Things are about to change drastically for everyone involved in California’s public pension system, including CalPERS, employers, employees, and taxpayers. Last week, on April 16th, the CalPERS’ Pension and Health Benefits Committee approved proposed changes that will most likely increase employer contributions among some public agencies by 50%. The following day, CalPERS Board of Administration put the final stamp of approval on changes to actuarial smoothing practices that will affect employers beginning in 2014-15 (for state and school workers) and 2015-16 (for public agencies.)
Most public pensions systems use smoothing techniques to stabilize contribution rates for employers. For example, amortization of gains and losses means that returns below or above the discount are not recognized in the same year but over a period of many years. When investment strategies of the pension fund are outperforming the implied discount rate, assets of the fund are understated. On the other hand, during bear markets, assets of the fund are overstated—which is exactly where CalPERS is today given huge losses in 2007 and 2008. Any change in smoothing techniques changes the actuarial value of pension fund assets, which directly affects future employer contribution needs.
The changes made to CalPERS’ smoothing techniques will result in higher contribution rates for employers. Depending on how certain rate-smoothing methods are implemented, higher employer contributions could be executed within a year or potentially be phased in over a period of 5 years.
To illustrate just how much these changes could affect employers’ contributions, we looked at revenues, retirement benefit expenditures, and total expenditures in 7 California cities: Irvine, Sacramento, San Bernardino, San Luis Obispo, Santa Clara, Stockton, and Pasadena (these representative cities are being used to illustrate a hypothetical impact and we are not implying that they will be affected). For our sample analysis, we assume that higher contributions will be fully implemented in the first year. Two scenarios are presented in the 5 tables below – one scenario where employer retirement contributions as a percent of total payroll increase by 25%, and the other where contributions increase by 50%.
For fiscal year 2009/10, employer contributions were as follows:
|Fiscal Year 2009/10||Employer Contribution|
|San Luis Obispo||9,249,600|
Assuming employer contributions increase by either 25% or 50%, the new contributions would be as follows:
|Employer Contributions After Changes||25% Increase||Additional Contribution||50% Increase||Additional Contribution|
|San Luis Obispo||11,562,000||2,312,400||13,874,400||4,624,800|
Of course, looking at these numbers without context doesn’t tell the whole story. By examining expenditures, we gain a more complete picture. There are two different ways to look at expenditures – total expenditures and net expenditures. Total expenditures are simply total operating expenditures plus capital outlays. Net expenditures are total expenditures minus functional revenues. Functional revenues are those revenues that have been designated and can only be used for a very specific purpose. The tables below illustrate potential changes to employer contributions as a percent of total expenditures. We depict both types of expenditures, although net expenditures are likely more appropriate because those are the discretionary expenditures funded by general revenues.
|Employer Contributions as Percent of Total Expenditures||Current Retirement Contribution as % of Total Expenditures||Retirement Contribution After 25% Increase||Retirement Contribution After 50% Increase|
|San Luis Obispo||9.2%||11.3%||13.2%|
|Employer Contributions as Percent of Net Expenditures||Current Retirement Contribution as % of Net Expenditures||Retirement Contribution After 25% Increase||Retirement Contribution After 50% Increase|
|San Luis Obispo||17.4%||20.8%||24.0%|
You don’t need a PhD in mathematics to recognize that the financial situation of these cities would change for the worse. In fact, it has been changing for the worse since 1998-1999, considering retirement expense as percent of total expenditures has doubled for most of the mentioned cities since that time. Increased labor costs have forced public agencies to slash services, reduce their work force and/or borrow money to fund operations. Increasing employer contributions will uphold this trend. But what other choices do cities have? Comparing their current and hypothetical budget situations sheds light on how untenable the situation could become:
|Fiscal Year 2009/10||Current Budget Balance||Budget After 25% Increase||Budget After 50% Increase|
|San Luis Obispo||(9,558,100)||(11,870,500)||(14,182,900)|
What could the City of Pasadena do? Their budget deficit could potentially increase by 200% or 400% depending on the change in employer contributions. As of 2009-10, the City of Pasadena spent 53% on public safety, 31% on general government, 17% on community development, 16% on culture and leisure, and 11% on transportation. Since public safety represents the largest share of expenditures, do the CalPERS’ changes imply a cut in public safety? Would the parks, theaters, and libraries remain open and maintained? How much would the City be able to spend on infrastructure and community development? Or would the City be forced to file for bankruptcy?
The relatively drastic nature of these changes is why there is so much riding on the current bankruptcy cases in the City of Stockton and the City of San Bernardino. If the judges decide that CalPERS obligations are not protected under state law (making the obligations negotiable), we will likely see a flood of municipal bankruptcies and the end of the public pension system as we know it. If the judges side with CalPERS, then local governments and public agencies will have no choice but to reduce services, reduce investment, and increase revenues.
Moreover, this might not be the last increase employers will see. CalPERS has said that it will review its optimistic discount rate in 2014. A decrease in the discount rate would most likely translate into further hikes in employer contributions. Although these are steps in the right direction, they nevertheless will put significant fiscal pressure on public agencies.