Pension costs: What cities need to know about the discount rate, Asset Liability Management process, and 115 trusts
Public agencies continue to navigate through the damaging effects that COVID-19 has had on their revenues, general fund returns, and the economy. Meanwhile, their pension obligations continue to grow, putting further strain on their impacted budgets. Pension systems face an uncertain economic outlook with discount rate targets that are mismatched with future expected returns. Discover how the City of Tracy, the Town of Yountville, and CalPERS officials are navigating these issues.
The Road Ahead for Managing Rising Pension Costs
There’s no denying that 2020 was a consequential year for California’s cities, with many facing the abrupt closure of businesses, including hotels, restaurants, and entertainment venues, all of which significantly impacted their revenues. Many cities still face a long road to full recovery, as they work toward building back up their lost revenues and adapting to a “new normal.”
In addition to COVID-19 related challenges, the rising costs of pensions continues to be an ongoing obstacle for cities. While CalPERS reported a healthy 21.3% investment return for fiscal year 2020-21, it simultaneously triggered a reduction in the discount rate from 7.0% to 6.8%, which the CalPERS Board will continue to review through their Asset Liability Management process during the rest of the calendar year. This announcement begs the question: What do changes to pension assumptions like these mean for cities? For most, the implications include a strain on future budgets due to higher required contributions and higher unfunded accrued liability.
In Northern California, the Town of Yountville is well-positioned to deal with these types of changes. They have been preemptively setting aside money into a Combination 115 Trust to prefund their Pension and Other Post-Employment Benefits (OPEB) for several years, with an adopted policy in place to support a financial commitment to fund these reserves. With the abrupt closure of many of its hotels and restaurants due to the COVID-19 pandemic, the Town of Yountville experienced a loss of $5.9 million in revenue for Fiscal Year 2019-20 and Fiscal Year 2020-21. However, due to its continued efforts to build up its Pension and OPEB reserves, Yountville benefited from a rainy day fund created exactly for these types of unexpected challenges.
During our session, “The Road Ahead for Managing Rising Pension Costs,” Yountville Town Manager Steven Rogers will share his insight about Yountville’s experiences throughout the pandemic. He will also explain how having OPEB and Pension reserves set aside in an IRC Section 115 Trust was utilized to navigate unforeseen fiscal difficulties and what the Town’s budgetary planning looks like as they move forward in the current economic landscape.
Building upon these considerations, our expert panel will provide additional details on the following topics:
- The latest updates on pension and OPEB liabilities
- How rising pension/OPEB costs affect cities’ balance sheets and long-term obligations
- Pension prefunding as a proactive approach to address the rising costs of pension
- Advantages of prefunding in a Section 115 Trust
- Options available for investing/using funds in a Section 115 Trust
Ultimately, while California cities do not have control over the many fiscal challenges they face, they do have options pertaining to how they prepare for and address the rising costs of pensions. The Town of Yountville’s strategy helped them work through the financial hardships caused by the COVID-19 pandemic thus far and is continuing to help them plan for the road ahead.
Session information: Thursday, September 23｜2:45-4:00 p.m. ｜ Meeting Room 9-11
CalPERS Discount Rate: The Process, Decisions, and Impacts for Cities
The key function of CalPERS is to ensure that there are sufficient funds to pay pension benefits now and — especially — in the future. The challenge is anticipating what those future costs (liabilities) will be and balancing those with how much money is coming in through contributions and investment growth (assets).
This is a complex equation and not one that can be made quickly or frequently. It requires a methodical, carefully considered process that combines the best-known assumptions and input from industry experts on demographics, capital markets, and macroeconomics.
This is known as the Asset Liability Management process, or ALM CalPERS Asset Liability Management. The process runs on a four-year cycle, with the key decisions occurring in the fourth and final year — 2021, in this case.
Much like saving for retirement or college tuition, CalPERS must determine annual contributions and how to invest the system assets as they accumulate, based on the ultimate goal of fully funding promised pension benefits. In many ways, the entire process is a question of risk tolerance: How much risk are stakeholders of the system willing to bear? Understanding that more investment income lessens the number of necessary contributions, it might be tempting to swing for the fences and invest aggressively. However, with increased risk comes the real possibility of potentially catastrophic investment losses and a lack of sufficient funds when needed.
During the League of California Cities Annual Conference and Expo, we will present information to session attendees regarding 1) the major decisions that will be made during this process, 2) considerations for making these decisions, and 3) possible impacts to employers and members. An overview of the ALM process is provided below.
For individual plans within CalPERS, the funded status and required contributions are determined using a set of actuarial assumptions that estimate the ultimate cost of the benefits that will be paid to the members of the plan. These assumptions include economic assumptions such as inflation and investment return, as well as demographic assumptions that project when or if members will retire, terminate employment, become disabled, or die. Estimates of future retirement benefits are then used to determine required employer and certain employee contributions to the plan.
As part of the ALM process, each actuarial assumption is reviewed and compared against actual recent experience and expected future experience. The actuary then makes any recommendations for changes to assumptions and presents them to the board for approval. Changes to these assumptions impact required contributions. For example, if the current assumptions are understating projecting benefits, new assumptions will be proposed that increase projected benefits and therefore employer and possibly member costs.
Discount rate assumption
The actuarial assumption to which the resulting contribution requirements are most sensitive is the discount rate assumption. Most public retirement systems set the discount rate equal to the expected long-term investment return. Small changes in the discount rate assumption can lead to relatively large changes to required contributions.
To estimate the expected long-term investment return, the system must first select an investment allocation made up of various asset classes. During the ALM process, the CalPERS investment team will present several candidate portfolios to the board for consideration. Each portfolio will have an expected long-term return based on its asset allocation. Higher allocations to classes such as global equity and private assets are generally expected to result in higher expected returns but also a higher level of volatility or risk.
The ALM process will re-assess system risks and investment policies given the changing world in which we find ourselves — decreased expectations for low-risk investment returns, COVID-19, and geopolitical uncertainty. The board is scheduled to make decisions regarding the asset allocation and actuarial assumption changes during the November meeting.
For CalPERS public agencies, the impact of these decisions on the required employer and PEPRA member contributions will be first experienced during the 2023-24 fiscal year.
Randall Dziubek is the deputy chief actuary for CalPERS and can be reached at Randall.Dziubek@calpers.ca.gov. Karin Schnaider is the finance director for the city of Tracy and can be reached at firstname.lastname@example.org.
Session information: Friday, September 24｜9:30-10:45 a.m. ｜ Ballroom A2-4