How higher interest rates could lift CalPERS and CalSTRS pension plans: ‘Good for savers’

Interest rate hikes the Federal Reserve announced Wednesday come with a modest upside for public pension funds such as CalPERS and CalSTRS.

The Federal Reserve raised its key interest rate by a quarter of a percentage point and signaled six more increases this year, which would push the rate to nearly 2% by December, a little above the pre-pandemic rate. The change is meant to slow inflation, which reached a 40-year high last month.

While the interest rate hikes raise borrowing costs for consumers, they also improve returns on stable, long-term investments, and California’s two largest pension funds, with a recent combined value of about $790 billion, benefit from stability.

“When interest rates go up, that’s generally good for savers, and public pension plans are a class of savers,” said Hank Kim, executive director of the National Conference on Public Employee Retirement Systems.

The Fed signaled the rate hikes would continue into 2023, potentially reaching 2.75% under its forecast.

How much the series of rate hikes will help remains to be seen for California’s pension funds, which have large holdings in public stocks along with private equity, real estate and other investments that are affected in various ways by inflation and global instability.

California State Teachers’ Retirement System spokesman Ricardo Duran said in an email that the teachers system is “more concerned with inflation and stagflation.”

“CalSTRS, like the financial markets, is pleased to see the Fed respond and take action,” Duran said in the email. “Moving interest rates back to so-called normal helps pensions in the long run. The road to normal is challenging.”

The rate hikes improve returns on fixed-income investments such as government-issued bonds, which are loans with terms of 10 to 30 years that pay periodic interest to bondholders until the loans mature.

Bond yields and interest rates have been unusually low since the Great Recession, making it harder for pension systems to earn enough to stay on top of their long-term debts.

“The last decade compared to history has not been typical or normal,” said Keith Brainard, research director for the National Association of State Retirement Administrators.

CalPERS, CalSTRS investment targets

In the 1980s and 1990s, yields on 10-year U.S. Treasury bonds were often higher than pension systems’ annual investment return targets, making it relatively easy to earn enough to keep up with long-term debts. The systems were “superfunded” in the late 1990s, with more money than they needed to cover all their debts.

Today, the California Public Employees’ Retirement System aims to earn 6.8% on its total investment fund each fiscal year, and CalSTRS aims to earn 7%.

But the yield on 10-year bonds hasn’t been above 7% since 1994. In 2020, the rate was 0.89%. And the pension systems have been underfunded since the Great Recession.

With lower bond yields, the systems have had to invest more money in riskier assets such as public and private equity. The systems have recorded big losses, as during the recession, and big gains, as happened last year. The underfunded systems have been charging local governments and the state much more money to make up for the bad years.

If interest rate increases work as planned, over time, pension systems’ fixed income portfolios will be able to provide returns closer to 3% or 4%, rather than “something less than that, that they have been providing in the last decade or so,” Brainard said.

“The key will be slow and steady, no-surprises-toward-normal rates,” Duran, the CalSTRS spokesman, said in an email.

That pattern could also help the pension systems return to full funding and reduce cost burdens on the state and on local governments that have been shoveling increasing loads of taxpayer money toward pension debts in recent years.

More bonds, less stocks

The Fed has been signaling that it planned to increase interest rates for at least the last six months to a year, said Kim.

“It’s something plans have been anticipating and probably have been welcoming,” Kim said.

CalPERS recently opted to increase its fixed income holdings from 28% to 30% of its total investment fund, which was valued at $471 billion as of Wednesday.

CalPERS also reduced its target allocation for stock market holdings, aiming to drop those holdings from 50% to 42% of its investments.

“We are a long-term investor with a diversified portfolio,” CalPERS spokeswoman Megan White said in an email. “We monitor the markets and interest rates, but we stay focused on our investment strategy.”

A summary of CalSTRS’ investment portfolio on the system’s website says 11% of its portfolio was invested in fixed income as of February, but the system also holds investments that would fall under the traditional definition of fixed income in other asset classes, Duran said in the email.

Stocks made up about 43% of CalSTRS’ investments, according to its most recent figures. The fund was valued at $318 billion at of Feb. 28.

Inflation has other consequences for the pension systems. The inflation rate led to cost-of-living increases of up to 4.7% for some CalPERS retirees this year. The COLAs will cost $765 million for the year, up from an increase of $242 million for the prior year’s COLAs.

And part of the Fed’s goal with the rate increases is avoiding another recession. The last two recessions hit California’s pension funds hard. While the systems have taken steps to better withstand the next downturn, big stock market losses would mean bigger pension bills for cities and the state, even with more favorable fixed income returns.

This story was originally published March 18, 2022 at 5:25 AM.