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.
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.