STUMP » Articles » California Watch: Calpers Valuation, Exits, and Governance » 9 October 2016, 11:17

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California Watch: Calpers Valuation, Exits, and Governance  


9 October 2016, 11:17

Prior posts on Calpers:

Well, there are more reactions now, and a few other things are going on.

As a recap, the issue is that California uses vastly different valuations depending on whether you’re staying in the plan or if you’re exiting.

My high-level take:

The inherent value of what was promised shouldn’t depend on:
-who did the promising or
-how they plan on fulfilling the promise

The promised amounts are what they’re worth.

That said, there’s the embedded option that the promise won’t be fulfilled. That option’s value does depend on who is promising — some sponsors are much more likely to renege than others.

If these valuations were broken into the two parts, I would be just fine with that approach to valuation. You would have the inherent promise value, using risk-free rates, and then the difference between that and what was held on the books would be the value of the default option.


I had a reaction piece already, but some parties take longer to respond than others.

Here’s Calpers’ response:

The Pension Debate: Our Focus is on the Future
September 28, 2016

By Richard Costigan, Dana Hollinger, and Bill Slaton

The recent back-and-forth debate over pensions for public employees always lands on important issues like employer contributions and discount rates. Lost in the discord, though, is what’s ultimately at stake: the financial future of millions of Americans.

So let’s get to the point and not fall into the tired trap of looking back: It’s time to put SB 400, the 1999 California legislation that changed benefits for public workers, behind us. That bill, passed by the state legislature, signed by Governor Gray Davis and supported by the California Public Employees’ Retirement System (CalPERS) Board of Administration, was a product of its time. Retirement security is too important today to get caught in a debate about the past.

When SB 400 became law, CalPERS was 137 percent funded and contributions by the public agencies that were members of the Pension Fund had dropped to near zero. Those agencies – the fire and water districts, cities, counties, and school districts that serve millions of Californians across the state – had saved billions of dollars in lower or no contributions for several years.

Even allowing for the severe economic downturn brought on by the dot-com bust in the early 2000s, CalPERS entered 2008 more than a 100 percent funded. No one saw what happened next.

The worst recession since the Great Depression hit – and investors across the globe watched as trillions of dollars in asset values were wiped out. Over the next two years, CalPERS’ funded status dropped by 40 percent due to investment losses, leading to the difficult funding challenges we face today. The changes outlined in 1999 were considered a reasonable way to give state workers, who hadn’t seen pay increases in several years, a chance to participate in booming economic times.

Hindsight is 20/20. This is the time for a new direction and new decisions designed to sustain the pension fund now and for generations to come. We began planning several years ago and have taken a proactive role to addressing the new environment.

Four years ago, we hired our first chief financial officer, and in 2012 and 2014 representatives from the insurance industry and public sector, both with financial experience, joined our Board. We established a process to take an innovative, integrated view of our assets and liabilities. We cut $300 million annually in investment fees, exited hedge funds, and eliminated high-fee Wall Street investment managers. We promote good governance in the companies in which we invest to improve value and further cut risk in our portfolio; and we’ve designed a carefully measured policy to reduce it even more.

We’re in a tough economic environment, and we know it will be hard to achieve strong returns over the next few years. As a Board, we’ll be examining our assets and liabilities from every conceivable angle, reviewing every economic assumption out there, to strengthen our fund and meet our obligation to our 1.8 million members.

Even as fiscal conservatives, we are committed to defined benefit plans. We strongly believe everyone should have a secure retirement. But we’re also committed to honestly and openly tackling the financial issues we face. The continued focus on the past distracts from all the work we’ve done to tackle the future head on.

Richard Costigan is chair of CalPERS Finance and Administration Committee and former deputy chief of staff for Governor Arnold Schwarzenegger. Dana Hollinger is vice chair and a Governor appointee to the CalPERS Board representing the insurance industry. Bill Slaton is a Governor appointee representing local governments.

Yes, I copied the full response.

I liked how they elided the discount rate issue, because that issue is entirely about financial security.


I’m going to pull in my knowledge from annuities, which I’ve worked on. I happen to know that one of the worst insurance company failures involved annuity promises that the insurer couldn’t make good on.

What essentially happened was this: Equitable Life UK had a popular annuity product that guaranteed a minimum annuity payment rate, and they valued that guarantee at zero. After all, that guarantee would only actually be worth something if interest rates dipped below 6% (or so), and that would never happen, right?



Anyway, not only did one of the oldest insurance companies get brought down for making promises they never made full provision for, the actuarial profession in the UK is no longer independent.

But here’s the deal: Equitable Life UK, just like insurers in the U.S., was required to hold reserves and capital for the promises they made. It just so happened both the insurer and the regulators were very wrong in determining how to value these. And actuaries were complicit in this, because it was their approaches that were deficient.


Anyway, insurers are supposed to hold the expected value of their promises (aka reserves), though reserves often have a certain amount of conservatism built in. And then they have to hold risk capital on top of that. This is supposed to cover a certain amount of deviation from expected. It’s not supposed to make failure impossible, but to make it less likely and also give a mark for when regulators step in and make insurers do their best to fix things.

Both insurance in the U.S. and private pensions have external funds that take over when their systems go insolvent: state guaranty funds in the case of insurers and the PBGC for private pensions.

They don’t necessarily make the promises whole, but they do prevent people from getting nothing. These guaranty funds, and the related regulators, have an interest in making sure that insurers and private pension sponsors put in as much assets to back those promises before they go belly up. (Because an insolvent plan gets their assets taken over by the backstop.)

There is no such backstop for public plans, other than the taxpayers.


So here’s a thing. That previous NYT piece on the closed pension that wanted to exit Calpers (and then did) talked about needing more money than what they were charged on a going-concern basis.

That plan sponsor did ultimately pay the money to Calpers and exit, so the handful of retirees from that plan should be getting 100% of their promised payments via Calpers.

That was the orderly exit, and yes, it was expensive.

But here’s another way it can go: reduced benefits when you can’t pay the exit fees.

CalPERS poised to cut retiree pensions in tiny Sierra town

She understood that Loyalton had broken with the California Public Employees’ Retirement System three years ago. She just didn’t know that her former employer’s departure from the nation’s largest public pension fund would cut into her own retirement.

That part of the deal was not clear until she and four of her peers received letters this month warning them that the Sierra County city’s failure to pay into CalPERS soon would lead to a reduction in pensions for her and four of her former peers.

“If I lose it, then I’m really in trouble,” said Jardin, 71.

The Loyalton retirees soon may have the unwanted distinction of becoming the first in the state to see their promised retirement benefits slashed because of their former employers’ inability to pay into the public pension fund.

Loyalton’s tiny city government is one of three agencies that are so far behind in payments to CalPERS that the fund is taking steps to reduce pensions for former workers.

Of the three, Loyalton faces the biggest bill if it wants to protect its retirees. It owes CalPERS a hefty termination fee of $1.6 million.

That’s equivalent to about $2,100 for each of the town’s 750 or so residents. It’s a sum that far exceeds the city’s resources, said Loyalton City Councilman and at-risk retiree John Cussins.

“Five retirees and the obligation is a million-six-sixty-one. Wow,” CalPERS board member Bill Slaton said at a public meeting earlier this month, drawing out the syllables in the sum.

Around the state, other local governments are watching how CalPERS handles Loyalton. It’s regarded as a bellwether for how the fund may work with financially distressed cities that cannot keep up with their pension obligations.

The ranks of those cities may grow as CalPERS acts to shrink a funding gap between what it pays out every year and what it earns from its member agencies and its investment returns. In recent years, investment income has lagged at less than the fund’s target of a 7.5 percent return rate, raising the prospect of a hike in fees for CalPERS members.

Loyalton’s pension problem “is a huge deal for anyone concerned about pensions bankrupting small cities and special districts,” said Republican Assemblyman Brian Dahle of Bieber, whose staff is working with the Loyalton pensioners. “If this goes down and CalPERS retirees start losing what they were promised, it will be a disaster.”

CalPERS’s board of directors in November is expected to vote on what to do with delinquent Loyalton, the California Fair Financing Authority and the Niland Sanitary District from Imperial County.

At a preview to that vote this month, the main question from the fund’s board members centered on why CalPERS had not acted faster to shrink its expenses for out-of-compliance members. Loyalton’s City Council voted to leave the fund almost three years ago and has not paid CalPERS since.

So yes, it is an option to stop paying Calpers. And Calpers will reduce retiree benefits in line with that.

Again, Calpers shows what it thinks the pension promises are really worth when somebody exits. I don’t necessarily have an issue with that valuation.

I have an issue that they didn’t recognize that value all along.


The disaster is not these high exit fees. Those exit fees should be high — not as a deterrent, but because these promises really are that expensive.

The disaster is that all these years, Calpers has been telling sponsors that the cost of paying for the pensions was a lot less than it actually is. The contributions should probably be a lot higher for lots of sponsors, not just the exiting ones.

Let’s take a look at what Calpers is telling sponsors to pay:

The Public Plans database doesn’t have payment info beyond 2013 as of right now, but the point is that the percentage of payroll to be paid has been climbing. The funding ratio has been eroding, even in these years of good returns.

It’s all very well for Calpers to say to look forward, and yes, they should, but part of dealing with the disaster of telling sponsors that the pension promises were a lot cheaper than they were is to look at the past behavior so you don’t do it again.

Those required payments are only going to keep climbing, and the disparity between how the pensions should be valued and how they are valued is one of the drivers behind that climb.


So let me give one of the people involved with the Public Plans Database her reaction time. From Alicia Munnell:

Appropriate discount rate for public plans Is not simple

The New York Times’ recent article “A Sour Surprise for Public Pensions: Two Sets of Books” told the tale of the tiny six-employee Citrus Pest Control No.2 pension fund that thought it was overfunded but instead received a large bill when CalPERS calculated its termination liability.

The article has already been criticized as “remarkably fact challenged.” First, CalPERS does not keep two sets of books. Rather, it uses a very conservative methodology to calculate withdrawal liability for plans (covering about one third of participating workers) that have essentially contracted out the management of their pension fund to CalPERS and then decide to withdraw. Second, the termination liability for these participating plans has been disclosed on CalPERS’ website for many years, so the tiny plan was not the victim of a nefarious plot.

More serious than the factual errors, however, is the implication that the “two sets of books” is an admission by CalPERS that it should be using a riskless rate for valuing and funding its plan. That is a simplistic assessment of a complex issue.

For financial reporting purposes, the argument is compelling that the benefits of public pension plans, most of which are guaranteed under state law, should be discounted by a rate that reflects their relatively riskless nature. Such a valuation would produce relatively low funded levels. A more conservative measure of the funded status would deter plans from offering more generous benefits in response to supposed “excess” assets, as happened during the 1990s when seemingly “overfunded” plans increased benefits. A lower assumed return would also reduce the incentive for plans to invest aggressively. And using a near riskless rate of return would inspire confidence in the reports of state and local plans by reporting liabilities in accordance with the latest finance principles.

The argument for using a riskless discount rate, however, pertains to reporting – investing and funding are different issues. Discounting the stream of future payments by the riskless rate does not mean that plans should hold only riskless assets. A number of considerations suggest that they should continue to invest in equities. For example, if the future resembles the past, the cost of funding pension liabilities will be lower than with an all-bond portfolio.

That said, the long-run returns assumed by state and local plans – currently the average is 7.6 percent – are too high. These rates should be reduced to 6 percent. In 2015, CalPERS’ board took steps that could reduce the rate from 7.5 percent to 6.5 percent, but the transition could take more than 20 years.

Public plans could reduce a lot of the criticism of not using a riskless rate for funding if they adopted more realistic return assumptions and explicitly recognized the risk that they hold in their investments by establishing some risk-sharing provisions if things turn out badly. Articles like “Sour Surprise,” however, do not help the process one iota.

Here’s John Bury’s response to Munnell:

Ms. Munnell is dangerously mistaken on both counts.

1. Selecting interest rates for public plans is as simple as it gets. Actuaries are told what rates to go with it and it is up to them to justify the use of those rates using jargon as arcane as necessary.

Exposing the actuarial profession’s capture by their clients is an essential first step in explaining how pension plans got to 30% funded ratios (both for public and multemployer plans).

What is not helpful is analysis like this:

“Determining funding contributions is a trickier issue. Academic models suggest the calculation should use a riskless rate. But contributing based on the riskless rate while investing part of the portfolio in equities produces ever growing funded levels. That outcome may sound great, but one of two things will happen. Politicians will raise benefits, increasing the commitments of public plans. Or they will reduce the contributions for successive generations, creating serious equity issues.”

A little thought here:

Going to a riskless rate would require about 99.99% of plans to start paying off huge unfunded liabilities over decades. Is it benefit increases in 2055 that Ms. Munnell fears?

Has any politician ever uttered the phrase: “I know the actuaries tell us to put in $2 billion but, dammit, think of grandkids, let’s put in $5 billion.”?

What Ms. Munnell has attempted to do is cut off a perfectly legitimate line of questioning with specious reasoning designed to maintain the status quo.

And to quote Dr. Horrible, the status is not quo.

A quote from one of the anonymous pension actuaries at the Actuarial Outpost:

Munnell seems to think that you use the risk-free rate in conjunction with all the detritus presently embedded in the standard actuarial model (including, e.g., amortizing unfunded liabilities as level percentage of 30 years of rising payroll). She should understand that those advocating the risk-free rate would generally use TUC, pay for G&L over very short, if not immediate, period, and hedge accrued liabilities as much as is practicable.

Not withstanding whatever misunderstanding she brings to the table, her proposals are ludicrous.

Not withstanding that they are ludicrous, ASB may require something similar: disclosure of accrued liabilities at the risk-free rate (“solvency liability”) in a vacuum (both textual and intellectual).

I have gotten to the point where I wonder whether any government entity can really be making these sorts of promises. A big part of it isn’t the very technical argument of how the pensions should be valued, in a mathematical sense.

It has to do with the very human and practical issue of alignment of issues. These are mitigated in insurance and private pensions because there are third parties outside the sponsors who set the rules for valuation and conduct oversight of the companies or plans.

There is no such independent group when it comes to public pensions.


This is a bit of a sideline, but I want to highlight what kind of oversight exists for Calpers.

The LATimes has been putting out good articles about Calpers and its history:

How a governor’s bid to exert control over California public pensions backfired

Gov. Pete Wilson tried to wrest key powers from the CalPERS board. A labor-led counterattack left the board more independent than ever.

Facing an unprecedented budget deficit shortly after taking office in 1991, Republican Gov. Pete Wilson made an unusual request of the state’s largest pension fund: Can you be more liberal in your predictions about the stock market?

If the California Public Employees’ Retirement System raised its official projection of investment growth, Wilson said, the state’s required contribution to the pension fund would go down by more than $300 million.

CalPERS rejected the idea, but Wilson still needed a way to balance the books. So he proposed a sweeping reorganization of CalPERS that attempted to grab more than just pension cash.

What happened next helped chart the course of pension politics over the past quarter century — and ensured that the autonomy of public pension funds would be spelled out in California’s constitution.

But the money was only the beginning. Wilson’s plan included two major changes to CalPERS operations: Forcing the fund to transfer control of actuarial projections — the prediction of investment profits — to his own administration, and a reorganization of the pension fund’s board of directors so a majority of its members would be appointed by the governor.

The changes to the board would have diminished the power of public employee unions, from whose ranks came many of the pension fund’s directors.


Proposition 162: The ‘potential costs are unknown’

In October 1991, critics of Wilson’s pension proposal filed a ballot measure that sought to permanently block the structural changes to CalPERS that the governor had sought. That year’s fight had suggested to labor that the pension fund’s autonomy needed bolstering in the state constitution.

The proposal qualified for the Nov. 3, 1992, statewide election as Proposition 162. It passed by a single percentage point.

The campaign pitch was straightforward, even though the ballot measure language was arcane. The language was also ironclad, giving directors “the sole and exclusive power over the management and investment of public pension funds.”

Prop. 162 covered dozens of local government pension funds too, assuring their independence from elected officials in cities, counties and special districts.

Perhaps even less understood was how the 1992 ballot measure would change the pension funds’ core mission.

For decades, CalPERS and local pension agencies had been required to balance three co-equal responsibilities: Provide retirement benefits to government workers; minimize the contributions needed by state and local governments; and spend reasonably on administrative operations.

The initiative revised those marching orders, amending the state constitution to decree that a pension fund’s responsibility to workers and their families would “take precedence over any other duty.”

The implication seemed to be that pension directors were no longer required to balance benefits with costs.

Prop 162 also gave CalPERS permanent control over the actuarial projections of its investment returns. Compared to some of the other pension funds in the country, Brainard said, CalPERS is “quite independent.”

The 1992 campaign also made it more difficult to reconfigure the pension board, where six of the 13 seats are reserved for public employee representatives and offer at least an indirect connection to politically powerful unions.

I highlighted a few things.

Note that one of the goals used to be minimizing contributions needed to be made. It’s a practical political goal, and one that’s usually there for public pensions but rarely explicitly made public.

But one of the main upshots generally is that those de minimis contributions have a way of blowing up in one’s face.

In any case, I have no beef with the goal being primarily financial security for participants. Awesome. That’s what it should be.

A FAQ on Calpers governance:

How do people get on the board?

Six of the 13 members are elected by active and retired employees to represent different constituencies, including state government workers, civil servants at other public agencies, and school employees.

The governor appoints two members: a local elected official and a representative of the life insurance industry. Legislative leaders select a member to represent the public.

That makes nine.

The remaining four members — the state treasurer, the state controller, the director of the California Department of Human Resources and a representative of the State Personnel Board — serve ex officio.

Which way does the board lean?

Its makeup is supposed to ensure a diversity of views and balanced decision-making. In practice, the board is heavily influenced by organized labor. The president, Rob Feckner, is a former bus driver for the Napa Valley Unified School District and a former president of the California School Employees Assn. He was elected to the board by school employees.

Two other board members elected by public workers, Michael Bilbrey and J.J. Jelincic, are former presidents of large public employee unions. Another, Theresa Taylor, is vice president and secretary-treasurer of the Service Employees International Union, Local 1000, which represents 95,000 state workers. Ron Lind, who was appointed by legislators, is former president of the United Food & Commercial Workers International.

I don’t even have an issue with the board being union-dominated. These people have a direct interest in making sure the pensions get paid. That should be the goal of the plan.

But here’s a problem:

What financial knowledge do these people have?

I am not assuming that these people have no relevant financial knowledge, skills, training, etc. But I wonder.

It’s one thing to be on a board, and get the tailored education that management gives the board members. It’s another to have broader knowledge so that you’re not taken in by plausible stories and strategies, like pension obligation bonds.

And the fix is not to get more politicians involved in the board (who can get captured by the unions, after all.)

The thing is, there’s no good fix for governments sitting on huge pots of money. This is why generally one wants them to be spending the money on stuff (services, buildings, etc.) rather than amassing that pot for all sorts of shenanigans, like divestment pushes and politically-favored investments.

There’s really no getting away from politicians messing about with stuff when you’ve got a huge pool of money and influence to throw around. That’s one of the reasons I favor DC-type plans for governmental employees, though there still are political footballs to be had there.

But I’m still thinking this through…my own realization from public pension fund behavior and problems of alignment of interests is what turned me against Social Security privatization.

Quis custodiet ipsos custodes?

But here’s my bottomline point: the ultimate problem of public pensions isn’t the discount rate, but that there cannot be any outside body that can oversee such plans.

Government is the ultimate authority. They make the rules. The only checks/balance there is the natural feedback loop from voters and taxpayers.

I used to think that the actuarial profession might be able to be that external body. But let’s face it: the actuaries are way outnumbered, even if we had the gumption to take on politicians.

Yes, there are plenty of us actuaries who don’t work in public pensions who don’t have trouble calling out public pension valuation practice, but we’re not the ones trying to get clients. Somebody like Robert North is very rare. (YAY BOB!)

We can have all the integrity in the world, but if nobody listens to us… well, we’re not much of a check, are we?

Another possible check on public pension practice is the municipal bond market, but there are problems there, too. Not all pension sponsors issue bonds, to begin with.

In any case, Calpers should definitely be looking forward – no issue with that. But that looking forward should include the reality that many of the plans participating in Calpers really can’t support the increasing contributions that Calpers will demand. It looks like Calpers can actually reduce pension benefits, no matter what the California constitution says, so I guess that’s one resolution.

But it’s likely to create a political backlash.

I suppose that’s the only oversight we can expect.

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