Wait…What was that?

The contestation of discount rates in states and municipalities is completely based in speculation.  All projected return rates from markets are, just as titled, presumptive.  The true issue at hand is whether or not to operate the pension fund accounting in a conservative or risky manner.  Surely, in 2010, when the average return rate was 2.3% for the fiscal year, even the GASB recommendation of lowering the average discount rate to as low as 5% could be considered risky.  However, by the close of fiscal year 2011, the average rate of return was 8.3%, making the GASB recommendation far too conservative for smart financial planning.

In a historical look at market fluctuations, cycles, and trends, we reveal the true nature of returns.  Excluding the shortsighted view of returns from the average annual market growth of the past 10 years, which is 4.5% and the past 5 years, which is 2.3%; growth has historically maintained above 8% from 1899 to the present.  If concern is posited regarding the Great Depression, from year-end 1928 to 2011, the average rate of annual return still remains 8.8%.  Removing the three years following October 1929, from 1932 to 2011 the average return rate is 11.1%, of course still including the recent bear market.

While all bear markets are troubling, they are the status quo of markets when coupled with bull markets.  States and municipalities must therefore look solely to their own investment strategies and capabilities when setting the discount rate on pensions.  In Washington State, as stated, the teacher’s union pension still remains above the 8% average return over the past 30 years, while still including the recent bear market.  In their case, adjustment would not be prudent.

However, states have adjusted their discount rates in light of the past 5 years.  Looking at the largest public pension fund in the country, state of California’s massive California Public Employees Retirement System (CalPERS), less than a month ago, the discount rate was lowered from 8% to 5.75%.  This rate was changed in combination with a sweeping pension reform that is projected to save California up to 45 billion dollars over the next 30 years.

Why did Gov. Brown decide to go conservative on the discount rate?  The answer to that is two sided.  First, the decision to lower the rate was in response to the recent budget crises that California has faced.  By lowering the rate, California is now obligated to amortize the pension liabilities at a higher rate in the future.  This boils down to having the money available if and when the money is needed.  It also allows for California to experience surplus returns, which can be used to further secure CalPERS.

The second facet of the lowering of the rate involves the public employee payment into the pension fund.  For contracting agencies and school districts, the intent would be to increase the employee’s contribution to 50% of the total annual normal cost through collective bargaining.  However, if that is not accomplished through negotiation by 2018, the employer could increase employee contributions up to 8% of pay for local miscellaneous and school members, up to 12% of pay for local police, firefighters, and county peace officers, and up to 11% of pay for all other local safety members.

Currently, public employees in California pay between 9 to 13% of their annual normal cost.  This increase, which in actuality is a fair and balanced approach, will once again help to maintain CalPERS far into the future.  So while California decided to lower the discount rate to increase their financial obligation, they also raised the normal cost payments of beneficiaries.  In essence, California has broken more than even on contribution to CalPERS, and has secured their pension fund.

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