could mean substantial fiscal risk to California governments, Moody's Investors service said Friday.

The CalPERS Board of Administration on Nov. 18 adopted a new "funding risk mitigation policy" that would reduce the discount rate - or assumed rate of return on the fund's investments - by a minimum of 0.05 percentage points to a maximum of 0.25 percentage points in years when investment returns outperform the existing discount rate, currently 7.5%, by at least four percentage points. CalPERS is trying to reduce the volatility of its returns by gradually lowering the discount rate that it uses to value its liabilities, and invest in less risky assets to reduce its exposure to market volatility.

The deal elicited immediate criticism from California Gov. Jerry Brown and other activists who want the rate dialed back more quickly, but the CalPERS board said it was mindful of not requiring increased contributions too quickly for local governments to bear.

But Moody's' new report said that while the new policy is a slight credit positive for California and the municipalities that participate in the pension system, it also warns that local governments are likely to get squeezed anyway.

"This new plan is the latest of several changes to assumptions and actuarial methods implemented by CalPERS in recent years," the rating agency said in its commentary. "As a result of these previous actions, state and local government contribution rates relative to payroll were already set to rise prior to the system's most recent action."

Normally, strong investment performance would lessen the need for contribution increases, but the new policy changes that, Moody's said.

"Without the new policy, strong investment performance would create an actuarial gain that all else being equal, would put downward pressure on contribution requirements," Moody's said. "Conversely, under the new policy, contributions will remain higher than they otherwise would immediately following such a gain, because the discount rate drop will push up liabilities and normal costs."

Tom Aaron, an assistant vice president at Moody's, said that California and its local governments remain very exposed through CalPERS. The "de-risking" process will take years to fully implement, perhaps as long as two decades, and a sharp fall in CalPERS' asset performance could impact participating government fiscal positions, Moody's said.

"Government exposure to pension asset investment earnings declines grows as the CalPERS plan demographics mature," Aaron said. "Fiscal conditions for California and participating local governments remain highly susceptible to CalPERS' asset investment performance, even under the new policy."

CalPERS' move to drop the discount rate does not impact Moody's adjusted net pension liabilities for participating local governments, Moody's said, because the agency uses a discount rate tied to a bond index as of the plan's measurement date. Moody's said in a September report that California currently has the highest adjusted net pension liability of any state, with a fiscal year 2013 figure of $189.4 billion. That is about 92.5% of revenues, 17th highest among states and above the 50-state median of 52.8% of revenues.

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