On July 20, 2022, the California Public Employees’ Retirement System (CalPERS) announced a 6.1% investment loss for FY2022. This is the 5th time in 30 years that CalPERS incurred a loss. The prior losses were in FYs 2001 / 2002 (the dot-com bubble burst) and FYs 2008 / 2009 (the Great Recession). The 30-year history of the CalPERS investment return is shown in the graph below.
The FY2022 loss followed a very strong FY2021, when CalPERS generated a 21.3% return. Call it reversion to the mean, market correction, or beginning of a recession… the future will tell.
The loss almost completely wiped out the progress made last year, pushing the California’s public pension system from 82% to 72% funded level, just slightly above the 71% level of 2020.
The loss was centered around very poor returns in the public stock and fixed income portfolios (-13.1% and -14.5%, respectively). The public securities losses were offset by very strong private equity and real estate returns (21.3% and 24.1%, respectively). It should be noted that the private equity and real asset return calculations usually lag by a quarter and still could be adjusted.
To quantify what the 6.1% investment loss means for your agency, it is important to understand the math of pension plan funding within the CalPERS system.
In order for the pension system to stay on track and avoid significant unfunded accrued liability (UAL) increases, CalPERS needs to average 6.8% in annual investment returns. This target is called the discount rate, or the minimum average rate of return that CalPERS needs to achieve in perpetuity so that its member agencies could meet their retirement obligations to employees, retirees, and other beneficiaries. Every time that CalPERS misses the return target, additional UAL is created.
A funding shortfall happens and new UAL is created every time that the investment return for the fiscal year drops below 6.8%. Thus, the FY2022 funding shortfall was 12.9% (6.8% discount rate plus 6.1% investment loss).
To approximate the FY2022 loss impact on your UAL, you need to multiply the market value of assets within your pension plan by 12.9%. That will be the approximate UAL amount that will be added to your pension plan for the year. For each $1 million in pension plan assets, roughly $129,000 in new UAL will be added to each agency’s account. This is not an insignificant amount by any stretch of imagination.
The new UAL will first be reflected in the 2022 actuarial reports, which CalPERS will publish in July/August of 2023.
If CalPERS continues to follow its current amortization practices, the FY2022 UAL will be amortized over a 20-year period starting with FY2025, with a five-year payment ramp-up. The 2025 UAL payment will be 20% of the full payment amount, the 2026 payment will be 40% of the full payment amount, the 2027 payment will be 60% of the full payment amount, and the 2028 payment will be 80% of the full payment amount. Only in 2029 will the payments be fully phased in and continue at that level for 15 more years.
Even though the cash flow impacts of the FY2022 investment loss will not be felt for awhile, the total cost impacts have already begun accruing. CalPERS starts charging its member agencies interest on the UAL as soon as it is incurred. The interest rate is the same as the discount rate, 6.8%.
On July 1, 2022, the new UAL started working against you. The situation is made worse by the negative amortization practice of CalPERS. Even though the interest starts accruing immediately, no payments are required until FY2025. Each year the accrued interest gets added to the UAL balance, and the following year you will be charged interest on top of that interest as well. Because of the payment delay and the ramp-up, each agency is put into a negative amortization situation that will end up costing additional money for two decades. This makes getting to the fully funded pension plan level even harder.
The poor 2022 performance will result in lower funded status of pension plans, higher UAL balances, and higher future UAL payments, as the effect of the loss will be spread over the next two decades. There should be no change to the Normal Cost contribution rates due to the investment loss.
The impacts of the FY2022 investment loss are illustrated below:
Each agency’s response to the UAL increase should be developed and evaluated in the overall context of your specific situation, taking into consideration your reserves, revenues, cash flows, capital improvements program, outstanding debt obligations, etc. The higher future UAL payments need to be reflected in the fees and rates that you are charging.
At the very least, you may want to take the following steps:
Ridgeline Municipal Strategies, LLC can help you evaluate the impacts of the FY2022 investment loss on your pension costs and implement appropriate pension cost optimization and mitigation strategies. You can contact us at 916-250-1590 or info@ridgelinemuni.com.
Ridgeline's assessment of CalPERS' FY2024 investment performance and its impact on the CalPERS member agencies.
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