How CalPERS has Created a Ticking Time Bomb

During the Stockton bankruptcy Judge Klein called CalPERS the “bully with a glass jaw.” Klein meant that CalPERS, as a servicing company, has no standing in the bankruptcy because the pension obligation is between the public agency and their employees and retirees.

That means as opposed to lobbying for increased benefits as they have beginning in 1999 when they convinced the state legislature to increase the pensions of safety employees from 2% to 3% per year of service retroactively, and threatening litigation if Vallejo or Stockton cut benefits, the role of CalPERS is to simply (1) determine the required employer and employee contributions necessary to responsibility fund each pension plan they manage, (2) invest the contributions, and (3) send retirees checks for their promised monthly benefits.

So how well is CalPERS doing its job as a servicing company?

CalPERS headquarters in Sacramento

With the new on line website PensionTracker.org recently developed by the Stanford University Institute for Public Research we can view objective data regarding CalPERS’ performance, along with all of California’s other state and local retirement systems. Combined, the total unfunded pension liabilities for all state and local government workers in California hit $281 billion at the end of the 2013 fiscal year (6/30/2013), the last year data is available for.

Unfunded liabilities for each system are estimated as:

• CalPERS public agencies (the Public Employee Retirement Fund, Judges’ Retirement Funds I and II, and the Legislators’ Retirement Fund): $116.7 billion.
• Independent county, city and special district systems: $88.2 billion.
• California State Teachers’ Retirement System (CalSTRS) agencies: $56.5 billion.
• The University of California Retirement System (UCRS): $12.0 billion.
• Pension Obligation Bonds issued: $8.1 billion.

These numbers, however, are based on a 7.5% discount rate on the liability. That is, the estimated value of all future payments to current and eventual retirees was discounted to a present value based on a 7.5% rate of return. For a retirement system to be 100% funded, the total invested assets in the fund have to be equal to this discounted future liability, based on the assumption that these invested assets will earn 7.5% annual returns, on average, over the next several decades. And because some of California’s government employers have borrowed money to make their annual pension fund contributions, these “Pension Obligation Bonds” also have to be taken into account when calculating the unfunded liability. PensionTracker.org calculates California’s pension system’s aggregate unfunded liability as follows:

“Total Unfunded Liabilities reflects the aggregate liabilities for the California Public Employees’ Retirement System (CalPERS), the California State Teachers’ Retirement System (CalSTRS), independent pension systems, the University of California Retirement System (UCRS), plus Pension Obligation Bond (POB) balances, minus the aggregate Market Value of Assets (MVA).”

While the formula to calculate a pension system’s unfunded liability is fairly straightforward, the assumptions that are made are not straightforward at all. The result is extremely sensitive to what annual rate-of return assumption is used. When the Institute applied a lower discount rate of 3.7%, the rate that CalPERS uses if an agency wants to exit their system, the unfunded liability tripled to $946 billion, an astonishing $75,000 worth of debt for every household in California. If this rate of return is so preposterously low, why is it the rate that CalPERS uses if an agency wants to exit their system?

But these numbers, as unaffordable as they seem, do not include unfunded retiree healthcare liabilities. A 2014 study of the 20 independent county pension systems by the California Public Policy Center, “Evaluating Total Unfunded Public Employee Retirement Liabilities in 20 California Counties,” indicates when bond debt and unfunded retiree healthcare benefits were added to the county systems, the total unfunded liability for retiree benefits in those counties almost doubled from $37 billion to $72 billion.

To create this mountain of debt CalPERS has been and continues to use several accounting gimmicks.

Smoothing of Investment Returns

Up until 2006 CalPERS smoothed its investment gains and losses over 4 years. Then in 2006 they went to a 15 year smoothing and beginning in 2015 they are moving to a 30 year smoothing. Extending smoothing significantly lowers unfunded liabilities and therefore employer and employee contributions, and passes the costs onto future generations.

Smoothing also masks CalPERS poor investment performances. CalPERS has been one of the worst performing pension funds in the nation with their investments returning only 5% from 2003 to 2013 and last year only 2.5%.

Here is how smoothing works. If the pension fund were to lose $100 million in investment assets in a year using the market value of assets the pension fund would show a $100 million loss from the previous year. But by using a 4 year smoothing the actuarial loss for that year would be $25 million carried forward 3 more years. Using 15 year smoothing the actuarial loss would drop to $6.6 million carried forward 14 more years. Using the new 30 year smoothing the $100 million loss would drop to $3.3 million carried forward 29 more years. Essentially using a 30 year smoothing takes investment returns out of the pension calculation formula. In other words, this is no way to reduce risk and a good way to increase unfunded liabilities.

Beginning in 2015/2016 CalPERS is dropping smoothing of stock market gains and losses and will move from a rolling to fixed amortization of the unfunded liabilities with the intent to pay off all the current unfunded liabilities over the next 30 years. This is still a long period of time to pay off the debts. Under federal ERISA rules for private pensions unfunded liabilities are paid off over 7 years.

Extending Debt Payments on the Unfunded Liabilities

As bad as 15 to 30 year smoothing is, there is more. Following the 2008 stock market crash and the loss of 30% of its assets, instead of amortizing the unfunded pension liabilities and paying them back over 9 years as they were doing, CalPERS went to a 30 year amortization.

This is similar to the difference between what you would pay monthly and over time on a 9 or 30 year mortgage, though a more appropriate comparison would be taking 30 years to pay off a credit card balance, since there is no asset with a useful life being purchased. With a 9 year mortgage your monthly payments are much higher than with a 30 year mortgage but the total cost over time with interest is significantly less over time. Worst of all, by doing this CalPERS is passing a mountain of debt, higher taxes and fewer services onto our children and grandchildren.

Using an Overly Optimistic Discount Rate

Pension funds use a discount rate on liabilities based upon the assumption that their investments are going to return an amount similar to the discount rate. Currently, most agencies use a 7.5% discount rate. However, that rate today is too high for 3 reasons; (1) fixed income investments are currently returning 4%, (2) stocks are projected to return under 7%, and (3) with a 75% funding ratio the pension fund does not have 100% of their liabilities in assets earning income. Taking into account these factors most experts would probably recommend CalPERS to use a 3.7% discount rate. They won’t, however, because as the Stanford study has shown it would triple unfunded liabilities, drastically increase annual pension payments by the employer, and show everyone that the current benefit levels are simply unaffordable. Adequately funding pensions under these assumptions would also push hundreds of California cities and counties into balance sheet insolvency and if more cash was required to be injected into the system as private pensions are required to do with their 90% funding level requirement, into bankruptcy.

CalPERS and Pension Reform

Recently CalPERS has been rushing to play up its good government bona fides just as talk of pension reform next year has been heating up. Earlier this month, former San Jose mayor Chuck Reed and former San Diego City Councilman Carl DeMaio filed two new initiative proposals for next year’s state ballot. CalPERS is right to be concerned, since polling numbers continue to show strong public support for pension reform.

The Reed DeMaio plans are not perfect reform since they only impact new hires, but they have the advantage of being put together by former officials who grasp the depth of the crisis. The CalPERS plan seems like an attempt to coopt pension reform. Given the skyrocketing costs they’re already facing, Californians need to be told the truth about the pension debt they and their children and grandchildren will be paying off for decades.

We need real pension reform now, but it’s not going to happen if public employee unions continue to oppose reform efforts and CalPERS continues to use accounting gimmicks to hide the enormous unfunded liabilities from taxpayers and government employees and retirees who have been promised unsustainable pensions the tax base simply can’t afford to pay.

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About the author:  Ken Churchill is the author of numerous studies on the pension crisis in California and is also the Director of New Sonoma, a pension reform group.