It’s The Lie That Gets You

How Funded Ratios can decline even when stock markets rise

The stock market is 70% higher than ten years ago yet CalPERS’s Funded Ratio (the ratio of assets to liabilities) is 20% lower than ten years ago. How does that happen? The answer is super-rapid liability growth.

That growth happens because public pension funds suppress the value of pension liabilities when they are created. They accomplish that by linking the discount rate used to value liabilities to the rate they expect to earn on assets. Later, those suppressed liabilities snap back with a vengeance.

As explained here, the discount rate should not be linked to the expected return on assets. For example, look at footnote 21 on page 72 of Berkshire Hathaway’s 2016 annual report, where that company reports the assumptions it makes with respect to its defined benefit pension plans:

2016 Berkshire Hathaway Annual Report, page 72

Notice how the discount rate is different — and much lower — than the expected return on assets. That’s because pension obligations are supposed to be discounted to present value at a rate reflecting the likelihood they will be paid. No matter how well Berkshire expects to perform from investing assets set aside to meet pension obligations, it owes the pension obligations. The same is true of pensions owed by California governments but, in stark contrast, see page 17 of CalPERS’s most recent annual report:

“The actuarial valuations are very sensitive to the underlying actuarial assumptions, including a discount rate of 7.65 percent, which represents the long-term expected rate of return.” [emphasis added]

Notice how CalPERS is choosing to value liabilities at the same rate as it expects to earn on assets. That’s like you owing $100,000 on a mortgage but because you think you’re going to earn twice as much as the mortgage interest rate from investing your cash in the stock market, you report your mortgage at only $50,000. That’s neither true — you owe the mortgage obligation regardless of how well or poorly you invest your other assets — nor sustainable.

As Nixon said, it’s the lie that gets you. CalPERS’s lies harm citizens.

By linking discount rates to investment return assumptions, CalPERS and its sister pension fund, CalSTRS, are being untruthful. The lies get exposed when citizens get hit with pension deficits. Californians are experiencing the pain as school districts, cities and the state cut back spending on classrooms, teachers, colleges, universities, parks and courts to finance pension deficits.

Journalists and elected officials must understand that the discount rate and the investment return assumption play two different roles. Public pension funds must de-link discount rates from investment return assumptions.

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