Rebuilding California’s Infrastructure (Financing Models & Recommendations)

California Cities Facing Huge Pension Increases from CalPERS

In their most recent actuarial reports CalPERS for the first time provided pension cost estimates for the next 8 years, from 2015 to 2023.

How high are these costs going for California’s cities who retroactively increased their pensions at CalPERS urging over the past 15 years? To answer that question I looked at the largest city in my county, Santa Rosa and this is what I found.

Data Sources for this Report

The data used to develop the spreadsheet analysis done as part of this report are NOT numbers that I calculated. The past numbers for 2002 to 2015 are taken directly from the City of Santa Rosa’s Comprehensive Annual Financial Reports found on the City’s website (This page has the links to Santa Rosa’s CAFRs from 2001 through 2015. In each of these CAFRs, the pension information is found in the section entitled “Notes to Basic Financial Statements” under the heading “Employees Retirement Plan.”). The projected growth of certain costs – such as retiree healthcare benefits (also known as “other post employment benefits,” or OPEB), the payroll and sales and property tax revenues – use inflation rates or growth rates similar to what CalPERS uses.

The future pension costs were obtained directly from the 2013 and 2015 Actuarial Reports prepared by CalPERS and found on the CalPERS website. Since the future costs are based upon CalPERS achieving a 7.5% net rate of investment return, I believe their costs are understated, but I used them anyway. But since the pension plan has $804 million worth of assets if the pension fund returns 6.5%, in a single year it will add $8 million to the City’s pension debt and a 5% return would add $20 million.

Looking at the data going back 16 years what I found is that in 2000, Santa Rosa’s pension contribution was $1.8 million and the plan was 122% funded, meaning there were $1.22 worth of invested assets in the fund for every $1.00 worth of benefits earned.

With CalPERS wholehearted support and assistance, on August 6, 2002, the Santa Rosa City Council passed a board resolution to enact a new contract with CalPERS that changed formulas from 2% per year of service at 55 years of age for non-safety Miscellaneous employees to a 3% at 60 formula.  The new formula was provided prospectively, meaning it only applied to future years of service, not past years.

For Police and Fire employees, the new contract was adopted retroactively so it applied to past and future years of service. Their formula went from 2% per year of service at 55 years of age to 3% at 50. This represents a more than 50% increase in the benefit, since along with the “multiplier” increasing from 2% to 3%, the age of eligibility dropped from 55 to 50. But it was the retroactive granting of this benefit that caused even more significant financial liability. This is because the multiplier was increased by 50% even for years already worked and raised pensions from 60% of salary to 90% of salary for 30 years of service.

These changes ended up having a serious impact on the pension costs and the unfunded liability because CalPERS used an overly optimistic rate of investment return of 8.25% compounded per year in their cost analysis. Over the past 15 years since the increase, CalPERS has only achieved a 5% compound rate of return. Many experts believe in this current low interest rate environment returns will remain at the 5% return level for the foreseeable future.

In July of 2003 the City took on $53 million worth of new debt by selling Pension Obligation Bonds (POB) and giving the proceeds to CalPERS to pay down the unfunded liability that was created by the new formulas. With interest these bonds will divert over $100 million from government services to debt service.

CalPERS Flawed Cost Analysis and Lack of Proper Disclosure

CalPERS cost analysis provided to the City in 2002 stated the cost for the new 3% at 50 formula for Safety members would be 13.27% of salary and the cost for the 3% at 60 formula for Miscellaneous members would be 9.87% of salary. However, as previously stated, these estimates were calculated assuming that pension assets would grow at 8.25% per year into the future. Since CalPERS investments have only averaged 5% over the past 15 years the increases have created $287 million in unfunded pension liabilities for the City as of 2015.

In addition, the analysis did not provide the City with any warning or disclosure regarding what would happen if the 8.25% investment return was not achieved. CalPERS simply wrote “For many plans at CalPERS the financial soundness of the plan will not be jeopardized regardless of the new formula choice made by the employer.”

The Growth of Pension Costs Since the Increase

In 2001, the City’s pension contribution was $1.5 million and in the first 4 years following the increase it grew to $11.5 million. In addition, the funding ratio dropped from 122% in 2001 to 70% in 2005 meaning the fund, instead of $63 million in excess assets now had $128 million in unfunded liabilities.

In 2006, the annual cost grew by another $5 million hitting $16.6 million and by 2015 had grown to $21 million. However, this was a very modest growth considering CalPERS lost 29% of its assets during the Great Recession in 2008 and 2009. CalPERS lowered contributions in order to help cities and counties who saw their tax revenues during the recession drop. So CalPERS extended the amortization period on the unfunded liabilities from 9 to 20 years and smoothed their investment gains and losses from 4 to 15 years into the future. Basically, these were accounting gimmicks that resulted in severe underfunding of the pension plan and these changes exist today. The chart below shows the growth of Santa Rosa public employee retirement costs (click here to see the underlying calculations).

Santa Rosa Retirement Cost Growth

However, now CalPERS is worried that the plans are not being properly funded and pension contributions need to be doubled over the next 9 years.

Projected Future Costs

In their 2015 actuarial reports, CalPERS provided the City with their normal employer contribution as a percentage of payroll and the unfunded actuarial liability (UAL) as a total cost each year from 2015 to 2023. Using a 3% payroll growth assumption and their UAL numbers, I calculated the annual costs going forward. In addition, I added the pension obligation bond debt service each year going forward along with the cost of retiree healthcare benefits using a 5% annual cost increase assumption as CalPERS does.

My analysis indicates that during the next 8 years, the cost for retiree benefits will increase from $31.0 million or 33.7% of payroll in 2015 to $59.1 million or 48% of payroll in 2023.

The nearly doubling of pension and retiree healthcare costs means the City will need to cut salaries, benefits, services and/or increase taxes each and every year going forward by $3.2 million per year to meet their retiree benefit costs.

Pension and Healthcare Costs as a Percentage of Tax Revenues

More important than pension costs as a percentage of payroll are pension costs as a percentage of tax revenues because tax revenues are what enables the City to pay for its benefits. Once retiree benefit costs exceed the City’s ability to pay them, they will no longer be able to be fully paid and at that point either they will need to be reduced in bankruptcy or through significant pension reductions. The chart below shows the growth of pension costs relative to that of general fund property tax and sales tax revenues.

churchill-2016-10-31-chart

The results of my analysis are staggering. Over the past 15 years’ sales and property tax revenues have climbed an average of 3% per year, while employee retirement costs have increased an average of 19% per year. This has led to a growth of retiree benefit costs from 3.5% of major tax revenues in 2001 to 47% in 2015 and an estimated growth to 70% of major tax revenues by 2023 (Editor’s note:  the city receives other revenues which may also be available to finance pension costs).

Growth of the Unfunded Liability

The unfunded liability of the pension plan is calculated by taking the assets in the plan minus the present value of the benefits already earned by current employees and retirees, considered the plan’s liability. The funding ratio is determined by dividing the market value of assets in the plan by the liability.

CalPERS discounts the long term liability by assuming before the money is paid to retirees, it will earn investment income. CalPERS currently uses an assumed 7.5% rate of investment return to calculate the liability and payments to the plan. So if the assumed investment return is lowered, the unfunded liability of the plan increases along with the cost of paying off the liability. Unfunded liability costs are borne by taxpayers and are not a shared expense with the employees.

Currently, using a 7.5% assumed rate of return, the pension fund has $287 million worth of unfunded liabilities and pension bond debt and is 74% funded. However, many experts believe in this low interest rate environment a lower investment return assumption should be used. Many experts think that a 5.5% to 6.5% rate should be used. Other experts believe a 3.5% rate should be used since this is about the rate private pension plans are required to use and what CalPERS uses if a City wanted to buy their way out of the CalPERS system. I won’t guess what the future investment returns will be, but here is what happens to the unfunded liability at various rates of investment return assumptions:

  • At 6.5% the unfunded liability would increase to $426 million and $50 million per year to would be added to the City’s pension costs.
  • At 5.5% the unfunded liability would increase to $585 million and $97 million per year would be added to the City’s pension costs.
  • At 4.5% the unfunded liability would increase to $755 million and $137 million per year would be added to the City’s pension costs.
  • At 3.5% the unfunded liability would increase to $967 million and $187 million per year would be added to the City’s pension cost.

Santa Rosa Analysis of Unfunded Liability at Various Rates of Investment Return

20161028-cpc-churchill1

City Pension Plan Status Using ERISA Standards

Under the Federal ERISA rules for private pensions, a high quality bond rate of return is used to determine the assumed rate of investment return. Today that is around 3.5%. ERISA also defines the health of a pension plan as follows:

  • Less than 80% funded is considered “seriously endangered”
  • Less than 70% funded is considered “at risk”
  • Less than 65% funded is considered “critical status”

So under ERISA standards, the City of Santa Rosa’s pension plan at 45% funded when assuming a 3.5% return is 20 percentage points below what ERISA would consider “critical status”. So one could more accurately describe the pension system as being on “life support”.  Also, under ERISA rules the pension benefits each year would stop being accrued until the plan becomes 60% funded to keep the hole from going deeper.

ERISA also requires the plan sponsor pay off their unfunded liabilities over 7 years. CalPERS currently allows public agencies to pay off their liability over up to 30 years. If the City was required to pay off its unfunded liability over the next 7 years, their annual contribution to the pension fund would grow from $28 million to $146 million in 2015 alone. So under ERISA rules pension costs would increase by $120 million per year and take them to 145% of payroll.

Conclusion

The City of Santa Rosa and all cities in California who retroactively increased pensions need to restructure their pension systems. Otherwise it is increasingly unlikely they will be able to afford the benefits that have already been earned and provide taxpayers with the services they deserve for their tax dollars.

City officials can no longer pretend a crisis does not exist. They would be well advised to form a Pension Advisory Committee and bring all the stakeholders to the table to look at all the options, have an actuary determine the savings for each option and make informed decisions to save the pension plan and benefits people are counting on to fund their retirement.

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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, an organization of financial experts and citizens concerned about Sonoma County’s finances and governance.

REFERENCES AND RELATED ARTICLES

California Court Ruling Allows Pension Changes, August 26, 2016

How CalPERS has Created a Ticking Time Bomb, November 30, 2015

The Devastating Impact of Retroactive Pension Increases in California, April 27, 2015

Evaluating Total Unfunded Public Employee Retirement Liabilities in 20 California Counties, May 6, 2014

Sonoma County’s Pension Crisis – Analysis and Recommendations, January 12, 2014

The Sonoma County Retroactive Pension Increase: Gross Incompetence or Billion Dollar Scam?, April 15, 2012

How Retroactive Benefit Increases and Lower Returns Blew Up Sonoma County’s Pensions, April 5, 2012

 

California’s Misguided Water Conservation Priorities

If you’ve recently driven on most any California freeway, you’ve seen the default message on the government-owned electronic billboards, “Severe Drought Conditions – Reduce Outdoor Water Use.”

The message seems reasonable enough. Several years of lower-than-average rainfall have left the state’s reservoirs depleted, so why should households be wasting water, indoor or outdoor? And if you think that reducing residential water consumption will make a difference, the solutions seem reasonable as well:  Let your lawn die, install drip irrigation to keep your perennials alive, plant “drought tolerant” plants, buy a side-loading washer, a low flow toilet, put a flow restrictor on your shower, etc., etc., etc. But will all of this make any difference?

20160817-CPC-water-quote

To answer this question it is necessary to determine just how much water is available to Californians, and how much of that water is being consumed by residential households in California. When making this analysis, we will not only estimate how much water California’s households purchase from their utility, but how much water is embodied in the food they eat.

TOTAL ANNUAL WATER SUPPLY AND USAGE IN CALIFORNIA

Here’s a rough summary of California’s annual water use. In a dry year, around 150 million acre feet (MAF) fall onto California’s watersheds in the form of rain or snow, in a wet year, we get about twice that much. [1] Most of that water either evaporates, percolates, or eventually runs into the ocean. In terms of net water withdrawals, each year around 31 MAF are diverted for the environment, such as to guarantee fresh water inflow into the delta, 27 MAF are diverted for agriculture, and 6.6 MAF are diverted for urban use. [2] Of the 6.6 MAF that is diverted for urban use, 3.7 MAF is used by residential customers, and the rest is used by industrial, commercial and government customers. [3]

Put another way, we divert 65 million acre feet of water each year in California for environmental, agricultural and urban uses, and the recommended 25% reduction in water usage by residential customers will save exactly 0.9 million acre feet – or 1.4% of our total statewide water usage. One good storm easily dumps ten times as much water onto California’s watersheds as we’ll save via a 25% reduction in annual residential water consumption.

#1 – Total Annual Water Supply and Usage in California20160817-CPC-CA-total-water-usage1

Armed with these facts, there’s a strong argument that cutting back on residential water consumption will not make a significant difference in California’s overall water use. And there are additional facts that can put this argument into an even sharper context: How much water do California’s households consume in terms of the water that was required to grow the food they eat, and how does that amount compare to the water they purchase from their utility for indoor/outdoor use?

THE “WATER FOOTPRINT” OF FOOD PER OUNCE AND PER CALORIE

While the information to determine this is readily available, it isn’t typically compiled in this context, so here goes. The best source of comprehensive data on the “water footprint” for various types of food comes from the Water Footprint Network [4], a project initially funded by UNESCO. An excellent distillation of that information was produced in April 2015 by Kyle Kim, John Schleuss, and Priya Krishnakumar, writing for the Los Angeles Times [5]. Information on calories per ounce was found on the website “fatsecret.com” [6]. That information is summarized on the following table.

#2 – Water “Footprint” per Ounce and per Calorie of Food20160817-CPC-water-footprint-per-food-category

As can be seen on the above chart, when evaluating the water efficiency of various food sources, it is misleading to rely only on gallons per ounce, since the number of calories per ounce are highly variable. But putting these two variables together to calculate a gallons per calorie measurement is quite useful. Clearly, meat products require a huge amount of water per calorie. The most efficient sources of meat protein are found in chicken, which at 0.37 gallons per calorie is around four times as water-efficient as red meat. Some sources of protein from vegetables are surprisingly efficient, including avocados at 0.20 gallons per calorie, and the almond – much maligned as a water waster – at 0.15 gallons per calorie. But we digress. How much water does it take to feed the average household in California, and how does that compare to the amount of water they buy from the utility for indoor/outdoor use?

TOTAL ANNUAL CONSUMPTION OF WATER-IN-FOOD PER HOUSEHOLD

The next table, below, provides this estimate based on a typical diet. The estimate of 2,000 calories necessary to sustain the average human (men, women, children) comes from WebMD [7]. The breakout of food consumption by category, while somewhat arbitrary, relies on data on “the average American diet” [8] compiled by researcher Mike Barrett, writing for the Natural Society website. In turn, Barrett relied on USDA and other government sources for most of his data, which is reflected here.

#3 – Total Annual Consumption of Water-in-Food per Household
20160817-CPC-water-in-food-consumption-per-capita

In one year, the average American consumes a quantity of food that required 1.3 acre feet of water to grow. In turn, at 2.91 people per household in California [9], the average household consumes a quantity of food per year that requires 3.9 acre feet of water to grow.

AVERAGE ANNUAL WATER USE PER CALIFORNIA HOUSEHOLD

Putting all of this together yields a revealing table, below, that shows that the average household purchases a relatively trivial amount of water from their utility, when compared to how much water they purchase in the form of the food they eat. By dividing the 3.7 million acre feet of water used by residences each year in California by the 12.8 million households in California [10], the average annual water consumption per household is 0.289 acre feet. By contrast, the amount of water that is eaten, so to speak, by the average California household is 3.9 acre feet, thirteen and a half times as much. By the way, it is irresistible to point out that drinking water, that quantity each human requires for their daily hydration, based on the 0.5 gallon per day recommendation from AuthorityNutrition.com [11], comes out to a paltry 0.0016 acre feet per year per household – not even a rounding error when compared to the other uses. Think about that the next time you have to ask for your water at a California restaurant.

#4 – Average Annual Water Use per California Household
20160817-CPC-average-water-use-per-household

OBSERVATIONS AND RECOMMENDATIONS

(1)  Projects that increase water supply via sewage reuse, runoff storage via reservoirs or aquifers, and desalination, are options that benefit all users, urban and agricultural.

(2)  Increasing the supply of water from diverse sources creates system resiliency which can be of critical benefit not only in the face of persistent drought, but also against catastrophes that may, for example, disable a pumping station on a major aqueduct.

(3)  The energy costs to desalinate seawater, approximately 4.0 kilowatt-hours per cubic meter, are overstated. Desalination plants can be co-located with power plants, eliminating power loss through transmission lines, whereas far-flung pumping stations consume significant amounts of electricity. Depending on transmission loss and desalination plant efficiency, the amount of lift beyond which desalination consumes less power than pumping is about 1,500 feet.

(4)  Public investment in water saving home appliances, for example via tax rebates to consumers to purchase them, by contrast, do not increase the overall supply of water.

(5)  It is nearly impossible to engage in excessive use of indoor water in a household, because 100% of the sewage is treated and released as clean outfall to the environment. Moreover, sewage is increasingly treated and reused as potable water, and eventually 100% of indoor water waste will be cycled immediately back for reuse by households.

(6)  One preferred way to reuse household sewage is referred to as “indirect potable reuse,” where the treated water is percolated into aquifers where it is eventually pumped back for household reuse. This practice has the virtue of banking the water against supply disruptions, recharging the aquifer which is especially beneficial in coastal areas where there can be salt water intrusion, and even, as water is repeatedly cycled through the aquifer, causing an ongoing improvement to the quality of the water in the aquifer as treatment progressively reduces levels of undesirable residual toxins.

(7)  While achieving 100% reuse of sewage will render indoor water conservation pointless, the virtues of outdoor water use are understated. Healthy landscaping, consisting of abundant vegetation including lawns, reduce the incidence of dust-borne pathogens, reduce the incidence of asthma, and clean and moisturize the air. Replacing grass playing fields with artificial turf introduces toxins, causes more ACL and other sports injuries, and retains heat – often to the point of making these faux fields unplayable unless they are, ironically, watered.

(8)  Simply giving up consumption of red meat would reduce the average household’s water consumption by nearly 2.0 acre feet per year. By comparison, the average Californian household’s total water consumption from the utility averages 0.29 acre feet per year. That is, just replacing consumption of red meat with an equivalent caloric intake of chicken will save the average household seven times as much water as they buy from the utility for all uses, indoor and outdoor.

Policies designed to reduce household water use are a good idea, but must be kept in perspective. Perhaps what has already been done is more than enough, and priorities might now shift towards investment in infrastructure to increase the supply of water. Nearly all water diversions in California, about 90%, are either to preserve ecosystem health or to supply agriculture. Indoor water overuse is becoming a myth, and will become entirely irrelevant as soon as 100% sewage reuse capacities are achieved. Outdoor water use should not be thoughtless, but allowing grass and perennials to die, or converting landscaping to “desert foliage,” is a cultural shift that is not necessary or desirable.

Along with investing in infrastructure to increase the supply of water, public education to help Californians adopt healthier diets would have the significant side benefit of being sound water policy. A trivial change in patterns of food consumption yields a major reduction in water required for food. For example, a public education campaign that caused a voluntary 10% reduction in red meat consumption (from 25.0% of all calories to 22.5% of all calories) would reduce California’s water consumption by 2.5 million acre feet per year. By comparison, total outdoor residential water consumption in California is estimated at only 1.8 million acre feet per year.

Perhaps, in lieu of renouncing escalating and entirely unnecessary mandates to reduce household water use, those of us who love our lawns might at least be granted a waiver if we were to present an annual affidavit to document our below-average consumption of red meat. Our smart refrigerators might actually submit the report to the utility, sparing us the paperwork.

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Ed Ring is the president of the California Policy Center

 

 

FOOTNOTES

(1) Total Precipitation in California during wet, average, and dry years:
California Water Supply and Demand: Technical Report
Stockholm Environment Institute
Table 2: Baseline Annual Values by Water Year Type and Climate-Scenario (MAF)
http://sei-us.org/Publications_PDF/SEI-WesternWater-CWSD-0211.pdf

(2) California water use by sector:
California Water Today
Public Policy Institute of California
Table 2.2, Average annual water use by sector, 1998–2005
http://www.ppic.org/content/pubs/report/R_211EHChapter2R.pdf

(3) California urban water use by sector:
California Dept. of Water Resources
2010 Urban Water Management Plan Data – Tables
Download spreadsheet “DOST Tables 3, 4, 5, 6, 7a, 7b, & 7c: Water Deliveries – Actual and Projected, 2005-2035”
http://www.water.ca.gov/urbanwatermanagement/2010_Urban_Water_Management_Plan_Data.cfm

(4) Water required to grow food – comprehensive resource:
The Water Footprint Network
http://waterfootprint.org/en/resources/water-footprint-statistics/
Their study explaining the data (downloadable PDF):
http://waterfootprint.org/media/downloads/Mekonnen-Hoekstra-2011-WaterFootprintCrops.pdf
The raw data (downloadable spreadsheet):
http://waterfootprint.org/media/downloads/Report47-Appendix-II.xlsx

(5) Graphic explaining water required to grow 1.0 ounces of various common types of food:
Los Angeles Times, April 2015
http://graphics.latimes.com/food-water-footprint/

(6) Tables showing calories per ounce of food:
Meat:
Lamb – https://www.fatsecret.com/calories-nutrition/generic/lamb-cooked
Pork – https://www.fatsecret.com/calories-nutrition/generic/pork-cooked-ns-as-to-fat-eaten
Beef – https://www.fatsecret.com/calories-nutrition/generic/beef-cooked-ns-as-to-fat-eaten
Chicken – https://www.fatsecret.com/calories-nutrition/generic/chicken-rotisserie-ns-as-to-skin-eaten
Starch:
Rice – https://www.fatsecret.com/calories-nutrition/generic/rice-white-cooked-regular
Pasta – https://www.fatsecret.com/calories-nutrition/generic/spaghetti-cooked
Wheat bread – http://www.fatsecret.com/calories-nutrition/usda/whole-wheat-bread
Potatoes – https://www.fatsecret.com/calories-nutrition/generic/white-potato-roasted
Vegetables & Fruit:
Broccoli – https://www.fatsecret.com/calories-nutrition/usda/broccoli
Asparagus – https://www.fatsecret.com/calories-nutrition/usda/asparagus
Cucumber – https://www.fatsecret.com/calories-nutrition/usda/cucumber-(with-peel)
Avocado – https://www.fatsecret.com/calories-nutrition/usda/avocados
Banana – https://www.fatsecret.com/calories-nutrition/generic/banana-raw
Spinach – https://www.fatsecret.com/calories-nutrition/usda/spinach
Peaches – https://www.fatsecret.com/calories-nutrition/usda/peaches
Tomatoes – https://www.fatsecret.com/calories-nutrition/generic/tomatoes-raw
Fluids:
Milk – https://www.fatsecret.com/calories-nutrition/generic/milk-cows-fluid-whole
Wine – https://www.fatsecret.com/calories-nutrition/usda/white-table-wine
Beer – https://www.fatsecret.com/calories-nutrition/generic/beer
Orange juice – https://www.fatsecret.com/calories-nutrition/usda/orange-juice
Nuts:
Almonds – http://flowingdata.com/2015/04/07/gallons-of-water-to-produce-foods/

(7) Daily calorie requirement for the average American:
WebMD
http://www.webmd.com/diet/features/estimated-calorie-requirement

(8) Average American diet by food category:
Mike Barrett, Natural Society
http://naturalsociety.com/average-american-diet-infographic/

(9) Average number of residents per household in California:
Point2Homes.com
http://www.point2homes.com/US/Neighborhood/CA-Demographics.html

(10) Total number of households in California:
Point2Homes.com
http://www.point2homes.com/US/Neighborhood/CA-Demographics.html

(11) How much water should the average human drink per day:
AuthorityNutrition.com
https://authoritynutrition.com/how-much-water-should-you-drink-per-day/

How a Major Market Correction Will Affect Pension Systems, and How to Cope

Summary:  Based on historical trends, three key aggregated stock market ratios – price/earnings, price/sales, and price as a percent of GDP – all show that publicly traded U.S. stock are overvalued by approximately 50%. This article explains the significance of these ratios, then, using a financial model developed specifically for this purpose, evaluates the impact of a major stock market correction on the funded status of California’s pension funds.

For all of California’s pension funds consolidated, the analysis finds that if the market corrects downwards by 50%, then recovers to grow at 5% per year, without benefit reductions, the required annual contribution will rise to 80% of pension eligible payroll. This will cost California’s taxpayers an additional $50 billion per year. If the market corrects by 50% then recovers to grow at 4% per year, without benefit reductions, the required annual contribution will rise to 113% of pension eligible payroll. This scenario will cost California’s taxpayers an additional $86 billion per year. The study evaluates the impact of benefit reductions, exploring cases where only new employees are affected, as well as cases where benefits earned for future work by existing employees are also affected.

When evaluating what level of benefit reductions can preserve pension systems without increasing employer contributions – which currently average about 33% of pension-eligible payroll – the study found the following:

In the case of a stock market negative correction of 50% followed by 5% annual growth, if the annual multiplier (the amount that is multiplied by years work times final salary to calculate an initial pension) is cut by 40% for new employees, the annual retiree cost-of-living adjustment is cut by 40% for new employees, the retirement eligibility age is raised by five years for new employees, AND the annual multiplier is cut by 20% for existing employees for future work, the current level of payments – approx. 33% – would be sufficient to bring the systems to 100% funded status by 2050.

In the case of a stock market negative correction of 50% followed by 4% annual growth, if the annual multiplier is cut by 40% for new employees AND existing employees for future work, and the annual retiree cost-of-living adjustment is cut by 40% for new employees AND existing employees, and the retirement eligibility age is raised by five years for new employees AND existing employees, the current level of payments – approx 33% – would be sufficient to bring the systems to 100% funded status by 2050.

The article concludes by recommending policymakers and stakeholders negotiate contingency plans to handle a major stock market correction that strikes an appropriate balance between costly tax increases and benefit reductions. The model used for this analysis can be downloaded here. Researchers at the California Policy Center may be available to assist those interested in using this model to analyze their particular pension system. 

INTRODUCTION

Pension systems rely on investment returns to ensure their ability to pay retired participants far more in retirement benefits than they, along with their employers, ever contributed into those funds during the times they were working. Public employee pension systems are particularly dependent on strong investment returns, because they are exempt from ERISA guidelines that mandate conservative, low-risk investments. Pension systems subject to ERISA are forced by its rules to make modest return-on-investment projections, and as a result they collect relatively more from their participants and their employers during their working years, and pay out relatively less in retirement benefits.

Because public employee pension systems make higher risk investments and depend on higher returns – in order to collect less from their participants and pay out more in retirement benefits – they are unusually vulnerable to sustained downturns in the stock markets. These pension funds typically have 70% or more of their assets invested in publicly traded stocks, and these investments are typically where they expect to earn the bulk of their high returns.

California’s public employee pension systems currently project between 7.0% and 7.5% per year on their investments. Some of the major funds have announced that over the next 20 years they intend to drop that projection to 6.5%. They adhere to this rather bullish long-term projection despite a stock market that in aggregate has returned almost nothing to its investors for nearly two years. Because public sector pension funds are so big, managing in aggregate over $4.0 trillion in assets nationwide, they cannot reasonably expect to beat the market. One of the premises of this article is that the historical performance of the stock market over the past 60 years, and especially over the past 30 years, is not an indication of similar returns from now on, and may in fact be counter-indicative.

This article will discuss the probability of a major market correction in part one. It will present a financial model to analyze the impact of this correction in part two, and it will present various options to policymakers in part three. It is important to emphasize from the outset, however, that there are no easy solutions to public pensions in the face of major downward correction in the market followed by a recovery that takes several years.

Last month we released a related article entitled “The Coming Public Pension Apocalypse, and What to Do About It.” That article is recommended reading for anyone interested in this topic. The format of this article parallels the earlier work but uses a different but complementary analysis in part one, and then relies on a comprehensive pension analysis model – prepared over the past two months and publicly introduced here – as a framework for discussion in parts two and three.

PART ONE:  USING KEY RATIOS TO ESTIMATE HOW MUCH THE MARKETS ARE OVERVALUED

In the previous article, part one surveyed the reasons why pension fund rates of return will fall dramatically. The emphasis was on causes, which can be briefly summarized in two categories, demographics and debt.

Causes of unsustainable stock market appreciation: Demographics and Debt

The challenge demographics poses to pension funds is based on the rapidly changing ratio of retirees to workers. According to the Federal Administration on Aging, using Census Bureau data, in 1970, 9.9% of the US population was over the age of 65. By 2030 that percentage is projected to more than double, to 19.3% of the U.S. population. This means that twice as many people, as a percent of the total population, will be retired and living on their savings. Simply put, this means they will be sellers instead of buyers in the market, driving down prices. Pension funds, where you would not expect such a dramatic change in the ratio of workers to retirees since their demographics are based on growth of the government workforce, not birth-rates, have also recently become net sellers in the markets, because the benefit enhancements they lobbied for starting around 1999 are now translating into a retired population of who are people retiring earlier with larger pensions compared to older pensioners.

The challenge rising levels of debt poses to pension funds is based on three related trends – interest rates, total market debt as a percent of GDP, and stock market appreciation. What has happened since 1980 has been a long-term downward trend in interest rates, a long-term upward trend in the stock market, and a long term upward trend in total debt as a percent of GDP. These trends are connected: Lowering interest rates stimulates borrowing which increases consumer debt and creates an incentive (fully realized) for increasing government debt. Each time interest rates are lowered, two things happen to the stock market, (1) corporate profits rise because new rounds of borrowing stimulate consumer and government spending, which in turn makes their stock worth more, and (2) more people are buying stock since the return they can get on loans has just gone down – also driving up stock prices. The problem with this model however is that it is unsustainable. Ever since the last stock market low in February 2009, interest rates have remained at or near zero, and debt as a percent of GDP has plateaued at roughly 350%. Lowering interest rates can no longer stimulate economic activity or stock market appreciation.

Evidence of unsustainable stock market appreciation: Three Key Ratios

(1) Aggregate Price/Earnings Ratio

The first table illustrates the historical trend for the price-to-earnings ratio for the S&P 500. The historical average price earnings ratio for publicly traded stocks in the U.S., as can be seen from looking at the trend line, is about 16x. Currently it is about 25x. It should be noted that while earnings are considered too volatile to serve as the most reliable indicator of whether or not a stock is overvalued or undervalued, the table here, developed by economist Robert Shiller, presents a “cyclically adjusted price to earnings ratio.” Using this technique, a rolling ten-year average earnings is calculated, and that is what is being depicted on the chart.

As can be seen, the stock market crash of 1929 was preceded by an aggregate P/E of 30. The overvalued stock market before the correction of 2000, soaring on internet IPOs for companies that, in many cases had no earnings, achieved a P/E of nearly 45 before the fall. And the overvalued stock market before the correction of 2009 had a P/E of just over 25. These high P/Es are not sustainable. The S&P 500 closed on July 8th, 2016 at a value of 2,129. If the P/E of the S&P 500 were to revert to a sustainable historical average of 16, the S&P index would fall by 36% to 1,362. And while that’s a usable projection, in reality when corrections occur, the P/E ratio falls below the average for a time, i.e., a correction to 1,362 might be a best-case scenario for the S&P 500.

Aggregate Price/Earnings Ratio, S&P 500
Last 136 years through 2016 

20160630 Schiller price earnings ratio

(2) Aggregate Price/Sales Ratio

If the price/earnings ratio, even smoothed to a ten year rolling average, is considered unreliable because earnings are volatile, then the lesser known price/sales ratio is a good way to take a second look. A price/sales ratio is relatively easy to grasp intuitively – it measures the annual revenue of the company divided by the value of the company. An aggregate price/sales ratio for the entire S&P 500 would simply be the total annual revenues of all 500 companies, divided by the total market value (expressed in their stock price x number of shares outstanding) of all 500 companies. The sustainable historical average price/sales ratio for the S&P 500 is 0.9x.

The next chart, going back to 1965, shows that aggregate price/sales ratios for the S&P 500 are at 50 year highs. As can be seen, at the 2000 peak the price/sales ratio was around 1.6x, and back in 2008 it moved just over 1.8x. Today the aggregate price/sales ratio for the S&P 500 is about 2.1x. If the P/S of the S&P 500 were to revert to a sustainable historical average of 0.9x, the S&P index would fall by 57% to 912.

Aggregate Price/Sales Ratio, S&P 500
Last 51 years through 2016
20150228_S&P-price-sales-ratio

(3) Market value of all publicly traded U.S. stocks/GDP

Another way, using ratios, to assess whether or not the U.S. stock market is overvalued is to compare the market value of all publicly traded U.S. stocks to the gross domestic product for the U.S. economy. The chart depicting the trends for this ratio since 1955 shows that it is just off a 60 year high. Before the 2000 correction the market cap/GDP ratio was 204%. Before the correction of 2009 it got up to 183%. And at the end of 2015 it was just under 200%. After both the 2000 and the 2009 correction the market cap/GDP ratio dove to around 100%. If public stocks in the U.S. were to revert to a market cap/GDP ratio of 100%, the S&P 500 would fall 50% to 1,064.

Market Value of all Publicly Traded U.S. Stocks / GDP
Last 60 years through 2015

20160416_Stock Market percent of GDP

The conclusion of this section, using the average of the three ratios just considered, is that if stock prices were to return to sustainable levels, the indexes would fall by 47%. This is consistent with the findings of the previous article, which demonstrated that debt formation can no longer be used to stimulate the economy and the markets because interest rates have been stuck at or near zero for the last seven years. The next section will examine the impact of a 47% correction on the pension funds.

PART TWO:  THE IMPACT OF A MAJOR MARKET CORRECTION ON CALIFORNIA’S PENSION FUNDS

To evaluate the impact of a major market correction on California’s state/local pension systems, we have created a model to perform “Pension System Long-Range Financial Analysis.” As will be demonstrated, this model projects the annual cash flow for a pension system through 2075 under a variety of assumptions. It also shows the assets, liabilities (NPV) and funding status for a pension system by year through 2075. Readers are invited to download this model, evaluate its internal logic, view the assumptions underlying the baseline case, and experiment with various scenarios.

Download model for “Pension System Long-Range Financial Analysis.”

Baseline Case: No change to pension benefits, no reduction in return on investments

As a starting point for comparisons, the model projects the future cash flow and funding status for all of California’s state and local government worker pension systems combined under the following assumptions:

  • Contributions are not increased.
  • Benefits are not reduced.
  • Annual returns on invested assets, with the exception of 2015 which we optimistically estimate yielded 2.0%, continue from 2016 through 2075 at 7.5% per year without exception.

Key cash flow and benefit assumptions input in this baseline case include the following:

  • The average participant works 25 years, and there is a five year gap, on average, between when the average participant retires, and when they become eligible for pension benefits.
  • The average benefit multiplier (amount that is multiplied by years worked times final salary to calculate the initial amount of a pension) for retirees through 1999 is 1.8%.
  • The average benefit multiplier for post 1999 retirees is 2.5%, to reflect the retroactive benefit enhancements that began in that year.
  • The average pension cost-of-living increase per year is 2.5%.

The model permits variations to the inputs that are beyond the scope of this report to describe in full, but retains sufficient simplicity that anyone downloading it with a reasonable understanding of spreadsheets and pension finance can examine them in detail. Comments and criticisms on the efficacy of this model are most welcome. To summarize a few of these features, the user can:

  • Vary the life expectancy – we have assumed a life expectancy increase of 0.15% per year,
  • Vary the number of workers according to the birth year of each participant – we have used Census Bureau data on California’s state/local workforce and state/local retirees to assume a roughly accurate total of 1.8 million pension “full-time equivalent” eligible workers and 1.8 million “full career” retirees, straight-lined at 60,000 participants per year of birth.
  • Vary the amount that the beginning salary of a worker increases each year – we have assumed 2.75% per year which translates into an average starting salary of $15,000 in 1960 becomes an average starting salary of $66K in 2015.
  • Change the amount of annual salary increase (promotion, “step increases,” and COLAs) – we have assumed 3.0% per year which translates into an average salary of $71K in 2015 for a worker hired in 1990. US Census estimates place the average salary for a state/local government worker in California at $72K. Our average pension eligible salary, using the above-noted assumptions, is $69K, which assumes an average overtime payment (not pension eligible) of 5%.

By inputting these assumptions and others into the model, it calculates the following results for California’s consolidated state/local pension systems at the end of 2015:  A funded ratio of 65%, total assets of $756 billion, total liabilities (NPV) of $1.16 trillion, incoming contributions of $34 billion, and contributions as a percent of payroll of 32%. These results are almost exactly consistent with the consolidated estimates as provided by the U.S. Census Bureau for 2014 and 2015. Those references are footnoted on the “data” tab of the model.

The results calculated by the model, based on this “business as usual” are surprisingly positive. They show the unfunded liability being consistently whittled away, such that by 2020 the consolidated systems are 72% funded, by 2025 they are 81% funded, by 2030 they are 91% funded, and by 2040 they are 118% funded.

All of that assumes, however, that from 2016 on, the consolidated system assets earn 7.5%. Every year without exception.

First Set of Downturn Cases:  The markets fall 47% in 2017, and earn 5% per year thereafter.

This set of cases is to show the impact of a severe market correction, followed by modest returns from then on. This set of cases assumes a 7.5% return in 2016, followed by the crash in 2017, followed by modest 5% returns from then on. The five cases depicted here reflect escalating reductions to benefits. In all cases, what is solved for is the contribution – as a percent of payroll – required for the systems to achieve 100% funding by 2030. The baseline, by the way, under this earnings scenario – that is, if no changes are made to benefits or contributions in the face of this market correction – has the pension systems completely out of funds by 2041.

In the chart depicted below, five cases are presented. The first one makes no changes to benefits, solving for what contribution as a percent of payroll is necessary to restore 100% funding to the pension systems by 2050. As can be seen, the required contribution “$ Contr” is 80% of payroll. Recall that the consolidated average for California’s state/local pension systems is currently 32%, which equates to $34 billion per year. Put another way, it would cost California’s taxpayers another $51 billion per year if the market corrects by 47%, recovers at an earnings rate of 5% per year, and no changes are made to pension benefits.

The next three cases in the chart below consider changes to new hire benefits starting in 2020. Case #2 lowers the pension multiplier for new hires from 2.5% to 2.0%; a significant change that goes further than any pension reforms being seriously considered. As can be seen, it results in a lowering of the required contribution for these systems to restore 100% funding by 2050 to 66% of payroll, still more than twice what it is today.

Case #3 shows the impact of lowering the annual multiplier for new hires from 2.5% to 2.0%, combined with raising the eligible retirement age by five years. This results in a lowering of the required contribution for these systems to restore 100% funding by 2050 to 52% of payroll. Case 3 is highlighted because it probably represents the extreme limit of what current discussions indicate might eventually be negotiable.

In an attempt however to establish parameters for what additional reforms might yield, Case #4 shows the impact of lowering the pension multiplier for new hires still further, to 1.5%. The result is significant, bringing the required contribution for these systems to restore 100% funding by 2050 to 43% of payroll. Case #5 delves into territory that some would consider reasonable; it lowers the pension multiplier for existing employees to 2.0% per year – but only from now on, not retroactively. This yields significant savings, lowering the required contribution to 35% of payroll in order to achieve 100% funding by 2050. This scenario represents a viable way to preserve defined benefits without costing taxpayers tens of billions per year.

Contributions Required as Percent of Payroll to Achieve 100% Funding by 2050
Assume -47% Market Correction in 2017, Followed by 5.0% Annual Returns1 - 5 percent results

Second Set of Downturn Cases: The markets fall 47% in 2017, and earn 4% per year thereafter.

It is possible however that 5% returns per year after a severe market correction may be too much. After the last major stock market crash, in 1929, it took several decades before the cumulative average returns post-1929 reached 5% per year. The next set of cases examines the results of a 47% market downturn in 2017, followed by four percent returns from then on. The results are dramatically different from the 5% return scenario in the first set of cases, and illustrates the extraordinary sensitivity of pension fund solvency to the long-term rates of return.

In Case #6, just as in Case #1, no change has been made to the benefits either for new or existing employees. As can be seen, going from a 5% post crash annual average return to a 4% post crash annual average return causes the required contribution as a percent of payroll to jump from 80% (Case #1) to 113% (Case #6). This translates into an increase to taxpayers of $85 billion per year.

The next four cases in this 4% earnings scenario depict the same set of benefit reductions as in the previous 5% earnings scenario. But in this case, by the time you get to Case #10 (4% post crash earnings), which has the same set of reductions as Case #5 (5% post crash earnings), instead of whittling the required annual contribution (to achieve 100% funding by 2050) down to 35%, it is still at 48%. For this reason, additional cases are considered.

Cases #11 and #12 impose additional reductions to benefits on existing employees. By lowering the pension multiplier to 1.5% for existing employees – again, only from now on – the required contribution drops to 41%. By raising the age of eligibility for benefits by five years for existing employees, the required contribution drops to a manageable 37%.

Contributions Required as Percent of Payroll to Achieve 100% Funding by 2050
Assume -47% Market Correction in 2017, Followed by 4.0% Annual Returns2 - 4 percent results

PART THREE:  CONCLUSION AND RECOMMENDATIONS

Based on historical trends, three key aggregated stock market ratios – price/earnings, price/sales, and price as a percent of GDP – all show that publicly traded U.S. stock are overvalued by approximately 50%. These indicators are supported by evidence that debt accumulation can no longer be useful as a tool to stimulate the economy or the stock markets, and that demographic trends – where an aging population is introducing more sellers into the markets – creates additional downward pressure on the stock markets.

It is easy enough to step back and claim that the rules have changed, that these unusually high stock market multiples can be sustained for additional decades, and that productivity improvements will enable the U.S. economy to support both massive debt and an aging population. Those who argue this position are betting that the U.S. economy, because of its diversity, sheer size, relatively lower levels of total market debt as a percent of GDP, relatively higher interest rates (i.e. still positive), stability and security, will become a refuge for wealth fleeing far more tumultuous economies elsewhere in the world. Staking the future of pension fund systems on this argument is a dangerous gamble. For more on why conservative rates-of-return may be inevitable, and imminent, read Michael Lebowitz’s two-part series, recently published by the California Policy Center, “The Death of the Virtuous Cycle,” and “The Fifteenth of August.”

For all of California’s pension funds consolidated, the analysis finds that if the market corrects downwards by 50%, then recovers to grow at 5% per year, without benefit reductions, the required annual contribution will rise to 80% of pension eligible payroll. This will cost California’s taxpayers an additional $50 billion per year. If the market corrects by 50% then recovers to grow at 4% per year, without benefit reductions, the required annual contribution will rise to 113% of pension eligible payroll. This scenario will cost California’s taxpayers an additional $86 billion per year. This analysis has also evaluated the impact of benefit reductions, exploring cases where only new employees are affected, as well as cases where benefits earned for future work by existing employees are also affected.

When evaluating what level of benefit reductions can preserve pension systems without increasing employer contributions, the study found the following:

In the case of a stock market negative correction of 50% followed by 5% annual growth, if the annual multiplier (the amount that is multiplied by years work times final salary to calculate an initial pension) is cut by 40% for new employees, and the annual retiree cost-of-living adjustment is cut by 40% for new employees, the retirement eligibility age is raised by five years for new employees, AND the annual multiplier is cut by 20% for existing employees for future work, the current level of payments would be sufficient to bring the systems to 100% funded status by 2050.

In the case of a stock market negative correction of 50% followed by 4% annual growth, if the annual multiplier (the amount that is multiplied by years work times final salary to calculate an initial pension) is cut by 40% for new employees AND existing employees for future work, and the annual retiree cost-of-living adjustment is cut by 40% for new employees AND existing employees, the retirement eligibility age is raised by five years for new employees AND existing employees, the current level of payments would be sufficient to bring the systems to 100% funded status by 2050.

Preserving defined benefit pensions in the face of a prolonged period of low investment returns will require the stakeholders in public employee pension funds to make hard choices. For example, lowering benefit accruals – just for future work by existing employees –  can have a significant impact on reducing the required contribution. Reducing benefits for new employees is helpful, but the savings to be realized are decades in the future and are therefore heavily discounted when calculating a current pension system liability. For this reason, only restricting benefit reductions to new employees means they must be severe indeed. Balancing benefit reductions between existing employees (for future work) and new employees yields far less severe overall reductions – although as demonstrated, if the average market returns dip below 5% in the long-term – there is no incremental way to preserve system solvency without also dramatically increasing the required contributions.

Policymakers and stakeholders should plan now. They should negotiate, at the least, contingency plans to handle a major stock market correction that strikes an appropriate balance between costly tax increases and benefit reductions. Should there be a significant stock market downturn, taxpayers themselves will have depleted savings. They should not have to endure higher taxes to maintain public sector retirement accounts, when their own retirement accounts have been equally affected.

 *   *   *

Ed Ring is the president of the California Policy Center.

 

UC Berkeley’s ‘income inequality’ critics earn in top 2%

Scholars from the University of California at Berkeley have played a pivotal role in making income inequality a major political issue. But while they decry the inequities of the American capitalist system, Berkeley professors are near the top of a very lopsided income distribution prevailing at the nation’s leading public university.

Among the most prominent of these scholars is Robert Reich, Chancellor’s Professor of Public Policy at the University of California at Berkeley. Reich’s 2013 film, Inequality for All, is an indictment of a rigged U.S. economy that makes a select few richer while consigning the middle class to stagnation. A review of the film and Reich’s other work suggests that the economist and former Clinton-era Labor Secretary provided numerous talking points for Bernie Sanders’ high-profile – though ultimately unsuccessful – presidential campaign.

While Reich helped popularize the income inequality theme, much of the intellectual heavy lifting has been done by UC Berkeley economist Edward Saez and his colleagues at the university’s Center for Equitable Growth (CEG). Saez has been researching income inequality since 2003, when he co-authored a paper on the topic with Thomas Piketty, the French economist whose book Capital in the Twenty-First Century also played a key role in popularizing the income inequality issue. The pair continue to collaborate.

Since these Berkeley academics preaches, we wondered whether the university community also practices greater equality. To answer this question, we examined distributional equity at the university, relying on publicly available data.

Statistical Comparisons of Inequality

Social science researchers often measure income inequality with the Gini Coefficient – a calculated value that can range between zero and one. The higher the Gini Coefficient, the more unequal the country, municipality or community. If everyone in a population has exactly the same income, that group’s Gini Coefficient is zero.  By contrast, if one individual receives all of a community’s income (and everyone else receives nothing), the Gini Coefficient is 1.

According to World Bank statistics, the average country had a Gini Coefficient of around 0.36 in 2012, when data for 68 countries were available. In 2013, the coefficient for the U.S. was 0.4106 – roughly the same as it was under Bill Clinton in 1997. The country with the lowest reported Gini was Ukraine (at 0.2474) and the highest was Haiti (at 0.6079). Scandinavian countries are among the most equal (between 0.26 and 0.29), while Latin American nations dominate the high Gini countries (with several over 0.50).

Within the United States, the Census Bureau reports Gini coefficients for over 500 cities.  The latest data available are for 2014. The city of Berkeley’s Gini score of 0.5356 places it in the top 5% of U.S. cities for income inequality. In California, it ranks third of 133 – behind Davis (another city dominated by a UC campus) and Los Angeles. Internationally, city of Berkeley’s score is virtually identical to that of Colombia.

Public employee compensation data allows us to measure income inequality on campus. The State Controller’s Public Pay database contains salaries for all UC employees, indicating which campus each employee is on. The Gini coefficient for the 35,000 UC Berkeley employees in the data set is 0.6600 – higher than that of Haiti.

Getting Rich from Researching and Critiquing Inequality

Income inequality at Cal extends to the university’s inequality research arm, the Center for Equitable Growth mentioned earlier. According to 2014 data from Transparent California, Center Director Emmanuel Saez received total wages of $349,350. Its three advisory board members are also highly compensated Cal professors: David Card (making $336,367 in 2014), Gerard Roland ($304,608) and Alan Auerbach ($291,782). Aside from their high wages, all four professors are eligible for a defined-benefit pension equal to 2.5% times final average salary times number of years employed. It is also worth noting that all four are in the top 2% of UC Berkeley’s salary distribution, and that Saez is in the top 1%. It could be that an effective researcher has to know his or her subject: thus to the study the top 1%, we suppose one has to be in the top 1%.

Pricey Textbook

BOOK CLUB: Cal economics students are pounded by high-priced textbooks.

Robert Reich receives somewhat lower compensation than the four CEG economists, collecting $263,592 in pay during 2014. But Reich’s salary was likely not his only source of income in 2014. Reich makes himself available to give paid speeches through a number of speaking bureaus, charging a fee estimated at $40,000 per talk. He is also likely to receive some income from his books, movies and pensions from previous employers.

Reich is not the only senior academic who can avail himself of significant income aside from that provided by his university employer. Because teaching and publication demands on tenured professors are relatively modest, there’s time to earn extra income from consulting and writing textbooks. The latter can be surprisingly lucrative, since many college textbooks sell for over $200 per copy. Last September, the Cal bookstore offered an introductory economics textbook for $294. Lucrative opportunities to supplement one’s income with consulting fees and royalties are typically unavailable to a college’s administrative staff.

Highly Paid Coaches and Administrators

Aside from tenured professors, UC Berkeley also provides generous compensation for athletic coaches and administrators. The highest paid UC Berkeley employee in 2014 was Daniel Dykes who received $1,805,400 for coaching the California Golden Bears football team, which went 5-7 that year and did not make a bowl appearance. Dykes was followed closely by Jeff Tedford (at $1,800,000), the Bears’ former coach who was still on the payroll in 2014 despite having been relieved of his coaching responsibilities. The next five highest paid UC Berkeley employees were also coaches.

UC Berkeley Chancellor Nicholas Dirks was paid $532,226 in 2014, but a unique perk substantially boosted his effective compensation.

Dirks House

HE BUILT A WALL AND YOU PAID FOR IT: Chancellor Dirks’ residence with new $700k fence.

Like all UC Chancellors, Dirks is provided with a free residence. According to the San Francisco Chronicle, University House – now occupied by Dirks – contains 15,850 square feet of living and meeting space. Living on campus has not been an unalloyed benefit for Chancellor Dirks, however. The home has been attacked on numerous occasions by student activists. In response, the university recently completed a metal fence around the home at a cost of $699,000 – two and a half times over budget.

Dirks’ cash compensation was slightly lower than that of former UC President Mark Yudof, who co-instructed one class at Cal’s Law School in 2014, receiving $546,057 for his time. According to the Sacramento Bee, “Yudof benefited from a UC policy that allows high-ranking administrators to receive a year of pay if they are preparing to teach again.” After stepping down as president, Yudof took a one-year sabbatical, co-taught one class in Fall 2014 and another in Spring 2015, and then retired.

Tenured faculty and administrators at Cal have also been shielded from harsh discipline, even when they engage in sexual harassment. According to a recent report in the San Jose Mercury News:

Astronomer Geoff Marcy received a warning last year despite the university’s finding that he had serially harassed students over nearly a decade. Former law school dean Sujit Choudhry received a 10 percent pay cut but was initially allowed to keep his position after he was found to have sexually harassed his executive assistant. And former Vice Chancellor Graham Fleming — who stepped down last April amid allegations he had sexually harassed a staff member — quickly landed an administrative job as ambassador for UC Berkeley’s new Global Campus, a satellite campus in Richmond.

The three Cal employees cited received generous compensation in 2014. Marcy collected $217,861; Choudhry made $472,917 and Fleming received $404,625. More recently, Berkeley has taken stronger disciplinary measures in response to media attention and pressure from UC’s system President Janet Napolitano. Fleming was fired and Choudhry resigned in March.

Life for the Other 99%

High compensation for tenured faculty does not necessarily come with a heavy teaching workload. Instead, most of the teaching burden appears to fall on junior faculty and teaching assistants.

Introductory classes at UC Berkeley often have several hundred students. Although a faculty member gives the lectures and designs the syllabus, students functioning as teaching assistants, readers and graders handle most live interaction with course participants, review their homework and score their exams. Students fulfilling these roles may be in a graduate program, but are often juniors or seniors.

In Fall 2013, Cal’s Intro to Computer Science – CS 61A – had 1,098 registered students, exceeding the capacity of the lecture hall. The assistant professor conducting the course, John DeNero, recorded lecture videos for those who could not fit into the room. He told the student newspaper: “Almost all of the learning in computer science courses happens in the lab and when they’re working on projects. So if you don’t fit in the room, you can definitely still participate in all the important parts of the course.” Students taking the class had access to 19 teaching assistants and 15 readers. DeNero was paid $46,643 in 2014 – likely exceeding the amounts paid to the enormous assistant and reading staff who now receive around $14 per hour. Thus, one of the university’s most important services – orienting new students to the fast-growing field of computer science – was delivered by poorly paid staff, without any input from its highly compensated senior faculty.

Although the City of Berkeley has a higher minimum wage than the rest of the state, Cal is exempt from this municipal minimum. In late 2014, The East Bay Express reported that the university was paying hundreds of student workers less than the $10 per hour city minimum.  More recently, the university implemented a UC-wide Fair Wage/Fair Work Plan under which the minimum wage rose to $13 per hour in October 2015 with subsequent increases to $14 per hour in October 2016 and $15 per hour in October 2017. It should be noted that, unlike other minimum wage requirements, UC’s minimums apply only to employees working more than 20 hours per week, so it is possible that some student workers will remain below the City of Berkeley minimum, currently set at $12.53.

It is difficult to assess how little of the teaching burden falls on the shoulders of tenured faculty.  The University of California’s Annual Accountability Report (covering all 10 UC campuses) indicates that most instruction is provided by “full-time permanent faculty.” This designation includes assistant and associate professors who have yet to obtain tenure. Further, the university employs a misleading metric for reporting relative instructional burdens between full-time permanent faculty, lecturers, visitors, adjuncts and others. Teaching loads are shown in “student credit hours (SCH),” which is the number of students enrolled in a given course times the number of credits earned from that course. If a permanent faculty member gives the lectures for a 4-credit course attended by 1000 students, 4000 SCH are added to the full-time permanent faculty total even though most instructional activities in the course are performed by juniors, seniors and graduate students.

Relatively low-paid and heavily worked staff also keep many of Cal’s core functions running. Administrative staff faced a round of layoffs in 2011 and are now undergoing a further workforce reduction despite increasing enrollment numbers. Meanwhile, unrepresented staff (those not unionized) have seen minimal salary growth in recent years. Although administrative tasks – such as managing financial aid applications, administering grants applications and maintaining university software platforms – may seem less glamorous than research, individuals performing these functions often work much harder than tenured faculty while earning far less.

Conclusion

The University of California at Berkeley has a great reputation, and the school continues to earn its high standing with a mixture of world-class scholars, outstanding students and (at least some) great facilities.

To attract excellent academics and administrators, the university must offer competitive compensation packages. In some cases, these packages will draw truly outstanding people who go on to do excellent work for the university. In other instances, these packages amount to sinecures enabling high-status individuals to receive compensation disproportionate to their contributions.

In this respect, Cal is no different from a large, publicly held corporation. Companies offer big salaries to CEOs and other high-level professionals, sometimes getting their money’s worth and other times not. Just as it isn’t reasonable to expect a tenured professor or senior administrator to be paid in line with entry-level employees, we shouldn’t expect senior university administrators and tenured professors to be paid the same as work-study students.

While it is true that the compensation ratios between the highest- and lowest-paid employees are greater at many large corporations than at universities, there is an offsetting consideration. A very large portion of compensation at UC Berkeley and other public universities is paid by federal and state taxpayers through grants and financial aid. This is not the case for private companies – at least those that don’t sell to the government.

The hefty salaries and generous pensions awarded to Berkeley administrators, professors and coaches are funded by taxpayers – most of whom earn far less than these academic luminaries. So if UC Berkeley economists are really opposed to income inequality and are concerned about low-paid workers, they might consider sharing some of their compensation with the teaching assistants, graders, readers and administrative staff at the bottom of Cal’s income distribution.

We’re not saying income inequality is a bad thing; we’re not saying that Reich, Saez and other Berkeley professors should make less than they do, or that student teachers ought to make much, much more. In fact, there are reasonable arguments that income inequality is not only inevitable and even ethical, but that it’s also a generally positive feature of advanced economies.

We are saying there’s something unusual in the Berkeley phenomenon – the high-profile role of high-income earners in criticizing income inequality.

ABOUT THE AUTHOR
Study author Marc Joffe is the founder of Public Sector Credit Solutions and a policy analyst with the California Policy Center. Joffe founded Public Sector Credit Solutions in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Before starting PSCS, Marc was a senior director at Moody’s Analytics. He earned his MBA from New York University and his MPA from San Francisco State University.

ABOUT THE CALIFORNIA POLICY CENTER
The California Policy Center is a non-partisan public policy think tank providing information that elevates the public dialogue on vital issues facing Californians, with the goal of helping to foster constructive progress towards more equitable and sustainable management of California’s public institutions. Learn more at CaliforniaPolicyCenter.org.

 

Comparing Federal and California State Retirement Exposures

Californians may be accustomed to living with the specter of a public pension crisis. But the federal government’s problem with its retirement system – including Social Security – is far worse, and yet none of the three remaining major-party candidates for president has a plan to do anything about it.

The California Policy Center generally focuses on state and local issues. But with just days left before California’s June 7, we offer this comparison of California and federal exposure to pension liability.

State Retirement Expenditures

According to the governor’s May Budget Revision, the state will make a total of $8.1 billion in pension contributions during the 2016-2017 fiscal year. This amount represents a sharp increase from the current fiscal year level of $7.1 billion and fiscal 2014-2015 contributions of $6.3 billion. (These numbers exclude Other Post Employment Benefit payments.)

The rapid increase is attributable to lackluster stock market performance, more conservative actuarial assumptions implemented by CalPERS and a teacher’s pension reform that increased the state’s responsibility for CalSTRS. However, even the newly increased contribution levels are unlikely to resolve chronic underfunding in both CalPERS and CalSTRS because these two systems assume a 7.5% annual rate of return, which seems unrealistic in today’s slow growth, low interest rate economy.

Figures 1 and 2 provide a longer term perspective on the growth of state pension costs. These graphs go back to the 1999-2000 budget year when the governor signed SB 400, a bill that provided a large, retroactive increase in pension benefits. In that year, pension contributions were only $1.2 billion.

StateVFed-Chart1

Figure 1

StateVFed-Chart2

Figure 2

Because of inflation and the growth of the state economy, it may be more helpful to look at state pension contributions in relation to some broader economic indicator. In previous CPC studies, we have shown pension costs as a percentage of overall government revenue – identifying a number of California cities and counties that devote over 10% of their income to retirement plan contributions.

The state’s position is much better than that of the most burdened counties and cities. In 2014-2015 (the last year for which audited financial statements are available), $6.3 billion of pension contributions represented 2.29% of total state revenues – including general fund revenue, other governmental fund revenue and business type activity revenue – which totaled $276 billion. We project that this ratio will rise to about 2.76% in 2016-2017.

For those interested in general fund statistics only, pension contributions accounted for 5.57% of general fund revenue (on a budgetary basis) in 2014-2015 and are projected to rise to 6.49% in 2016-2017. These ratios overstate California’s pension burden, because many employees are compensated with resources outside the general fund.

On the other hand, some California state spending effectively subsidizes pension costs incurred by city, county, school districts and special districts. For example, most of the state’s $87.6 billion education budget for 2016-2017 will be distributed to local educational authorities, which will use some of these funds to make employer contributions to public employee pension systems.

As Ed Ring reported in a recent CPC study, total California government employer pension contributions in 2013-2014 were $21.2 billion. While only one quarter of this total was directly paid by the state government, some portion of the local government share would not have been made in the absence of state aid payments.

Ring’s report also offers some insight into how much state pension contributions would have to rise if more realistic return assumptions were used.  For example, if pension funds used a 5.5% return assumption, pension fund contributions would have to triple from current levels.

Social Security

The vast majority of federal retirement expenditures take the form of Social Security benefits. Because most American workers are eligibility for Social Security, the program is quite large. In the current federal fiscal year, Social Security expenditures are projected to be $911 billion or just over 27% of federal revenues. About 83% of these costs take the form of retiree and survivor benefits, 16% goes to disabled workers and under 1% covers administrative expenses.

Each year, the Social Security Board of Trustees publishes an actuarial report. The report includes short- and long-term projections, with an emphasis on the status of the Social Security trust fund. The latest report shows that the trust fund contained about $2.8 trillion in assets at the end of calendar year 2014. The report also projects that the trust fund will be exhausted in 2034 based on a set of intermediate cost assumptions. The report also includes projections based on two alternative scenarios: one reflecting higher-cost assumptions (such as greater longevity) and lower cost assumptions. Under the high-cost scenario, the trust fund would be exhausted by 2030, while under the low-cost scenario the trust fund maintains a positive balance throughout the report’s 75-year projection horizon.

Although discussion of Social Security often revolves around the trust fund, this emphasis is misplaced. Unlike CalPERS or CalSTRS, the Social Security trust fund does not contain real assets. Instead, it holds special-issue U.S. Treasury bonds. Since the trust fund is part of the federal government, its assets are merely IOUs issued by its owner. The situation is analogous to an individual removing money from his piggy bank and replacing it with a note showing the amount he plans eventually to put back.  This may be a good commitment device, but any financially knowledgeable third party would not consider the note a meaningful asset.

One might argue that the Treasury bonds in the trust fund represent a claim on federal assets, but as shown in its latest audited financial statements, the federal government has a negative net position. Total federal assets of $3.2 trillion are easily exceeded by $13.2 trillion of federal debt securities held by the public and $8.2 trillion of other liabilities. So the IOUs held by the Social Security trust fund compete with claims held by many external parties for a relatively small pool of federal assets.

While the trust fund assets are not economically meaningful, they do have a legal significance – but even that is less than meets the eye. Under current law, if the trust fund is exhausted, benefit payments must be immediately reduced so that they are equivalent to Social Security revenues, which mostly derive from Federal Insurance Contribution Act (FICA) taxes paid by employees and employers. Under the trustee’s intermediate scenario, benefits would fall to 79% of the then-current level when the trust fund is exhausted in 2034.

However, this sudden, sharp reduction is extremely unlikely. Given the large number of Social Security recipients, the high voting propensity of older voters and the power of AARP, the benefit cut would almost inevitably be reversed, with additional costs borne by the general fund. There is a recent precedent for general fund transfers of this type: when Congress temporarily reduced FICA taxes in 2011 and 2012, the loss of trust fund income was offset by general fund transfers.

Rather than view Social Security through the trust fund prism, its fiscal impact is better understood in terms of its net impact on the consolidated federal budget. In other words, we should look at the difference between Social Security revenues and expenditures. The trustee report includes interest on the Treasury bonds held by the Social Security trust fund, but this notional income should be disregarded: the interest is paid and received by the same entity, the federal government.

Figure 3 shows Social Security’s net cash flow in constant dollars back to 1957. Projected revenues are depicted by three lines, with shaded areas in between. The middle line reflects the trustee’s intermediate assumptions, with the low cost and high cost scenarios shown by the lowest and highest lines respectively. As the chart shows, program revenues and expenditures were roughly equal for the first three decades. Between the late 1980s and the last decade, revenues exceeded expenditures, often by large margins. In the late 1990s, this surplus helped balance the federal budget; later, it offset budget deficits that developed under the George W. Bush Administration.

StateVFed-Chart3

Figure 3

Increased disability insurance claims associated with the Great Recession and the beginning of baby boomer retirements ushered in a series of negative net balances beginning in 2010. These deficits are expected to continue under all three trustee scenarios, and to become quite large under the intermediate and high cost assumptions. By 2040, the shortfall reaches $371 billion under the intermediate scenario and $610 billion under the high cost scenario – in 2015 constant dollars.

Unprecedented deficits of this magnitude have very serious implications for the federal budget, especially when combined with escalating Medicare and Medicaid costs. Last year, the Congressional Budget Office projected that the ratio of publicly held debt to GDP will increase from 74% currently to 107% by 2040.

Federal Employee Retirement Programs

The federal government also has a large number of employees and retirees eligible for defined pension benefits. According to its latest annual report, the Civil Service Retirement and Disability Fund, paid $81 billion of retirement benefits in fiscal year 2015, or 2.49% of federal revenues. The system reported an Unfunded Actuarial Liability of $804.3 billion and Assets of $858.6 billion, implying a funded ratio of only 51.6%. Further, the fund’s assets are almost entirely invested in U.S. Treasury securities. Similar to the Social Security Trust Fund, the economic meaning of these investments is questionable.

The Defense Department also provides retirement benefits. The latest available actuarial report shows $54.8 billion of benefits paid in fiscal year 2013 and a 35% funded ratio. Last year, President Obama signed a Defense Authorization Bill containing a military pension reform. Instead of a straight defined-benefit plan, new recruits joining the armed forces after January 1, 2018 will be placed in a hybrid plan containing a 401(k)-style component with an employer match. The defined benefit component will remain, but will be reduced by 20%. This reform should improve the program’s funded ratio, but won’t reduce military pension costs by very much – if at all. Under the current system, service members must remain in the military for 20 years to become eligible for pension benefits. Vesting in federal matching payments under the new defined contribution plan will begin after two years.

Comparing the Federal and State Governments

Overall, the federal government has much greater exposure to pension costs that does the state of California. Civilian and military pension benefits consume a proportionately larger amount of the federal revenue than the share of total state revenue absorbed by CalPERS and CalSTRS contributions. Further, the federal government is responsible for providing most American workers pension benefits through Social Security, which absorbs more than a quarter of federal revenue and has an inadequate level of pre-funding, even if one considers Treasury securities to be an acceptable investment vehicle for a federal retirement system.

That said, it is worth considering some advantages the federal government has relative to the state in dealing with pension costs. First, the U.S. constitution does not provide a right to accrued benefits. In an emergency, Congress and the president could cut or terminate benefits to Social Security recipients, federal civilian retirees or veterans. This is not the case for the state of California.

As Alexander Volokh points out: “In California, when a public employee begins work, he not only acquires a right to the pension accumulated so far — presumably zero on the first day, and increasing as he works longer — but also the right to continue to earn a pension on terms that are at least as generous as the ones then in effect, for as long as he works. And if pension rules become more generous in the future, then those more generous terms are the ones that are protected.”

As I discussed earlier, I do not expect Social Security benefits to be reduced when the trust fund runs out, so the fact the Social Security recipients do not have access to the courts may be a distinction without a difference.  But it is still true that the federal government has a tool for reducing benefit costs – especially during a fiscal emergency – that is not available to the state.

Further, there is a widespread belief that the federal government is less vulnerable to a fiscal emergency than California because it has access to the printing press. In other words, if the federal government cannot obtain enough tax revenue to pay retirement benefits, it could do so with newly created money.

While this is a fair distinction, it comes with a couple of caveats. First, at the national level, money creation has become the role of the Federal Reserve, which has some degree of political independence.  Strictly speaking, the president cannot order the Fed Chair to create money. Second, U.S. state and local governments have been able to create circulating IOUs in the past. During the Depression, numerous cities issued scrip, while, in 2009 the state issued IOUs to vendors amidst a budget crisis. These IOUs were eventually traded on a secondary market.

These caveats notwithstanding, it is true that a central government controlling an international reserve currency does have more fiscal flexibility than a state which is legally obligated to balance its budget each year. So the federal government’s ability to absorb pension obligations is greater than California’s. This is fortunate, because the federal governments exposure is so much greater.

Solutions

We have seen that both California and the federal government face high and rising pension costs, and that each has not fully accounted for these obligations. The drivers of these problems are similar, and are duplicated throughout much of the developed world:  retirement of the large baby-boom generation, increased longevity and a failure of political institutions to deal effectively with long-term problems.

While the specific policies to improve pension sustainability differ across jurisdictions, the basic ideas are similar. These include:

  • Paring back benefit levels, especially for the most highly paid, most affluent beneficiaries.
  • Increasing retirement ages and then indexing them to longevity.
  • Increasing employee contributions.
  • Replacing deceptive accounting techniques and rosy actuarial assumptions, with conservative, fact-based financial reporting.

Finally, libertarians and fiscal conservatives working on these issues should re-evaluate their tactics. In 2005, George W. Bush’s strategy of using the impending Social Security crisis to justify a partial switch to personal accounts was roundly rejected by Democrats and Republicans alike. While many of us in the public-sector pension reform community like the idea of 401ks, we need to understand that employees – especially those who are risk-averse or financially unsophisticated – prefer defined benefits. Rather than attacking defined-benefit plans, we should try to fix these plans so that they don’t bankrupt the governments that offer them.

Comparing Fresno City and County Pension Systems

As the Fresno Bee recently reported, the city of Fresno’s pension systems are in much better financial shape than the Fresno County Employees’ Retirement Association (FCERA). As of June 30, 2015, the city’s two systems reported a combined $349 million of assets (at market value) in excess of actuarially accrued liabilities. By contrast, FCERA’s assets were $1.043 billion below its liabilities. Actuarial surpluses are rare in California, and the discrepancy between the city and county is so great that we thought it would be worth diving into the finances of Fresno’s retirement system to explain the contrast.

The systems provide extensive financial reports on their websites. The two most useful are Comprehensive Annual Financial Report (which includes financial statements and 10-year histories for many data points) and the Actuarial Valuation Study (which provides in-depth data about system assets, contributions and benefit payments). FCERA posts its reports at http://www.fcera.org. The two city systems – one for Fire and Police, and one for non-public safety employees – publish their reports at http://www.cfrs-ca.org/.

Table 1 below compares some key metrics across the plans.

The Valuation Value of Assets (VVA) is used by system actuaries to determine future contributions. But for our purposes, VVA is less useful than the Market Value of Assets (MVA). While MVA is simply the total market value of all the bonds, stocks and other investments the system holds, VVA includes various smoothing adjustments – reporting practices, some of them legitimate, that can mask liabilities.

Benefits

Contributing to the difference in the financial health of Fresno’s city and county systems is the difference in benefit levels. For example, the City of Fresno limits public safety pensions to no more than 75% of final average salary (as per Section 3-333 of the municipal code). The county imposes no similar cap and also provides very generous benefit accrual rates, in some cases exceeding 3% per year of service. According to calculations we performed using the county system’s Benefit Calculator, a Tier 1 public safety employee retiring at age 60 with 30 years of service would get a pension equal to 97% of final salary. Tier 1 employees were hired before 2007; newer county employees receive less generous benefits.

The city does not cap miscellaneous employee benefits, but its employees earn substantially less credit for each year of service. According to the city’s Benefit Calculator, a miscellaneous employee retiring at age 65 with 30 years of service would receive 72% of final compensation, compared to 97% for a county employee retiring at the same age and the same number of service years.

 

Asset Returns

Another potential distinction between the city and county systems is investment performance. A pension plan can improve its actuarial balance by achieving higher asset returns. Over the five years ended June 30, 2015, the city’s investments outperformed the county’s. FCERA generated annualized investment returns net of fees of 9.8%. The two Fresno city systems, whose assets are jointly managed, achieved net returns of 10.9% over the same period. This 1.1% difference compounded over five years is fairly significant. One billion dollars growing at the county’s rate of 9.8% becomes $1.596 billion after five years, while the same amount growing at the city’s 10.9% annual rate becomes $1.677 billion – $81 million more.

However, when we look at the 10-year period that includes the Great Recession, the performance numbers reverse. Over the 10 years ended June 30, 2015, county assets grew at an annual rate of 6.8% versus 6.4% for the city. Both of these return rates are below the annual asset return rates assumed by each system (more on this below).

Further, it’s worth noting that funding levels for all systems declined over the 10-year period. Between June 30, 2005 and June 30, 2015, FCSERA’s funded ratio based on VVA declined from 91.5% to 80.7%. The Fresno Fire & Police plan saw a decline from 126.4% to 119.6%, while the city’s Employee Retirement System witnessed a funded ratio decline from 139.8% to 109.2%.

 

Discount Rates

In general, the market value of a plan’s assets is fairly easy to determine and is not subject to substantial estimation error. Most plan assets are invested in stocks and bonds that trade frequently and whose values are easy to establish independently.

By contrast, plan liabilities are based on numerous assumptions. How much a plan will have to pay in the future depends upon when employees retire and when they pass away. Expressing these future benefit payments in current dollars requires the choice of a discount rate – a choice subject to controversy.

Fresno city plans use a higher discount rate than FCERA. The city’s ERS and Fire & Police plans both assume annual returns of 7.50% and then use that rate to discount future benefit payments. FCERA uses a slightly more conservative rate of 7.25%. Both of these assumptions exceed the actual 10-year returns experienced by the city and county pension systems, and thus should arguably be reduced.

But to compare the systems, we don’t need to determine the ideal discount rate; we simply need to apply the same rate to each system. If we reduce the city’s discount rate from 7.5% to 7.25%, pension liabilities across the two city systems would increase about $61 billion and their funded ratio would fall by about 3.5%. (These estimates are discussed in an appendix at the end of this study). While significant, this fact only explains a small portion of the 38.3% gap in funded ratios between the city and county systems.

 

Mortality Assumptions

While the pension literature includes much discussion of discount rates, less has been written about mortality assumptions. But good death rate estimates are important: if beneficiaries live a lot longer than expected, pension payments will be much greater than forecast. This recently became clear in Detroit, where city officials faced a sudden spike in projected retirement payments after its pensions actuary switched to a new mortality table.

Mortality tables are produced by the Society of Actuaries. Most public pension plans use a table from the Society’s RP-2000 Mortality Tables Report produced in the year 2000. The large increase in Detroit’s projected pension costs occurred after actuarial firm Gabriel Roeder switched to the Society’s new RP-2014 Mortality Tables.

The RP-2000 report included a supplemental schedule that can be used to scale mortality rates to future years. The scaling procedure assumes a steady improvement in longevity, and thus a steady decrease in mortality rates over time. By applying the adjustment factor from the scaling schedule multiple times, an actuary can approximate what a future mortality table might look like. For example, by applying the scaling factors to the 2000 mortality rates 15 times an actuary can approximate 2015 mortality rates. In Detroit, Gabriel Roeder did not apply the scaling factor, thereby causing the big change when it transitioned to the newer mortality table.

Both the Fresno city plans and FCERA use the RP-2000 Combined Healthy Mortality Table and then scale the death rates from this table with factors in Mortality Projection Scale AA. However, there is an important difference. The city performs the scaling six extra times: it uses mortality rates scaled to 2021, while FCERA uses death rates scaled to 2015. This means that the city plans are projecting fewer deaths at any given retiree age – and therefore greater liability – than does FCERA.

The county’s mortality projections are thus more “optimistic” than those of the city plans, in the sense that its approach anticipates shorter-lived recipients – and that translates into lower expected benefit payments. The sooner an employee is assumed to pass away the less he or she is projected to receive from the system. If FCERA performed the same scaling as the city plans, its reported funding level would be worse. Without more data, we cannot say how much worse.

Finally, it ‘s worth noting that retirement rate assumptions differ between the city and county systems. The difference may be justified, and the impact is unclear. Since the plans have different benefit structures, they present different incentives to workers timing their retirements. When an employee retires early, he or she will receive benefits for more years but generally at a lower rate. So a change in retirement-age assumptions, may raise or lower projected system costs.

 

Conclusion

Overall, our conclusion is mixed. Fresno’s Employee Retirement System and Fire & Police Retirement System offer less generous benefits that the Fresno County Employees’ Retirement Association. This difference in benefit levels makes a substantial contribution to funding disparities between the systems.

FCERA uses a more conservative discount rate, while the city plans use more (financially) conservative mortality assumptions. These modeling differences affect the disparity between reported city and county funding levels, but they do not represent real differences and simply muddy our understanding of relative system performance. Ideally, all California pension systems would use the same actuarial assumptions (unless there are real demographic differences between workforces) so that we would be able to perform accurate comparisons.

 

Appendix: Recalculating AAL Using a Different Discount Rate

A pension system’s AAL is the discounted amount of future benefit payments. Unless one has a table of projected future benefit payments, it is impossible to precisely calculate AAL using another discount rate.

In 2013, Moody’s adjusted pension liabilities by using more conservative discount rate assumptions. The rating agency’s method of restating liabilities involves projecting forward the system’s reported liability for 13 years and then discounting the result back for 13 years using the more conservative rate. Moody’s refers to the 13-year re-discounting period as a “common duration” and recognizes that applying the same duration to all plans could be a source of estimation error.

Moody’s also noted at the time that more precise estimates would be possible once pension plans implemented enhanced reporting required under Government Accounting Standards Board Statements 67 and 68.

Under these new rules, pension systems must report the “Sensitivity of Net Pension Liability to Changes in the Discount Rate.” This new schedule shows the Net Pension Liability calculated using the current discount rate, a rate 1% higher and another rate 1% lower. For the Fresno city systems, we have Net Pension Liabilities based on rates of 6.5%, 7.5% and 8.5%.

We can estimate the impact on Net Pension Liability by linearly interpolating between the 6.5% and 7.5% values. For the two Fresno systems combined, the estimated impact of a change in discount rate from 7.5% to 7.25% is $69 billion.

Net Pension Liability as reported under GASB Statement 67 is higher than each system’s Actuarially Accrued Liability. In the case of the Fresno city systems, the difference is about 11.5%. If we reduce the Net Pension Liability difference of $68 billion by 11.5%, we arrive at the $61 billion estimate presented in the main text.

The author wishes to thank Lisa Schilling at the Society of Actuaries and Bill Bergman of Truth in Accounting for their assistance with some technical points in this study. Any errors are my responsibility.

The Coming Public Pension Apocalypse, and What to Do About It

When the next market downturn hits, every public employee pension fund in the United States will face severe challenges. Because public employee pension funds are not subject to the same rules that private pension funds have to adhere to – namely, the restrictions on risky investments as specified in the federal Employee Retirement Income Security Act of 1974 – they will be hit much harder in a downturn than private pension funds. Some states will face more significant challenges than others. California is destined to be one of the hardest hit.

This discussion of California’s coming public pension apocalypse has three sections. Part one will make the case, yet again, that public employee pension funds cannot possibly hope to earn the rates of return over the next 20 years that they earned over the past 20 years. Part two will show the precise impact that lower rates of return will have on the unfunded liability, the normal contribution, and the unfunded contribution – using projections that show all of California’s state and local public employee pension funds in a consolidated report. Those who are already convinced that pension funds are headed for trouble are encouraged to skip immediately to part two, to see exactly how many hundreds of billions we’re talking about.

Finally, this discussion will offer recommendations to mitigate the impact of the coming public employee pension apocalypse, and pave the way for more sustainable programs in the future. These recommendations are in three parts – how to restore the pension funds, how to restore economic vitality to Californians, and policies to advocate at the federal level.

PART ONE: WHY PENSION FUND RATES OF RETURN WILL FALL DRAMATICALLY

“For the first time in the pension fund’s history, we paid out more in retirement benefits than we took in contributions.”
–  Anne Stausboll, Chief Executive Officer, CalPERS, 2014-2015 Comprehensive Annual Financial Report

There are few examples of a seemingly innocuous statement with more significance than Anne Stausboll’s admission, buried in her “CEO’s Letter of Transmittal,” summarizing the performance of CalPERS, the largest public employee retirement system in the United States. Because what’s happening at CalPERS – they now pay more in benefits than they collect in contributions – is happening everywhere in America.

For the first time in history, America’s public employee pension funds, managing well over $4.0 trillion in assets, are becoming net sellers, not buyers. And as any attentive student of economics will tell you, when there are more sellers than buyers, prices drop. Behind this mega economic trend is a mega demographic trend: across the developed world, certainly including the United States, an increasing percentage of the population is retired. The result? An increasing proportion of people who are retired and slowly liquidating their lifetime savings – also driving down asset values and investment returns.

Current events create volatility in the market and returns have been flat for the past 18 months. Turmoil in the Middle East. A long overdue slowdown to China’s overheated economy. Depressed energy prices. But there are two long-term trends that will keep investment returns down. Demographics is one of them: The more retirees, the more sellers in the market. The other mega-trend, equally troubling to investors, is that debt accumulation, which stimulates spending, has reached its limit. We are at the end of a long-term, decades-long credit cycle. The next three charts will illustrate the relationship between interest rates, debt formation, and the stock market during two critical periods – the first one following the stock market peak in December 1999, and the second following the stock market peak in September 2007.

The first chart, showing the federal funds rate over the past 30 years, shows that when the stock market peaked in December 1999, the federal funds rate was 6.5%. Within three years, in order to stimulate borrowing that would put more cash into the economy, that rate was dropped to 1.0%. Once the stock market recovered, the rate went back up to 4.25% until the stock market peaked again in the summer of 2007. Then as the market declined precipitously for the next 18 months through February 2009, the federal funds rate was lowered to 0.15% and has stayed near that low ever since.

The point? As the stock market has recovered since February 2009 to the present, unlike during the earlier recoveries, the federal funds rate was never raised. This time, there’s no elbow room left.

Table 1-A
Effective Federal Funds Rate – 1985 to 2015

20160111-UW-ER-fedrate

To put these low interest rates in context requires the next chart which shows total U.S. credit market debt as a percent of GDP over the past 30 years. Consumer debt, commercial debt, financial debt, state and federal debt (not including unfunded liabilities, by the way), is now estimated at 340% of U.S. GDP. The last time it was this high was 1929, and we know how that ended. As it is, even though interest rates have stayed at nearly zero for just over seven years, total debt accumulation topped out at 366.5% of GDP in February 2009 and has slightly declined since then. The point here? Even low interest rates, this time at or near zero, no longer stimulate a net increase in total borrowing, which in turn puts cash into the economy.

Table 1-B
Total U.S. Credit Market Debt – 1985 to 2015

20160111-UW-ER-debtGDP

Which brings us to the Dow Jones Industrial Average, a stock index that tracks nearly in lockstep with the S&P 500 and the Nasdaq, and is therefore an accurate representation of the historical performance of U.S. equities over the past 30 years. As you can see from this graph and the preceding graphs, the market downturn between December 1999 and September 2002 was countered by lowering the federal funds rate from 6.5% to 1.0%. Later in the aughts, the market downturn between September 2007 to February 2009 was countered by lowering the federal funds rate from 5.25% to 0.15%. But during the sustained market rise for the seven years since then, the federal funds lending rate has remained at near zero, and total market debt as a percent of GDP has actually declined slightly.

Table 1-C
Dow Jones Industrial Average – 1985 to 2015

20160111-UW-ER-DJIA

It doesn’t take a trained economist to understand that the investment landscape has fundamentally changed. The trend is clear. Over the past 30 years, debt as a percent of GDP has doubled (from 150% to over 350%), then remained flat for the past seven years. At the same time, over the past 30 years the federal lending rate has dropped from high single digits in the 1980s to pretty much zero by early 2009, and has remained there ever since. The conclusion? Interest rates can no longer be used as a tool to stimulate the economy or the stock market, and the capacity of the American economy to grow through debt accumulation has reached its limit.

For these reasons, achieving annual investment returns of 7.5%, or even 6.5%, for the next several years or more, is much harder, if not impossible. Conditions that produced stock market growth over the past 30 years no longer exist. Public employee pension funds, starting with CalPERS, need to face this new reality. Debt and demographics create headwinds that have changed the big picture.

PART TWO: THE IMPACT OF LOWER RETURNS ON CALIFORNIA’S PENSION FUNDS

“Pension-change advocates failed to find funding for a measure during the depths of the 2008 recession and the havoc it wreaked on government budgets, so they won’t pass (a measure) when the economy is doing well.”
–  Steve Maviglio, political consultant and union coalition spokesperson, Sacramento Bee, January 18, 2016

It’s hard to argue with Mr. Maviglio’s logic. If the economy is healthy and the stock market is roaring, fixing the long-term financial challenges facing California’s state/local government employee pensions systems will not be a top political priority. But that doesn’t mean those challenges have gone away.

One of the biggest problems pension reformers face is communicating just how serious the problem is getting, and one of the biggest reasons for that is the lack of good financial information about California’s government worker pension systems.

The California State Controller used to release a “Public Retirement Systems Annual Report,” that consolidated all of California’s 80 independent state and local public employee pension systems into one set of financials, but they discontinued the practice in 2013. The most recent one issued, released in May, 2013, was itself almost two years behind with financial data – using FYE 6-30-2011 financial statements, and it was almost three years behind with actuarial data – used to report funding ratios – using FYE 6-30-2010 actuarial analysis. Now the state controller has created a “By the Numbers” website, but it’s hard to use and does not provide summaries.

No wonder it’s so easy to assert that nothing is wrong with California’s pension systems!

The best source of easily understood compiled data on California’s pensions comes from the U.S. Census Bureau. Since that data is better than nothing, here are some critical areas where roughly accurate numbers can be reported.

The Cash Flow, Money In vs. Money Out

What is the net cash flow of these pensions funds? How much are they collecting in contributions and how much are they distributing in pension benefits? This information, especially if it can be compiled over a period of years, determines whether or not pension funds are net buyers or sellers in the markets. The reason this matters is because if America’s pension funds, with over $4.0 trillion in assets, are net sellers, they put downward pressure on stock prices. They’re that big.

Table 2-A
California State/Local Pension Funds Consolidated

2014 – Cash Flow

20160201-UW-Ring-1

This cash flow (above) shows that during 2014, California’s state/local pension funds, combined, collected 30.1 billion from state and local agencies, and paid out $46.1 billion to pensioners. They are paying out 50% more than they’re taking in, and this is a relatively recent phenomenon. Historically, pension funds have been net buyers in the market. Now, pension funds across the U.S., along with retiring baby boomers, are sellers in the market. This is one reason it is difficult to be optimistic about securing a 7.5% average annual return in the future, despite historical results. And as for that healthy 15.4% return on investments in 2014? That was offset in 2015 and 2016 so far, when the markets were flat. It is also noteworthy that employee contributions of $8.9 billion are greatly exceeded by the $21.2 billion in employer (taxpayer) contributions. How many 401K recipients get a 2.5 to 1.0 matching from their employer?

The Asset Distribution and Portfolio Risk

What is the asset distribution of these pension funds? How much have they invested in relatively risk free, fixed income bonds, vs. their investments in stocks and other variable return assets?

Table 2-B
California State/Local Pension Funds Consolidated

2014 – Asset Distribution

20160201-UW-Ring-2

This asset distribution table (above) indicates that the ratio of riskier, variable return investments to fixed return investments is nearly four-to-one. What if stocks fail to appreciate for a few years? What if real estate values don’t continue to soar? What if there simply aren’t enough high-yield investments out there to allow these assets, valued at a staggering $751 billion in 2014, to throw off a 7.5% annual return? This is a precarious situation. If these projected 7.5% returns were truly “risk free,” the ratios on this table would be reversed, with most of the money in fixed return investments.

The Effect of Lower ROI on the Unfunded Liability and Required Contributions

What is the amount of the unfunded liability for these pension funds? And of the total amount collected and invested each year in these funds, how much is the “unfunded contribution” – the amount allocated to pay down the unfunded liability and eventually restore the systems to 100% funding – and how much is the “normal contribution” – the amount required to fund future pension benefits just earned in that particular year by active workers?

This question, for which neither the State Controller, nor the U.S. Census Bureau, can provide timely and accurate answers, is the most complex and also the most important. While consolidated data is not readily obtainable for these variables, by assuming these pension systems, in aggregate, are officially recognized as 75% funded, we can compile useful data:

Table 2-C
California State/Local Pension Funds Consolidated

2014 – Est. Funding Status and Required Contributions at Various ROI

20160516-CPC-Ring-pension-liabilities

The above table, column one, estimates that at a 75% funded ratio, at the end of 2014 the total pension fund liabilities for all of California’s state and local government pension funds was just over $1.0 trillion, with unfunded liabilities at $250 billion. The second column in the table shows, using conventional formulas adopted by Moody’s investor services for analyzing public pensions, that if the annual rate-of-return projection is lowered to a slightly more realistic 6.5% (already being phased in by CalPERS), the unfunded liability jumps to $380.1 billion, and the funded ratio drops to 66%. For a detailed discussion of these formulas, refer to the California Policy Center study “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County.”

The lower portion of the table spells out the consequences of lower rates-of-return in terms of required annual payments. The first row shows the required normal contribution as a percent of payroll, based on an average retirement age of 57 and an average annual pension multiplier of 2.5%. To evaluate the methods used to arrive at these percentages, refer to the California Policy Center study “A Pension Analysis Tool for Everyone.” The second row shows the taxpayer’s share of the normal contribution, in billions, under the assumption the employees are paying one-third of the normal contribution via payroll withholding.

The final row in the lower portion of the table shows the required unfunded contribution under various ROI assumptions. Using standard amortization formulas, and a 20 year payback term, at a 6.5% rate-of-return assumption, it would take a payment of $34.5 billion per year to return California’s pension funds to 100% funded status by 2036. Since the total taxpayer payments into California’s pension funds – refer back to table 1 – were only 21.2 billion in 2014, it is pertinent to wonder just how much the official numbers would report for the normal contribution, in aggregate, in 2014, vs. the unfunded contribution.

The significance of these numbers can’t be overstated. Even if pension funds earn 7.5% per year, taxpayers should be putting $38.1 billion into them each year, instead of only $21.2 billion. That’s a shortfall of $16.9 billion per year. If pension funds earn 6.5%, it will cost taxpayers $52.3 billion per year. That is an increase of 150% over what is currently being paid. And if they earn 5.5% per year – a return for which most ordinary savers would invest every spare penny they have – it will require a taxpayer contribution of $67.6 billion per year, over three times what is currently being paid.

The implications of this are staggering. A city that pays 10% of their total revenues into the pension funds, and there are plenty of them, at an ROI of 7.5% and an honest repayment plan for the unfunded liability, should be paying 17% of their revenues into the pension systems. At a ROI of 6.5%, these cities would pay 24% of their revenue to pensions. At 5.5%, 32%. And so on. It is impossible for these levels of payments to be sustained, but that’s exactly what will be necessary if the markets drop, and reforms are not implemented.

PART THREE: HOW TO MITIGATE THE IMPACT OF THE PUBLIC PENSION APOCALYPSE

Recommended Pension System Reforms to Maintain Solvency

(1) Make it possible to increase employee contributions. Social Security withholding can be increased or decreased at the option of the federal government. If collections into public employee pension funds are inadequate, increase the withholding from employee paychecks – not only for the normal contribution, but also to help pay the unfunded contribution.

(2) Make it possible to decrease benefits. Nothing in Social Security is guaranteed. Benefits can be cut at any time to preserve solvency. Decreasing benefits may be the only way to preserve defined benefit pensions. Equitable ways to do this must be spread over as many participant classes as possible. For example, the reform passed by voters in San Jose (severely reduced in scope after union litigation) called for suspending cost-of-living increases for retirees, and prospectively lowering the annual rates of benefit accruals for existing workers.

(3) Increase the retirement age. This has already been done several times with Social Security. Pension reforms to-date have also increased the age of eligibility for benefits.

(4) Calculate benefits based on lifetime earnings. Social Security calculates a participant’s benefit based on the 35 years during which they made the most. Public sector pensions, inexplicably, apply benefit formulas to the final year of earnings, or the final few years. These pension benefits should be calculated based on lifetime earnings.

(5) Make the benefit progressive. The more you make and contribute into Social Security, the less you get back. At the least, applying a ceiling to pension benefits should be considered. But it would serve both the goals of solvency and social justice to implement a comprehensive system of tiers whereby highly compensated public servants, who make enough to save themselves for retirement, get progressively less back in the form of a pension depending on how much they make.

Recommended Policy Initiatives to Increase Economic Vitality

(1) Massive Public/Private Investment in Infrastructure

(a) Rebuild California’s aqueducts and develop additional aquifer and surface storage for runoff harvesting. Build desalination plants on the southern California coast. Upgrade existing dams and pumping stations. Permit farmers to contract with California’s urban water districts to sell their water allocations. Build the Sites and Temperance Flat reservoirs. Create water abundance and make water cheap.

(b) Build new power stations. Whether these are 5th generation nuclear power stations, or new natural gas fired power plants, the immediate establishment of an additional 20%+ of generating capacity in California would result in significant lowering of utility rates and make California a net exporter of electricity.

(c) Permit development of offshore oil and gas using slant drilling from land. It is no longer necessary to develop offshore drilling rigs to extract energy reserves. There are cost-effective ways to bring this energy onshore without the risk of an oil spill from an offshore platform.

(d) Permit development of natural gas and shale oil reserves in California.

(e) Permit development of new mines and quarries in California.

(f) Build additional pipeline capacity into California to import and export natural gas to and from elsewhere in North America.

(g) Permit development of a liquid natural gas terminal off the California coast. Get California onto the global LNG grid to import and export natural gas and further diversify sources of energy and income. Create energy abundance and make energy cheap.

(h) Upgrade existing roads, bridges, and freeways. Begin working on “smart lanes” that will facilitate cars and mass transit vehicles driving on autopilot.

(i) Upgrade California’s existing freight and passenger rail infrastructure. When practical, integrate passenger and freight service on common rail corridors in large cities where high population densities make passenger rail economically viable. Increase the speed of intercity passenger rail to 100+ MPH, which can be done on upgraded but already existing track. Improve the interstate rail links emanating from California’s major seaports, to help them remain competitive.

(2) Balance State and Local Government Budgets

(a) Lower the wages of all state and local government workers by 20% of whatever amount they make in excess of $50,000 per year. Lower the wages of all state and local government workers by 50% of whatever amount they make in excess of $100,000 per year. Include in “wages” ALL forms of compensation.

(b) In addition to the steps recommended in the previous section, solve the financial crisis facing pensions by imposing special tax assessments on state and local government pensions in the amount of 50% of all pension payments in excess of $60,000 per year and 75% of all pension payments in excess of $100,000 per year (in 2016 dollars). Adopt the same reformed financial rules governing pension liability estimates that already apply to private sector pension plans.

(c) Require 75% of all K-12 and Community College employees to be teachers in a classroom.

(d) Faithfully implement the federal welfare reforms already adopted by most other states in 1996 during the Clinton administration.

(3) Change the Rules in Sacramento

(a) Implement fundamental curbs on the rights of public sector unions, including: Grant all public sector workers the right to opt-out of union membership and payment of any union dues including agency fees. Prohibit government payroll departments from collecting union dues. Allow all public sector employees to negotiate their own wages and benefits and not be bound by collective bargaining terms if they wish. Prohibit public sector unions from negotiating over long term benefits, and require all current wage and benefit agreements to expire at the end of the term for the elected officials who approved the agreements. Prohibit public sector unions from engaging in political activity of any kind.

(b) Discontinue California’s “CO2 auctions,” which have devolved into a redistribution scheme, taking money from middle class ratepayers and giving it to bankers, politically connected green entrepreneurs, and public sector payroll departments. Repeal AB32. Crucially, lift the crippling burden of land use regulations that keep the prices of homes and commercial property artificially high in California.

(c) Revisit all business-friendly recommendations made by business associations such as the bipartisan California Chamber of Commerce. This would not include compromise positions in support of public sector unions and crony capitalist environmental regulations. This would include banning mandatory project labor agreements or requiring union only contractors on government funded projects.

Recommended Policies to Advocate at the Federal Level

(1)  Balance the Federal Budget. Until the federal government limits its spending to what it collects in tax revenue, it will continue to push for lower interest rates to help fund the deficits. This will stimulate borrowing and consumption instead of savings and production. The cycle of using debt accumulation to finance growth must be broken.

(2)  Restore Partner Liability to Banks. If consumer banks and investment banks were managed by partners who would be personally liable for losses, they would not engage in speculative activity, shielded from personal accountability. As it is, today’s financial firms are not only managed by officers who carry minimal personal liability for their actions, but they are publicly traded entities despite being nothing more than financial intermediaries.

(3)  Reintroduce the Provisions of Glass Steagall. Which the Clinton administration eviscerated in the 1990’s. In brief, this post-depression reform prevented banks from using consumer deposits for speculative investments. Consumer banks and investment banks were required to operate as separate entities.

(4)  End the War on Short Sellers and Harmonize Regulations. Short selling financial assets is one way that financial bubbles are identified and popped before they get too big. Short sales keep valuations realistic and expose financial charades. They should be properly regulated with a uniform set of international rules, but they play a vital role in a healthy market.

(5)  Increase Required Reserve Ratios. Banks are currently permitted to use customer deposits to advance loans to borrowers. Currently they are only required to hold cash equivalent to 10% of their total deposits. Increasing this ratio would increase the financial resiliency of banks.

 *   *   *

Ed Ring is the executive director of the California Policy Center.

Pension burden in 5 California counties now over 10%

Years after the Great Recession slammed their Wall Street investments, at least five California counties have broken through the 10 percent ceiling, spending at least one of out of every $10 to fund their government-employee retirement programs.

The resulting strain on local budgets, called the pension burden, is revealed in California Policy Center’s latest analysis of county reports.

Five California counties reported that their pension contributions now exceed 10 percent of total revenues: Santa Barbara County (13.1 percent), Kern County (11 percent), Fresno County (10.7 percent), San Diego County (10.4 percent) and San Mateo County (10 percent). We will consider each below.

A sixth county, Merced, is also expected to report that its required contributions topped 10 percent of 2015 revenue when it files its audit. We estimate Merced’s payments at slightly over 11 percent of revenue.

CPC’s review of audited financial statements filed by 30 California counties shows pension contributions accounting for between 3 percent and 13 percent of total county revenue.

“For years, public employee union leaders denied the pension burden was even close to 10 percent,” my colleague Ed Ring notes. “This study shows the burden is now approaching 15 percent of revenues.”

The surveyed counties, which account for more than 95 percent of California’s population, made over $5.4 billion in pension contributions during the fiscal year. These counties also made $660 million of debt service payments on pension obligation bonds, raising total pension costs to over $6 billion last year.

That figure accounts for about one-sixth of all California state and local pension contributions (not including payments on pension obligation bonds), estimated at $30.1 billion in 2014.

As investment markets remain relatively flat, it seems likely that many California counties will bow to pressure to cut government services or to raise cash through debt instruments or taxes.

METHODOLOGY

In 25 of 30 counties, we used 2015 audits. Five other counties had yet to file their 2015 reports; in these instances, we estimated revenues and pension contributions from 2014 audits, 2015 budgets and actuarial valuation reports.

Most large counties operate their own pension systems, rather than relying on CalPERS. These county systems often also serve special districts and even cities in the county. Our survey was limited to pension contributions made by the county governments themselves, and excluded separately reporting units – that is, entities that participate in county systems but produce their own financial statements.

In 2015, state and local governments implemented new accounting standards promulgated by the Government Accounting Standards Board (GASB). Aside from reporting net pension obligations as a liability on the government’s balance sheet, GASB Statement Number 67 requires filers to report “Actuarially Determined Contributions” and actual contributions made to their defined benefit plans. The Actuarially Determined Contribution (ADC), previously known as the Actuarially Required Contribution, is calculated by an independent actuary. The ADC is supposed to be the amount sufficient to finance pensions for current and future retirees while gradually closing any gaps in pension funding.

For the 25 larger counties that had released 2015 audits by late February, we recorded ADCs and total revenue, and calculated the quotient of these two values in order to get a rough idea of the relative burden that public employee contributions place on county finances. Because pension systems usually require their actuaries to assume high rates of return on their investments (typically 7.25 percent or more), it’s arguable that reported ADCs understate actual pension burdens.

That said, the reported ADCs provide a reasonable basis for comparison across counties. Further, California public agencies generally make pension contributions roughly equivalent to their ADCs, so the ADC is at least a good gauge of near-term pension burdens.

Total county revenues, ADCs and pension cost ratios appear in the following table:

California County Pension Burden
Total Annual Pension Payments As Percent of Total Annual Revenue
20160312-CPC-Joffe-County-Pensions2

  1. Santa Barbara County

Despite its strong economic performance, Santa Barbara County had the highest pension cost burden among the 25 counties we reviewed – by a considerable margin. Employer contribution rates ranged from 20.8 percent to 59.5 percent, and have risen substantially since 2007. Employer contribution rates represent the percentage of public employee salaries a public agency contributes to its pension plan; they are generally higher for public safety employees, who receive more generous retirement benefits.

In the fiscal year ended June 30, 2015, the Santa Barbara County Employees’ Retirement System (SBCERS) suffered a decline in its funded ratio, from 81.1 percent to 78.4 percent. The drop was largely due to a disappointing 0.83 percent return on plan assets, compared to an assumed 7.5 percent annual asset return.

Despite the decline, SBCERS is still on somewhat stronger footing than the state’s CalPERS – which was about 73.3 percent funded on June 30, 2015. SBCERS is also amortizing its unfunded liabilities faster than CalPERS, using a 17-year timeframe versus 30 years for CalPERS.

SBCERS ended the fiscal year with an unfunded liability of $698 million, about 93 percent of which was the responsibility of county government (the rest belongs to courts and special districts). The system was last fully funded in 2000.

According to a 2007 report commissioned by the county auditor, the system’s position deteriorated for a variety of reasons including poor investment performance and benefit improvements granted by elected officials. The report does not detail these benefit improvements, but they included a change to the final average salary calculation used to determine benefit levels. Liberalizing final average salary calculations can enable pension spiking – a practice under which employees work extra overtime or get last-minute promotions at the end of their careers to maximize pension benefits.

  1. Kern County

Although Kern County’s ADC/revenue ratio is two points lower than that of Santa Barbara County, its situation is worse in a variety of ways. According to the most recent Kern County Employees’ Retirement Association (KCERA) actuarial valuation report, the system was only 64.08 percent funded as of June 30, 2015 – down from 65.11 percent the previous year.

Also, as of June 30, 2015, the county had $284 million in outstanding pension obligation bonds. If the $51 million in scheduled debt service on these bonds is added to the $201 million in Actuarially Determined Contributions the county was required to make, its pension cost burden would exceed that of Santa Barbara County – which has not issued pension obligation bonds.

KCERA’s funded ratio reflects an assumption of 7.5 percent annual returns on its portfolio. This contrasts with an actual fiscal year 2015 return of only 2.3 percent. On the other hand, KCERA is trying to amortize its unfunded liabilities more rapidly than CalPERS – employing an 18-year amortization period versus 30 years for CalPERS. KCERA’s severe underfunding and rapid amortization help drive relatively high pension contribution rates, which range from 37.8 percent for Kern’s court employees to 63 percent for public safety employees.

Kern County shows other signs of fiscal distress. In January 2015, county supervisors declared a financial emergency, prompted by the precipitous decline in oil prices. When the emergency was declared, oil companies paid about 30 percent of the county’s property taxes. That said, it is worth noting that property taxes accounted for just 15 percent of the county’s total 2015 revenue. Counties receive a substantial portion of their revenue from state and federal grants, so declines in a major source of county tax revenue are often less damaging than they are for cities.

After the emergency declaration, Standard and Poor’s affirmed the county’s A+ rating (four notches below the agency’s top AAA rating) and changed its outlook to negative. No downgrade has followed.

Kern County’s liabilities exceed its assets, leaving it with a negative Net Position – another sign of fiscal stress. Since most of a government’s assets are already committed to specific requirements (like paying debt service) or tied up in capital assets that are difficult to sell, analysts often focus on its Unrestricted Net Position – a measure of reserves that could be freely allocated by elected officials. Kern County has a negative Unrestricted Net Position of almost $2.3 billion – suggesting a serious fiscal problem.

On the other hand, the county has a strong general fund balance – equal to more than six months of general fund expenditures. As we have reported elsewhere, low or negative general fund balances have been the best predictor of municipal bankruptcy in recent years.

More recently, the county made further budget cuts which could result in closures of fire stations, jails and other facilities. If the county was not paying over $1 in every $8 for pension contributions and pension obligation bond debt service, these reductions might not have been necessary.

  1. Fresno County

Like Kern County, Fresno County has used pension obligation bonds (POBs) to address pension underfunding. As of June 30, 2015, the county had $454 million in POBs outstanding. This balance actually exceeds the $402 million principal amount of the POBs when they were issued in 2004, because much of the 2004 offering consisted of capital appreciation bonds (CABs). Interest on CABs is added to principal over the life of the bond and then paid at maturity.

In fiscal year 2015, Fresno was scheduled to pay over $37 million in debt service on its POBs. If this is added to the $153.5 million in Actuarially Determined Contributions the county was obliged to make, its pension-cost-to-revenue ratio would (like Kern County’s) exceed that of Santa Barbara County’s, which did not issue POBs.

Fresno County has the highest employer contribution rates as a percentage of payroll of the counties discussed here. In fiscal year 2015, contribution rates range from 37.4 percent to 74.6 percent for certain public safety employees. The county’s retirement program provisions are relatively generous. According to the system’s actuarial report, most plans allow members to retire at age 50. If they remain on the payroll after 55, many classes of employees accrue additional benefits at accelerated rates.

On the plus side, the Fresno County Employees’ Retirement Association is amortizing its unfunded liabilities over a 15-year period and has a relatively strong funded ratio – 79.4 percent (down from 83 percent at the end of 2014).

Illustrating that optimistic investment forecasts plague local government financials, Fresno County assumes annual asset returns of 7.25 percent. Its actual return in fiscal 2015 was a dismal -0.10 percent.

  1. San Mateo County

Like Santa Barbara County, San Mateo County has a strong economy, so it’s surprising to see it near the top of our list. One driver of the county’s pension burden appears to be high employee salaries. Since pension benefits are based on final average salaries, high employee compensation translates into high pension benefits.

A San Jose Mercury News story revealed that San Mateo County had 78 employees paid over $200,000 in the 2013 fiscal year. More recent data available on Transparent California shows that number grew to 90 employees in 2014.

Employee contribution rates ranged from 28.3 percent to 65.5 percent. For a single employee earning $200,000, the county’s annual pension contribution could be as a high as $130,940.

A 2012 San Mateo Civil Grand Jury report noted that county pension contributions had grown from $78 million in fiscal 2006 to $150 million in fiscal 2012, but the plan continued to generate substantial unfunded liabilities. The jury made a number of recommendations including “significantly decreasing the number of county employees through outsourcing and/or reducing services, and by attrition.”

The county’s board of supervisors agreed with most of the Grand Jury’s findings but did not specifically respond to the call for headcount reductions.

In late 2013, the board of supervisors decided to make extra contributions to SamCERA (the San Mateo County Employees Retirement Association) in order to more rapidly cut its unfunded liability. The supervisors authorized a one-time payment of $50 million in fiscal 2014 followed by annual $10 million payments in each of the next nine fiscal years. These payments, totaling $140 million over 10 years, are above the county’s Actuarially Determined Contribution.

The extra contributions have improved SamCERA’s funded ratio despite lackluster stock market performance in the most recent fiscal year. The system’s funded ratio rose from 73.3 percent in 2013, to 78.8 percent in 2014 and to 82.6 percent in 2015. The system achieved portfolio returns of 3.5 percent in fiscal 2015 as opposed to a 7.5 percent projected return rate.

Since 2013, the system’s unfunded liability has fallen from $954 million to $702 million. SamCERA amortizes unfunded liabilities over a 15-year period. Given the improvement in SamCERA’s funded ratio, it seems likely that San Mateo County will fall off the list of highly burdened counties in future years.

CONCLUSION

Generous benefits, aggressive return assumptions and (in some cases) high employee pay have left a number of California counties heavily burdened with pension costs. This year’s poor stock market performance will likely mean additional stress.

Over the longer term, the state’s 2013 pension reform should provide some relief, as newly hired employees receive less generous benefits. But if the stock market continues to be weak or if county systems make poor investment choices, asset returns will remain below the 7.25 percent-7.50 percent typically anticipated in actuarial valuations. Under those circumstances, employer contributions and overall pension burdens may continue to rise. The result will likely be ballooning public debt, pressure to raise taxes and cuts in government services.

 *   *   *

About the author:  Marc Joffe is the founder of Public Sector Credit Solutions and a policy analyst with the California Policy Center. Joffe founded Public Sector Credit Solutions in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

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.
Read more

California Ranks 50th in State Spending Transparency: What We Can Do About It

Although many California political leaders espouse their support for transparency, the state lags behind most others in opening its spending data to public scrutiny.  So while Lieutenant Governor Gavin Newsom, has called on governments to “lean into [the] notion of openness and transparency,” the state he may soon lead is leaning in quite the opposite direction.

In its March 2015 report card, the US Public Interest Research Group (US PIRG) gave California a grade of “F” for its efforts to provide spending transparency – a distinction shared only by two other states, Alaska and Idaho.  US PIRG also assigned each state a more granular numerical score on a 0-100 scale. California’s score of 34 placed it last among the fifty states – 9 points below Alaska.  US PIRG notes:

California…is weighed down by the bureaucratic fragmentation of its information. While the state has made some interesting and useful data sets available to the general public … California does not succeed in providing a “one-stop” transparency portal.

Bureaucratic fragmentation has also frustrated private efforts to elicit the state’s checkbook. In 2013, American Transparency – a not-for-profit that operates openthebooks.com – filed a Public Records Act with the State Controller’s Office (SCO) requesting detailed state spending data. SCO’s legal counsel rebuffed the request on the grounds that the controller does not hold all the spending records, and is not required under the Public Records Act to create records not already in its possession. Apparently state spending data is scattered across roughly 500 agencies, departments and commissions which pay some or all of their vendors directly.

The fragmentation issue might be resolved by Senate Bill 573 which would require the governor to hire a Chief Data Officer, who would then be tasked with creating a state-wide open data portal leveraging information from all state agencies. The bill, proposed by Dr. Richard Pan (D-Sacramento), received favorable publicity but was tabled by the Senate Appropriations Committee on August 27. Pan would have to re-introduce the bill next year if he wants it to pass before the next legislature is seated.

In the meantime, it will be up to civil society organizations to advance state spending transparency. As a part of our state’s civil society, we at the California Policy Center are eager to help.

Starting with Medi-Cal Reimbursements

Ideally, a state checkbook should contain all vendor payments. It need not include employee salaries because these are already published by both SCO and by Transparent California. While it would be extremely challenging for one or more outside organizations to compile all of this spending, a large portion of it can be assembled by examining a few of California’s largest agencies.

The entity that makes the most vendor payments is the Department of Healthcare Services which administers the state Medi-Cal program. In the last fiscal year, Medi-Ca106191228-20140630-Audl payments totaled $87 billion, including $17 billion from the General Fund, $14 billion from Special Funds and $56 billion in Federal Funds.

So just getting our hands around the payments made by this one department would go a very long way toward documenting the state’s overall spending.  Over the next few weeks, the California Policy Center will compile a DHCS checkbook to demonstrate the benefits of state spending transparency.

Our preliminary review suggests that the number one recipient of Medi-Cal funding is Los Angeles County USC Medical Center, known locally as LAC+USC. The 664-bed county hospital received over $700 million in Medi-Cal funds during the fiscal year ended June 30, 2014. LAC+USC is one of three LA County public medical centers. The two other county hospitals together received an additional $700 million in Medi-Cal funding during the same fiscal year, yielding a total of over $1.4 billion in state and federal Medi-Cal funds devoted to LA County hospitals. Medi-Cal reimbursements accounted for over 70% of all three hospitals’ patient revenues.

The prevailing view is that Medi-Cal payments are too low to adequately compensate providers. But, in the case of LAC+USC, the hospital reported $77 million of “Net Income”, i.e. revenues in excess of expenses, also known as “profit” in the private sector.  That said, it should be noted that the hospital suffered a loss on operations, and was profitable because it received $284 million in non-operating revenue.

Most of LAC+USC’s expenditures take the form of employee compensation and benefits, as well as physician fees. These three categories accounted for over $900 million of the hospital’s $1.375 billion in total operating expenses.

A review of 2013 Transparent California data shows that nine out of the ten highest paid Los Angeles County employees are physicians – apparently affiliated with one or more of the three County hospitals. All nine of these doctors received total compensation from the County in excess of $500,000 during calendar year 2013.

It appears that at least a couple of these individuals received compensation from other medical facilities. For example, Dr. John Peter Gruen, a neurosurgeon who received a total of $628,001 in County compensation is also affiliated with Huntington Memorial Hospital in Pasadena and Keck Medical Center of USC.

As this brief analysis suggests, the ability to obtain state spending details and juxtapose this information with other data sets should yield new insights into how our tax dollars are being managed. Next month, look to this space for much more information about California Medi-Cal spending.

 *   *   *

About the author:  Marc Joffe is a policy analyst for the California Policy Center. He is also the founder Public Sector Credit Solutions, established in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

Will California Voters Support Pension Reform?

A bipartisan coalition led by former San Jose Mayor Chuck Reed and former City Councilman Carl DeMaio have filed a pension reform ballot measure in California. The group seeks to qualify the measure for a possible November 2016 vote by California voters.

The California Policy Center examined polling conducted by a variety of sources and CPC also commissioned its own polling study through the polling firm Penn Schoen Berland. CPC’s poll utilized online interviews in English and Spanish from August 17-21, 2015 among n=1,002 likely voters in California.

Overwhelming Public Support for Pension Reform

CPC’s review of a number of statewide polls conducted in recent years confirms that California voters have shown overwhelming support for pension reform.

A statewide poll issued by the Public Policy Institute of California in September found that 72 percent of likely voters say public pension costs are a problem and 70 percent say voters should make decisions about retirement benefits. As in previous PPIC polls, 70 percent favor giving new government employees a 401(k)-style plan rather than a pension. The change has strong bipartisan support: Republicans 74 percent, independents 69 percent, and Democrats 65 percent.

The CPC poll used several questions to examine voters knowledge of and assessment of issues facing state and local government pension funds – as well as the level of compensation and benefit packages provided to government employees.

(1) Would you say the financial health of the pension funds for state and local government employees in California are in a better place, worse place, or about the same place as they were ten years ago?

(%) California
Likely Voters
Better place 14
Worse place 46
About the same place 25
Don’t know 15

(2)  As far as you know, are CalPERS and CalSTRS in debt or do they have a surplus?

(%) California
Likely Voters
In debt 30
Have a surplus 16
Don’t know / unsure 55

(3)  As far as you know, on average, are state and local government employees…?

(%) California
Likely Voters
Paid more than employees in the private sector 41
Paid less than employees in the private sector 34
About the same 25

(4)  As far as you know, on average, do state and local government employees…?

(%) California
Likely Voters
Get bigger pensions than employees in the private sector 60
Get smaller pensions than employees in the private sector 19
About the same 21

 *   *   *

Attorney General’s Title and Summary Impacts Support

In August, the DeMaio and Reed blasted Attorney General Kamala Harris for issuing what they called a “biased” Title and Summary of the pension reform measure the coalition filed. The Title and Summary is what voters actually see on the ballot and the Attorney General has a Constitutional obligation to provide a fair and accurate description.

Putting aside the debate over whether the Title and Summary is fair and accurate, the polling shows the Attorney General’s Title and Summary from a polling perspective does indeed have a major negative impact on the ballot proposal.

In March 2015, the coalition conducted its own poll of California voters that demonstrated solid support for the concepts contained in the ballot proposal – specifically asking this question:

Would you vote yes – in favor of, or no – against a ballot measure that would give voters the right to reform pension benefits for state and local government workers, would require voter approval before obligating taxpayers to guarantee lifetime pensions benefits for new state and local government employees, and would require new government employees to contribute at least half the cost of their retirement benefits?

California Voter Support for Pension Reform

20151116-CPC-DeMaio

CPC’s poll used the Title and Summary provided by the Attorney General – with the Title and Summary crafted by the AG resulting in less support for the measure.

PUBLIC EMPLOYEES. PENSION AND RETIREE HEALTHCARE BENEFITS. INITIATIVE CONSTITUTIONAL AMENDMENT. Eliminates constitutional protections for vested pension and retiree healthcare benefits for current public employees, including those working in K-12 schools, higher education, hospitals, and police protection, for future work performed. Adds initiative/referendum powers to Constitution, for determining public employee compensation and retirement benefits. Bars government employers from enrolling new employees in defined benefit plans, paying more than one-half cost of new employees’ retirement benefits, or enhancing retirement benefits, unless first approved by voters. Limits placement of financial conditions upon government employers closing defined benefit plans to new employees. Summary of estimate by Legislative Analyst and Director of Finance of fiscal impact on state and local government: Significant effects—savings and costs—on state and local governments relating to compensation for governmental employees. The magnitude and timing of these effects would depend heavily on future decisions made by voters, governmental employers, and the courts.

California Voter Support for Pension Reform
Using Attorney General’s Title & Summary

(%) California
Likely Voters
Vote yes to support 36
Vote no to oppose 33
Undecided 32

 *   *   *

Many Arguments in Favor of Pension Reform Poll Well

After testing the Title and Summary, CPC polled arguments that might be used by proponents of pension reform to justify major changes in state and local pension benefits.

(%) California Likely Voters

 

Much more likely Somewhat more likely Somewhat less

likely

Much less

likely

Many government employees are abusing the system to spike their pensions. In 2013, one former assistant fire chief in Los Angeles collected a government pension of $983,000. In San Diego, a former city librarian now collects $234,000 annually, and a politician in that same city started cashing full-pay pension checks at age 32. Last year alone, over 41,000 retired state and local government employees cashed pension checks of $100,000 or more! This proposal would end abuses like these. 52 27 12 9
This proposal does not take away any pension benefits lawfully earned by government employees. The proposal simply prevents any spiking of pensions going forward and also reforms benefits for any newly hired government employees going forward. It will not affect current retirees. In this way, we are fixing our pension problem while protecting the seniors and families who depend on current benefits. 47 40 8 5
Backroom deals by politicians created the California pension crisis. Politicians take campaign contributions and support from powerful government unions and in return, politicians give the unions sweetheart deals that mean bigger pension benefits. Politicians have even voted to spike their own pensions. This proposal provides a “check” on state and local politicians by requiring voter approval of any future pension deals. With this proposal, voters will be able to stop the politicians from doing backroom pension deals that taxpayers can’t afford. 47 31 13 9
If you are concerned about public safety you should support this pension reform proposal. If we don’t reform government pensions now, many cities and counties will be forced to cut police and fire services to divert our tax dollars to bail out government pension funds. For example, the Oakland Police Department no longer responds to 44 different crimes as a result of cutbacks that were necessary to fund pensions. Elsewhere in the state, fire stations have had to scale back hours of operation and in some cases close in order to pay rapidly rising pension costs. 44 40 8 8
Pension debt has grown exponentially in California, rising from $6.3 billion in 2003 to $198 billion in 2013. And when combined with unfunded liabilities for retiree healthcare programs, taxpayers owe almost $350 billion to fund future retirements for government employees. Without immediate action, the cost of government pensions will double in the next five years alone. This proposal will shrink the debt and save taxpayers billions. 44 34 14 7
Politicians and bureaucrats who run the government pension program are cooking the books and misleading the public. Last year the head of the pension program pled guilty to taking bribes and helping friends collect millions in a fraudulent investment scheme. The situation is getting worse as taxpayers lose billions from dubious investment decisions made by a board with significant conflicts of interest. This proposal would reform the government pension program, which is why the powerful elites who profit from the government pension program are opposing it. 44 30 15 11
Many government employees contribute nothing at all towards the costs of their pension benefits, leaving taxpayers to pick up the whole tab. This proposal would require new government employees to contribute at least half the cost of their retirement plans, similar to what most private sector employees have to contribute. 43 32 17 8
If you are concerned about quality education for our children you should support this pension reform proposal. If we don’t reform government pensions now, many cities and counties will be forced to cut after school programs, close libraries, and parks and recreation in order to divert our tax dollars to bail out government pension funds. For example, cities like San Jose had to restrict library hours of operation in order to pay for rapidly rising pension costs. 40 34 17 9
Mounting government pension debts have forced major cuts in important services. For example, pension contributions in Los Angeles have grown from 3% of the city’s overall budget to nearly 20% in just the last decade, crowding out other public needs. Already in cities and counties across California, higher pensions costs have meant cuts to after school programs, closures and brownouts at fire stations and cancellations of road repairs. With this pension reform proposal, we can generate savings to restore these important services. 39 34 20 7
Voters should take a close look at who opposes this pension reform proposal. One Sacramento union boss leading the charge against reform collects a pension of $183,690 annually. He says government employees trade off pay for a secure retirement. However, according to the Sacramento Bee newspaper, the average salary for employees like him is $163,000 annually plus health care and retirement at age 55. Those same union leaders are lying about this pension reform proposal because they want to keep their taxpayer-funded gravy train going. 39 29 18 15
Cities across California are being crushed under the weight of mounting pension debt. Because of pensions, major cities such as Vallejo, Stockton, and San Bernardino have already gone bankrupt, which resulted in massive cuts in important services such as police and fire protection. Unless we approve this pension reform proposal, many more cities throughout California will be forced to declare bankruptcy and make similar extreme cuts in our services. 38 36 16 9
Voters should take a close look who opposes this pension reform proposal. In 2012, the teachers unions blocked legislation that would have given local officials the power to fire teachers convicted of sexually abusing their own students even though this meant that sexually abusive teachers got to keep their jobs. Those same unions are lying about this pension reform proposal because they want to block the common-sense reform it would bring. 38 27 22 13
The pension reforms in this proposal are fair. The new benefits provided to government employees would be no better, and no worse, than the benefits provided to workers in the private and non-profit sectors. For police and fire, the measure provides a guarantee of death and disability benefits mirroring exactly what the US Military receives. 37 41 14 9
 

 *   *   *

Arguments in Opposition to Pension Reform Offer Mixed Bag of Results

(%) California Likely Voters
(among those who saw “anti” messaging first)
Much less

likely

Somewhat less

likely

Somewhat more likely Much more likely
This pension proposal is promoted and funded by Tea Party Republicans including a young billionaire Texan who is spending $50+ million dollars to take away from school bus drivers, teachers, nurses, and firefighters their hard-earned retirement benefits. He hates government so much that he wants to strip millions of middle and working class Californians of their retirement security. 53 19 17 11
This proposal to eliminate public pensions in California is led and funded by a Texas wheeler-dealer billionaire named John Arnold. Arnold is spending $50+ million dollars of his fortune to dismantle retirement plans for firefighters, nurses, and teachers. Moving California state and local government employees to 401(k) accounts would mean billions more for Arnold and his cronies to split in higher Wall Street fees. 48 21 19 13
Many public employees like teachers, police, and fire fighters do not receive Social Security or have very limited benefits. This proposal would eliminate their pensions and would undermine their ability to retire with dignity, as they will have no safety net if their 401(k) investments lose their value before or during their retirement through no fault of their own. 47 25 19 9
This pension reform proposal would likely eliminate the current death and disability benefits for new police, firefighters, and other public employees. It would be disgraceful to take these important protections away from families of police and fire fighters who make the ultimate sacrifice to protect Californians. 47 24 20 9
If enacted, this ballot measure will cost the taxpayers millions, or even billions for extra elections. Every contract at all levels of government could be on the ballot, costing school districts, cities, and counties millions of dollars to hold these elections. And it will unleash expensive lawsuits which will be litigated in the courts, with taxpayers footing the bill. 45 34 14 7
This proposal would eliminate state constitutional protections for current and future employees, breaking promises made to teachers, nurses, and firefighters by rewriting their pension benefits without negotiation. This would devastate middle class families who have contributed to these pension plans and have made long-term financial planning decisions based on the promises made to them when they were hired. 45 25 19 11
This proposal to eliminate public pensions in California is led and funded by greedy investors including America’s youngest Wall Street billionaire who made his stash out of the collapse of Enron. If a statewide pension-gutting proposal is passed in California, public sector employees will be moved to 401(k) plans, which would mean a windfall in investment fees for Wall Street. It’s as bad as when George W. Bush tried to privatize Social Security. 44 27 19 10
Pensions are important compensation for public employees, including those who work in K-12 schools, higher education, hospitals, and police protection.  Public employees earn an average of 7% less than their private sector counterparts. Adequate pensions also serve as valuable recruitment and retention tool. If we approve this proposal’s massive cuts in pension benefits, we will need to either pay government employees more or risk hiring less-qualified government employees, which will lead to lower-quality services. 38 26 20 16
This measure is part of an extreme agenda to eliminate collective bargaining for government employees in California. The proposal allows voters to increase or decrease compensation and retirement benefits of government employees without any negotiation or collective bargaining. This undermines the ability of the government and employees to negotiate and agree on contracts. These complex issues should be settled at a bargaining table, not the ballot box. 38 24 24 14
This proposal would take away vested benefits that were promised to current public employees. For example, a state employee with 8 years of service could lose retiree healthcare benefits she would have earned after 10 years under her current employment contract. This is unfair to workers and their middle-class families, especially single mothers, because many accepted lower as a tradeoff better retirement and healthcare plans. 37 32 20 11
This proposal exaggerates the pension problem. Public employees are not retiring to lavish and luxurious pensions. In 2012, California passed extensive pension changes that raised the retirement age for new workers and require all employees to pay half of their pension costs. Thanks to Governor Brown’s reforms, $100,000 plus pension payments have all but been eliminated. The average public employee pension is just $2,500 a month – hardly the gold-plated plan overhaul that the other side claims. 31 29 28 11

 *   *   *

Significant Support for Pension Reform After Title and Summary Is Explained

Among voters who were exposed to the case for pension reform immediately after the Title and Summary was provided, support shifted dramatically back in favor of the pension reform proposal.  CPC concludes that the Title and Summary as currently written confuses and scares voters, but once the proposal is clearly explained to voters, confident support returns.

(%) CA Likely Voters
Vote yes to support 63
Vote no to oppose 18
Undecided 19

 *   *   *

Pension Reform Likely to Have Major Impact on 2016 Elections

The presence of a pension reform issue in the midst of the 2016 elections in California could have a profound effect on both candidate races and the debate over a variety of tax increase measures being considered for the 2016 ballot.

(1)  In the November 2016 election, which of the following types of candidate would you be most likely to vote for?

(%) California
Likely Voters
A Democrat who opposes the proposal 24
A Democrat who supports the proposal 18
A Republican who opposes the proposal 12
A Republican who supports the proposal 20
None of the above 5
Not sure 22

(2)  If a candidate from a political party different from your own supported this proposal, would that make you…?

(%) California
Likely Voters
Much more likely to support that candidate 9
Somewhat more likely to support that candidate 23
Somewhat less likely to support that candidate 11
Much less likely to support that candidate 17
No difference 41

(3)  Some people say that we should approve tax increases on the wealthy and extend the temporary sales tax enacted in 2012, because the state still need that money to close the budget deficit. Without these funds, we will have to cut funding for schools and for other important public services.

Other people say that the politicians are only raising taxes to pump more money into these failing state and local government pension systems to continue unsustainable government pension payouts (including their own) with our tax dollars. None of this money will go to school funding. We should enact pension reform first before considering any more tax increases.

Which of the following comes closer to your view?

(%) California
Likely Voters
Approve tax increases  on the wealthy and extend 2012 tax increases 37
Enact pension reform first 32
Neither of the above 15
Unsure 17

 *   *   *

Voters Not Swayed Significantly By Groups on Pro and Con Side of Pension Reform

CPC evaluated voter views of a variety of groups that are likely to take positions both for and against pension reform proposals.

As it related to this proposal, how much would you trust the information you might receive from the following organizations or institutions?

(%) California Likely Voters A lot of trust /

very credible

Somewhat trust / somewhat credible Trust just a little / not very credible Do not trust at all / not at all credible
Police and firefighter unions 22 39 25 14
Teachers’ unions 18 35 23 23
CalPERS 13 35 33 19
Government employees’ unions 11 31 27 31
Public sector unions 11 30 34 25
California Chamber of Commerce 10 41 33 16

 *   *   *

About the Author:  Former San Diego city councilman and lifelong entrepreneur Carl DeMaio is now tackling state-wide fiscal reform policy. While on the City Council, DeMaio led the effort to cut red tape on small businesses, reform the city’s contracting processes to expedite infrastructure projects, and enact some of the toughest “Sunshine Law” open government requirements in the nation. In 2012, DeMaio crafted and led a citizens campaign to qualify and pass the “Comprehensive Pension Reform” Initiative – the first-of-its kind measure to switch San Diego from a Defined Benefit Pension Plan to a 401(k) retirement program. In 2003, DeMaio founded the American Strategic Management Institute (ASMI), which provides training and education in corporate financial and performance management. In late 2007, DeMaio sold both of his companies to Thompson Publishing Group. DeMaio holds a BA in International Politics and Business from Georgetown University.

"For the Kids" – Comprehensive Review of California School Bonds, Executive Summary (Section 1 of 9)

See the complete California Policy Center report For the Kids: California Voters Must Become Wary of Borrowing Billions More from Wealthy Investors for Educational Construction (complete, printable PDF Version, 4 MB, 361 pages)

Links to all sections of this study readable online:
You are Here: Executive Summary: “For the Kids” – Comprehensive Review of California School Bonds (1 of 9)
More Borrowing for California Educational Construction in 2016 (2 of 9)
Quantifying and Explaining California’s Educational Construction Debt (3 of 9)
How California School and College Districts Acquire and Manage Debt (4 of 9)
Capital Appreciation Bonds: Disturbing Repayment Terms (5 of 9)
Tricks of the Trade: Questionable Behavior with Bonds (6 of 9)
The System Is Skewed to Pass Bond Measures (7 of 9)
More Trouble with Bond Finance for Educational Construction (8 of 9)
Improving Oversight, Accountability, and Fiscal Responsibility (9 of 9)
Guide to all Tables and Appendices – Comprehensive Reference for Researchers


Executive Summary 

Few Californians realize how much debt they’ve imposed on future generations with their votes for bond measures meant to fund the construction of new and modernized school facilities.

From 2001 to 2014, California voters considered 1147 ballot measures proposed by K-12 school districts and community college districts to borrow money for construction via bond sales. Voters approved 911 of these bond measures, giving 642 school and college districts authority to borrow a total of $110.4 billion.

California voters also approved three statewide ballot measures during that time to authorize the state to borrow $35.8 billion. That money has supplemented local borrowing for construction projects at school and college districts, and the state has spent all but $195 million of it.

That’s a total of $146.1 billion authorized during the last 14 years for state and local educational districts to obtain and spend on construction projects. All of it has been borrowed or will be borrowed from wealthy investors, who buy state and local government bonds as a relatively safe investment that generates tax-exempt income through interest payments.

Current and future generations of Californians are already committed to paying these investors about $200 billion in principal and interest — a number that will grow as school and college districts continue to borrow by selling bonds already authorized by voters but not yet sold.

And more borrowing is coming.

In 2016 California voters may be asked to authorize the state to borrow as much as $9 billion for school construction. More than 100 school and college districts may ask voters to approve borrowing a total of several billion more dollars. Officials at the country’s second largest school district, the Los Angeles Unified School District, claim they need more than $40 billion for additional construction and plan to ask voters to approve borrowing several billion in 2016.

It is time to be wary. The California Policy Center believes that most Californians are unaware and uninformed about this relentless borrowing and the amount of debt already accumulated to pay for school construction. Most voters cannot explain how a bond measure works and do not get enough information to make an educated decision about the wisdom of a bond measure.

California voters who want to learn more before voting will have difficulty finding relevant information. Where does an ordinary Californian find out how much money a school or college district has already been authorized to borrow from past bond measures, or the principal and interest owed from past bond sales that still needs to be repaid, or the projected changes in assessed property valuation and how they affect tax and debt limits, or the past and projected student enrollment? The state does not offer a clearinghouse of information for the public to research and compare data about bond measures and bond debt for educational districts. Much of the information available about debt finance for educational districts is oriented toward interests of bond investors rather than people who pay the debt.

Californians who recognize a need for their own local educational districts to refrain from accumulating additional debt have significant obstacles to overcome. State law gives supporters of bond measures a systematic strategic advantage when local districts develop bond measures and put them before voters for approval. Campaigns to support bond measures are funded and even managed by financial and construction industry interests that will profit after passage. And after voters approve a bond measure, educational districts are tempted to take advantage of ambiguities in state law and use bond proceeds for items and activities not typically regarded by the public as construction.

To help to fix these deficiencies, this report encourages the California legislature and the executive branch to adopt five sets of recommendations:

Five Categories of Recommendations
1Provide Adequate and Effective Oversight and Accountability for Bond Measures
2Enable Voters to Make a Reasonably Informed Decision on Bond Measures
3Eliminate or Mitigate Conflicts of Interest in Contracting Related to Bond Measures
4Reduce Inappropriate, Excessive, or Unnecessary Spending of Bond Proceeds
5Improve Understanding of Bond Measures Through Public Education Campaigns

At a time of low interest rates, California school and community college districts may benefit in some circumstances from borrowing money to fund school construction, just like households benefit from home mortgages and car loans. But California voters — and their elected representatives — need to become much more informed about the debt legacy they are leaving to their children and grandchildren.

Emotional sentiment, lobbying pressure from interest groups, and eagerness to circumvent frustrating tax and debt limits in state law can overwhelm a prudent sense of caution. Irrational decisions that burden future generations cannot necessarily be fixed after the public finds out about them.


Section Summaries

Section 2. Why This Report Matters: More Borrowing in 2016

Californians will be asked in 2016 to continue taking on debt for construction of educational facilities, but one elected official is leery. Governor Jerry Brown wants to change the funding system for school construction. He is concerned about debt that Californians have accumulated from years of allowing the state and local educational districts to relentlessly borrow.

That money borrowed through bond sales will have to be paid back — with interest — to the investors who bought them. Voters have limited understanding of bonds and how bonds provide funds for construction, and elections focus on what voters will get rather than how they will pay for it. To the detriment of future generations, few Californians realize the huge amount educational districts have been authorized to borrow and the huge amount of debt accumulated.

Section 3. Quantifying and Explaining California’s Educational Construction Debt

Whatever voters are asked to approve in 2016 will not launch a new program to fix long-neglected schools to serve a rapidly expanding state population while providing smaller class sizes. That thinking is a legacy of the 1990s that seems to endure today despite 14 years of most bond measures passing at a 55 percent threshold for voter approval. Arguments for another state bond measure in 2016 ignore or downplay how local school and college districts and the state obtained authority in the past 14 years to borrow $146.1 billion for educational construction.

If voters are not told or reminded of recent borrowing patterns, how can they make an informed decision on future borrowing? To rectify the lack of availability of statistics on total bond debt in California for educational facility construction, the California Policy Center collected, synthesized, and analyzed data regarding California educational construction finance. The California Policy Center believes it is the first and only entity to painstakingly research and present an accurate and comprehensive record of all state and local educational construction bond measures considered by voters from 2001 through 2014.

Section 4. How Educational Districts Acquire and Manage Debt

It’s likely that most California voters have limited familiarity with the organization and governance of their local school and community college districts. When voters authorize their local educational districts to borrow money for construction by selling bonds, presumably they trust that the local school or college district will exercise prudence in managing the process. Sometimes their trust is betrayed.

To discourage abuse of the school construction finance system, voters need to be aware of how their local government is organized and managed. They also need to realize that state law does not explicitly give Independent Citizens’ Bond Oversight Committees broad authority to review construction programs funded by bond measures.

How can voters become informed about bonds and the process of borrowing money for educational construction through bond sales? Is there a way to explain in clear plain language what actually happens after voters approve a bond measure and authorize a school or college district to borrow money via bond sales?

Section 5. Capital Appreciation Bonds: Disturbing Repayment Terms

In 1993, California law was changed so that school and college districts could use an innovative form of debt finance called zero-coupon bonds, also known as Capital Appreciation Bonds. These bonds allow school and college districts to borrow now for construction and pay it back — with compounded interest — many years later. The borrowing strategy has been a tempting and dangerous lure for elected school and college boards.

Some people think Capital Appreciation Bonds are a “ticking time bomb” or the “creation of a toxic waste dump.” Others regard critics as uninformed and contend that these debt finance instruments are beneficial for school and college districts. Since the people who will be paying off many of these Capital Appreciation Bonds are now children or not even born yet, there isn’t much incentive to stop the flow of borrowed money that doesn’t need to be paid back for a generation or two.

Section 6. Tricks of the Trade: Questionable Behavior with Bonds

Californians who want more spending on educational construction often express their resentment of a 2000 law limiting taxes and debt resulting from bond sales. It was passed in order to strengthen campaign arguments to voters in support of Proposition 39, which lowered the approval threshold for local bond measures from two-thirds to 55%. School districts have adopted several strategies to get around these limits in state law. One of them is very obscure but 100% successful: obtaining waivers from the State Board of Education.

Meanwhile, some districts are stretching legal definitions to use proceeds from bond sales to pay for items that resemble instructional material more than construction. One example is personal portable electronics such as iPads. Some of the state’s largest districts are purchasing this kind of technology while giving little assurance to the public that long term bonds aren’t the source of the money. This equipment may be obsolete well before the bonds mature, meaning that future generations will pay for these devices long after they are outdated and discarded.

Section 7. The System Is Skewed to Pass Bond Measures

Considering the advantages that supporters have in preparing and campaigning for a bond measure, perhaps it’s noteworthy that voters reject about 20% of local bond measures for educational construction. At every stage of the process, interests that will benefit from bond sales can take advantage of a system that favors passage of a bond measure. Some issues of concern include use of public funds to develop campaigns to pass bond measures, significant political contributions to campaigns from interests likely to benefit from construction, involvement of college foundations as intermediaries for campaign contributions, and conflicts of interest and alleged pay-to-play contracts.

Section 8. More Trouble with Bond Finance for Educational Construction

While compiling the comprehensive information provided in this study, California Policy Center researchers identified numerous other troubling aspects of bond finance. School and college districts are evading compliance with the law and making irresponsible decisions. Ordinary voters lack enough data to make an informed vote. Community activists who seek deeper understanding find themselves stymied.

Section 9. Improving Oversight, Accountability, and Fiscal Responsibility

This report encourages the California legislature and the executive branch to adopt five sets of recommendations that will help to fix these deficiencies.

Five Categories of Recommendations
1Provide Adequate and Effective Oversight and Accountability for Bond Measures
2Enable Voters to Make a Reasonably Informed Decision on Bond Measures
3Eliminate or Mitigate Conflicts of Interest in Contracting Related to Bond Measures
4Reduce Inappropriate, Excessive, or Unnecessary Spending of Bond Proceeds
5Improve Understanding of Bond Measures Through Public Education Campaigns

The California Policy Center rejects the idea that additional oversight and accountability isn’t needed or desirable. Some legislative reforms and education programs (both public and private) can overcome voter cynicism, frustration, apathy, and ignorance.

Tables and Appendices of “For the Kids: California Voters Must Become Wary…”

Tables A1 to A6

Table A-1 California K-12 School Districts 2013-2014 – Ranked by Enrollment

Table A-2 California Community College District Enrollment Fall 2014 Ranked by Number of Students

Table A-3 Details of Bond Indebtedness Waiver Requests from California School Districts to State Board of Education 2002 through March 2015

Table A-4 California School Construction & Finance History

Table A-5 Arguments for Capital Appreciation Bonds

Table A-6 Arguments Against Capital Appreciation Bonds

Appendices A to L

Appendix A – All California Educational Bond Measures Pass and Fail – 2001-2014 Ranked by Percentage of Voter Approval

Appendix B – All California Educational Bond Measures Approved by Voters – 2001-2014 Ranked by Amount Authorized to Borrow

Appendix C – All California Educational Bond Measures Rejected 2001-2014 – Ranked by Amount NOT Authorized to Borrow

Appendix D – All California Educational Bond Measures Approved With a Two-Thirds Threshold Since November 2000 Enactment of Proposition 39 – Listed By Election Year

Appendix E – All California Educational Bond Measures 55 Percent – 2001-2014

Appendix F – All California Educational Bond Measures Repurposed or Reauthorized Since November 2000 Enactment of Proposition 39 – Listed by Election Year

Appendix G – All California Educational Bond Measures Approved by Voters with 55 Percent Threshold Since November 2000 – Results if Prop 39 Had Not Been Law

Appendix H – All California Educational Bond Measures Approved by Voters Under 55 Percent Threshold Since November 2000 Enactment of Proposition 39 – Failures Under 2:3 Threshold

Appendix I – All California Educational Bond Measures Approved by Voters – 2001-2014 Ranked by Amount of Debt Service

Appendix J – All Educational Districts in Which Voters Authorized Borrowing Via Bond Sales Since Proposition 39 – Ratio of Current Debt Service to Amount Authorized

Appendix K – All Educational Districts in Which Voters Authorized Borrowing Via Bond Sales Since November 2000 Enactment of Prop 39 – Ratio of Current Debt Service to Total Yes Votes

Appendix L – All Educational Districts in Which Voters Authorized Borrowing Via Bond Sales Since November 2000 Enactment of Prop 39 – Ranked by Amount Authorized Per Yes Vote

###

More Borrowing for California Educational Construction in 2016 (Section 2 of 9)

See the complete California Policy Center report For the Kids: California Voters Must Become Wary of Borrowing Billions More from Wealthy Investors for Educational Construction (complete, printable PDF Version, 4 MB, 361 pages)

Links to all sections of this study readable online:
Executive Summary: “For the Kids” – Comprehensive Review of California School Bonds (1 of 9)
You are here: More Borrowing for California Educational Construction in 2016 (2 of 9)
Quantifying and Explaining California’s Educational Construction Debt (3 of 9)
How California School and College Districts Acquire and Manage Debt (4 of 9)
Capital Appreciation Bonds: Disturbing Repayment Terms (5 of 9)
Tricks of the Trade: Questionable Behavior with Bonds (6 of 9)
The System Is Skewed to Pass Bond Measures (7 of 9)
More Trouble with Bond Finance for Educational Construction (8 of 9)
Improving Oversight, Accountability, and Fiscal Responsibility (9 of 9)
Guide to all Tables and Appendices – Comprehensive Reference for Researchers


Why This Report Matters: More Borrowing in 2016

Californians will be asked in 2016 to continue taking on debt for construction of educational facilities, but one elected official is leery. Governor Jerry Brown wants to change the funding system for school construction. He is concerned about debt that Californians have accumulated from years of allowing the state and local educational districts to relentlessly borrow.

That money borrowed through bond sales will have to be paid back — with interest — to the investors who bought them. Voters have limited understanding of bonds and how bonds provide funds for construction, and elections focus on what voters will get rather than how they will pay for it. To the detriment of future generations, few Californians realize the huge amount educational districts have been authorized to borrow and the huge amount of debt accumulated.

Interest Groups Want Voters to Consider Another State Bond Measure

When the California Policy Center published this report, the California Attorney General had approved circulation of petitions through September 21, 2015 for a proposed statewide ballot initiative entitled the “Kindergarten Through Community College Public Education Facilities Bond Act of 2016.” Professional signature gatherers set up tables at grocery stores and other public locations trying to cajole citizens into signing petitions to “help the kids” by putting the measure on the ballot.

If this proposal qualifies for the ballot and voters approve it, the State of California will have the authority to borrow $9 billion through selling bonds to investors. According to the petition, this $9 billion will ensure that “K-14 facilities are constructed and maintained in safe, secure and peaceful conditions.” As reported in the Sacramento Bee, school construction interests and residential housing developers want this bond measure, or one like it, on the ballot in 2016.

Proponents point out, accurately, that most of the money that voters authorized the state to borrow in 1998, 2002, 2004, and 2006 has been distributed as matching grants to local educational districts. As of April 15, 2015, $195.4 million remains3 from $35.4 billion approved to borrow as a result of three statewide ballot propositions in the 2000s.

The petition for the Kindergarten Through Community College Public Education Facilities Bond Act of 2016 lists four “findings” explaining what the state could do if it borrowed $9 billion:

1. Career technical education facilities to provide job training for many Californians and veterans who face challenges in completing their education and re-entering the workforce.

The history of recent bond measures on the state and local level shows that voters are inclined to support more government spending when veterans are cited as beneficiaries. Poll results confirm this. A “State of California School Bond Measure Feasibility Survey” of likely voters conducted January 30 to February 9, 2014 for California’s Coalition for Adequate School Housing (C.A.S.H.) indicated that “more than six-in-ten are highly concerned about unemployment among veterans.”

2. Upgrade aging facilities to meet current health and safety standards, including retrofitting for earthquake safety and the removal of lead paint, asbestos and other hazardous materials.

Again, the “State of California School Bond Measure Feasibility Survey” concluded that “more than two-thirds agree that many California public schools need significant health and safety improvements,” specifically the statement that “many schools and community colleges throughout California are old, outdated and need upgrades to meet current health and safety standards, including retrofitting for earthquake safety and the removal of lead paint, asbestos and other hazardous materials.”

3. Studies show that 13,000 jobs are created for each $1 billion of state infrastructure investment. These jobs include building and construction trades jobs throughout the state.

Influential construction interests are part of the coalition supporting this statewide bond measure. This statement acknowledges their pivotal role in the campaign to pass it.

4. Academic goals cannot be achieved without 21st Century school facilities designed to provide improved school technology and teaching facilities.

Once again, the “State of California School Bond Measure Feasibility Survey” concludes that “in particular, voters believe that funds must be directed towards upgrading vocational/career education programs, repairing classrooms and science labs and upgrading technology.”

These are deliberately chosen arguments to justify borrowing another $9 billion for community college and K-12 school district construction projects. In fact, these were the same arguments used in newspaper opinion pieces and position papers in 2014 to support Assembly Bill 2235, which if signed into law would have asked state voters in the November 2014 election to authorize borrowing $4.3 billion for school construction through bond sales.

Regardless of whether the four arguments listed above for a statewide bond measure are factually valid, they have been tested through polling and other voter research and shown to be effective in winning voter support. Surely a 2016 campaign for a state bond measure will use them.

How do these arguments stand in the larger context of bond indebtedness for the State of California and its community college districts and K-12 school districts? This report provides some of that context and introduces information never before available to the public.

Governor Brown Worries About Debt and Seeks Change in School Construction Finance

Governor Jerry Brown has used his executive power to thwart legislative efforts to place a statewide bond measure for educational construction on the 2016 ballot. Assembly Bill 2235 never received an opposition vote as it passed the Assembly and moved through Senate committees with support from numerous interest groups. Voters didn’t get to consider it in the November 2014 election only because Governor Brown didn’t want it on the ballot. As reported by a Capitol Public Radio reporter, the bill author issued a statement explaining its abandonment: “The governor has made it clear that he does not want a school bond on the same ballot as the water bond and rainy day fund. We do not expect the legislature to send the bill on him.”

Meanwhile, the Governor is taking a leading role in calling for change in how state and local governments fund California school construction. He submitted a state budget proposal to the California legislature in January 2015 with an introduction stating that funding commitments “must be honestly confronted so that they are properly accounted for and funded.” It warned that “budget challenges over the past decade have also resulted in a greater reliance on debt financing, rather than pay-as-you-go spending…From 1974 to 1999, California voters authorized $38.4 billion of general obligation bonds. Since 2000, voters authorized more than $103.2 billion of general obligation bonds”

Table 1: All General Obligation Bonds to Be Paid Off Through
California’s General Fund
Amount Authorized to Borrow$135.2 billion
Amount Borrowed$105.7 billion
Amount Authorized But Not Borrowed$29.5 billion
Amount Owed in Principal (June 1, 2015)$72.4 billion
Amount of Debt Service Owed (June 1, 2015)$131.8 billion
Amount of Debt Service to Be Paid 2015-2016$6 billion
Sources: “Schedule of Debt Service Requirements for General Fund Non-Self Liquidating Bonds (Fixed Rate),” California State Treasurer, June 1, 2015, accessed June 28, 2015, www.treasurer.ca.gov/bonds/debt/201506/general-fixed.pdf and “Authorized and Outstanding General Obligation Bonds,” California State Treasurer, June 1, 2015, accessed June 28, 2015, www.treasurer.ca.gov/bonds/debt/201506/authorized.pdf

Concern About Debt Growing from State Matching Grants for Local Educational Districts

One funding commitment Governor Brown “confronted” in his proposed fiscal year 2015-16 budget was the State of California’s debt accumulated from funding construction of facilities for local school districts. California voters approved bond measures in 2002, 2004, and 2006 authorizing the state to borrow $35.4 billion via bond sales for school and college construction, and only $195 million remains to be borrowed. According to internal California State Treasurer documents, debt service on those three state bond measures is $56.7 billion.

According to the Governor’s 2015-16 Budget Summary, “the Administration has noted the following significant shortcomings” related to school bond finance over the past two years:

The current program does not compel districts to consider facilities funding within the context of other educational costs and priorities. For example, districts can generate and retain state facility program eligibility based on outdated or inconsistent enrollment projections. This often results in financial incentives for districts to build new schools to accommodate what is actually modest and absorbable enrollment growth. These incentives are exacerbated by the fact that general obligation bond debt is funded outside of Proposition 98. These bonds cost the General Fund approximately $2.4 billion in debt service annually.

This statement is surprising and controversial recognition that some school districts spend money on new school construction that perhaps isn’t needed. The proposed budget summary also notes that large school districts have in-house professional facilities departments that can take advantage of the first-come, first-serve application system to get funding from the State Allocation Board for local school construction.

Another surprising admission in the Governor’s budget proposal is acknowledgement that voters approve four out of five proposed local bond measures, thus providing a relatively easy flow of money for school construction: “The current program was developed before the passage of Proposition 39 (which reduced the local bond vote threshold from a two-thirds supermajority to 55 percent) in 2000, which has since allowed local school bonds to pass upwards of 80 percent of the time.”

The budget summary also reported that the California Department of Finance had met with parties interested in educational construction and developed a set of recommendations, including three related to bond finance:

1. Increase Tools for Local Control: Expand Local Funding Capacity

While school districts can pass local bonds with 55% percent approval, assessed valuation caps for specific bond measures and total caps on local bonded indebtedness have not been adjusted since 2000. In order to provide greater access to local financing, these caps should be increased at minimum by the rate of inflation since 2000.

Based on the Consumer Price Index of the U.S. Bureau of Labor Statistics, the inflation rate from November 2000 (when voters approved Proposition 39) to May 2015 was 36.6%. Therefore, under this proposal the California legislature would increase tax and debt limits at least 36.6% above existing amounts. However, the flaw in this proposal is that it does not account for increases in property value or total assessed property valuation in California since 2000. (See Section 5 of this report for background on tax and debt limits.)

2. Expand Allowable Uses of Routine Restricted Maintenance Funding

Current law requires schools to deposit a percentage of their general fund expenditures into a restricted account for use in maintaining their facilities. Rather than requiring that these funds be used solely for routine maintenance, districts should have the ability to pool these funds over multiple years for modernization and new construction projects. Expanding the use of these funds will provide school districts with yet another funding stream to maintain, modernize, and construct new facilities.

This proposal injects a bit of “pay-as-you-go” from district general funds into educational facilities construction — a departure from the bond debt financing that has driven school construction since the enactment of Senate Bill 50, the Leroy F. Greene School Facilities Act of 1998.

3. Target State Funding for Districts Most in Need

State funding for a new program should be targeted in a way that: (1) limits eligibility to districts with such low per-student assessed value they cannot issue bonds at the local level in amounts that allow them to meet student needs, (2) prioritizes funding for health and safety and severe overcrowding projects, and (3) establishes a sliding scale to determine the state share of project costs based on local capacity to finance projects.

This recommendation is based on the perception that the current first-come, first-served funding system allows certain school and college districts to win a disproportionate amount of state matching grants at the expense of other districts that may have a more legitimate need but lack the resources and wherewithal to take advantage of opportunities.

Finally, the list of recommendations concludes with a message:

…it is the intent of the Administration to advance the dialogue on the future of school facilities funding. School districts and developers should have a clear understanding of which limited circumstances will qualify for state assistance. Over the course of the coming months, the Administration is prepared to engage with the Legislature and education stakeholders to shape a future state program that is focused on districts with the greatest need, while providing substantial new flexibility for local districts to raise the necessary resources for school facilities needs.

These proposals are not new ideas. A 2003 report from the Public Policy Institute of California analyzed school bond measures and identified disparities among districts based on wealth and region. In response to these findings, the report suggested raising state debt limits for bond measures to reduce the impact of changes in assessed property valuation. It also recommended adoption of a plan that would give deserving school and college districts access to state construction funds without having to match these grants with local funding.

State Legislative Initiatives

The stage is set for change in California school construction financing. Subsequent to the release of the proposed budget from the Governor, state legislators introduced bills such as Senate Bill 114 and Assembly Bill 148. These bills would make some mild changes to the state’s school construction program, while at the same time placing a statewide bond measure on the November 2016 ballot to borrow money (for a yet unidentified amount) via bond sales for school construction.

The author of Senate Bill 114 explained the purpose of the bill:

Funding for the School Facilities Program is virtually gone and there is a backlog in applications for state assistance…while the state’s growing debt service is of concern, it is unclear whether local districts have the capacity to generate sufficient revenue at the local level to meet their specific facility needs. The “winding down” of the current program, and the Governor’s call for change, present an opportunity to rethink the administrative and programmatic structure of the State Facilities Program…

Supporting one or both of these bills are the California School Boards Association, the California Faculty Association, the California Association of School Business Officials, the American Federation of State, County, and Municipal Employees union (AFSCME); the Los Angeles Unified School District, and the Riverside County Superintendent of Schools. Further debate will reveal if these groups are willing to withhold potential objections to some of the Department of Finance proposed changes to educational construction finance in exchange for having another statewide bond measure on the 2016 Presidential general election ballot.

No formal opposition to these bills has yet emerged, but at this time the bills are just a frame, to be expanded with more detailed proposals.

Sources

“Request for Title and Summary for Proposed Initiative: Kindergarten Through Community College Public Education Facilities Bond Act of 2016,” Office of the California Attorney General, January 12, 2015, accessed June 28, 2015, https://oag.ca.gov/system/files/initiatives/pdfs/15-0005%20(Education%20Bond%20Act).pdf

“California School Builders, Others to Gather Signatures for November 2016 Bond Measure,” Sacramento Bee, January 12, 2015, accessed June 28, 2015, www.sacbee.com/news/politics-government/capitol-alert/article6143364.html

“AB 148 School Facilities: K–14 School Investment Bond Act of 2016 – California State Assembly Education Committee Analysis,” California Legislative Information, April 28, 2015, accessed June 28, 2015, https://leginfo.legislature.ca.gov/faces/billAnalysisClient.xhtml?bill_id=201520160AB148#

“State of California School Bond Measure Feasibility Survey,” California’s Coalition for Adequate School Housing, Date, accessed June 28, 2015, https://www.cashnet.org/meetings/2014_Annual_Conference/documents/38_LegislativeUpdate_Bond_Feasibility.pdf

“Text – AB 2235 Education Facilities: Kindergarten-University Public Education Facilities Bond Act of 2014,” California Legislative Information, accessed June 28, 2015, https://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201320140AB2235

“No School Bond, Lawmaker Suspension Measures On November Ballot,” Capitol Public Radio, August 19, 2014, accessed June 28, 2015, www.capradio.org/articles/2014/08/19/no-school-bond,-lawmaker-suspension-measures-on-november-ballot/

“2015-16 Governor’s Budget Summary,” Department of Finance – California Budget, January 9, 2015, accessed June 28, 2015, www.ebudget.ca.gov/2015-16/pdf/BudgetSummary/FullBudgetSummary.pdf

“2015 California’s Five-Year Infrastructure Plan,” Department of Finance – California Budget, January 9, 2015, accessed June 28, 2015, www.ebudget.ca.gov/2015-Infrastructure-Plan.pdf

“Governor’s Budget Summary 2015-16: K Thru 12 Education,” Department of Finance – California Budget, January 9, 2015, accessed June 28, 2015, www.ebudget.ca.gov/2015-16/pdf/BudgetSummary/Kthru12Education.pdf

“SB 50 – Chaptered. Leroy F. Greene School Facilities Act of 1998: Class Size Reduction – Kindergarten University Public Education Facilities Bond Act of 1998,” Official California Legislative Information, August 27, 1998, accessed June 28, 2015, www.leginfo.ca.gov/pub/97-98/bill/sen/sb_0001-0050/sb_50_bill_19980827_chaptered.html

“Fiscal Effects of Voter Approval Requirements on Local Governments,” Public Policy Institute of California, January 27, 2003, accessed June 28, 2015, www.ppic.org/content/pubs/report/R_103KRR.pdf

“Text – SB 114 Education Facilities: Kindergarten Through Grade 12 Public Education Facilities Bond Act of 2016,” California Legislative Information, June 3, 2015, accessed June 28, 2015, leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201520160SB114&search_keywords=

“Text – AB 148 School Facilities: K–14 School Investment Bond Act of 2016,” California Legislative Information, May 6, 2015, accessed June 28, 2015, leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201520160SB114&search_keywords=

“Senate Education Committee Legislative Analysis – AB 148 School Facilities: K–14 School Investment Bond Act of 2016,” California Legislative Information, March 25, 2015, accessed June 28, 2015, http://leginfo.legislature.ca.gov/faces/billAnalysisClient.xhtml?bill_id=201520160SB114#

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Quantifying and Explaining California’s Educational Construction Debt (Section 3 of 9)

See the complete California Policy Center report For the Kids: California Voters Must Become Wary of Borrowing Billions More from Wealthy Investors for Educational Construction (complete, printable PDF Version, 4 MB, 361 pages)

Links to all sections of this study readable online:
Executive Summary: “For the Kids” – Comprehensive Review of California School Bonds (1 of 9)
More Borrowing for California Educational Construction in 2016 (2 of 9)
You are here: Quantifying and Explaining California’s Educational Construction Debt (3 of 9)
How California School and College Districts Acquire and Manage Debt (4 of 9)
Capital Appreciation Bonds: Disturbing Repayment Terms (5 of 9)
Tricks of the Trade: Questionable Behavior with Bonds (6 of 9)
The System Is Skewed to Pass Bond Measures (7 of 9)
More Trouble with Bond Finance for Educational Construction (8 of 9)
Improving Oversight, Accountability, and Fiscal Responsibility (9 of 9)
Guide to all Tables and Appendices – Comprehensive Reference for Researchers


Quantifying and Explaining California’s Educational Construction Debt

Whatever voters are asked to approve in 2016 will not launch a new program to fix long-neglected schools to serve a rapidly expanding state population while providing smaller class sizes. That thinking is a legacy of the 1990s that still seems to endure today despite 14 years of most bond measures passing at a 55 percent threshold for voter approval. Arguments for another state bond measure in 2016 ignore or downplay how local school and college districts and the state obtained authority in the past 14 years to borrow $146.1 billion for educational construction.

If voters are not told or reminded of recent borrowing patterns, how can voters make an informed decision on future borrowing? To rectify the lack of availability of statistics on total bond debt in California for educational facility construction, the California Policy Center collected, synthesized, and analyzed data regarding California educational construction finance. The California Policy Center believes it is the first and only entity to painstakingly research and present an accurate and comprehensive record of all state and local educational construction bond measures considered by voters from 2001 through 2014.

The amount of authority approved by voters is a higher percentage than the percentage of the number of bond measures approved by voters because larger bond measures proposed by larger districts passed at a higher rate than smaller bond measures proposed by smaller districts.

Table 2: Local Educational Bond Measures Considered by California Voters After Passage of Proposition 39 in November 2000
Number on Ballot1147
Number Approved911
Number Rejected236
Percentage Approved79.42%
Percentage Rejected20.58%
Amount Proposed to Authorize$124,350,056,744
Amount Proposed to Authorize (including 16 reauthorizations)$125,080,421,744
Amount Authorized$109,620,418,737
Amount Authorized (including 16 reauthorizations)$110,350,783,737
Amount Rejected$14,729,638,007
Percentage of Authority Approved (including 16 reauthorizations)88.22%
Percentage of Authority Rejected (including 16 reauthorizations)11.78%
Amount Authorized Through Three Statewide Bond Measures$35,766,000,000
Total Amount Proposed to Authorize (State and Local Bond Measures)$160,116,056,744
Total Amount Proposed to Authorize (State and Local Bond Measures) (including 16 reauthorizations)$160,846,421,744
Total Amount Authorized (State and Local Bond Measures)
(including 16 reauthorizations)
$146,116,783,737

How Did It Become So Easy to Pass Bond Measures?

A new era of generous borrowing for educational construction in California was inaugurated by the enactment of Proposition 39. Approved by 53.4% of voters in the November 7, 2000 election, it reduced the voter approval threshold for most educational construction bond measures from two-thirds to 55 percent. (Because the measure imposes restrictions on districts using the new 55 percent threshold, a minority of districts have continued to propose measures requiring a two-thirds vote.)

This lowered obstacle apparently encouraged local educational districts to take the risk of proposing many more bond measures at much higher amounts for voters to approve. As shown in Tables 3 and 4, dropping the voter threshold from 66.67% to 55% transformed the approval of educational bond measures from a 50-50 chance to a commonplace outcome.

As shown in Table 5, between now and 2055, California’s taxpayers will pay about $200 billion in principal and interest payments to investors who have bought bonds issued by the state and by local educational districts in order to get funding for facility construction.

Table 3: Local Educational Bond Measures Considered by California Voters After Passage of Proposition 39 in November 2000
55% ApprovalTwo-Thirds
Approval
Total
Number on Ballot10371101147
Number Approved85754911
Number Rejected18056236
Percentage Approved82.64%49.09%79.42%
Percentage Rejected17.36%50.91%20.58%
Table 4: Local Educational Bond Measures: Results If Proposition 39 Wasn't Law
Under Prop 39
(55% and 2/3)
If Prop 39 Wasn’t Enacted (2/3)
Total Number of Bond Measures on Ballot11471147
Number of Bond Measures Approved911423
Percentage of Bond Measures Approved79.42%36.88%
Total Amount Authorized to Borrow
(includes reauthorizations)
$125,080,421,744$52,712,273,012
Percentage of Authorization Amount Approved88.22%42.15%
Table 5: Total Amount of Debt Service for Educational Facility Construction
Amount for 642 School and College Districts for Which Voters Approved Bond Measures Since Proposition 39 Passed in 2000$136,867,456,924
Amount for Three Bond Measures That Voters Approved for State of California Since Proposition 39 Passed in 2000$56,668,673,695
Estimate for Several Dozen School Districts Where Voters Approved Bond Measures Only Before Enactment of Proposition 39 or Lack Data$2,000,000,000
Estimated Amount for Several Bond Measures That Voters Approved for State of California Before Proposition 39 Passed in 2000$4,500,000,000
Approximate Total$200,000,000,000

How Was Debt Service Determined?

California Policy Center researchers identified, calculated, and tallied aggregate debt service for almost all of the 642 California local educational districts in which voters approved borrowing money for construction through bond sales after the election of November 7, 2000. On that date, California voters approved Proposition 39 and reduced the threshold for voter approval of most bond measures for construction from two-thirds to 55 percent.

This debt service data was obtained using tables included in about 650 “Official Statements” posted on a publicly-accessible and free-to-use Electronic Municipal Market Access (EMMA) website administered by the Municipal Securities Rulemaking Board (MSRB).

Example of Official StatementWhat are these statements? Federal law generally requires underwriters in a primary offering of municipal bonds of $1 million or more to obtain and review an Official Statement from the issuer of those bonds. (Many smaller bond offerings also have Official Statements.) In a dense report of more than 200 pages, these statements disclose financial information meant to inform a potential buyer and reduce the chance of “fraudulent, deceptive, or manipulative acts or practices.”

Official Statements include a chart that indicates how much aggregate principal and interest the issuer of the bonds would owe each year if the bonds weren’t refunded (“called in” or redeemed so that new bonds can be issued at a lower interest rate) or paid off early. California Policy Center researchers entered each district name into the EMMA system, identified the most recent bond offering or bond refunding from the list of bond issues, downloaded the associated Official Statement, located the aggregate debt service chart, and calculated the total debt service for 2015 and/or later years.

Using these Official Statements to extract data required diligence. Firms that produce the statements do not use a specific standard format, so the aggregate debt service table appears in different places. Tables differ in title, format, or details of content. Older Official Statements are not optimized for word searches. A few tables do not total up the annual debt service, thus forcing the user to convert the table into a spreadsheet and calculate the total using a formula. A handful of Official Statements outright lacked aggregate debt service tables.

Tables may even contain erroneous data. After some confusion, researchers realized that an Official Statement for the Napa Valley Unified School District contained major errors. It indicated total debt service as $77 million instead of the actual $665 million and also indicated a November 5, 2002 bond measure as authorizing $219 million instead of the actual $95 million. This was an unfortunate district to have an erroneous Official Statement: a California Watch article published in the San Francisco Chronicle just three months before the Official Statement was posted identified the Napa Valley Unified School District as a district where taxpayers will eventually “pay dearly for bonds.” In 2009 it borrowed $22 million through Capital Appreciation Bond sales that will cost $154 million by the time the last bonds in the series mature forty years later, in 2049.

Researchers also had to be cautious about accurately identifying school districts with similar names. For example, Central, Oak Grove, and Columbia are words shared by more than one school district. And “College School District” in Santa Barbara County is not a community college district. Some of the inconsistencies found in cross-referencing various sources for bond measure data seem to be a result of misidentifying districts with similar-sounding names.

Even after these challenges were overcome, researchers recognized that the list of debt service for school and college districts needs to be considered with some caveats. (Table 6 is “Cautionary Considerations When Evaluating Current Debt Service Data for School and College Districts.”) Researchers are also aware of arguments that debt service — even when considered with other financial data — is not always a useful way to assess whether or not school or college districts have been irresponsible in their choices for debt finance of facilities construction. A few of those arguments are listed in Table 7: Why Some Analysts Downplay Debt Service Data.

Despite these potential limitations, aggregate debt service amounts available through Official Statements posted on EMMA provide new insight into the long term debt obligations owed by California local educational districts for facilities construction. This data set represents a major advance in informing Californians about the tremendous debt accumulated by educational districts that borrow money for school construction by selling bonds.

Table 6: Cautionary Considerations When Evaluating Current Debt Service Data for School and College Districts
1For some school or college districts, debt service may be relatively low compared to the total amount authorized to borrow because those districts haven't issued all of the bonds (or any of the bonds) yet. When those districts sell all of the bonds in the amount authorized by voters, debt service will be higher.
2An educational district in a wealthy area can have high debt service but also have high and stable total assessed property value. That high debt service may be inappropriate, but it is not as risky as the same debt service in a less affluent district with unstable property values and an uncertain economic future.
3Some California educational districts do not have debt service listed in the appendices because they recently sold bonds through “private placement.” These transactions do not require Official Statements to be posted on EMMA. Without an Official Statement, long term debt obligation from bonds is more difficult to obtain. And when obtained through annual financial reports, that number may be outdated compared to information available in an Official Statement.
4The appendices indicate all aggregate debt service for 642 districts in which voters approved bond sales since Proposition 39 was enacted in 2000. This means there may be some distortions when comparing data, for the following reasons:

Aggregate debt service listed for districts may originate from bond measures approved by two-thirds of voters as far back as 1987 and up through November 7, 2000. This means that debt service for some districts may appear disproportionately high relative to the amount authorized by voters to borrow from 2001 through 2014.

There are a handful of districts that have current debt service resulting from bond measures approved in 2000 or earlier but have not asked voters to authorize additional borrowing since the November 7, 2000 election. That debt service is not included in the grand total reported here.

Likewise, California voters approved several ballot propositions before Proposition 39 was enacted in 2000, including a $9.2 billion bond measure passed in 1998 that included $6.7 billion for K-12 school districts and $2.5 billion collectively for community college districts and the California State University and the University of California campuses.
5Several K-12 school districts have merged in the past 15 years. Some Official Statements segregate debt service for the districts before they merged, and some combine the debt service.
6Several community college district and K-12 school districts have created “School Facilities Improvement Districts” carved out from the complete jurisdiction of the districts. Some Official Statements segregate debt service for these sub-districts, and some combine the debt service for the sub-districts with the debt service for the complete district.
7Debt service tables in Official Statements do not account for Bond Anticipation Notes, Certificates of Participation, lease revenue bonds, and other ways that educational districts borrow money.
8Community Facilities Districts funded by Mello-Roos bonds are not included in Official Statements.

Sources

Electronic Municipal Market Access (EMMA) website administered by the Municipal Securities Rulemaking Board (MSRB) http://emma.msrb.org

“Napa Valley Unified School District,” Electronic Municipal Market Access (EMMA), May 9, 2013, accessed June 28, 2015, http://emma.msrb.org/EA524107-EA408291-EA805228.pdf

“School Districts Pay Dearly for Bonds,” San Francisco Chronicle, January 31, 2013, accessed June 28, 2015, www.sfgate.com/education/article/School-districts-pay-dearly-for-bonds-4237868.php

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