The Devastating Impact of Retroactive Pension Increases in California

On January 27th, 2015 Kern County declared a fiscal emergency citing lower tax revenues from oil producers and growing unfunded pension liabilities as the cause. A review of their pension costs and growth of their unfunded liabilities over the past decade indicates the word “growing” is an understatement. A more accurate term would be “soaring”. The pension costs and liabilities indicate they, and not oil tax revenues are the root cause of their financial problems.

In reviewing past reports, Kern’s pension problems began 13 years ago when their Board of Supervisors decided to retroactively increase pensions to the highest levels allowed by law without developing a sound plan to pay for the increased cost. They were not alone in increasing pensions retroactively. In 2001 the state retroactively increased pensions under Senate Bill 400 for safety employees (prison, police and fire), with cities and counties following suit with their safety employees. Then non-safety general employee unions also wanted a piece of the action, and most had their pensions retroactively increased to various new formula levels they chose.

Sonoma and Kern County’s Pension Increase

For all active general employees, supervisors in both counties raised benefit levels back to the date people were hired providing a multiplier that went from 2.34% to 3% per year of service at 60 years of age. All safety employees had their multipliers reset from 2% at 50 to 3% at 50 years of age. These increases, along with lower than anticipated investment earnings, have increased pension costs in Kern County by 500% from an annual cost of $41 million in 2001 to $233 million today. Sonoma County’s costs have increased by 466% from $14.8 million in 2001 to $69 million today. And both of these amounts do not include the cost of their pension bond debt, more on that later.

The Unanticipated Consequences of the Retroactive Pension Increase

In Sonoma County, the increases had many unanticipated consequences that added significantly to the actuaries estimated cost impact on the pension fund.

The new formulas combined with additional items considered pensionable increased the average pension by $16,486 the year after the increase went into effect. An annuity that would pay this amount per year would cost $300,000.

The average age of new retirees dropped from a previously assumed age of 62 to 57 for general employees and from 56 to 51 for safety employees. So in addition to higher pensions, retirees received the enhanced pension for 5 additional years of their life.

The increase accelerated the number of new retirements from an average of 130 per year before the increase to 200 after. Salaries increased by 8.5% annually on average the first 3 years after the increase , versus the assumed rate of 4% because of promotions of existing employees to fill in the newly vacated management positions.

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A Billion Dollars in Pension Obligation Bonds

As a result of their additional pension costs, both counties separately issued about $500 million in pension obligation bonds. These are debt obligations issued without voter approval and for that reason are considered controversial since state law requires voter approval for any debt exceeding $300,000. The County sells the bonds and places the bond proceeds into the pension fund. The county then pays off the bond holders with interest, mostly from the county’s general or discretionary funds resulting in a total cost of about $1 billion per county when interest is included.

Yet, even with the dramatic growth of annual contributions and half a billion dollars in bond funds, the benefit increases have taken Kern’s pension plan from a surplus of $46 million in 2000 to an unfunded liability today of just under $2 billion. Sonoma’s unfunded liability has grown from $47 million in 2001 to $449 million today.

The Serious Problem with Interest Bearing Unfunded Pension Liabilities

These unfunded balances also carry interest payments because they are the present value of the money the county would need to place in the fund today, to fund the pension benefits that have already been earned. Since the money is not in the fund generating investment returns, each county needs to pay interest on the unfunded liability in an amount equal to their assumed rate of investment return which is 7.75% for Kern and 7.5% for Sonoma. This unfunded liability can be paid off over up to 30 years which triples the cost and means our kids will be paying for benefits earned in the past, something commonly referred to as intergenerational theft.

For example, if Kern County decides to pay its $2 billion liability over 30 years which it may need to do, the cost to taxpayers with interest is $6 billion. These are dollars that will not be available for other services such as maintaining roads and parks, keeping libraries open, and providing essential support services to those in need.

Both Counties are Facing Service and Balance Sheet Insolvency

Sonoma County has a $640 million backlog in road maintenance and the worst roads in Northern California. Due to pension costs, Sonoma County only has the money to maintain pavement preservation on 14% of its roads. In addition, Kern County has reached and Sonoma County is approaching balance sheet insolvency. Currently, Kern County lists $1.8 billion in net assets on its balance sheet. But new Government Accounting Standards Board (GASB) rules that became effective this year will require the county to add its $2 billion in pension liabilities to its balance sheet wiping out its net assets. The new standards will reduce Sonoma County’s net assets from $1.4 billion to about $500 million. In addition, Sonoma County has a large unfunded retiree healthcare liability of $311 million that should be listed as a liability though not currently required by the new standards. GASB is looking at this issue now.

When the next round of financial statements are issued, GASB changes will show the true net assets of cities and counties with their pension liabilities and the true financial condition of municipalities throughout the state will become visible, and shocking. A study one by John Dickerson indicated that for the 8 Northern California counties with their own pension funds GASB will reduce their Net Assets from $10 billion to $1 billion.

Without Pension Reform the Options are to Cut Services or Raise Taxes

Without substantive pension reform and a more equitable sharing of the costs between the employee and employer, there are really only two ways to deal with these liabilities, continue to cut services or raise taxes.

In addition to sharing costs, municipalities should consider a combination of hiring freezes, lay- offs, pensionable salary freezes or cuts in pay. Eliminating overtime and special pay items are other options that should be explored.

So far, most politicians are ignorant of the pension problem or they lack the courage to take on the government employee unions, bringing them to the mistaken idea that raising taxes is a preferred alternative to reforming the system. However, as noted in places like San Diego and San Jose, raising taxes to pay for pension costs is being repudiated by the voters.

Citizens Strongly Support Pension Reforms

A recent Reason-Rupe poll found 72 percent of respondents were concerned about their local and state governments’ ability to fund public employee pensions as currently promised. Of those surveyed, 76 percent of respondents believe that pension reform is a high priority for governments. Only 7 percent believed that nothing needs to be done to reform the system. Within the options for reform, there is support for transitioning to a 401k-style system for current (59 percent) and future retirees (67 percent). If reform is not palatable to elected officials for whatever reason, politicians should know that 66 percent of the public favor shifting public employees from guaranteed pensions to 401K style accounts if taxes would not have to be raised and 74% are opposed to raising taxes to pay for pensions.

The bottom line is taxpayers believe they deserve services they have received in the past for their tax dollars. At the same time, employees who have been promised benefits that are unaffordable lack retirement security and many worry that their pensions will be there when they retire. This is especially relevant after the rulings in Detroit and Stockton where the judges ruled pensions can be impaired in bankruptcy.

Simply looking at the math, it is obvious that pension systems in Sonoma and Kern counties – and in hundreds of cities and counties throughout the state – are in dire need of redesign and the longer politicians wait to fix them, the harder and more painful the changes are going to be.

The Time for the State Legislature to Act is Now

Reform is difficult in California due to what is referred to as the “California Rule”. Under years of judicial interpretation of the Contracts Clause in the constitution, governments in California are not able to reduce pension formulas for existing employees going forward and they cannot even require employees to contribute money towards paying off the unfunded liability that was mostly created by their retroactive pension increases.

However, some legal scholars believe if cuts are necessary to save the system, and there is a fiscal emergency, then benefits for existing employees can be cut. Maybe Kern County will be the test case.

In the meantime, instead of letting more cities and counties declare fiscal emergencies, the California legislature needs to act to amend the constitution so politicians and judges in favor of the status quo will stop standing in the way of solutions to this growing crisis.

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About the Authors:  This report is a collaborative effort headed by Ken Churchill, the director of New Sonoma, an organization of financial and business experts and concerned citizens dedicated to working together to solve Sonoma County’s serious financial problems. Ken Churchill has over 40 years of business and financial management experience as founder, CEO and CFO of a solar energy company and environmental consulting firm. He sold both companies and now grows wine grapes and produces wines under his Churchill Cellars label. For the past three years, Ken has been actively researching and studying the pension crisis and published a report titled The Sonoma County Pension Crisis – How Soaring Salaries, Retroactive Pension Increases and Poor Management Have Destroyed the County’s Finances.

11 replies
  1. john m. moore says:

    This is an excellent article. However, you mis-stated the California Rule. The lead case of Kern v. City of Long Beach correctly follows the Rule, as recognized by Amy Monahan in her analysis of the California Rule. The Rule requires a statutory basis; in Kern, the statute was a Charter provision explicitly granting a specific pension benefit. The supreme court held that such a statute granted a “vested contract right” that could only be changed going forward for “new hires.” It is the vested contract right that is constitutionally protected.The contract clause does not create vested rights(see Monahan Article). Cities and counties that do not have a statute creating a specific pension benefits do not have vested contractual pension rights. In every case that has declared a vested contractual pension right there was a statute that both parties conceded created such a vested right, or was found by the court to have created a vested contract right. Decades of successive contracts(MOU’s), granting benefits, or contracting with a benefits administrator, did not create vested rights(per two recent cases), because there was no legislative intent(statute) to create a vested contract right.

  2. Jody Morales says:

    This is an excellent report on the calamitous effects of SB400 and our elected officials’ secretive, likely illegal negotiations to insure that safety and top management especially benefitted by the enhancements. Discovery of these clandestine activities is a game changer and all counties are well advised to have their grand juries investigate the 2001-2006 time frame and discover what happened in their governments.
    Thanks, Ken, for being a vigilant watchdog on behalf of all taxpayers. Marin County has recently uncovered similar acts involving our officials during that time and we are pursuing a remedy.

  3. Rex the Wonder Dog! says:

    I have said this many times in the past, what CalTURDS did in 1999 under SB400 was classic, straight up, 100% FRAUD. CalTURDS left off the downside, they left off the middle/moderate side and ONLY gave the best case scenario, to “induce” the legislature to approve it. “But for” the fraud, SB400 would not have passed. And for all the partisan lackeys who claim it is only the Dems fault, Lou Correra’s bill was passed by BOTH parties, on a 70-7 CA Assembly floor vote on September 10, 1999. It was thus illegal, and is subject to both criminal and civil prosecution under RICO, which provides for treble damages on the civil side.
    Take a look for yourself at the CalTURDS fraud, with their SB400 handout to the state legislature; https://docs.google.com/file/d/0B7w9In9khv39UHFIRk92NWI2TGM/edit?pli=1

    This state could wipe CalTURDS SB400 right off the map, if it wanted to based on fraud. The fact is the public employees have grown so powerful, from money laundering to both parties, that until the entire system collapses no action will be taken. The trough feeders will milk it dry until it fails, ala Detroit, Vallejo and Stockton. ONLY then you will see changes, because there will be NO other option.

  4. SkippingDog says:

    What “two cases” are those, john m. moore? Perhaps you can have Rex the Wonder Dog litigate them on your behalf, since he has so much court experience.

  5. David Wren says:

    Wonderful article. When we started our crusade to solve the problem in Marin County, the attorney for the local firefighters union told us in a county sponsored pension workshop the current level of compensation was necessary to attract employees. We didn’t know enough at the time to point out that there was no problem attracting safety workers before the astronomical increase in compensation that came with SB 400. An important fact is that most cities and towns can’t afford their current levels of safety unless the cost of service is being paid for by the next generation, (which is what is happening now). We don’t seem to have any political leaders who are willing to go to the public and say “Folks, we can’t afford all the firefighters and police unless we have the next generations pay for it. Is that what you want to do?” It is simply unjust. Is that what this country is about?

  6. Tough Love says:

    Skippy, Getting a bit crotchety as you’ve been aging in retirement ?

    You used to be more tough-provoking.

  7. David Kersten says:

    Ken,

    I wanted to see if I could interview you about your research in Sonoma County and Kern County on the pension issue? I am working on a documentary film series on the pension issue and fiscal stress. For my recent interview with Joe Nation on the pension issue please visit: http://www.kersteninstitute.org

    I just need to know how to get in touch with you? Thanks.

    David Kersten
    Kersten Institute

  8. HenryfAcosta says:

    I worked for the federal government for 44 years and we have never ever received 3% for each year we work. I received 2% (and get 80% of an average of my top three years), and also contributed to my federal IRA.
    I actually contributed 25% of my pretax income to my retirement and now have a good one. The state totally screwed up the retirement system by giving 3% to employees that can retire at 50 which is way too young.
    I will vote NO on any bond issue to fund the retirements because they are way too high. My neighbor only worked for 30 years for the city and gets 95,000 a year in retirement. I worked 44 years and only get 65 a year. The state screwed themselves and will have to find out a way to fix it. I think they should have left the old retirement system alone.

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