The governing board of the California State Teachers’ Retirement System (CalSTRS, the pension fund that provides benefits to retiring California educators) has made the decision to lower the rate of return from the current 8 percent to 7.75 percent — a decision that experts like CalSTRS Chief Investment Officer Chris Ailman and CalSTRS Deputy CEO Ed Derman believe will help stabilize the fund over the long haul. We spoke with Ailman and Derman to help CTA members understand the situation and what’s being done to improve the position of the pension fund through these tough economic times.
What does the rate of return mean?
Chris Ailman: There are two inputs into a retirement fund, contributions and investment earnings, and the Teachers' Retirement Board uses the rate of return assumption to set the average future earnings for investments over the next 30 years.
This is a difficult assumption to get right, but a key one to the health of the system, so the board looked at 120 years of past financial information and talked to many financial industry experts in the 10 months leading up to the recent changes.
In this case, the lowering reflects the recognition that CalSTRS investment returns will be more modest than the 9.1 percent that we’ve achieved in investment return annually over the past 30 years. Since 1995, our actuary has predicted an 8 percent return on investments, which would paint a rosy picture had it not been for the drastic economic downturn of 2008-09, which is forcing the hand of many a pension system, including CalSTRS, to downgrade its forecast of income from investments.
And because investment returns account for the majority of the income the system uses to pay benefits, it means there will be more pressure to make up that lower rate from the system's other sources of income — its employers, the state of California, and possibly even its members.
What amount will the rate of return be lowered from and down to?
Ed Derman: The Investment Return Assumption, which we use to plan our funding over the next 30 years, has been set at 8 percent since 1995. It was revised downward to 7.75 percent on Dec. 2, 2010.
Chris Ailman: Keep in mind that while this is a forecast, year in and year out, our goal remains the same: to beat the markets and generate the highest return for the level of risk we're comfortable taking.
What effect do you feel lowering the rate of return will have on the fund short and long term?
Chris Ailman: In the short term, the effect is very little, so we do not expect to make any changes to the current year investment plan. Our task now is to meet or exceed a 7.75 percent rate of return for the next 30 years, but for the investment staff, we know we still need to make an additional $10 billion this year.
Long term, it does have profound impact. You have to realize it was a very difficult decision for the board. They reviewed this over 10 months. As I mentioned, there are just two inputs to a retirement fund — so if you expect less from investments, it puts more pressure on contributions. Since our rates are set by law, it raises the urgency for CalSTRS to work with the California Legislature, the governor and its members to develop solutions to contribution rates that everyone can accept.
We know it's very tough on teachers and the California education system, and the last thing anyone wants is higher contribution rates for the state, school districts and educators. But the bottom-line lesson from the 2008 financial crisis and the first decade of the 2000s was that the overall cost to retire went up for everyone, teachers and the general public.
Will lowering the rate of return mean that teachers inevitably contribute more?
Ed Derman: The lawyers who have reviewed this for CalSTRS have concluded that the contribution rates charged to existing members cannot be increased to pay for the benefits that are already in place. Therefore, existing teachers would not be called upon to contribute more to pay for the liabilities associated with the current benefit plan. Higher contributions can be imposed on new teachers, however, as well as employers and the state. If the rates don't change at all, CalSTRS will eventually deplete the trust fund and retirement costs would fall entirely to the state. The rates will need to go up for new members, because none of us can expect investment returns to generate a double-digit return for the next two decades. However, only the Legislature can increase contribution rates.
What is the amount of the unfunded liability?
Ed Derman: We won't know the current unfunded liability until we complete the valuation — a snapshot of the health of the system — in the spring of 2011. If the new, reduced investment return assumption had been applied to the last valuation, it would have increased the unfunded liability from $41 billion to $45 billion. CalSTRS is currently funded at the level it was funded in 1990.
Can you give us a simple analogy to explain the situation with the unfunded liability?
Chris Ailman: The Investment Committee here at CalSTRS knows I love to use analogies, so let's use a mortgage. For all of us, the bank or mortgage company tells us how much we need to pay. In the CalSTRS case, the actuary tells us the rate, which we call the normal cost of the pension. However, since about 2000, we have been paying less than the required rate, in other words underpaying the mortgage bill. Since it's financed over 30 years that underpayment compounds to a big number. Looking at it today, the bank, or our actuary, says we need to pay more per month to pay off the mortgage and make up for the lost ground from the past few years.
When was the unfunded liability at its lowest?
Chris Ailman: In 2000, CalSTRS had a $1.9 billion actuarial surplus. In its 96-year history, CalSTRS has been fully funded only three years before the decade of the 2000s. The Internet bubble and 9/11 plunged the country into a major recession and the investment portfolio declined.
How do you get the fund back up to a respectable amount?
Chris Ailman: Pension experts consider 80 percent funding to be a healthy level. This latest move puts CalSTRS at the 76.5 percent funding level, increasing the gap between the assets at hand and the pension obligation, which hasn’t changed. Sure, that's below what's considered healthy, but it's not insurmountable. But it is important to remember that the specific funding level is not as important as having sufficient funds to be able to pay benefits into the indefinite future, and given our current assets and liabilities, that is not the case unless contributions are increased.
A pension plan should range between 80 percent and 100 percent to be considered a healthy plan — 90 percent would put us right there. As mentioned before, there are just two ways to get there. One is bringing in more contributions, and obviously, that will take time. The other is through higher than expected investment returns. It's not insurmountable. We did it before, in the 1980s through the 1990s, with nearly double-digit average annual returns. However, the past 120 years of U.S. stock market history and our current environment tell us it is not reasonable to expect that pace of investment income to return. I want to point out that the current economic malaise is also not likely to persist for decade after decade. To make a higher than expected return we either take on more risk or find opportunities to generate profit that others miss. The board has already decided we don't want to take on more risk to try to earn a higher return. So the key to better results is to tactically manage the portfolio in the global market and find growth opportunities around the world. I think our diversified portfolio will find pockets of opportunity as it has in the past. I wish I could tell you we can make it back to 90 percent funding as fast as we did in the 1980s to 1990s, but right now that is not very likely.
Is there a silver lining to all this?
Chris Ailman: First of all, I'd like to remind our members that CalSTRS has been around since 1913 and survived the Great Depression without missing a payment, so we'll survive this crisis. I also want to assure our members that their defined benefit is guaranteed by both the California and U.S. constitutions as well as through case law. The state of California, as the system's guarantor, will be obliged to pick up the tab should all of the assets of CalSTRS be depleted. Finally, even though rates may go up, or new members may be faced with 401(k)-type defined-contribution plans or higher contributions, our current members can count on the defined benefit they signed up for.
Facts on CalSTRS changes
CalSTRS has lowered its expected rate of return from 8 percent to 7.75 percent.
What this means for the pension fund: As the unfunded liability continues to increase, CalSTRS members, the California Legislature and the governor will need to develop solutions to contribution rates that everyone can accept.