CalPERS Board Selects Discount Rate

Rich Lee, Finance Director for the City of San Mateo

As a part of its quadrennial Asset Liability Management (ALM) cycle, the CalPERS Board recently selected a 6.8% discount rate. The discount rate is the projected return on investment (ROI) over the next thirty years, as well as the level of risk that CalPERS is willing to take in order to achieve that ROI. As a precursor to the ALM cycle, CalPERS issued a press release touting its “Toward a 7% Solution” strategy that espoused “More and better assets” that I wrote about in February 2021.

In July 2021, CalPERS reported a preliminary ROI of 21.3% for fiscal year 2020-21. At first blush, higher interest returns may seem favorable, but interest is a measure of risk, and the deviation from the discount rate means that CalPERS’ investment portfolio is taking on too much risk. As such, the Funding Risk Mitigation Policy (RMP) was triggered, which reduced the discount rate from 7.0% to 6.8%. The investment gain – the difference between the 7.0% discount rate and the 21.3% ROI, will be amortized over 20 years, with a ramp-up over the first five years (1/5th or 20% of the annual amortization amount recognized each year), beginning in the actuarial valuations with a measurement date of June 30, 2021, which applies to the pension contribution rates for 2023-24. The reduction of the discount rate will be amortized over 20 years with no ramping, as ramping for changes in actuarial assumptions was eliminated beginning in measurement periods of June 30, 2019.

With the above in context, the CalPERS Board considered a number of candidate portfolios that incorporated a variety of asset allocations and degrees of risk tolerance. It came as no surprise that the asset allocation for every candidate portfolio increased the allocation for private equity and most introduced leverage as a part of the allocation strategy:

Private equity is the only asset class that is projected to earn greater than 7.0% over the next ten years. However, it is also the asset class with the greatest volatility, hence, the higher projected interest rate given the risk.

Every candidate portfolio also introduces an asset allocation of 5% for private debt. At present, CalPERS’ private debt investments are through external investment managers and pay approximately $150 million in fees for every $1 billion in private debt over a five-year period. CalPERS intends to bring private debt investments in-house to reduce the associated management fees. Over the past two legislative sessions, the CalPERS Board has backed legislation to preclude private debt investments from the Public Records Act. In the last legislative session, the bill was ultimately pulled, as it did not pass the Senate Judiciary Committee. CalPERS has stated that it needs the exemption to be competitive with other private debt market participants, and without it, it would be difficult to attract “worthwhile private debt borrowers”. While CalPERS has stated that they do not need the legislation to bring private debt in house, they have indicated that they will continue to seek the legislative exemption.

The table below reflects the projected impact to employer contribution rates as a result of the selection of the 6.8% discount rate, 21.3% ROI for 2020-21, and other changes in assumptions:

The actuarial valuations that will incorporate the above assumption changes will take effect for the pension contributions for fiscal year 2023-24, which should become available in July/August 2022.

Did you find this article helpful?

We are sorry that this article was not helpful to you

Tell us how we can improve this article:

Rich Lee has served local municipalities all throughout the San Francisco Peninsula over the past 16 years, including South San Francisco, Los Altos Hills, Millbrae, Foster City, and since January 2019, as the Finance Director for the City of San Mateo.

Rich was recently elected as President-Elect of the California Society of Municipal Finance Officers (CSMFO) in October. He has also served in other leadership roles, including Board Member, local Chapter Chair, and Vice-Chair of the Career Development Committee. In 2019, he was appointed to GFOA’s Ethics Committee.

Rich is also an active freelance bass trombonist and has performed with several artists, including Barbra Streisand, Peter Cetera, Gladys Knight, Bernadette Peters, and the San Francisco Opera Orchestra. He has also performed and recorded several albums with local jazz big bands, including the Electric Squeezebox Orchestra.

During the pandemic, Rich developed audio and video engineering skills and received two awards from Music In Place, a non-profit organization providing support to San Francisco Bay Area musicians to continue creating music while sheltering in place. His latest music project to ring in the holiday season is available on Youtube.

Articles: