The state of California’s retirement plan, Calpers, recently announced that it will gradually lower its projected investment returns. The annual return projection will be lowered from 7.5% to 6.5%, though the process will take place over many years.
The lowering of projected investment returns is really a reflection of reality. In recent decades investment returns have been quite good from virtually all categories. These include stocks, bonds, real estate, and private equity.
Strong investment returns over the past 30 years have to a large extent been a function of a significant drop in interest rates. This has allowed for strong performance obviously in the bond market, but has also supported higher valuations for real estate and stocks.
With interest rates near record low levels we will not have the benefit of lower rates going forward. In addition the growth rate of the U.S. and other developed countries has been slowing. This implies that future earnings growth for companies will be less, impacting stock market returns.
The significance of future investment returns reflects how much money the state needs to set aside to meet the retirement needs of government employees. The higher the investment returns are the less money that has to be placed in the retirement fund. Lowering the projected investment return means the state has to increase its reserves in the retirement plan.
The state of California has approximately $300 billion in its retirement plan. Unfortunately, even with that large sum of money, the state is likely over a $100 billion short of meeting its long term retirement obligations. Lowering the projected investment return to 6.5% would increase that shortfall by approximately another $60 billion.
Besides the large Calpers retirement fund, California teachers have their own separate retirement plan. Their plan is also very large with nearly $200 billion in assets. However, it will also likely be experiencing shortfalls with lower future investment returns.
The underlying issue is that most government workers are covered with defined benefit pensions, while private workers generally have 401K plans. As life expectancy rates have increased the amount of money needed to fund pensions has grown.
This problem is not unique to California, but exists for many cities and states. The problem is especially serious for the state of Illinois. This is also a problem with our Social Security system, though the federal government can more easily borrow money versus states.
To meet this long-term shortfall the state of California will have to make some choices. There are basically three possibilities. The state can increase taxes, it can reduce the size of its budget, or government employees will be faced with less generous pensions, or will have to have more money deducted from their paychecks. Most likely some combination of those alternatives will take place.
Currently the state of California is in a healthier financial position compared to how things were several years ago. We have the highest income tax rates in the country and higher income people, especially in northern California have been doing well in the technology sector, which has helped to replenish the state coffers. Unfortunately, the income of the rich in California is highly variable and budget shortfalls will likely occur again when the economy inevitably slows.
The projected retirement shortfall in California is not something that is going to create an immediate problem. It is something that will gradually intensify over a long period of time. The move by Calpers to lower its investment return projections is a move in the right direction, though they could be criticized for moving a little too slow.
When making financial projections it is always best to be conservative. This is true for everyone, whether it is an individual planning a budget, or the state forecasting its retirement obligations. With the state in a somewhat healthier position currently, now is certainly an appropriate time to consider longer-term issues.