CalPERS Announces 21.3% FY2021 Return and Lowers Discount Rate to 6.8%

On July 12, 2021, the California Public Employees’ Retirement System (CalPERS) announced a near-record 21.3% investment return for FY2021. A higher rate of return was achieved only once since 1993 – in 2011 – when CalPERS cleared a generational record 21.7%. This is a welcoming news to the California public agencies looking for all the help they can get to achieve better funding levels in their pension plans.

Market appreciation in the private equity and public equity asset categories were the primary reason for the strong performance, which brought the overall funded status of the pension system from 71% to approximately 82%.

However, the strong performance triggered the activation of the CalPERS’ Funding Risk Mitigation Policy, adopted in 2015 to gradually reduce the discount rate in years when investment returns significantly exceed benchmarks. Concurrently with the announcement of the investment returns, CalPERS said that the discount rate will be lowered from 7% to 6.8%. That reduction is projected to lower the system’s funded status to approximately 80%, taking away some of the investment gains’ benefit.

The discount rate is the minimum rate of return that CalPERS needs to achieve in perpetuity so that its member agencies could meet their retirement obligations to their employees, retirees, and other beneficiaries. The higher the discount rate, the more money CalPERS expects to make by investing contributions of public agencies and their employees. When the discount rate is lowered, CalPERS is indicating that their future investment returns will be lower and higher contribution amounts are required.

The announced lowering of the discount rate is not final, as CalPERS is in the middle of a regular experience study, the results of which are expected to be announced in November 2021, which may require an additional decrease of the discount rate.

The discount rate is also the rate of interest that CalPERS charges its member agencies on their Unfunded Accrued Liability (UAL) balances. While the lowering of the discount rate will lead to lower interest charges, the savings will be offset by an increase of the UAL balance due to the lower future earnings.

While we are waiting for more details from CalPERS on how exactly the impacts of the strong earnings and lower discount rate will be implemented, the following things are clear:

• The strong 2021 performance will result in higher funded status of pension plans, lower UAL balances, and lower future UAL payments, as the effect of the gains will be spread over the next two decades;
• The reduction of the discount rate will result in lower funded status of pension plans, higher UAL balances, and higher future UAL payments, as a new actuarial base will be added to account for the lower future earnings.
• The reduction of the discount rate will also result in higher Normal Cost rates.
• The net effect of the investment performance and discount rate decrease on the UAL will still be positive.
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According to our sources at CalPERS, the new discount rate will not be taken into consideration in the upcoming 2020 Actuarial Reports (expected to be released in August / September of 2021), which will still be based on the 7% rate. The 2021-22 and 2022-23 UAL payments will remain unchanged, but the 2023-24 payments will be calculated at the new discount rate, which will also be applied against the outstanding UAL amortization bases.

Ridgeline Municipal Strategies, LLC can help you evaluate the impacts of these changes on your pension costs and implement pension optimization strategies that will help you take advantage of these changes.