Wednesday, May 24, 2017

Pensions Crash in California

California Cover Up, Pension loan would cover up wealth transfers to employees. By David Crane, 5/19/17

California proposes to issue a pension obligation bond to finance extra contributions to the state pension fund, CalPERS. It would also cover up wealth transfers from citizens to state employees. Here’s how it works:

When pension promises are made by the state to its employees, both the state and employees incur costs (“Normal Costs”) in the form of contributions to CalPERS with the hope that the sum of contributions and investment earnings will be sufficient to fund the promised pension payments. If investments earn at the rate CalPERS used when setting the Normal Cost, everything works out. But if investments earn at a lower rate, deficits (“Unfunded Liabilities”) arise.

In contrast to joint sharing of Normal Cost, employees don’t share in the cost of Unfunded Liabilities. 100% of that cost falls on citizens, whose services get crowded out and taxes get raised to pay off the liabilities.

As the astute reader will infer, employees profit from the highest possible investment return assumption being used by CalPERS to set Normal Costs. The higher that rate, the lower the Normal Cost, which is their only cost. But the higher that rate, the greater the likelihood of Unfunded Liabilities.

Because public employees control CalPERS, investment return assumption rates have been set at levels virtually guaranteeing the creation of Unfunded Liabilities. That transfers wealth from citizens to employees. The transfer has been huge: citizens are already on the hook for $60 billion of Unfunded Liabilities for state employee pensions accruing interest at 7.5% per year and more transfers are occurring every day CalPERS continues setting Normal Costs unfairly low.

Now, Jerry Brown proposes to borrow from a citizen-funded restricted fund to boost pension contributions. The loan would be of a variable rate nature that, based on current yield curves, is expected to cost 3–4% but is not capped. The proposed source of repayment for the loan is a taxpayer-funded account established by Proposition 2 to accelerate payments on certain state debts but that’s just a fig leaf since state debts eligible for acceleration dwarf the size of the Proposition 2 fund. No investment return is guaranteed and citizens have all the risk. Employees take no risk and will collect their pensions regardless of the outcome.

If enacted, Brown’s proposal would set a terrible precedent. With $70 billion in restricted funds and more coming in from a recently boosted gas tax, what’s to stop more such loans? Every public-employee-controlled pension fund would learn the same trick and be rewarded for transferring wealth from citizens to employees by setting Normal Costs unfairly low. Also, who would enforce payback of the loan? In which state official’s political interest would it be to press for repayment? There is good reason to believe repayment would be deferred or ignored.

Brown should withdraw his proposal. He has a reputation as a straight shooter but there is nothing straightforward about this Rube Goldberg scheme. If not withdrawn, the legislature should assign its evaluation to an independent source not staffed by public employees or affiliated with or compensated by public employees, who have an obvious conflict of interest.

Politicians keep looking for an easy way to address pensions but that path was closed a decade ago when the state chose not to lower investment return assumptions to reasonable levels and boost Normal Cost contributions. It was easy then but because Unfunded Liabilities compound at high rates, the balances due now are huge and growing. The only paths that seriously move the needle are boosted taxes, reduced services, or reduced future pension benefits for current employees and retirees. The first two paths have already been trod with three tax increases since 2009 and reduced shares of the budget for universities, courts, parks and social services. The third path has not even been approached. Current employees and retirees benefitted from keeping Normal Cost unfairly low. It’s time for them to share in the pain being suffered by citizens.

David Crane Lecturer at Stanford University and president of Govern For California

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