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California’s Pension Crisis Part 2: What Went Wrong With Public Finance In The Golden State?


This posting is a continuation of a series of articles discussing the public pension crisis in California.

In Part 1 of this series I discussed how the 1999 passage of Senate Bill 400, which increased state workers’ pension benefits, represents one of the main reasons for today’s skyrocketing pension liabilities among state and local governments in California. While some argue that pension obligations are not the reason for our governments’ fiscal difficulties, considering CalPERS is the largest unsecured creditor for the bankrupt cities of Vallejo, Stockton, and San Bernardino, they certainly play a role.

To further investigate the pension crisis and its effects, Part 2 looks more carefully at the fiscal woes the state and the City of San Bernardino are currently facing, and includes a discussion of the unique case between bondholders and CalPERS.

San Bernardino is the only city in California history to stop making payments to CalPERS for employee benefit obligations – which it did following its bankruptcy filing. Two other recently bankrupt cities, Stockton and Vallejo, have continued making payments, snubbing their other creditors. As a result of San Bernardino’s actions, CalPERS is suing the City for failing to pay its pension obligation.

One of two possible outcomes is likely in this case. Either the judge will decide that CalPERS is correct in claiming that benefits were vested properly and under no circumstances can cities renegotiate their pension obligations (this could have a tremendous impact on the municipal bond market), or the judge will decide that all creditors, including CalPERS, are on a level playing field. Under the second scenario, it is likely many employers would choose bankruptcy to renegotiate expensive pension obligations.

The discount rate assumptions made by CalPERS in 1999 (8.25%) turned out to be terribly wrong. The markets (equities, real estate, alternative investments) had a different plan. First, the tech bubble burst and then, several years later, the real estate market collapsed in the wake of the housing bubble. These financial crises put a colossal dent in CalPERS‘ assets. Of course because pension benefits are guaranteed, when market growth doesn’t pay, somebody still has to.

For most of the last fiscal year (ending in June 2012), CalPERS posted an annual return of below 1% and indicated that employer contributions would most likely increase. Average annual returns for the three, five, and ten year periods are 11.4%, -0.1%, and 6.1%, respectively (from CalPERS Comprehensive Annual Financial Report, Fiscal Year Ended June 30, 2012). Both long-term averages are well below the assumed discount rate.

And while during calendar year 2012 CalPERS posted a solid return of 13.3%, actuarial calculations are based on fiscal year returns, making the calendar year return somewhat irrelevant when it comes to employer contributions. As we have seen in the past, financial markets can turn quickly which means the 1-year return could look drastically different in six months when the CalPERS fiscal year ends.  Until CalPERS posts solid fiscal year returns, there is really nothing to write home about.

CalPERS made the following employer contribution rate guarantees in 1999: “No increase over current employer contributions is needed for these benefit improvements” and “CalPERS fully expects the State’s contribution to remain below the 1998/99 fiscal year for at least the next decade.”

At the time, the total contribution rate for all state employees combined was 5%. The table below shows current contribution rates as a percent of payroll for the State of California as reported by CalPERS:

State of California Contribution Rates (% of payroll)

Employer Plan 2012/2013 2011/2012 2010/2011
Miscellaneous 20.5% 18.2% 18.7%
Safety 18.1% 16.4% 17.5%
Police/Fire 30.3% 27.4% 28.7%
California Highway Patrol 33.7% 31.3% 31.2%

Source: CalPERS

When CalPERS made those guarantees, it was referring to State of California contributions, but many local governments also acted on the claims – coming as they were from one of the nation’s largest and most powerful investment organizations. Today, as a result, government is on the hook for an enormous unfunded liability, which will ultimately be paid for by taxpayers, while employee contributions are capped at between 8% and 11% of pay. Governor Brown recently touted the state’s balanced budget and potential surplus, but left out any discussion of unfunded retirement liabilities to the tune of $181 billion (from 2013-14 California Governor’s Budget Summary, Figure INT-04, Page 7).

The City of San Bernardino was one of numerous cities that took action based on CalPERS 1999 bill. Two years after the state enacted its new benefit formula, San Bernardino changed its formula for police and fire from 2% at age 50 to 3% at age 55. In other words, the City’s police and fire employees would now receive 3% of their salary for each year of service at age 55. The formula for miscellaneous workers went from 2% at age 60 to 2% at age 55. Municipalities were not required to act on SB 400, however many did, arguing that increased salaries and/or pension benefits were necessary to attract top talent.

San Bernardino experienced financial difficulties only three years after the changes to their benefit formula occurred. Facing significant unfunded pension liabilities, the City borrowed money to pay off its CalPERS debt by issuing a $50,000,000 (from California Debt and Investment Advisory Commission Searchable Database) pension obligation bond (from Tim Reid, Cezary Podkul, and Ryan McNeill, "Special Report: How a Vicious Circle of Self-Interest Sank a California City." Reuters, November 13, 2012). Yes, borrowing money to pay for a liability.

Four years later, in 2009, the City again improved the benefit formula for police, fire, and miscellaneous workers. Police and fire employees now received 3% of their annual salary at age 50, whereas miscellaneous workers were now able to use 2.7% at age 55 to calculate their pension benefits.

For San Bernardino’s police and fire workers, the two formula changes represented a 50% increase in pension benefits overall. However, employee contributions remained capped at 9%. When the returns assumed by CalPERS were not realized, and benefits and employee contribution rates remained unchanged, the employer's (a.k.a. taxpayers) contribution had to increase to fund the liabilities.

City of San Bernardino Contribution Rates (% of payroll)

Employer Plan 2012/2013 2011/2012 2010/2011
Miscellaneous 17.4% 17.2% 13.3%
Police/Fire 30.1% 28.3% 23.1%

Source: CalPERS

As pension contribution rates grow, cities have a choice to raise revenues, reduce other expenditures, or file for bankruptcy. In San Bernardino, according to official bankruptcy documents, CalPERS is owed $143 million, and Wells Fargo, the City’s second largest creditor, $46.1 million. In its suit CalPERS is claiming that their debts are non-negotiable and that benefits are the vested rights of employees. Bondholders, however, disagree. They see CalPERS as just another creditor who should wait in line to get paid alongside everyone else.

And in an additional twist, the City of San Bernardino’s second largest creditor, Wells Fargo, is a holder of a pension obligation bond that was used to pay for previously unfunded obligations. Is it fair that CalPERS’ liabilities are non-negotiable but creditors that paid for unfunded obligations could lose their entire investment?

If the judge decides to side with CalPERS, the municipal bond market would be rattled and we could witness a series of downgrades in municipality credit ratings. That would increase the cost of borrowing for cities, further straining their budgets. The ratings formula would have to include obligations to CalPERS – the smaller the liability the better the rating, but try to find a municipality with a small, unfunded obligation. And a looming question is what if a city defaults on all creditors but CalPERS and still faces severe cash flow issues? Do they keep cutting services? How far do they go?

On the other hand, if the judge rules that CalPERS is just another creditor, we could see a flood of municipal bankruptcies. And it would likely represent the beginning of the end for California’s extremely generous public pensions. When cities and counties facing tremendous pension burdens realize that liabilities to CalPERS are in fact negotiable, bankruptcy will become a viable option. CalPERS and public unions will likely be forced to renegotiate their formulas and apply them retroactively – just as benefits were increased retroactively.

If CalPERS had successfully realized its 1999 discount rate assumptions, we wouldn’t be having this difficult discussion today. Unfortunately, their conclusions were decidedly wrong (read more about the problematic basis for their analysis in Part 1). Californians have made revenue adjustments at the state and local level. Now, as the pension crisis mounts, it is time to seriously look at adjusting the cost side of the equation. Otherwise, the situation will only grow worse.

Part 3 coming soon: What are the best solutions to California’s pension crisis?


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