Welcome to the new normal for public pension funds.
CalPERS' proposed move to reduce its investment return goal from 7.5 percent annually to as low as 6.5 percent in coming years is raising eyebrows because of the pension fund's size — the largest in the United States.
But if it does drop that target, the California Public Employees' Retirement System will be only the latest pension fund to lower investment projections.
Those moves are in acknowledgement of a belief that the days of 8 percent returns or higher for many funds are likely gone for a while, given persistently low inflation and interest rates. The target cuts, in turn, can lead to increased contributions from employees and their employers to fund the pension systems as their reliance on investment returns decreases.
"We're in the midst of what I would call a secular shift in the return assumptions," said Keith Brainard, research director of the National Association of State Retirement Administrators. "That has occurred particularly in the wake of sustained reductions of interest rates."
"It's a longer-term issue," Brainard said of the trend by public pension funds to reduce their targets. "There's a continuous, ongoing review of, among other factors, the [return] rate by all or most public pension funds, so there's a continuous, multiyear trend toward lower rates."
He noted that "about two-thirds of the public pension funds that we follow have reduced their return assumptions since 2008, some more than once."
In fact, CalPERS, which has nearly $295 billion under management, is one of those funds that has already cut its target since the financial meltdown of 2008. CalPERS in 2011 lowered its goal from 7.75 percent annually to the present rate of 7.5 percent.
But this new proposal by CalPERS isn't a simple, one-time cut in the investment target.
Instead, CalPERs is proposing that if its investments have profits of 4 percent or more of its target in a given year, the fund would dial back its target rate for future years by anywhere from 0.05 percent to 0.25 percent. The fund would also then shift some of its money into more conservative investments, with potentially lower rates of return.
"They're looking at something that is a little more nuanced," Brainard said. "They'll essentially book their [higher-than-projected] returns and take a little bit of risk off the table."
CalPERS says the move will help "smooth out" risk over the long term, and that the target rate eventually could move down to as low as 6.5 percent annually. CalPERS already has moved to lower its risk of big investment downturns last year by pulling out its entire $4 billion investment in 24 hedge funds and a half-dozen hedge funds of funds.
While CalPERS' strategy of reducing its investment target rate if it sees big investment gains in a given year is unusual, its lowering of expectations is not.
"From our perspective, this is sort of an ongoing trend," said Amy Resnick, editor of the trade publication Pensions & Investments.
Resnick noted that Oregon's public employee pension fund lowered its assumed rate of return this summer from 7.75 percent to 7.5 percent.
"Two years ago, they had gone from 8 percent to 7.75 percent," she said.
The New York State Common Retirement Fund, which is the third-biggest public pension fund in the U.S., cut its target last month from 7.5 percent to 7 percent. The target had been as high as 8 percent in 2010.
Those targets, as with CalPERS', are not statements by the funds of actual expected investment returns each year. Some years will see gains, and some years will see losses, but the targets are what the funds expect to see in annualized average gains over a long term, as long as 40 years.
"There's nobody saying that just because there's a target, we're going to get there," Resnick said.
On Wednesday, Illinois Comptroller Leslie Munger said a $560 million November pension payment will be delayed due to a cash crunch stemming from the state's budget impasse.
Despite the delay, state pension funds will be paid in full by the end of fiscal 2016, Munger said at a news conference in Chicago.
Resnick said that "pension funds are conservative investors and the things they buy aren't kicking off yield" that would justify higher investment targets than the ones they are setting now.
"On the bond side, we've been in a sustained low-rate environment," she said. And every time the Federal Reserve talks about raising its benchmark interest rate from nearly zero "it somehow gets pushed back," Resnick said.
And, "no matter if rates rise, they're not going to go from zero to 5 percent overnight. Pension funds are going to be investing in a generally low interest rate environment for a while," she said.
And, "It's also a reflection of the reality of investing in conventional investments," Resnick said. "Assumptions of higher returns are just not realistic nowadays."
Another assumption that public pension funds are making in setting lower investment target rates is that inflation will remain low for some time.
Brainard of the National Association of State Retirement Administrators said that instead of funds assuming that inflation will run at 4 or 4.5 percent annually, many funds are now projecting that inflation will be at 3 or 3.5 percent annually.
Because inflation is factored into the projected rate of investment return for a fund, any reduction in the assumed inflation rate can lead to the the fund reducing its projected rate for its investments.
But a contrary example is in Texas, where a major public pension fund so far has avoided joining the trend of reducing investment projections.
The Teacher Retirement System in Texas, which manages about $132 billion for more than 1.4 million current employees and beneficiaries, reduced its inflation rate assumption last month while reviewing its current investment target rate. TRS, which estimated a 3 percent rate of inflation, now is assuming a 2.5 percent inflation rate.
Despite that reduction in the estimated inflation rate, the TRS board did not reduce its investment target rate, which remains at 8 percent annually. That means that even though inflation is assumed to be lower going forward, TRS believes its investments can produce returns that make up for it.
"There was no recommendation to lower the rates of return," said TRS spokesman Howard Goldman. "I can't remember when it's not been 8 percent."
—Reuters contributed to this report.