The 7 Percent Non-Solution

After we wrote about CalPERS’s plan to employ debt leverage to improve its chances of earning its investment return assumption of 7 percent per annum, some of you asked if earning that return would close the gap (“unfunded liability”) between the assets CalPERS manages to meet pension liabilities owed by the employers for whom CalPERS administers pension obligations.

The answer is “no.” In fact, CalPERS has to earn much more than 7 percent for the unfunded liability not to grow. That’s because CalPERS discounts pension liabilities at the same rate as the investment return assumption. As a result, once liabilities exceed assets, assets must earn more than the investment return assumption to keep the unfunded liability from growing.

As an illustration, page 115 of CalPERS’s latest Comprehensive Annual Financial Report discloses a “Funded Status “ of 70.2 percent, which means CalPERS invests assets of $70.20 for every $100 of pension liabilities. The difference — $29.80 — is the unfunded liability. Because the $100 in liabilities is a discounted present value derived by using a 7 percent discount rate, liabilities will accrete (grow) another 7 percent over the following year. Hence, a year later liabilities will be $107. To keep the unfunded liability at $29.80, assets would have to reach $77.20, which would require a return of closer to 10 percent. A more detailed description is available here.

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Originally posted on Medium, 7/8/20.