California Plans’ Lowered Discount Rates Will Increase Pension Costs

S&P Global Ratings estimates CalPERS and CalSTRS will contribute $2 billion more a year toward pension costs.

By PLANSPONSOR staff | March 15, 2017
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In a report from S&P Global Ratings, the agency notes that the two largest public pension systems in the U.S.—California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS)—both have committed to lowering their discount rates without changing their funds' asset allocations.

The CalPERS' board voted on December 21, 2016, to lower the discount rate to 7.375% from 7.5% in the upcoming actuarial valuation for June 30, 2016; 7.25% in the 2017 valuation; and 7.0% in the 2018 valuation. Six weeks later, on February 1, 2017, the CalSTRS board decided to move slightly faster, reducing its discount rate to 7.25% in the 2016 valuation and 7.0% in 2017 from 7.5%.

The agency explains that CalPERS' discount rate had an inflation assumption of 2.75% and a real rate of return of 4.75%. The real rate of return is scheduled to decrease 0.5% over the next three years while the inflation assumption is stable and will be looked at in 2018 in the experience study, which CalPERS conducts every four years. The impact on the cost of earning a year of service (the normal cost) will add 1% to 3% of pay for non-safety groups and 2% to 5% for most safety groups. S&P expects most unfunded liability payments to increase 30% to 40% over the next seven years as the costs are realized. For the state alone, that will ultimately mean contributing $2 billion a year more toward pension costs.

The substantial increases in current projections are primarily the result of poor investment returns over the past two years, the report says. Reducing the discount rate will accelerate the slope of cost increases, intensifying the pressure that state and municipalities will face as growing pension contributions account for larger portions of their budget, especially in this slow revenue growth environment.

Another recent analysis from S&P Global Ratings showed many plans across the country are lowering assumed long-term rates of return in light of global economic headwinds, which further contributes to declining funded ratios and puts a strain on cities' credit ratings.

NEXT: CalSTRS’ lowered discount rate effect on schools