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California’s Pension Crisis Part 1: What Went Wrong With Public Finance In The Golden State?


Why do so many state and local governments seem to be in a constant struggle to balance their budgets? One reason is the volatility of public revenue streams. Government revenues are highly cyclical – they increase rapidly during booms, and shrink even faster during busts. During the real estate boom, governments were collecting plenty of revenues from property, income, and sales taxes. When the housing bubble burst, revenues took a dramatic hit. Of course, the government does not have direct control over business cycles and consumer spending patterns so they can’t necessarily be held responsible for revenue shortfalls. But the other side of budget deficits, expenditures, is under the government’s full control. And trends in expenditures are quite different from trends in revenues. By comparison, expenditures increase rapidly during booms and fall at a much slower rate during busts.

California’s finances illustrate the difference. In fiscal year 1998/99, the state had a surplus in the general fund; it generated $58.6 billion in revenues and spent $57.8 billion. By 2008, revenues increased by 41% to $82.8 billion, while the expenditures soared to $91 billion (a 57% increase). During the same period the payroll for state workers soared from $8.6 billion to $15.9 billion (“Impact of Economic Downturn on Employer Contributions and Changes to the CalPERS Smoothing Methods,” by Ron Seeling, Chief Actuary, CalPERS) due to both increased wages and 40% more workers. In 1998, CalPERS had $172.1 billion in assets and pension liabilities stood at $12.8 billion. By 2008, assets grew to $212.2 billion (up 23%), while liabilities spiked to $33.3 billion (up 160%). Zooming in a bit – from 1998/99 to 1999/00 assets grew to $191.2 billion (up 11%), and liabilities grew to $18.6 billion (up 46%). While the increase in pension liabilities can be attributed to a few things, including skyrocketing payroll (topic for another day), this one-year increase can be solely attributed to Senate Bill 400 (SB400), which boosted active state workers’ pension benefits retroactively to the date of hire. Already retired workers received a 1% to 6% pension increase.

We need to remember that the state had a budget surplus in 1998 and the S&P 500 was on a spectacular run during the decade – starting below 400 and trading above 1200 in 1999. Returns were high, and the average person could throw a dart at a financial page of a local newspaper and pick a stock that would generate double-digit returns. CalPERS, a sophisticated institutional investor, also had spectacular returns.

When the actual returns are higher, in this case significantly higher, than the discount rate, pension obligations of employers decrease and market growth funds the benefits. In other words, if the funds earn better returns than expected, employers can reduce their contribution while still offering the same future benefit amounts. In 1999, right before SB400, employer contribution as a percentage of payroll equaled 0% percent for miscellaneous, industrial, and school workers. Employer contribution rates were 7.5% for state safety, 0% for state peace officers and firefighters, and 13% for California Highway Patrol (CHP). Seeing these contribution rates and double-digit investment growth, CalPERS board, led at that time by William Crist, thought it would be a great idea to increase pension benefits and change the actuarial formula.

According to official CalPERS documents, SB400 was motivated by the idea that the state’s retirement and pension plans were not meeting its goals. Specifically, in support of SB400, CalPERS cited several failings of the pre-SB400 system, saying that:

  1. Retirees were not keeping pace with increased cost of living;
  2. The two tiered system was an inadequate, inferior plan;
  3. State and school pension benefits had fallen behind that of most local governments;
  4. School employees’ final average compensation basis was disadvantageous;
  5. Safety employee recruitment demands higher benefits.

State workers had the following benefits prior to SB400 going in effect (from “State Employee Compensation: The Recently Approved Package,” Legislative Analyst’s Office, December 6, 1999):

  1. 2.0% at 60 – State Miscellaneous and Industrial
  2. 2.0% at 55 – State Safety
  3. 2.5% at 55 – State Peace Officer/Firefighter
  4. 2.0% at 50 – California Highway Patrol

To address these problems CalPERS proposed the following changes:

  1. Immediate 5% increase for all current state and school retirees
  2. Eliminate second tier benefits, ensuring everyone has the top=tier benefits
  3. School employee pensions based on highest one-year salary rather than 3 consecutive years
  4. Improve pension benefits:
    • 2.0% at 55 – State Miscellaneous and Industrial
    • 2.5% at 55 – State Safety
    • 3.0% at 55 – State Peace Officer/Firefighter
    • 3.0% at 50 – California Highway Patrol

What do these pension benefit numbers mean? For each year of service, employees get the above-mentioned percentage of their salary as a pension benefit. So, after 30 years of service, at age 55, miscellaneous and industrial employees receive 60% of their salary base for the rest of their lives. The picture is rosiest for CHP employees: After 30 years of service a CHP officer can receive 90% of their salary base for the rest of his/her life. Assuming an officer joins the service at age 20, they would receive a 90% pension from age 50 onward.

In absolute terms, California pension benefits may not provide much perspective. To get a better idea of how the Golden State stacks up, we compare California’s numbers to the national average and to the private sector. It appears that the national average pension formula for public workers is 1.8% at age 65 (in some cases at age 60). In the private sector nationwide (for the few employees who still have a defined benefit plan), benefits at age 65 are calculated by multiplying 1.4% of salary base by years of service (“California Public Sector Retirement Programs and Compensation,” Capitol Matrix Consulting, July 2011). In this context, California is home to some fairly generous retirement benefits versus the rest of the nation. In fact, compared to the private sector average, most California public employees, with the exception of state safety, receive nearly twice as much in pension benefits per year of service as their private sector counterparts.  Even California’s pre-SB400 benefit schedule was more generous than the national average for the private or public sector. 

Some have argued that the generous benefit formulas compensate workers for the higher cost of living in California. But wages are already adjusted for the higher cost of living. In other words, nominal wages are higher in California as a result of higher living costs, so applying a fixed percentage to those wages already takes into account those higher living costs.

Another frequent argument is that workers in the private sector are better compensated for their work, and thus require fewer employer pension benefits. This argument is simply incorrect. According to the Bureau of Labor Statistics, nationwide, employer cost per hour worked in the private sector is $30.61. Compare to the $41.10 in employer cost per hour worked in the public sector—almost 35% higher than private-sector workers. These statistics represent ‘total compensation’, which includes wages, paid leave, supplemental pay, insurance, retirement, and other legally required benefits. But even if we focus on wages alone, public sector employees are still earning as much or more than their private sector peers. According to the Quarterly Census of Employment and Wages (QCEW), public sector wages during the first quarter of 2012 averaged $61,400 per year in California compared with the $58,000 per year for private sector wages. The argument that  private sector workers earn higher wages and thus require fewer benefits falls flat. Public sector workers are earning higher wages and receiving better benefits.

As the crafting of SB400 was coming to fruition, the actuaries working for CalPERS did a great job analyzing various market-performance scenarios. They knew that the chance of seeing market returns like those of the 1990s was small.  According to board meeting minutes, there were three scenarios put forward. Two scenarios analyzed fund performance, employer contribution rates and funded ratios using actual investment returns for selected 10-year periods. The first of these used market returns from July 1947 to July 1956. During this period the average annual return was 12.1%. Using this discount rate employer contribution rates for fiscal year 2010/2011 would equal 0% – which means that the wisdom of the CalPERS’ investment committee would pay for the pension benefits. The second used returns from July 1966 to July 1975, when the average annual return was 4.4%.  Here the average employer contribution (for all employers) went from 0% in 1999 to a staggering 28% in 2010. Finally, the third scenario used an average annual return of 8.25%. Under this scenario, by fiscal year 2010/2011 employer contributions for all workers would equal nearly 5%. In other words, the cost of the pension system was calculated to range from 0% to 28% depending on what happened in the equity markets—quite a large band.

So which scenario was presented to the lawmakers? Unfortunately for taxpayers, it was the rosiest outlook that assumed markets could grow in the double-digits indefinitely. Ultimately, one discount rate was used for actuarial purposes and another for generating support for SB400 in the Legislature.

CalPERS also asked lawmakers to change the actuarial formula. Prior to SB400 90% of assets were used in calculating total market value of the fund. Increasing the number to 95% does miracles – it adds more assets to the fund and therefore reduces the costs to the employers.

The bill ultimately passed with overwhelming support in both houses of the State Legislature. There were only seven no votes in the Assembly (Sam Aanestad, Dick Ackerman, Steve Baldwin, Marilyn Brewer, Howard Kaloogian, Tom McClintock, and Bruce Thompson) and zero opposition in the Senate. Twenty-two Republicans in the Assembly and all 15 Republican Senators voted yes. On Jan 1, 2000 all state workers received their pension raises – retroactively. Interestingly, benefits cannot be reduced retroactively.

The process would not be politics without last minute changes to the bill (“1999 Pension Law Bites Local Budgets,” Mary Lynne Vellinga, Sacramento Bee, Aug 17, 2003.) Apparently, a clause was added under the radar, allowing every local agency to increase benefits to their own employees using the same benefit schedule. The original intention of the bill was for state workers to receive an increase, but this clause expanded the improved benefits to every state and local government worker.  As of October 2012, local government workers made up 77% of all state/local government employees. Granted, CalPERS didn’t force any local agencies to change their benefits, but many did, including the now embattled City of San Bernardino. Many localities argued that if they didn’t also change their benefit schedule, they would not be able to compete for qualified personnel.

And as if the generous benefits weren't enough, some entities took it to the next level through reclassifications. According to the Sacramento Bee, in 1960 approximately 1 in 20 workers were classified as peacekeepers. By 2004, that number grew to 1 in 3 ("Pension Jackpot – Many More Winning Safety-Worker Label," John Hill and Dorothy Korber, Sacramento Bee, May 9, 2004). Even law enforcement officers became fed up with reclassifications and attempted to form their own union in 2008. According to the Peace Officers of California, in 2008 over 60% of the California Union of Safety Employees included non-peace officers, such as milk inspectors, billboard inspectors, DMV drive test employees, lab technicians, smog-check employees, and dispatchers ("The Birth of A New State Employee Union," Peace Officers of California, November 21, 2008).

Arithmetic tells us that the solution to California's pension crisis has to be to increase revenues or reduce the expenditures of the fund. An unbiased, reasonable person would probably choose a combination of both. If employees received benefit increases retroactively, why can't benefits be reduced for current employees retroactively? Until recently, CalPERS has only opted to increase revenues and maintain benefits. It is true that some changes have been made for future hires, but an overwhelming majority of members still have the generous pension formula. As CalPERS requires higher contributions, local agencies are forced to either reduce their other expenditures or increases their revenues. Both of these affect the residents of California – either through the elimination of public services (education, safety, etc.) or through higher taxes. To date, Governor Jerry Brown has had some success negotiating with CalPERS and a small reform to the system will take effect January 1, 2013. However, until major changes are made to the public pension system we are just wiping away the blood while the wound continues to bleed.

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