Pension systems face these same decisions when they weigh what investment portfolio to adopt. For CalPERS, factors such as risk and obligations are weighed every four years during our Asset Liability Management (ALM) process.
What Is Asset Liability Management?
We completed the ALM review this past December, when the CalPERS Board of Administration approved a new investment portfolio. This portfolio will be implemented starting July 1, 2018.
As part of the process, the board received an in-depth review of CalPERS assets (what we invest in) and liabilities (what we pay out in pension payments) from our investment, actuarial, and finance teams. The Board also examined other factors such as market projections, member and workplace demographics, and input from consultants and stakeholders.
The board then reviewed four investment “candidate portfolios.” One took on more risk than the current portfolio, one kept the risk level about the same, and two portfolios had less risk than the current portfolio.
For example, the riskier portfolio would increase the amount of stocks held, and lower the amount of bonds. This is riskier because stock prices shift more than bond rates. The benefit is that the portfolio could return more. The risk is the portfolio could have a much lower return if there is a downturn in the economy.
Each candidate portfolio was made up of different asset allocations and various risk levels. Board members weighed each portfolio carefully. Ultimately, they were looking for the portfolio that would best achieve three goals: protect the funded status of our plans; stabilize employer contribution rates; and achieve the long-term rate of return.
Considering each of these factors, the board voted to adopt a portfolio that was closest to CalPERS’ current asset allocation and takes on a similar amount of risk. This portfolio projects a long-term investment return of 7 percent.
Discount Rate: A Key Component of ALM
In December, the board also determined the discount rate, which helps determine how much employers contribute to the pensions they have promised their employees. The board voted to maintain the decision made in 2016 to move the discount rate down to 7 percent over the next three years.
This decision was made after hearing extensive comment from employers. CalPERS’ employers are the cities, schools, and other public agencies that contract with us to administer the pensions they have promised their employees. Employer feedback was important because if the discount rate was lowered again, employers would have to pay more to meet their pension obligations.
Employers would be responsible for the increased cost because they set the pension benefits of their employees. It is a common misconception that CalPERS makes this decision to set employee benefits. The truth is that CalPERS only administers the benefits, which are funded through a mix of employer contributions, employee contributions, and investment returns.
Improving the Stability of the Fund
It’s clear the CalPERS Board had to weigh several factors and interests while making important decisions about the investment portfolio and the discount rate. Risk, obligations, the investment market, and costs to employers were just a few of the important considerations at hand.
In the end, the board voted on an investment portfolio that takes advantage of what the financial markets have to offer, but Board members were also mindful that taking on too much risk would be harmful to the Fund.
The board also considered costs to employers. Employers told Board members that lowering the discount rate more than 7 percent would make it very challenging to meet their payments.
While there are many factors at play, the CalPERS Board puts one priority above all else—they focus on their fiduciary duty and stabilizing the Fund so pensions can be paid for generations to come.