Subject: Reforming California’s Public Employee Pension Systems
According to the brief by SIEPR, there has been a concern that CalPERS might be going for broke. The main reason is because CalPERS uses a high discount rate to estimate the value of its liabilities. As a result of the use of high discount rates, the pension plans’ liabilities are underestimated. People are worried that if no effort will be made in short to balance the pension underfunding, CalPERS will not be able to reverse the current shortfall. Furthermore, a significant portion of the CalPERS portfolio is invested in equity instruments, which have higher risks and are subject to significant volatility. The instability of the assets might not generate enough cash flow to support the liabilities.
The discount rate CalPERS uses to compute the value of their liabilities is 7.75% which is complying with GASB Statement #25 and computed from the expected average annual investment return. Portfolio manager focused on maintaining high funding ratios (assets divided by liabilities) prefers such a high discount rate since the present value of the liabilities would be lower and makes the funding ratios higher. However, using the expected return on investments ignores the market volatility; therefore, I would suggest the government be more conservative and consider using a discount rate lower than the expected return.
Given the 16-year duration of CalPERS liabilities, the right discount rate should be equivalent to the yield of a bond which has a duration of approximately 16 years and shares similar risks with CalPERS liabilities. The use of a 10-year Treasury bond as the risk free discount ratio in SIEPR is somewhat arbitrary because the duration of the 10-year bond is approximately 8 years and is shorter than the duration of the CalPERS liabilities. It would be more appropriate to use the yield of the 30-year Treasury bond as the risk free discount rate for purposes of such a comparison since it has an...