CalPERS’s Unfunded Pension Liabilities
CalPERS, California’s state-run pension fund that manages pension assets set aside to meet pension liabilities owed by the state and other California governments, just published a Funding Progress report as of June 30, 2015:
Viewers can see that Liabilities (AAL) rose at a faster rate than Assets, even though CalPERS earned a 6.2% annual return on Assets over the same period. That led to a near-quadrupling of Unfunded Liabilities (Unfunded AAL), from $29 billion to more than $111 billion.
Rapid liability growth results from CalPERS choosing a high discount rate to suppress the initial valuation of pension liabilities. Here’s how it works:
Let’s say you owe $100 in two years. To calculate the present value of that obligation, you must choose a discount rate. The discount rate is supposed to reflect your creditworthiness. If you are a good credit, a low discount rate is appropriate. If you are a bad credit, a high discount rate is appropriate. Let’s say you’re a good credit that can borrow money at 4.25 percent. At that discount rate, a $100 liability due in two years would be valued at $92 today, $96 in one year, and $100 on the due date. In contrast, let’s say you’re a weak credit that has to pay 7.5 percent to borrow money. A $100 liability due in two years would be valued at $87 today, $93 in one year, and $100 on the due date. Ie, the lower the rate, the higher the initial value, the slower the growth. The higher the rate, the lower the initial value, the faster the growth. The growth of a discounted liability is known as “accretion.”
Even though the the State of California is an excellent credit, CalPERS chooses a high discount rate. By doing so it suppresses the initial value of pension promises but at the cost of faster growth (accretion). (This is explained in more detail here.) Once there is a gap, CalPERS must earn even more than its expected rate of return for the gap not to grow.
Because unfunded pension liabilities attract interest at 7.5 percent, ~$300 billion will be diverted from services to pay off $111 billion of liability.
NB: CalPERS’s figures are from 18 months ago. Unfunded liabilities have grown since then.