Blog entry Jack Ehnes

Economic Assumptions Help Plan for the Future

The funding for your Defined Benefit pension is based on several economic assumptions. Among the most critical of these planning factors are the investment return assumption and the assumed inflation rate.

Projecting these and other long-term factors helps to determine the actuarial valuation, or financial health, of the pension plan. Actuarial assumptions are generally reviewed every four years, and in stable economic times the assumptions might go unchanged for many years. But the historic market downturn in fiscal year 2008-09, and ongoing concerns about the future of the financial markets, prompted an earlier review and this thoughtful action on the part of the Teachers’ Retirement Board.

Investment Assumption Lowered

After 10 months of thoughtful analysis and discussion, the Teachers’ Retirement Board at its December 2010 meeting lowered the assumed rate of return on investments from 8 percent to 7.75 percent. The board also reduced by 0.25 percent its assumed inflation rate to 3 percent and its assumed wage inflation rate to 4 percent. The moves acknowledge an expectation of reduced future investment earnings and lower inflation.

Lowering these assumptions reduces the projected long-term funding level of the system from 78 percent to 76.5 percent. Funding levels are the percentage of current liabilities covered by existing assets.

Investment returns, which fund a majority of each benefit dollar paid, together with contributions are the only sources of income for the fund. Reducing investment returns expectations creates pressure to increase contributions. Member, employer and state contribution rates are set by law, and may only be increased by the state through legislation. If nothing is done, the fund will deplete its assets in less than 35 years and the state will be constitutionally responsible for paying the difference between the amount of contributions coming in and the amount of benefits paid out to our members.

With this recent change to the assumptions, Teachers’ Retirement Board members faced a difficult decision in fulfilling their fiduciary duty to California’s educators. They understood that acknowledging the potential for lower future investment returns is an important and prudent step in the development of a solution to the long-term financial challenges facing CalSTRS.

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