Thursday, February 2, 2017

Another pension fund lowers discount rate to 7%

If a pension fund has to pay out $100 in 30 years, and earns 7.5% on its investments, it must save 100/(1.075)^30=13.14 today.  If it earns only 7.0%, the amount that it much save increases by 15%.

Calstrs, the second biggest pension fund in the world, just admitted that it is reducing its target rate of return (also its discount rate) from 7.5% to 7.0%.  The increase in savings is split between the teachers and the State of California, the employer of the teachers.
Approximately 80,000 current members of Calstrs could see an increase in their yearly pension contributions of $200 or more as a result of Thursday’s move, Calstrs said. The state of California has already budgeted an extra $153 million for its pension contribution to cover the rate change, bringing the total contribution to $2.8 billion.

1 comment:

  1. This strategy has been adopted around the country for some time now especially in the beginning of the recession. Only then it was a reactive posture, where billions of dollars were lost and the pension funds not only had to find ways to stop the hemorrhaging but also to infuse money into the funds to keep it alive. Almost always, both the employees and their employers were asked to share the increased contributions. In my organization, we were not asked to layout cash but instead we had to forego our annual wage increase which was put into the pension fund by the employers along with their contribution.
    On the other hand, The California State Teacher’s Retirement Systems, CalSTRS, decision to reduce its target rate of return is a proactive move. The pension fund has done its due diligence and assess the market potential into the future and the findings were unfavorable. To maintain the current rate of return of 7.5% requires the fund to continue investing in certain stocks and bonds which promised to be too risky. Hence to protect its investors from the effects of another downturn and to mitigate the risk the fund decided to shift approximately $12 billion to treasury bonds, hedge funds and other low risk investments (Martin, 2015). The lower the risk the lower the rewards hence the lower rate of return and the corresponding higher contribution by both employees and employers to maintain the value of future payments.
    According to Froeb (2016) the Present Value (PV) of the investment that would earn $100 (future value, FV) in 30 years can be calculated using the discounting equation:
    PV = FV/ (1+r)^k
    Where r is the rate of return and k is the number of years.
    Therefore, at a rate of 7.5%
    PV = $100/(1+.075)^30
    PV = $100/8.7549
    PV = $11.42

    And at the lower rate of 7.0%

    the PV = $100/(1+.07)^30
    PV = $100/7.6122
    PV = $13.14

    Percentage Increase in PV


    $1.72/$11.42 = 0.15/ 15%

    All investment decision involves a trade-off between current sacrifice and future gain. Here the payout amount is the same but the cash outflow at the beginning of the investment is lower for the first option. At a glance to a lay person, the first investment option is very attractive. However, the experts at Calstrs could peel back the layers and analyze the risk, and the probability of the 7.5% yield is very low due to the high-risk investments. Hence the management of Calstrs decision to go with the lower risk portfolio. This strategy offers significant diversification benefits to offset the risk of more volatile asset classes, such as stocks, real estate, private equity and fixed income (Starkman & Peterson, 2015).

    Froeb, L. (2016) Another pension fund lowers discount rate to 7%. Managerial Econ February 2, 2017. Retrieved from Accessed February 2, 2017

    Froeb, L. M., McCann, B. T., Shor, M. & Ward, M. R. (2016). Managerial Economics: A Problem-Solving Approach. Fourth Edition. Cengage Learning, Boston. Print

    Martin, T. W., (2015). Giant U.S. Pension Fund Calstrs to Propose Shift Away From Stocks, Bonds. The Wall street Journal. September 2, 2015. Retrieved from Accessed February 2, 2017.

    Starkman, D. & Petersen, M. (2015). Pension fund CalSTRS weighs shift to safety. The Los Angeles Times. September 2, 2015. Retrieved from Accessed February 2, 2017.