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.
Effective Federal Funds Rate – 1985 to 2015
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.
Total U.S. Credit Market Debt – 1985 to 2015
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.
Dow Jones Industrial Average – 1985 to 2015
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.
California State/Local Pension Funds Consolidated
2014 – Cash Flow
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?
California State/Local Pension Funds Consolidated
2014 – Asset Distribution
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:
California State/Local Pension Funds Consolidated
2014 – Est. Funding Status and Required Contributions at Various ROI
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.
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Ed Ring is the executive director of the California Policy Center.