What CalPERS’ New 6.8% Discount Rate Means for Employers?

What CalPERS’ New 6.8% Discount Rate Means for Employers?

December 9, 2021

On November 15, 2021, the CalPERS Board of Administration voted to keep the discount rate at 6.8%, consistent with the previously announced automatic reduction from 7%. This change will be reflected in the FYE2021 actuarial valuation reports published in July/August of 2022.

Besides lowering the discount rate, CalPERS also implemented changes to several economic and demographic assumptions.

What is the CalPERS discount rate?

The discount rate is the minimum rate of return that CalPERS needs to achieve to be able to fund pension benefits under the assumptions that it uses to calculate plan participant contribution requirements.

Additional Unfunded Accrued Liability (“UAL”) is created each year when investment returns fall below the discount rate. For example, for the FY2020, when CalPERS achieved a 4.7% investment return while targeting a 7% discount rate, every agency saw its UAL go up by 2.3% of the market value of assets in its pension plans ($23,000 per each $1 million).

In years when investment returns exceed the discount rate, the UAL is reduced.

Other economic and demographic factors also impact the UAL, but the investment performance in comparison to the discount rate typically has the most weight.

What impact will the lowering of the CalPERS discount rate have on employers?

The reduction of the discount rate means that going forward CalPERS does not expect to make as much return on its investments as before. Since the investment return expectation is factored into the contribution calculation, it also means that CalPERS has not been collecting enough money from participating agencies and their pension plans are underfunded. In other words, when the CalPERS’ discount rate goes down, the UAL goes up. As the UAL balance grows, the future UAL payments and the interest accrued on the UAL grow also.

CalPERS lowered the discount rate concurrently with announcing a very strong investment performance of 21.3% for the FY2021. Since the investment return exceeded the 7% discount rate in place during the year, the excess returns will lower the UAL balance by 14.3% of the market value of assets within the pension plans. The future UAL payments and the interest accrued on the UAL will also be reduced.

The idea behind combining the lowering of the discount rate with the strong investment performance is to allow a portion of the excess investment income to cover the UAL increase from the lowering of the discount rate. Since the FY2021 excess return was significant, it will be more than sufficient to offset the impact of the discount rate reduction.

Based on Ridgeline’s review of several agency pension plans, the combined impact of the 2021 investment returns and the lower discount rate, after allowing for the scheduled UAL payments, is a roughly 20% reduction of the UAL from the FYE2020 level. In other words, the FYE2021 balance is likely to be approximately 80% of the FYE2020 balance.

This only applies to the local agency pension plans that have not recently prepaid or refunded their UAL. The plans that have prepaid or refunded their UAL may find themselves in situations where they are slightly overfunded.

In addition to increasing the UAL, the discount rate reduction will also result in a small increase to the Normal Cost of the pension plans. While some agencies may be able to pass a portion of this cost increase to their employees, many will not be able to do so.

The impacts of the 2021 investment returns and the discount rate reduction will start showing up in the local agencies’ UAL payments starting in FY2024.

In light of these changes, if your agency is considering paying down or refunding the UAL in FY2022, make sure to consult with your municipal advisor about the appropriate refunding percentage to avoid superfunding your pension plans.

What is CalPERS doing to achieve investment returns at the new discount rate?

Prior to FY2021, CalPERS struggled with achieving investment returns comparable to their discount rate. Their 20-year average rate of return was only 5.5%, significantly below the 7-8% discount rate in effect during the period. This investment underperformance was one of the key reasons for the consistent growth of the UAL.

Going forward, CalPERS is modifying its asset allocation mix to increase private assets (private equity, real estate, and private debt) from 21% to 33%, while reducing the allocation to public equities. Additionally, CalPERS is also adding a 5% leverage allocation to increase asset diversification. The implementation strategy for these changes will be developed and presented by July 2022.

Will these changes be enough to help CalPERS achieve the target investment return and was the lowering of the discount rate by only 0.2% enough? Time will tell. But a scenario where CalPERS continues to underperform is not out of the realm of possibilities. In that case the participating agencies are likely to continue to deal with the management of unfunded pension liabilities.

What about other actuarial assumption changes?

Besides lowering the discount rate, CalPERS also modified several other economic and demographic assumptions. The modification was done after a comprehensive experience study, which has to be prepared every four years.

The actuarial assumptions are regularly reviewed to ensure that contribution requirements are set as correctly as possible, since overly optimistic assumptions lead to insufficient contributions, while overly pessimistic assumptions lead to excessive contributions.

The following assumptions were modified:

  • Economic Assumptions:
  • ~ Price inflation assumption was lowered from 2.50% to 2.30%
  • ~ Wage inflation assumption and payroll growth assumptions were increased from 2.75% to 2.80%
  • Demographic Assumptions:
  • ~ Expected life spans were increased, especially for members with higher retirement benefits
  • ~ Retirement probabilities were adjusted for various employee categories
  • ~ Salary scales were adjusted for various employee categories
  • ~ Non-industrial disability retirement rates were slightly reduced for public agency members

The following graphs from CalPERS summarize the impact of the assumption changes on the public agency Miscellaneous and Safety Plans.

Source: CalPERS

Source: CalPERS

The assumption changes will go into effect with the FYE2021 actuarial valuation reports.

The experience study looked at the data through June 30, 2019, which preceded the COVID-19 pandemic. So far CalPERS found “no compelling reason to assume COVID-19 will affect experience” going forward.

As new information becomes available, we will continue to inform you here on the current and future changes at CalPERS and what they mean for you.

Contact Ridgeline to discuss how these changes impact your pension costs and what pension cost optimization strategies are appropriate for your agency.