Calpensions

A decade ago, when this blog began, the big public pension fund that covers half of all California non-federal government employees, CalPERS, lost about $100 billion during a stock market crash and international financial crisis.

The value of the nation’s largest public pension fund plunged from $260 billion to $160 billion. The funding level of the projected assets needed to pay future pension costs fell from 101 percent to 61 percent.

The California Public Employees Retirement System regained full funding after past drops, but none were of this size. And now the maturing system had nearly as many retirees collecting pensions as active workers paying into the system.

Generous retroactive pension increases granted during a previous stock market boom were raising costs. Pension debt was beginning to soar as payments from government employers and recovering investment fund earnings failed to keep pace.

The unprecedented investment loss raised a question. Would pension costs become unaffordable, eat up too much of government budgets needed for staff and services, and force significant pension cuts or a major reform of the retirement system?

Answer: Not yet.

A wave of worry that pension costs were “unsustainable” seemed to crest in 2012. A year of cost-cutting reform saw former Gov. Brown’s mild legislation, ballot measures with deeper cuts in San Diego and San Jose, and the Stockton and San Bernardino bankruptcies.

Brown’s reform, limited to new hires, mainly bends the cost curve a little by requiring several more years of work to earn previous pension amounts. The courts quickly blocked a key part of the San Jose reform and the San Diego reform was ruled illegal last year.

A federal judge’s opinion in the Stockton case said CalPERS pensions can be cut in bankruptcy. But Stockton and San Bernardino did not try to cut their biggest debt by far, saying pensions are needed to be competitive in the government job market.

In 2012 CalPERS also began a long-delayed series of four employer rate increases that doubled annual state and local government pension costs. Since the crash annual employer payments to CalPERS have increased from $7.7 billion to $15.6 billion last year.

CalPERS investments, expected to pay two-thirds of future pension costs, more than doubled since the $160 billion bottom in 2009, reaching $397 billion last week during a record bull stock market. The S&P 500 stock index went from 677 in 2009 to 3,235 last week.

But what’s owed for future pensions grew even faster than projected revenue. So the debt or “unfunded liability”, zero in 2007 when CalPERS was 101 percent funded, ballooned to $150 billion by 2018. The funding level has remained at about 70 percent for the last two years.

Surprisingly, as pension costs soared to an all-time high and continue to grow, there are signs that spending a larger part of government budgets on pensions has become less alarming and is now part of the usual budget landscape — in a word, normalized.

Often a direct connection between growing pension costs and tax increases and staff and services cuts may not be obvious or known to the public. For whatever reason, a once-hot pension issue, and target ripe for reform, has noticeably cooled.

“Today, 63 percent of adults say that the amount of money being spent on public employee pension or retirement systems is a big problem (29%) or somewhat of a problem (34%),” a Public Policy Institute of California survey said last March.

“This share is a record low (72% January 2005, 76% January 210, 79% March 2011, 83% December 2011, 82% January 2014, 68% September 2015, 63% today).” Pensions as a big problem reached 47 percent in 2011 before dropping to 29 percent last March.

When San Diego and San Jose put reforms on the ballot, their pension and retirement health care were 20 percent of the general fund. Another of the six big cities with their own pension systems, Los Angeles, now spends 20 percent of its general fund on retirement.

The last big proposal for Los Angeles pension reform came in the fall of 2012 from former Mayor Richard Riordan. Warning of bankruptcy, he made an aborted attempt to gather signatures for an initiative switching new hires to 401(k)-style plans.

Officials from nearly two dozen cities warned the CalPERS board in November 2017 that rising pension costs were forcing cuts in staff, services and employee pay. A mention of possible bankruptcy by an Oroville official was widely reported.

After large staff and pay cuts, Oroville voters approved a 1-cent sales tax increase in 2018. The current city budget, described as balanced for the first time in years, added 16 new staff positions and said $2 million went into a pension pre-funding trust.

In 2015 the League of California Cities “strategic priorities” called for reforms to reduce “pension unfunded liabilities and insolvency risks”. This year’s priorities call for “collaboratively” working to “secure new revenue tools” and “flexible prudent policies” to pay pension costs.

The cooling of the pension issue comes as the average annual payments local governments must make to CalPERS reaches a level the pension fund’s former chief actuary thought a decade ago would be unsustainable.

“I don’t want to sugarcoat anything,” Ron Seeling, the CalPERS chief actuary then, told a seminar sponsored by the Public Retirement Journal in August 2009 attended by many local government officials.

“We are facing decades without significant turnarounds in assets, decades of — what I, my personal words, nobody else’s — unsustainable pension costs of between 25 percent of pay for a miscellaneous plan and 40 to 50 percent of pay for a safety plan … unsustainable pension costs. We’ve got to find some other solutions.”

This fiscal year, the average cost of the 1,391 CalPERS plans for miscellaneous or non-sworn employees reached 25.2 percent of pay and will increase to 27 percent next year, according to the annual CalPERS Funding Levels and Risk Review issued in November.

Hitting the high end of what Seeling thought would be unsustainable, the average cost of the 518 CalPERS safety plans for police and firefighters this fiscal year is 49 percent of pay, increasing to 52.7 percent of pay next fiscal year.

The average safety cost reflects a wide range from less than 15 percent of pay to more than 100 percent of pay. A rate based on 100 percent of pay means, for example, that for every $1 in base salary paid a policeman or firefighter, another $1 must be paid to CalPERS.

Seeling was talking about what employers pay CalPERS. Employees pay much less, a rate set by bargaining and statute that does not increase to pay the soaring debt or “unfunded liability”. For most it’s 8 to 10 percent of pay, but a few pay as much as 15.5 percent.

So, why are soaring California Public Employees Retirement System pension costs, now at a level the former chief actuary thought would be unusustainable, apparently less alarming than he expected?

Local governments not only have a wide range of pension costs but also sharp differences in ability to pay. Some make extra payments to cut debt. Since August local governments can invest in a CalPERS trust fund to save money for future pension payments.

As in Oroville, voters have been willing to approve tax increases. More than two-thirds of local majority-vote general sales tax add-ons (336) and extensions (53) were approved from 2001 through 2018, according to the California Local Government Finance Almanac.

A CalPERS policy to avoid surprises and budget shock, and allow time for budget planning, gives local governments a six-year projection of expected costs based on investments earning 7 percent. The impact of lower earnings and changes in other costs is included.

To soften the blow, CalPERS cost increases are phased in over several years. The last big cost increase lowered the investment earnings forecast used to discount future debt from 7.5 percent to 7 percent.

The CalPERS board dropped the discount rate in three steps over seven years. The last step is not reached until 2024-25, when local government costs are projected to level off and begin to slightly decline.

A League of California Cities study issued early in 2018 said “pension costs will dramatically increase to unsustainable levels.” The average city is projected to spend 15.8 percent of its general fund on CalPERS costs in fiscal 2024-5, up from 8.3 percent in 2006-7.

An average of 15.8 percent of the general fund is below the 20 percent that helped trigger reform attempts in San Diego and San Jose. But if the League study is correct, the deepest actual budget squeeze, not just the projection, is still four years away.

Cities may renew dire warnings about rising pension costs if CalPERS considers another drop in the discount rate during a rebalancing of its investments next year. Last August Wilshire Consultants lowered its 10-year CalPERS earnings forecast from 6.2 to 5.9 percent.

Among the more than 2 million active and retired CalPERS members, which includes state workers and non-teaching school employees, cities are in a “public agencies” group with counties, special districts, joint powers authorities, and nonprofit organizations.

Cities can be hardest hit by rising pension costs because much of their spending is on employees, particularly police and firefighters. CalPERS pushed legislation for generous pensions that drive up city costs, as shown in the League study done by Bartel actuaries.

A CalPERS bill, SB 400 in 1999, gave the Highway Patrol a pension formula (3 percent of final pay for each year served at age 50) widely adopted by local police and firefighters. CalPERS erroneously said it would not cost taxpayers an additional “dime”.

In 2001 CalPERS backed a bill, AB 616, that gave non-sworn local government employees the option of bargaining for three increasingly generous pension formulas, topping out at “3 percent at 60”. CalPERS offered to inflate the value of investments to help cover costs.

Others in CalPERS are not as vulnerable to soaring pension costs as local governments. State workers and non-teaching school employees get funding from the deep-pocketed state that cannot, unlike cities, go bankrupt or be eliminated like some public agencies.

CalPERS cut several pensions after a struggling small city, Loyalton, stopped payments to the pension fund. Three years ago 182 pensions from a disbanded joint powers authority, LA Works, were cut 58 percent. Its managers were charged with embezzlement.

In contrast, Brown made a $6 billion extra payment to CalPERS to cut state worker pension debt. Gov. Newsom’s first budget calls for a four-year $5.9 billion extra payment to cut pension debt for state workers and the California State Teachers Retirement System.

Long-delayed funding legislation in 2014 gave CalSTRS, which unlike CalPERS was unable to raise employer rates, limited power to raise payments from the state, while also doubling school district rates over seven years, a painful bite from school budgets.

Some anxiety about rising pension costs was reduced by Brown’s reform, the Public Employees Pension Reform Act. For employees hired after Jan. 1, 2013, retirement ages are increased, big pensions capped, and workers pay a little more over time.

Because the reforms are limited to new hires, CalPERS estimates savings from the reform will be $28 billion to $39 billion over 30 years, not a major dent in an unfunded liability of $151 billion over three decades as of June 30, 2018.

Under current CalPERS projections assuming investment earnings average 7 percent, the change to lower-cost members hired under PEPRA is expected to begin to slightly lower the cost curve in about four years.

On its own, CalPERS began a reform this year that will save money by paying off debt from new investment losses over 20 years rather than 30 years. Faster payment of a $1 million loss, for example, cuts the repayment from $2.7 million to $2 million.

Before switching to the 30-year payment in 2013, CalPERS had been using a “rolling” or “open” amortization allowing annual refinancing that, theoretically, might never pay off the debt.

The new reform also changes the payment from a percentage of pay to an amount covering the interest, now 7 percent, the assumed amount earned if there had been no loss. Debt had been allowed to grow until about year 17 of the 30-year period, when pay hikes made the percentage big enough to cover interest.

A shorter payment period for new losses (any annual earnings below 7 percent) requires a higher payment expected to be offset by gains later. At the urging of cities, the new level payment that covers annual interest is phased in over five years, reducing the savings.

Pension funds that quickly recovered from losses a decade ago, such as the Wisconsin and Dutch systems regarded as models by some, not only promptly pay off debt from investment losses but also can cut pension payments to retirees if needed.

In San Jose and San Diego, the local ballot measures used two different methods to cut pension costs. The San Jose measure gave workers the option of earning a lower pension in the future or paying more to continue earning the same amount.

Leaving much of the measure intact, a lower court overturned the option as a violation of the “California Rule,” a series of state court decisions believed to mean the pension offered at hire becomes a vested contract right that can be cut only if offset by a comparable new benefit.

The San Diego initiative switched all new hires, except police, to a 401(k)-style individual investment plan. The state Supreme Court ruled former Mayor Jerry Sanders violated state labor law by failing to bargain with unions before pushing the initiative.

Brown’s major pension cost cut was rejected by the Legislature: a federal-style “hybrid” plan for new hires combining a lower pension and a 401(k)-style plan. A CalPERS analysis said current pension plans would be undermined if closed to new members.

“Well, that tells you you’ve got a Ponzi scheme,” Brown told a legislative committee in 2011. “Because if you have to keep bringing in new members, then the current system itself is not in a sustainable position.”

In a Ponzi investment fraud, made famous by convicted Wall Street swindler Bernie Madoff, money used to pay investors high returns on their accounts comes not from earnings but from new investors.

When statewide pension reform initiatives were regularly proposed before the issue cooled off, polls showed strong support for switching new hires to 401(k)-style plans often called a “defined contribution” in retirement plan discussions.

“About two in three Californians (67%) and likely voters (70%) favor changing the pension system for new public employees to a defined contribution system, while one in five (20% each) oppose it,” said a Public Policy Institute of California survey in September 2015.

“At least six in 10 Californians have favored this idea since we began asking this question in 2005.”

Most large companies have switched from pensions to 401(k) plans, shifting investment risk to the employee and avoiding long-term pension debt. The employer usually makes an annual payment or defined contribution to the employee’s individual investment account.

Public pensions and unions don’t want government employees switched to 401(k) plans. In a move toward equity, a public pension coalition push to improve retirement for everyone helped create new state-run automatic-IRA plans for private-sector workers like CalSavers.

Former Gov. Arnold Schwarzenegger initially included a new-hire 401(k) switch in a reform package rejected by voters in 2005. He dropped the switch after hard-hitting union TV ads said police and firefighter widows would be deprived of death benefits.

A wealthy Republican Silicon Valley executive, Meg Whitman, who spent $140 million of her own money running against Brown in 2010, supported a 401(k) switch early in her campaign. She rejected a request to fund a pension reform initiative.

One version of a bipartisan initiative proposal in 2015 could have resulted in a 401(k) switch. But like previous proposals, the initiative ended in a dispute over whether former state Attorney General Kamala Harris wrote a biased ballot summary making voter approval unlikely.

Now reformers hope union challenges to minor parts of Brown’s reform will produce a state Supreme Court decision loosening the California Rule that only allows pension cuts that are offset by a comparable new benefit, erasing any cost savings.

The high court avoided considering the California Rule while upholding a ban on “air time”, the employee purchase of additional service years to boost pensions. A decision last March said employees had no vested right to air time protected by contract law.

Next up is the first of two unanimous appeals court rulings that have conflicting views of how pensions may be cut. Both were issued in union challenges to a part of the Brown reform that curbs boosting county pensions by “spiking” final pay with a wide range of add-ons.

A consolidation of cases from Alameda, Contra Costa and Merced counties has been fully briefed and awaits oral arguments. The Alameda ruling allows pension cuts without offsetting benefits if it can be shown they are necessary for “successful operation” of the system.

The appeals court ruling in a Marin County anti-spiking case completely overturns the California Rule by finding employees only have a vested right to a “reasonable” pension. The Marin case, along with two others, was put on hold until the court rules on Alameda.

Pointing to the appeals court rulings, Brown told reporters in January 2018 he has a “hunch” the court will modify the California Rule. He later told the Sacramento Bee that without change employee wages could be suppressed and government services jeopardized.

“If we do it right, people who have a pension and what they’ve earned will never be changed,” Brown said. “But you can’t say that five minutes after you sign your employment application, for the next 30 or 35 years that not one benefit can be changed. That’s a one-way ratchet to fiscal oblivion.”

Another part of Brown’s reform is aimed at avoiding past excesses that added to the current pension debt. During a stock market boom two decades ago, surpluses in all three state pension systems were spent by increasing pensions, while payments into the systems were cut.

The plan to pay less and get more was said to be financed by strong investment earnings, unleashed by Proposition 21 in 1984. Voters approved a shift from predictable bonds to stocks and other “prudent” investments with higher yields, but also higher risks of losses.

In addition to a 50 percent Highway Patrol increase, SB 400 in 1999 increased state worker pension formulas cut earlier in the decade and boosted state retiree pensions. State CalPERS contributions were cut from $1.2 billion in 1997 to less than $160 million in 1999 and 2000, then began soaring to $6.8 billion this fiscal year.

Between 1997 and 2014, CalPERS said, SB 400 accounted for 18 percent of the state pension cost increase, other benefits 5 percent. CalPERS has not done a similar calculation for the local government cost increase from adopting the SB 400 Highway Patrol “3 at 50” pension formula.

Among a half dozen CalSTRS bills around 2000, one diverted a quarter of the 8 percent of pay pension contribution from teachers (2 percent of pay) into a new Defined Benefit Supplement for a decade, giving teachers a lump sum or annuity in addition to their pensions.

An annual CalSTRS actuarial valuation showed that if there had been no contribution cuts and benefit increases around 2000, the CalSTRS funding level in fiscal 2017-18 would have been 84.9 percent instead of 65 percent, reducing the need to double school district rates.

For a remarkable two decades, most University of California employers and employees made no payments into the UC pension plan. Investment earnings covered current and future costs, peaking in 2000 when the system was 156 percent funded.

The reckoning came in 2010 when UC began phasing in a 14 percent of pay employer rate increase over five years. A UC staff report said if normal cost contributions had been made during the two decades, the UC plan would have been 120 percent funded not 71 percent.

Brown’s reform, PEPRA, bans suspending employer and employee contributions needed to cover the annual normal cost, the pension earned during a year. The big cost now, as pensions are underfunded, is the growing debt or unfunded liability from previous years.

PEPRA does not cover the UC Retirement Plan or the pension systems of the half dozen large cities. But it does cover CalPERS, CalSTRS and the 20 independent county retirement systems operating under a 1937 law.

As expected in a maturing pension system, CalPERS retirees are on a path to outnumber active workers. That means replacing money from investment losses will take an even bigger bite of government payrolls.

A mature pension fund that needs to pay more retiree pensions grows much larger than the active worker payroll. So when CalPERS investments have a loss (currently any annual earnings below 7 percent), a much larger percentage of the payroll is needed to cover the loss.

Rates paid by local governments are already at an all-time high and growing, averaging 50 percent of pay for police and firefighters. A record decade-long bull stock market did not close the CalPERS funding gap, still only about 70 percent of future pension costs.

A “risk mitigation” plan to reduce losses in the next downturn shifts some investments to bonds, less risky but usually lower yielding. Now when CalPERS is most in need of higher investment earnings, its own consultant is predicting a 5.9 percent return for the next decade.

CalPERS worries that soaring pension costs could become unaffordable. If a local government terminates its contract for pensions that are not fully funded, the pensions that CalPERS has a fiduciary duty to protect could be cut to close the gap.

“The greatest risk to the system continues to be the ability of employers to make their required contributions,” the annual CalPERS risks report said last November, noting employer strain is difficult to assess.

“Evidence such as collections activities, requests for extensions to amortization schedules and information regarding termination procedures indicate that some public agencies are under significant strain.”

Here’s an example of how the mature growth of assets increases the percentage of pay needed to cover an investment loss of 1 percent: If the assets are 5 times more than payroll, it’s 5 percent of pay paid for over 20 years. If the assets are 10 times more than payroll, it’s 10 percent of pay.

Local government police and firefighter assets in 2009 were about 6.5 times more than payroll, a chart in the CalPERS risks report shows, climbed to 10.8 times more than payroll in 2018, and are projected to reach 13.6 times in 2024.

“It is difficult to reduce plan maturity measures without lowering benefits or settling benefit obligations with retirees through lump-sums or annuity purchases,” said the report.

Another factor that could increase assets is progress toward full funding. If investment earnings hit the 7 percent target and life spans and other assumptions don’t change, CalPERS expects to have enough assets to be 100 percent funded in 25 to 30 years.

Dropping the earnings forecast from 7.75 percent to 7 percent is one reason CalPERS funding remains low. Other factors are low government bond interest rates and a low inflation forecast, which is 2.5 percent of the 7 percent earnings target.

Another reason CalPERS has low funding is a four-year delay in beginning major employer rate increases, from 2009 to 2012, and low debt payments not large enough to prevent debt from growing. In a 30-year payment, debt grew until about year 17.

When Seeling, the former CalPERS chief actuary, warned in 2009 of “unsustainable” future employer costs, he also said that employer rates set for local governments in 2011 would be “smoothed” to lower costs.

Instead of a rate increase of 4 to 20 percent of pay, Seeling said, the smoothing would reduce the rate hike to a more manageable 0.5 to 2 percent of pay.

A Pew Charitable Trusts report issued last year said eight state retirement systems, rebounding from investment losses in 2008-09 unlike CalPERS, were 95 percent funded or more by 2017, the latest 50-state data available.

Pew said the eight systems provide a road map to sustainable pension funding that pays 100 percent of actuarial recommended contributions, has policies to manage risks and costs, and automatically reduces benefits or increases contributions during downturns.

The average contribution in 2017 of the eight states (Idaho, Nebraska, New York, North Carolina, South Dakota, Tennessee, Utah, and Wisconsin) was less than a quarter of the contributions paid by the three worst-funded states (Illinois, Kentucky, and New Jersey).

“The Wisconsin Retirement System (103 percent funded) maintained total contributions between 2014 and 2017 that exceeded by 36 percent the amount needed to keep pension debt from growing, resulting in positive amortization of over $1 billion,” the Pew report said.

The report has no comparison of pension formulas. But it seems likely few if any states top the generosity of the costly CalPERS “3 at 50” provided police and firefighters hired before the Brown reform on Jan. 1, 2013, capped at 90 percent of final pay.

Dozens of California cities give non-sworn employees hired before the reform the uncapped CalPERS “3 at 60” formula that provides a pension of 60 percent of final pay after 30 years of service at age 50 and 120 percent of final pay after 40 years of service at age 60.

A California pension is legally regarded as deferred salary. Getting a pay raise for retiring under the “3 at 60” formula begins in the benefits chart with 102 percent of final pay after 34 years of service at age 60, up from 99 percent of pay at 60 after 33 years of service.

In the aftermath of the huge CalPERS investment loss a decade ago, record pension costs are the main result so far. But the failure to regain proper pension funding during a decade of record stock market and economic growth could add to the legacy.

At only 70 percent funded, CalPERS is more vulnerable to another big investment loss that could drop funding below 50 percent, a red line actuaries say could make a return to full funding difficult if not impossible.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com. Posted 8 Jan 2020.

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