Has Sacramento really balanced the state’s budget?

Thanks to Proposition 30 with its retroactive tax increase and an improving economy, the state claims that it has balanced its General Fund budget.  This may be technically correct but ignores some very unpleasant realities.

Claiming to have balanced the budget ignores the growing unfunded liabilities associated with public employee pensions and other unfunded retirement benefits, mainly health care.  This also ignores the fact that the state has fallen behind in maintenance and expansion of its infrastructure.

Ignoring these liabilities is possible because state and local governments in California use cash accounting.  Except for very small companies, private sector businesses are required to use accrual accounting under which increases in liabilities are required to be recorded in profit and loss statements and major assets have to be depreciated with depreciation showing up on the profit and loss statement.

Under cash accounting, only the year’s actual cash outlays are recorded in the budget.  If the state or local government doesn’t make a pension payment, it is not recorded as part of the year’s expenses.  For retiree health care, these expenses typically aren’t even funded. Even though these obligations accumulate indefinitely and are the obligation of future taxpayers, they are not required to be recognized on public agency balance sheets as long term liabilities. Similarly, the cost of  deteriorating roads and other infrastructure aren’t recorded anywhere in state and local governments’ financial statements.  There aren’t any depreciation schedules and the accumulating costs of deferred maintenance and essential expansion of the state’s infrastructure are not recorded.

How bad is this problem?  Until recently, it’s been very difficult to find and summarize these financial problems.  However, as highlighted in a recent Los Angeles Times article by Marc Lifsher, California Pension Funds are Running Dry, there is a new data source thanks to the efforts of the California state controller John Chiang (who was just elected state treasurer).  The Controller’s office has assembled data from 130 state and local pension funds and other data at ByTheNumbers.sco.ca.gov.

The following are two charts from the state controller’s website under the heading “Interesting Charts.” They are annotated to illustrate the problems that should concern us.

Total California Public Pension Fund Assets
Change Between 2003 and 2013

20150114_Fletcher_Pensions-1

As can be seen on the above chart, statewide defined benefit pension fund assets suffered a loss of 30 percent in the 2008 recession. Five years later, they have not even recovered to their pre-recession values. During this time pension liabilities have continued to grow.  How big is this problem?

Total California Public Pension Unfunded Liabilities (Officially Recognized Amount)
Change Between 2008 and 2013

20150114_Fletcher_Pensions-2

This second chart, above, shows that during the five year period between 2008 and 2013 the official unfunded liabilities of these defined benefit pension funds has grown 200 percent from $65 billion to $198 billion.  This is almost twice the size of the state’s current year General Fund budget of $107 billion.

Even this total understates the problem.  For example:

(1)  The state’s pension funds assume an investment return of 7.5 percent per year or higher and also assume there will be no recessions such as in 2008.  Single-employer private sector pension funds assume a more conservative rate of return closer to 5.0 percent per year.  California’s unfunded pension liability would increase by another $200 billion or more if a more conservative investment rate of return is used such as 5 percent (ref. “Calculating California’s Total State and Local Government Debt“).

(2)  Retiree health care expenses are largely unfunded but are an obligation for the state’s taxpayers just like pension benefits.  The best estimate we’ve see for unfunded retiree health care is $150 billion, approaching the value of unfunded pension obligations.

(3)  What about infrastructure maintenance and expansion to meet the state’s growth requirements?  The current year’s value of these costs would be reflected as depreciation expenses under accrual accounting that is required for private sector financial statements. In 2012 the American Society of Civil Engineers estimated the current unfunded infrastructure requirement necessary to upgrade California’s roads, bridges, ports, rail, dams, aqueducts and other civil assets at a staggering $650 billion (ref. “2012 Report Card for California’s Infrastructure“).

In addition to these state obligations we can’t ignore unfunded entitlements for federal Medicaid and welfare payments.  These are beyond the scope of this article but add to the problem we’re concerned about, rapidly growing unfunded obligations that will bury future taxpayers and crowd out other essential public spending.

We should also note that state and local government pension systems are not covered by Employee Retirement Income Security Act (ERISA) that single-employer private sector pension plans must conform to.  ERISA has strict requirements for minimum funding of pension plans, defines what is a reasonable rate of investment return in valuing pension fund assets, and dictates actions that must be taken if pension fund assets drop below a certain level.  None of these rules apply to California’s public employee pension funds.  ERISA also requires that pensions be funded during an employee’s working years. The cost of benefits earned today cannot be passed on to future pension fund contributors or taxpayers as can happen with public employee pension plans.

There is also an equity issue.  Should future taxpayers be required to pay for retiree pensions and health care that were earned years earlier?  The earlier taxpayers got the benefit of the public employees services without paying the full cost of these services.  These future costs will crowd out spending on schools, infrastructure, and other items.

Are we anti-public employee for questioning the level of post retirement benefits or their underfunding?  That’s not our intention.  Politicians and unions are not doing these employees any favors by underfunding their retirements.  Future taxpayers will not be able to cover the costs of these underfunded benefits and also maintain the schools, infrastructure, and other government services they need.  There will be a day of reckoning when it’s clear that there isn’t enough money set aside for these obligations and we can’t raise taxes enough to cover the difference.  We’ll be forced to recognize that all our debts and unfunded obligations can’t be met.  There won’t be any winners when this day arrives.  Nationwide, the amounts of unfunded retirement benefits, debts, and entitlements are too large for a federal bailout.

There is also an element of “heads I win tails you lose” to this issue.  The true cost of public employee retirement benefits, pensions and health care, are understated by using optimistic financial assumptions and by passing on a significant portion of these costs to future taxpayers.  However, as it stands today, the bill for any shortfall is totally the taxpayers responsibility.

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About the Author:

William Fletcher is a business executive with interests in public finance and national security. He retired as Senior Vice President at Rockwell International where most of his career was spent on international operations and business development for Rockwell Automation. Before joining Rockwell, he worked for Bechtel Corporation, McKinsey and Company, Inc., and Combustion Engineering’s Nuclear Power Division, and was an officer and engineer in the U.S. Navy’s nuclear program. His international experience includes expatriate assignments in Hong Kong, Europe, the Middle East, Africa and Canada. In addition to his interest in California’s finances, he is involved in organizations dealing with national security and international relations. Fletcher is a graduate of Tufts University with a BS degree in Engineering and a BA degree in Government. He also graduated from the U.S. Navy’s Bettis Reactor Engineering School.

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