The Impact of Potential CalPERS Policy Changes on Employer Contributions and on Plan Members

Govern For California

· December 15, 2020

Govern For California

· December 15, 2020

Don Boyd (Co-Director), Gang Chen (Co-Director and Associate Professor), and Yimeng Yin (Economic Researcher and Modeler)

The State and Local Government Finance Project, Center for Policy Research, Rockefeller College, University at Albany

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Summary

At the request of the Carla and David Crane Foundation, we examined a wide range of potential changes to CalPERS pension benefit policies for state plan members, without regard to legal or political feasibility. We modeled these changes for plans for state members of PERF A in CalPERS, whose assets account for approximately 52 percent of PERF A assets and 37 percent of CalPERS assets. The estimates we give below are based on this subset of CalPERS. If policies were applied to the entire CalPERS, the impacts on employer contributions would be about 2.7 times as large as described below, assuming the impacts on non-state- member plans are proportional.

We found that:

Reducing the benefit factor for new service by 50 percent would:
- Reduce annual required employer contributions by approximately 25.7 percent ($1.8 billion) in the initial year and 29.7 percent ($2.9 billion) in the 10th year.
- Reduce unfunded liability by 20.2 percent initially and 20.8 percent in the 10th year.
- Reduce the annual retirement benefits for an illustrative mid-career active member aged 45 in 2018 by 18.3 percent at all retirement ages compared to what otherwise would have occurred.
Suspending the COLA until the plan is 100 percent funded would:
- Reduce annual required employer contributions by approximately 21.6 percent
  
  ($1.5 billion) in the initial year and 29.3 percent ($2.8 billion) in the 10th year.
- Reduce unfunded liability by 27.5 percent initially and 48.3 percent in the 10th
  
  year.
- Reduce the annual pension benefit at age 80 by 27.2 percent for an illustrative
  
  mid-career active member aged 45 in 2018 (the initial retirement benefit would not be affected) and by 25.7 percent for an illustrative retiree aged 65 in 2018 compared to what otherwise would have occurred.
Combining the above two policies would reduce annual required employer contributions by approximately 44.9 percent ($3.1 billion) in the initial year and 56.2 percent ($5.4 billion) in the 10th year, and reduce unfunded liability by 45.8 percent initially and 66.5 percent in the 10th year. The annual pension benefit at age 80 would be reduced by 41.7 percent for an illustrative mid-career active member aged 45 in 2018, and by 25.7 percent for an illustrative retiree aged 65 in 2018 compared to what otherwise would have occurred.
Under a variant of the COLA policy that suspends the COLA until the plan is 100 percent funded calculated under a stricter liability discounting assumption of 5 percent, similar to a policy in Rhode Island, the COLA would be suspended for a much longer period. Employer contributions and unfunded liabilities would be further reduced depending on the extent to which, for purposes of calculating CalPERS liabilities, plan actuaries decided to lower the COLA assumption to reflect the longer period of COLA suspension.

We also examined several variants of these policies that entail considerably less-significant changes. These variants would have smaller impacts on employer contributions, unfunded liability, workers, and retirees. The results are summarized below, and more details are available on request.

Policies we modeled

We examined two groups of potential policy changes, (1) reductions in the benefit factor for new service and (2) suspensions and reductions in the COLA, separately and in combination.

Reductions in the benefit factor for new service

The benefit factor is the rate at which benefits are earned each year. For example, suppose an employee earns 2 percent of their final average salary for each new year of service. After 25 years of service the employee would expect to retire with a benefit of 50 percent of his or her final average salary.

If after the employee worked 10 years the benefit factor for future service were cut in half (e.g. from 2 percent to 1 percent), then the employee would have earned 20 percent over the first 10 years (10 years x 2 percent) and would earn 15 percent over the next 15 years (15 years x 1 percent) for a total expected benefit at retirement of 35 percent of the final average salary rather than 50 percent.

Reductions in the benefit factor affect both newly hired workers and existing workers, but do not affect benefits already earned by existing workers. Benefit factor reductions do not affect retirees. Benefit factor reductions lower the pension plan’s liability and therefore reduce required contributions by government employers.

We examined reductions in the benefit factor of 25 percent and 50 percent.

Suspensions and reductions in the COLA

A cost of living adjustment (COLA) is an increase in post-retirement pension benefits. COLAs may or may not be tied to inflation. For example, if a retiree currently receiving a $40,000 pension has a fixed 2 percent annual COLA that is compounded each year, then next year they will receive a pension of $40,800 and the year after that they will receive $41,616. After 10 years the pension would be $48,760.

If the COLA were suspended for 3 years because of poor plan funding, then a retiree initially receiving $40,000 would receive $45,947 after 10 years rather than $48,760.

Reductions and suspensions of COLAs affect retirees, but do not affect newly hired workers and existing workers (until they become retirees). COLA reductions and suspensions lower the pension plan’s liability and therefore also reduce required contributions by government employers.

We examined policies that make COLAs contingent upon the plan’s funded status, where the COLA is suspended entirely or cut in half when the plan is not fully funded. We examined these policies under two different methods of calculating plan funding: the current approach, which assumes the plan will earn 7 percent annually, and an alternative approach, similar to a policy enacted in Rhode Island, which assumes for purposes of this calculation only that the plan will earn 5 percent annually.

Assumptions and methods

We examined the potential impacts of these changes using a pension policy simulation model that incorporates the most important features of CalPERS and allows us to examine alternative benefit, contribution, and investment policies. Details of our model may be found in papers listed here.

We focused on the state members of PERF A of CalPERS, whose assets account for about 52 percent of PERF A assets. The initial year of our analysis is 2018, the most-recent year for which data were available at the time of the analysis. We also show results for 10 years after policy changes are implemented (2028).

We examined alternative policies under current CalPERS investment return assumptions. We also examined the policies under an asset shock scenario in which the portfolio falls initially by 24 percent, before gradually recovering; these results are not presented in this report but are available upon request. The tables below present results under CalPERS current investment return assumptions.

Impacts on employer contributions

The table below shows the estimated impact of the policy alternatives we modeled on employer contributions and unfunded liabilities. The estimates assume that employer contributions and unfunded liabilities are reduced immediately to reflect the lower actuarially determined contributions (ADC) and lower actuarial liabilities caused by the alternative policies.

Reducing the benefit factor for new service by 50 percent would reduce annual required employer contributions by 25.7 percent ($7.0 billion to $5.2 billion) and reduce unfunded liability by 20.2 percent ($60.2 billion to $48.0 billion) in the initial year, compared to the baseline scenario. In the 10th year the policy would reduce annual required employer contributions by 29.7 percent and reduce unfunded liability by 20.8 percent.

With the current funded ratio of about 70 percent for the state-member plans in CalPERS, the policy that suspends the COLA entirely when the plan is below 100 percent funded, assuming return assumptions are achieved every year, would suspend the COLA for 17-22 years depending on member category and reduce annual required employer contributions by approximately 21.6 percent in the initial year and 29.3 percent in the 10th year. This policy would reduce unfunded liability by 27.5 percent initially and 48.3 percent in the 10th year.

Combining both policies would reduce annual required employer contributions by approximately 44.9 percent in the initial year and 56.2 percent in the 10th year. This policy would reduce unfunded liability by 45.8 percent initially and 66.5 percent in the 10th year.

Policy variants that reduce the benefit factor by 25 percent for new service and cut the COLA by 50 percent when the plan is below full funding, and the combination of the two, would lead to impacts about half as large as those of their full counterparts. These variants are shown in the table below.

Under the variant of the COLA policy that suspends the COLA when the plan is below 100 percent funded, with funding calculated under the stricter investment return assumption of 5 percent, the COLA would be suspended for a much longer period. Required employer contributions and unfunded liabilities may be further reduced depending on the extent to which plan actuaries lower the COLA assumption in the calculation of liabilities and contributions to reflect the longer period of COLA suspension.

Impacts on plan members

The table below shows the impact of the alternative policies on three illustrative state peace officers. We examine a mid-career peace officer aged 45 at the time of reform, which is quite close to the average age of current active members. We examine two retirees, one aged 55 at the time of reform, and one aged 65, the latter of which is quite close to the average age of retirees. We compare the annual pension benefits for these members when they reach different ages, under the current policy and under the alternative policies. (See the appendix for a table that provides an alternative view by comparing the present values of total future pension benefits and a table that shows the estimated impacts on employer contributions for the component of PERF covering state peace officers and firefighters.)

Reducing the benefit factor for new service by 50 percent would reduce the initial annual pension benefit for the mid-career active member from $140,000 to $114,333 (-18.3 percent) and reduce the annual benefit at age 80 from $229,685 to $187,576 (-18.3 percent) compared to what otherwise would have occurred. Existing retirees are not affected by this policy change.

The policy that would suspend the COLA when the plan is less than 100 percent funded, modeled under the current amortization schedule and assuming the plan’s investment return assumption is achieved every year, would suspend the COLA for 22 years. It would reduce the annual benefit at age 80 by 27.2 percent for the mid-career worker currently aged 45 ($229,685 to $167,313), by 34 percent for the retiree currently aged 55 ($147,655 to $97,419), and by 25.7 percent for the retiree currently aged 65 ($121,128 to $90,000).

Combining the two policies would have a greater impact on active members as their benefits would be affected by both the benefit factor reduction for new service and the COLA suspension when they retire. For the illustrative active member aged 45, the combined policy would reduce his or her annual benefit at age 80 from $229,685 to $133,960. This is a reduction of 41.7 percent, compared to 18.3 percent under the benefit-factor reduction policy in isolation and 27.2 percent under the COLA suspension policy in isolation.

Note: The calculation above does not take into account the Purchasing Power Protection Allowance (PPPA) policy of PERF, which is intended to maintain retirement benefits at 75 percent of the initial benefit level by granting additional COLA adjustments. The total annual outlay for PPPA is limited to 1.1 percent of accumulated member contributions. For the examples in the table above, PPPA would be triggered under policies that suspend the COLA entirely, but the 1.1 percent limit also would be triggered. Thus, employer contributions would have to increase to reflect the PPPA, but only to the extent of the 1.1 percent limit.