June 24, 2021

From blue chips to meme stocks, from crypto to real estate, almost ever broad investment category has enjoyed banner returns over the past year. One of the results of those investment gains will be improved funding levels for California’s public pension systems, which rely on investment gains to provide over half of promised benefits.

However, the extraordinary gains over the past fiscal year will almost certainly trigger an as-yet-unused CalPERS policy to slightly reduce the discount rate. The policy is designed to strengthen the system even further and will directly affect contribution rates for employers and some employees, although not until the 2023-24 fiscal year.                           

The policy, called the Funding Risk Mitigation Policy (pdf), first implemented in 2015, states that when investment returns exceed assumptions by at least 2 percent, the discount rate, or assumed rate of return, will be reduced slightly. The higher the returns, the more the discount rate is reduced.

In general, a lower discount rate means the system can pursue less volatile investments and have a better chance to meet its investment goals, but it also means somewhat higher upfront costs for employers and employees. When a pension system fails to meet its investment goals, however, the result is an unfunded liability that results in even higher costs, especially for employers.

At the end of the third quarter, CalPERS investments had gained 15 percent for the year, over twice the assumed rate of 7 percent. In mid-July, when they announce their final returns for the fiscal year, if that number holds, the Funding Risk Mitigation Policy would trigger a reduction of the discount rate to 6.9 percent. If returns come in even higher, the discount rate could be reduced further. Returns of at least 17 percent would reduce the rate to 6.85 percent, returns of 20 percent would reduce the rate to 6.8 percent, and if returns somehow exceed 24 percent the discount rate would drop to 6.75 percent.

While those changes would make contribution rates higher than they would otherwise be, the overall result would still be lower rates than currently projected. The policy essentially shares the benefit of the extraordinary investment gains between future contribution rates and a reduced discount rate.

Complicating all of this, the CalPERS board is in the final months of its regular, though infrequent, review of its investment portfolio, a review that could also result in a reduced discount rate and commensurate changes to the investment portfolio. The results of that review could result in a decision as early as this November and will take effect for local agencies in the 2023-24 fiscal year (schools and the state are affected one year earlier).

Counties that are interested are encouraged to monitor and participate in the CalPERS board and committee meetings over the next few months, where these consequential issues will be discussed, debated, and decided.