California Healthcare Districts in Crisis

INTRODUCTION

While financial conditions in California cities have improved markedly since 2012, many of the state’s 78 healthcare districts are struggling. Last April, Palm Drive Healthcare District in Sebastopol filed for protection under Chapter 9 of the federal bankruptcy law.  In December, the West Contra Costa Healthcare District, which operates San Pablo-based Doctors Medical Center received a $3 million bailout from Contra Costa County after district voters rejected an additional parcel tax. Palm Drive and West Contra Costa are the two most visible cases of healthcare district financial problems, but our review suggests that they are not alone.

Healthcare districts are local governments dedicated to providing health services to their residents. They are special districts that operate independently from city and county governments. Although voters elect district board members, public awareness of these entities is often limited. Perhaps as a result, many of these districts have strayed from their original functions or even outlived their reason for being,

In the 1940s, California experienced a shortage of acute hospital beds, especially in rural and suburban areas, partially due to an influx of wounded soldiers returning from World War II. The state legislature responded in 1945 by passing the Local Hospital District Law. This act authorized the creation of local taxing districts to build and operate hospitals in medically underserved areas. Most of today’s healthcare districts were formed as hospital districts in the late 1940s and 1950s.

District hospitals created under the law were typically small, independent facilities. Many of the hospitals have had difficulty keeping up with industry changes in recent decades. Fee for service medicine has been largely replaced by third party payment and managed care, while the length of hospital stays has declined sharply. Large healthcare organizations, like Kaiser Permanente and Sutter Health, have proved better able to adopt to the new environment.

In some cases, hospital districts responded by closing their hospitals or transferring them to larger providers. Rather than dissolve, some districts diversified into other medical services prompting the legislature to rechristen the “hospital districts” as “healthcare districts” in 1994.  In other cases, districts continue to operate inefficient hospitals to the detriment of local taxpayers. We anticipate more bankruptcies in this area. Although harmful to creditors, bankruptcies and dissolutions of some healthcare districts may be the best outcome for local taxpayers and other stakeholders.

BANKRUPTCY FILINGS BY CALIFORNIA HEALTHCARE DISTRICTS

The Palm Drive district bankruptcy filing is the twelfth chapter 9 bankruptcy petition by a California healthcare district in the last twenty years. The following table lists these filings:

Healthcare District Bankruptcies – 1996 to 2014

Year

Health Care District Court

Case Number

1996 Heffernan Memorial Hospital District Central 95-10251
1996 Corcoran Hospital District Eastern 96-15051
1997 Kingsburg Hospital District Eastern 97-15254
1999 Southern Humboldt Community Health Care District Northern 99-10200
2000 Chowchilla Memorial Hospital District Eastern 00-13597
2000 Sierra Valley District Hospital Eastern 00-30288
2001 Alta Healthcare District Eastern 01-17857
2003 Coalinga Regional Medical Eastern 03-14147
2006 West Contra Costa Healthcare District Northern 06-41774
2008 Valley Health System Central 07-18293
2009 Sierra Kings Health Care District Eastern 09-19728
2014 Palm Drive Hospital District Eastern 14-10510

 

Most of the bankrupt districts have not been dissolved. West Contra County Healthcare District continue to operate Doctor’s Hospital amidst ongoing financial crises culminating in the County bailout mentioned above.  On the other hand, Alta Healthcare District sold its facilities and no longer offers services, but remains in existence. Of the 12 districts listed above, only Valley Health System appears to have been liquidated.

FINANCIALLY CHALLENGED CALIFORNIA HEALTHCARE DISTRICTS

Below we look at a few of the more challenged districts. Along with this report, we have published a map of the state’s hospital districts with selected financial information and links to audited financial statements we have located. The visualization is available at http://www.govwiki.info/pdfs/Analysis/HealthCareDistricts.html.

California Health Care Districts – Positive vs. Negative Equity

 

To view district information, click on one of the green, red or black polygons. The coloration is based on the district’s reported equity, or the difference between its assets and liabilities (this concept is sometimes referred to as “Net Position”. Districts that reported negative equity (liabilities exceeding assets) are colored red; those that reported positive equity are colored green.  District that did not report an equity positon are colored black. Map boundaries were obtained from Association of California Healthcare District’s web site.

Sources:

Margaret Taylor, California’s Health Care Districts, California HealthCare Foundation, 2006. http://www.chcf.org/~/media/MEDIA%20LIBRARY%20Files/PDF/C/PDF%20CaliforniasHealthCareDistricts.pdf

Jennifer Baires. County supervisors approve $12 million for floundering West Contra Costa hospital. http://www.mercurynews.com/my-town/ci_27056277/county-supervisors-approve-12-million-floundering-west-contra

Robert Rogers, San Pablo: Voters reject tax to fund Doctors Medical Center, May 7, 2014. http://www.contracostatimes.com/contra-costa-times/ci_25711650/san-pablo-voters-reject-tax-fund-doctors-medical

Dan Verel, Palm Drive files for bankruptcy, plans to suspend services, North Bay Business Journal, April 7, 2014.  http://www.northbaybusinessjournal.com/90443/palm-drive-files-for-bankruptcy/

California State Controller’s Office. Special Districts Raw Data for Fiscal Years 2003-2013. https://bythenumbers.sco.ca.gov/Raw-Data/Special-Districts-Raw-Data-for-Fiscal-Years-2003-2/vi4x-fbus

*   *   *

Eden Township Healthcare District (ETHD), Alameda County

Residents of Southern Alameda County voted to form a hospital district in 1948.  In 1954, Eden Township Hospital began operations. Today, the district no longer operates a hospital and is deeply in debt.

According to its 2014 audited financial statements, the district took out a $54 million line of credit from US Bank in 2007. Between 2010 and 2013, the bank agreed to six loan modifications – repeatedly extending payment deadlines and changing other terms of the loan agreements. Had the financing been secured through the municipal bond market rather than a more flexible bank lender, ETHD would have been required to report multiple events of default. Currently, ETHD owes US Bank $45 million payable on February 1, 2016.

ETHD also owes $19 million to Sutter Health. This debt arose from a legal judgment that Sutter won against the district in connection with the transfer of San Leandro Hospital. In 2004, ETHD purchased San Leandro Hospital and leased it to Sutter. In 2008, it gave Sutter an option to purchase the hospital and the right to recoup any losses from operations at the time of purchase. These losses proved to be substantial and by the time Sutter acquired the hospital in 2012, the accumulated losses greatly exceeded the purchase price. ETHD tried unsuccessfully to litigate away these costs, but ultimately failed in court. On June 2013, Sutter was awarded $17.2 million including damages. By late December 2014, the debt remained unpaid and had grown to $19 million with the accrual of interest.  The district has recently sought a hardship ruling which would allow it to pay Sutter over time.

ETHD currently owns and leases three medical arts buildings. It also administers a community health grants program funded by the 1998 sale of its original facility – Eden Township Hospital. Leasing and grant-making now represent the sum total of the district’s activities.

ETHD does not currently levy taxes on its 360,000 residents, but – as a governmental entity – it has the ability to place parcel taxes on the ballot and can also petition Alameda County Supervisors for a bailout. Also, as a governmental entity, it incurs election costs whenever board members’ terms expire. Given the nature of its activities (which could be easily provided by private not-for-profits) and the liabilities it has accumulated, district residents might best be served by a bankruptcy filing and liquidation.

According to district CEO Dev Mahadevan – who contacted CPC after seeing the original version of this study – the district is constrained from declaring bankruptcy because its assets exceed its liabilities. Because the assets are primarily in the form of land and buildings, ETHD lacks the cash to service its debts. Liquidating the district’s debt by selling most of its assets would require voter approval. In an email message, Mahadevan told me: “Our overhead, including election costs every two years runs around 8% of our total expenses. We don’t have expensive benefits costs and pension plans which the County department of health, with a similar mission has. Lastly, a private non-profit does not act in the public realm. We are witness to this every day and every week, right here. Sutter Health is a private, non-profit charitable organization; however, their interests are not focused on Castro Valley, Hayward or San Leandro but on the “East Bay”: a larger area and a much larger and more diverse population. Their meetings and deliberations are definitely NOT public. These are arguments that convinced our Local Agency Formation Commission (LAFCO) of our reason to exist and continue!”

With respect to the last point, I have found no evidence of a LAFCO eliminating any healthcare district. It appears that the LAFCO process has a bias toward creating and maintaining governmental units, rather than dissolving them.

Sources:

Rebecca Parr, Castro Valley: Health care district to file hardship claim to pay debt, Contra Costa Times, December 31, 2014. http://www.contracostatimes.com/breaking-news/ci_27236342/castro-valley-health-care-district-file-hardship-claim

Eden Township Healthcare District. 2014 Audited Financial Statements. http://ethd.org/wp-content/uploads/2014/11/FY-2014-Audited-Financials.pdf

Eden Township Healthcare District. 2015 Budget. http://ethd.org/wp-content/uploads/2014/06/Budget-Approved-FY15.pdf

Eden Township Healthcare District. History. http://ethd.org/about-ethd/history/

Why Should Eden Township Healthcare District Exist. Newark Editor. Castro Valley Patch. March 20, 2013. http://patch.com/california/castrovalley/why-should-eden-township-healthcare-district-exist

Local Agency Formation Commission of Alameda County. Eden Township Healthcare District Municipal Service Review Final. December 9, 2013. http://www.acgov.org/lafco/documents/finalmsr2013/eden-final.pdf

Eden Township Healthcare District – The Community Health Advisory Committee: A Brief History. http://ethd.org/wp-content/uploads/2014/10/CHAC-101414-Attach-B.pdf

*   *   *

Palo Verde Health Care District, Riverside County

The Palo Verde Health Care district operates a small, rural hospital in Blythe – near the Arizona border. The hospital opened in 1937 and then came under district control in 1948. In the early 2000s, Palo Verde Hospital was operated by LifePoint Hospitals. At the beginning of 2006, Lifepoint terminated its operating agreement; since then, the elected district board has managed the hospital directly.

The results have not been good. The district reported a loss of $4.4 million in the fiscal year ending June 30, 2013 after losing $2.4 million the previous year. If losses continue, the district’s $4.1 million of remaining equity will soon be exhausted.

Small, rural hospitals under all ownership types have been under pressure for many years. Although their problems are often attributed to inadequate Medicare and Medicaid reimbursement rates, they often face low utilization as the population shifts away from rural areas and the length of patient stays shortens.

According to its most recent quarterly filing with the California Office of Statewide Health Planning and Development, the hospital is licensed to operate 51 beds but is staffed to handle a capacity of only 34 beds. The hospital reported a staffed bed occupancy rate of only 28%, implying that only 10 patients were staying in the facility on an average day. With such a small number of patients, the hospital is challenged to cover its fixed costs, such as executive pay. According to Transparent California, former CEO Peter Klune received $432,000 in total compensation during 2012.

A January 2013 editorial in the Palo Verde Valley Times surveyed a long history of litigation affecting the local hospital and concluded that the facility should be privatized. A few months after the editorial appeared, the district became embroiled in further legal action. Three dismissed hospital officials – including the former CEO – alleged that patients requiring air transport were being directed to an airline owned by a district board member. This choice of carrier was often detrimental to patients, who could reach a larger medical center more quickly via helicopters departing from a helipad at the hospital.

Sources:

Hospital Quarterly Disclosure Report, Palo Verde Hospital, California Office of Statewide Health Planning and Development, Quarter ending September 30, 2014. https://siera.oshpd.ca.gov/OpenFacsimile.aspx?oshpdid=106331288&rpedate=9%2F30%2F2014%2012%3A00%3A00%20AM&rpttype=A&outputtype=P&SystemId=4&rptid=47095

Times Editorial: Palo Verde Hospital needs to be privatized, Palo Verde Valley Times. January 3, 2013. http://paloverdevalleytimes.com/main.asp?SectionID=36&subsectionID=807&articleID=18118

Former hospital CEO, finance director and CNO file federal suits against Healthcare District, President Sartin and board members Hudson and Burton, Palo Verde Valley Times, July 31, 2013. http://paloverdevalleytimes.com/main.asp?SectionID=1&SubSectionID=1&ArticleID=19010

Palo Verde Healthcare District, Financial Statements, June 30, 2012. http://paloverdehospital.org/ArchiveCenter/ViewFile/Item/841

Palo Verde Health Care District, History, http://paloverdehospital.org/index.aspx?nid=62

*   *   *

Kern Valley Healthcare District, Kern County

The district operates both an acute care hospital and skilled nursing facility near Lake Isabella, northeast of Bakersfield. As of September 30, 2014, the district had $10.6 million in assets and $17.6 million in liabilities, yielding a negative net position slightly in excess of $7 million.  Recent performance appears to be near breakeven with $155,000 in net income reported to the state controller for fiscal 2013.

I was unable to locate audited financial statements for the district. This is surprising since KVHD has municipal debt securities outstanding, and municipal issuers are generally required to publish audited financial statements on the EMMA system.

Unlike Palo Verde Hospital, the Kern Valley facilities have fairly robust utilization. In the three months ending September 30, 2014, the district reported 65% occupancy of its 99 licensed beds. KVHD’s financial challenge appears to relate more to its patient mix. About 85% of the district’s patient days were compensated by Medi-Cal, which typically provides lower reimbursement rates than either Medicare private insurance.

The large Medi-Cal share is likely due to the inclusion of a skilled nursing facility in Kern Valley’s service mix. Low income elderly patients become eligible for Medi-Cal long term care coverage once they exhaust most of their assets.

While the skilled nursing facility provides steady income, it has also opened the district to liability. In 2006 and 2007, three patients died at the home due to drug overdoses and nursing neglect. Investigators also determined that 23 other residents received unnecessarily large doses of antipsychotic drugs apparently administered for the purpose of keeping them quiet.  The allegations resulted in a federal fine and a prison term for one of the facility’s nurses, as well as community service for a doctor and the district’s former CEO.  Although I could not find evidence of any civil suits being filed against the district, such filings are clearly a risk – potentially tipping the financially vulnerable district into bankruptcy.

Sources:

Kern Valley Finance District, Unaudited Financial Statements for the three months ended September 30, 2014. http://www.kvhd.org/wp-content/uploads/2014/10/Finance-10-14.pdf

Hospital Quarterly Disclosure Report, Kern Valley Health District, California Office of Statewide Health Planning and Development, Quarter ending September 30, 2014. https://siera.oshpd.ca.gov/OpenFacsimile.aspx?oshpdid=106150737&rpedate=9%2F30%2F2014%2012%3A00%3A00%20AM&rpttype=A&outputtype=P&SystemId=4&rptid=46820

Chisum Lee and A.C. Thompson. Gone Without a Case: Suspicious Elder Deaths Rarely Investigated. Pro Publica. December 21, 2011. http://www.propublica.org/article/gone-without-a-case-suspicious-elder-deaths-rarely-investigated

Pamela McLean. Three Years in Prison for Nurse in Elder Abuse Case. Redwood Age. January 14, 2003. http://redwoodage.com/content/view/267223/49.

Steve Clawkins. 3 Arrested in Nursing Home Deaths in Lake Isabella. February 20, 2009. http://articles.latimes.com/2009/feb/20/local/me-nursing-home-deaths20

*   *   *

John C. Fremont Hospital District, Mariposa County

John C. Fremont Hospital District operates a hospital and freestanding medical clinics in a sparsely populated area of the state. The district’s boundaries are the same as those for Mariposa County, which has less than 18,000 residents scattered across 1463 square miles.

The hospital has 34 beds and a 70% occupancy rate according to its September 30, 2014 disclosure report. Occupancy has declined from 87% in 2009.

According to its audited financial statements, the district was carrying $8.0 million in long term debt and had a net position of -$2.7 million. Fremont lost $1.0 million in fiscal 2013. Unaudited results suggest that Fremont is no longer losing money, but it lacks the cash to pay off obligations as they become due. Further, the hospital requires a seismic upgrade to meet earthquake safety standards set by the state legislature.

Consequently, the district will need to continue to rely upon debt financing to operate. This can be a costly proposition as evidenced by Fremont’s 2010 bond issue.  The unrated securities carried coupons of between 7% and 8.55%. If the district was part of a larger entity, it would most likely be able to secure bond financing at substantially lower rates.

Sources:

John C. Fremont Healthcare District, Financial Statements with Independent Auditors’ Report, June 30, 2013. http://www.jcf-hospital.com/docs/12_13_Audited_Financials.pdf

John C. Fremont Healthcare District, Official Statement: $2,000,000 Certificates of Participation.  Augist 1, 2010. http://emma.msrb.org/EP524372-EA313657-EA709355.pdf

Hospital Quarterly Disclosure Report, John C. Fremont Healthcare District, California Office of Statewide Health Planning and Development, Quarter ending September 30, 2014.  https://siera.oshpd.ca.gov/OpenFacsimile.aspx?oshpdid=106220733&rpedate=9%2F30%2F2014%2012%3A00%3A00%20AM&rpttype=A&outputtype=P&SystemId=4&rptid=47179

*   *   *

Lindsay Local Hospital District, Tulare County

Although not in financial distress, Lindsay Local Hospital District illustrates issues that can occur in smaller districts that have ceased to operate hospitals. LLHD does not have a functioning web site; minutes of director meetings, budgets and audited financial statements do not appear to be publicly available, complicating the efforts of media and citizens to ensure that tax moneys flowing to the district are spent effectively.

According to State Controller’s Office special district data, LLHD collected $440,000 in property tax revenue during fiscal 2013. The district collected $157,400 in other revenue mostly by renting office space to medical providers. LLHD incurred $507,000 in expenses and reported net income of $101,200.

A 2011 staff report for the Tulare County Local Agency Formation Commission (LAFCO) reported that district funds were being spent on the following:

  • Equipment for the Lindsay High School football team
  • A portion of the salary for a nurse staffed by Lindsay’s Healthy Start Program
  • Matching funds for a Agricultural Worker Health and Housing Program grant awarded by the Rural Communities Assistance Corporation
  • City Wellness Center Solar Panels

The LAFCO report also estimated that the district’s five board members were paying themselves $1200 per year each – the maximum allowable under state law. It is not clear whether the district also incurs election costs, and, if so, how much those are.

A 2012 article in the Porterville Record suggested that if LLHD was dissolved, property taxes would still be collected and remitted to the state.  The article also quoted the district’s attorney as saying that without LLHD healthcare would be almost unavailable in Lindsay – quite an overstatement given the services the district actually subsidizes.

In 2014, ABC Action News 30 quoted Board Chairman Gary McQueen as follows: “People aren’t paying any more than they were if we didn’t exist, it would just go to the county. So this way we keep X amount of dollars that goes to our district and we spend it on needs of health care.” This comment appears to be correct. District funding is included in the 1% ad valorem tax rate applied to homeowners within LLHD’s boundaries. Their tax rate would be unlikely to change if the district was dissolved, but if tax revenues went directly to the city or county, a largely redundant administrative structure could be eliminated.

Sources:

Tulare County LAFCO, Health Care Districts, 2011 http://lafco.co.tulare.ca.us/documents/ItemVI2HDandMADMSRFinals.pdf

Emily Shapiro, Lindsay Hospital District continues to provide health care, The Porterville Reporter, September 28, 2012. http://www.recorderonline.com/lindsay-hospital-district-continues-to-provide-health-care/article_7cefd4bf-cb6e-5e26-9c70-15ec4575b3a9.html?mode=story

Mariana Jacob, Race to Choose Lindsay Hospital District Director Raises Concerns. ABC Action News 30. October 10, 2014. http://abc30.com/politics/race-to-choose-new-lindsay-hospital-district-directors-raises-concerns/346015/

*   *   *

CONCLUSION

While the formation of hospital districts may have been a wise public policy in the aftermath of World War II, many of these entities are now struggling.  Several districts that continue to operate hospitals are experiencing poor financial performance compared to privately owned facilities. Districts that close or sell their hospitals try to find new missions, but may not be doing so in a cost-effective manner.

Although run by elected officials, the accountability of health care districts is often much less than that of general purpose governments or school districts. Board elections are low profile affairs attracting limited voter attention. Board proceedings, budgets and audited financial statements are less readily available to the public.

Once bureaucracies have been created they are hard to eliminate. But extraneous bureaucracies hinder public sector performance. The state and county governments should consider policies that encourage healthcare districts with underperforming hospitals to close these facilities, transfer them to private not-for-profit agencies or place them under direct County supervision. Policy changes should also encourage the elimination of districts that no longer maintain hospitals. Office leasing, grant making and operating wellness centers are functions that can be performed by the private sector or general purpose governments.

*   *   *

Marc 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.

Analysis of the Reasons for San Diego Police Department Employee Departures

Summary:  The San Diego Police Officers Association and, to some degree, the San Diego media has long held that low pay was a significant factor in the department’s attrition rate that required pay increases to solve. A recent City-commission study that found the SDPD’s compensation (base pay range + cost of benefits) was near the bottom of the cities surveyed has prompted widespread support for further pay increases for the SDPD.

A review of all available data demonstrates that the attrition rate for the SDPD is overwhelmingly driven by retirement, not officers leaving for other agencies. In fact, the rate of officers leaving for other agencies in the past five years has dramatically declined from the prior five year period and has never represented as much as 1% of the total force in any given year. In the two most recent years, 2013 and 2014, retirement accounted for 60% of the total attrition rate and officers leaving for other agencies accounted for only 10%.

Moreover, the staffing shortfall itself would have been entirely avoided had the City not cancelled or greatly reduced the number of budgeted new recruits to hire over the past ten years.

Further, we find a pair of serious issues with the City-funded salary survey. First, the survey incorporates cities from entirely different markets, such as the Bay Area, LA-area, etc. many of which, such as San Francisco, have dramatically higher costs of living and higher rates of public pay in general. After restricting the comparison to only those cities within San Diego County, the pay disparity found is greatly reduced.

Additionally, the City passed a series of non-pensionable pay raises beginning in FY2014 which are not captured in the study’s analysis of base pay ranges. Consequently, the pay disparity reported is overstated.

Finally, we look at the theory arguing for an increase in public pay to match those of nearby agencies with higher level of pay and find it severely misguided. When job openings for 25 positions are met with over 3,000 applicants, implementing agency-wide pay raises in an attempt to retain the less than 1% who depart for other agencies in any given year is not merely ineffective, it is fiscally irresponsible.

*   *   *

“The San Diego Police Department is woefully understaffed and has clearly shown, over an extended period of time, it cannot correct its staffing crisis without increasing the compensation of sworn police officers and recruits.”
– Jeffrey T. Jordan, VP, San Diego Police Officers Association

On the contrary, the San Diego Police Department’s (SDPD) current staffing shortfall is the result of repeated City decisions that have prevented thousands of prospective recruits who wish to serve from doing so.

Presently, the department is short approximately 250 officers from its 2018 targeted goal of 2,128 budgeted sworn staffing positions.

This shortfall, rather than being caused by uncompetitive salaries that are insufficient to attract or retain officers, is the result of events that demonstrate just the opposite — the City stopped or greatly reduced hiring in the face of thousands of prospective recruits willing to join. Specifically, the City cancelled or reduced scheduled academy classes that would have otherwise brought in over 400 new officers since 2004, more than enough to completely alleviate the current shortfall.

The City’s Independent Budget Analyst Office (IBA) reported that during 2004 and 2005 the City canceled five budgeted academy classes which “could have resulted in an infusion of 150-175+ new recruits.”

In retrospect, this cancellation could not have occurred at a worse time. The City would experience a higher-than-expected attrition rate in the coming years — driven predominantly by officers leaving for retirement.

In 2007, the IBA warned that 251 officers would take advantage of the Deferred Retirement Option Plan (DROP) in the next five years and that retirement would be the largest component of officer attrition going forward. They further advised that It could take 3-5 years to return to more typical sworn staffing levels. This will depend largely on the City’s ability and efforts to recruit new qualified candidates.” (Emphasis added.)

Unfortunately, the City’s ability to recruit new candidates would be seriously compromised when budget decisions in FY2009 and FY2010 resulted in the City cutting its quarterly academy class sizes from 50 to 25. In FY2011 the City cancelled all but one academy class, a decision that “resulted in a lost opportunity to add approximately 57 additional recruits.”

And what did happen after the hiring freeze of 2011 ended? The SDPD received over 3,000 applicants for just 25 positions in its first academy class of 2012, according to 10News.  This is symptomatic of a larger trend – a tremendous, unmet demand to work in law enforcement in the San Diego area. For example, the following year the nearby San Diego County Sheriff’s Department received over 4,000 applicants for their 275 deputy positions.

Further, when the City authorized increasing the academy class size to 43 in FY2015, the first class easily reached capacity, with 41 new recruits and an additional five officers who are leaving other agencies to come work for the SDPD. (Classes are authorized to accept slightly more than the budgeted amount of 43 to accommodate for potential drop-outs.) With four classes scheduled for the year, up to 172 new recruits could be added by close of FY2015.

THE DATA

An analysis of the data does not support the assertion that officers leaving the San Diego Police Department to work at other agencies is the primary cause of the staffing shortfall.

Despite an abundance of prospective recruits eager to work for the SDPD at current compensation levels, the union has seized upon the current shortfall as an opportunity to lobby for higher wages. The union has long stated (as far back as 1985) that paying salaries less than competing agencies will result in a high rate of attrition as SDPD officers leave for greener pastures elsewhere.

Yet recent data reveals this is simply not true. Over the last five years, the SDPD lost an average of 103 police officers a year, with only 13 a year going to other agencies. Even assuming that all officers leaving for other agencies left for higher pay, this represents only a small minority of SDPD departures, and less than 1 percent of the entire force lost to other agencies per year.

Recent increases in the overall attrition rate is overwhelmingly driven by an increase in retirement — in both 2013 and 2014 retirement accounted for 60 percent of the attrition rate, with officers leaving for other agencies accounting for only 10 percent of departures.

The San Diego County Sheriff’s Department is frequently cited by the union as a potential poacher for underpaid SDPD officers. Yet the Sheriff’s attrition data says otherwise. Since 2010, only a total of 17 SDPD officers transferred to the Sheriff’s Department, with 11 arriving in 2014. However, the Sheriff’s Department itself lost 16 officers to other agencies in both 2013 and 2014. This would suggest that the SDPD’s recent attrition rates are not the result of an SDPD-specific crisis, but are in line with similar agencies of their size and region.

Nonetheless, the City implemented an officer retention program beginning in 2014 that authorized a seven percent raise in non-pensionable pay over the next five years for all sworn officers.

Additionally, the City expanded its officer retention program in 2015 with a $3.2 million expenditure for increased overtime pay. Despite this, a recent study comparing SDPD compensation with other California agencies has prompted everyone from the union to the Mayor to call for further pay increases.

Notably, the summary findings from the study compares base pay ranges only, which omits the 7 percent salary increase in non-pensionable pay and additional overtime authorized for the SDPD beginning in FY2014. It thus overstates the pay disparity reported.

Further, the study’s surveyed employers include cities from entirely different markets, such as San Francisco, Oakland, and San Jose. In addition to being located in opposite ends of the State, the Bay Area cities have dramatically higher costs of living than San Diego. Consequently, the average salaries of all government employees in these cities, not just police officers, are significantly higher than those found in San Diego or the San Diego area generally.

A more meaningful comparison would be restricted to competing agencies in the San Diego area only; doing so greatly reduces the pay disparity found.

San Diego Police Department
Base Pay Midpoint as Percent of Market Average by Job Title

20150114-CPC_Fellner_SDPD-1a

The study reported that the SDPD’s base pay midpoint ranged from 78% to 90% of the “market” average, as represented by the blue bar in the chart above, with the “market” defined as the 19 statewide employers surveyed. However, if the comparison is restricted to the six cities located within San Diego County plus the San Diego County’s Sheriff Department, the SDPD’s base pay ranges from 84% to 98% of the average.

THE THEORY

Flawed logic underlies the theory that pay parity is essential to retaining trained police officers.

Even if the current staffing shortfall is not caused by low pay and even if officers going to other agencies are a much smaller component of attrition than retirement, should not SDPD salaries be increased to parity with nearby, competing agencies?

Two factors are important when considering this question. The first is that such a salary policy would guarantee ever-increasing levels of public pay and taxation. It would entail every agency presently paying “below market” rates increasing its pay to the higher rates paid by other agencies, which in turn will now use that level as its salary baseline, which the follower-agencies would then seek to match, and so on and so forth.

Additionally, the argument assumes that competing agencies are capable of absorbing any and all lower-paid police officers. There are, however, only a finite number of positions at competing agencies. So the idea that any imbalance in pay would result in a mass exodus from one agency to the other is simply not plausible.

Decisions whether salary levels are adequate should be based on whether or not sufficient talent is being attracted, and subsequently retained, at current salary levels. We have seen the SDPD has no trouble attracting an excess of applicants and recruits, when the city chooses that course. Additionally, the number of officers leaving for other agencies has been extremely modest over the past five years, never representing even 1 percent of the force in any given year.

The first half of FY2015 data does project that 24 of this year’s projected 136 departures will leave for other agencies. This mild uptick is likely attributable to the recent increase in hiring authorized by the Sheriff’s Department and other agencies that are seeing their budgets return to pre-recession levels. As noted above, this pull is not something perpetual that can go on indefinitely.

Even in an abnormally higher year, the number of officers leaving for other agencies is a small fraction of the total attrition rate, and represents a mere 1.3 percent of the total force. Is it really appropriate to implement agency-wide pay raises for such a small minority, particularly when thousands of willing applicants want to join the ranks at current pay levels?

CONCLUSION

With half of the force eligible for retirement by 2017, it is likely the attrition rate will continue to grow in the coming years.

To address its staffing shortfall without creating an unnecessary additional burden on taxpayers, the City has several options. It can:

  1. Maintain or modestly expand academy class size while continuing to focus on improving recruitment methods.
  2. Prioritize the importance of recruitment to avoid eliminating or reducing academy classes in future years.
  3. Reform pensions to encourage the most experienced and valued officers to stay past the average SDCERS Safety retirement age of 51. A change to pension formulas that would allow for maximum benefits to be received at 55, instead of 50, would help. Benefits could still be available as young as 50, but on a sliding penalty scale similar to what Social Security employs.
  4. Consider implementing service contracts for new recruits that incentivize them to stay with the SDPD for a set period of time.

In sum, the current shortfall is predominantly caused by two features: an artificial restriction on the supply of available labor and an abnormally high rate of retirement incentivized by lucrative pensions that average $94,425 a year.

Ironically, not only will an increase in pensionable compensation fail to address the true cause of the problem, it will further exacerbate the city’s primary cause of attrition – retirement – by increasing the average pension and corresponding incentive to retire early.

The claim that the SDPD’s staffing shortfall was created because of low pay contradicts all available evidence. Policies based on this claim will not only fail to address the source of the problem, but also create an unnecessary financial burden for the City and its taxpayers.

*   *   *

About the Author:  Robert Fellner is Research Director for TransparentCalifornia.com, a joint project of the California Policy Center and the Nevada Policy Research Institute.

Average CalPERS Pension Up To 5 Times Greater Than Comparable Social Security Payouts

CalPERS officials are fond of saying that their average pension benefit is only about $31,500 – suggesting that CalPERS members’ benefits are at Social Security-type levels.

On this basis, they argue it’s a “myth” that public pension benefits are excessive.

But is that really true? What happens when something like Social Security’s benefit assumptions – a full career of employment and minimum income levels – are used in the comparison?

When accounting for these factors, CalPERS is unable to hide behind the misleading cover of a raw average – CalPERS benefits are up to 5 times greater than the comparable Social Security payout.

We filtered the 2013 CalPERS pension data for retirees with at least 30 or more years of service credit to create parity in the comparisons between the Social Security benefit estimates, which assume 35 years of employment and a retirement age of 64 and 4 months. Social Security estimates were generated with the Social Security Administration’s Quick Calculator Benefit Estimates tool in October, 2014. CalPERS 2013 data is provided by TransparentCalifornia.com. By contrast, the average age of retirement for CalPERS members is only 60.

Next, we analyzed CalPERS retirees by their pensionable compensation. The top pensionable compensation bracket is greater or equal to $117,000 – the maximum taxable earnings limit for Social Security. The remaining brackets move down in 25% increments from there.

20150102_Fellner_PvsSS-1

While the CalPERS values above represent the actual average pension received for the 2013 year, the Social Security benefit is an estimated figure. The SSA’s Benefit Estimator Tool requires a final salary, similar to pensionable compensation, in order to generate its estimates. We used the average pensionable compensation of the respective CalPERS retirees being compared to as the final salary for estimating the comparable Social Security benefit.

For example, the actual average pensionable compensation of all full career CalPERS retirees with a pensionable compensation of greater or equal to $117,000 was $146,250. Therefore, we used $146,250 as the final salary for generating the comparable Social Security benefit – $26,292.

These values, along with the average years of service of the respective CalPERS retirees, are displayed in the table below.

20150102_Fellner_PvsSS-2b

As shown above, CalPERS retirees with a reported pensionable compensation of at least $117,000 or more received an average 2013 pension benefit of $126,833. Additionally, the average years of service credit for these retirees was 33.85 and their average pensionable compensation was $146,250. By comparison, an employee who worked at least 35 years under Social Security and had a final salary of $146,250 can expect to receive a pension benefit of $26,292 in 2014.

Said differently, the CalPERS retiree with a pensionable compensation of at least $117,000 received a pension benefit nearly 5 times greater than a comparable private sector employee can expect to receive from Social Security. Those in the $87,750-$117,000 bracket received a benefit nearly 4 times greater than the comparable Social Security amount, while those with a final salary of less than $87,750 were receiving benefits over 3 times the comparable Social Security benefit.

It should be noted that the comparison of Social Security to CalPERS is not an apple to apple comparison. Most private employees participate in a defined contribution plan that will supplement their Social Security benefits. On the other hand, public employees who do not participate in Social Security are also not responsible for paying Social Security taxes. Further, CalPERS provides extremely generous health benefits for all of its members, regardless of income level, which are not captured in the values quoted above. Currently, these health benefits can cost up to $18,000 a year.

Nonetheless this comparison is a useful starting point to provide context for the value of CalPERS benefits, as opposed to obscuring them by quoting raw averages only.

Another striking inequity is the age of retirement a private sector worker needs to reach to receive full benefits, compared with a CalPERS retiree.

There is enormous value in the ability to retire at an earlier age rather than at a later one. For CalPERS retirees, they may retire as early as 55 and receive full benefits that are significantly greater than private sector retirees who, on average, have to work more years and retire later at life. For CalPERS safety officers (police/fire) they may retire as early as 50 and receive their maximum benefits.

This structure further compounds the disparity between CalPERS benefits and comparable Social Security benefits. Not only are CalPERS retirees receiving benefits that dwarf what Social Security can offer; they are able to retire up to a full decade earlier than private sector workers as well.

Given the cap on Social Security benefits, the trend demonstrated above is not surprising. As the maximum Social Security benefit one could receive in 2014 is capped at $31,704, compared to the lack of any cap whatsoever for CalPERS benefits, those public employees who receive larger salaries are going to receive exponentially greater pension benefits than what Social Security offers.

The aim of Social Security is to be a progressive tax that takes from those earning more and, consequently, least in need of assistance, and gives to those who earn less and are more in need of assistance in retirement. CalPERS, however, is essentially a wealth maximizing system. It provides lavish pension benefits for its members, with the highest earners receiving the largest share.

Perversely, these benefits are primarily funded by taxpayers who receive dramatically reduced retirement benefits from Social Security and, subsequently, are faced with a burden the CalPERS full-career retiree is immune from – the need to defer present spending in an attempt to supplement their meager Social Security benefits once in retirement.

As troubling as the inequity of CalPERS is, the more pressing issue is that it’s simply not sustainable in the long run. There are good reasons why defined benefit pension systems are heading towards extinction in the private sector.

The public sector, however, has held onto the defined benefit plan system. Given the substantial benefits CalPERS provides to their members, public employees and their unions have strong incentives to lobby on its behalf.

While a private firm would jettison any system that produces the long term liability associated with California’s defined benefit plans, politicians have little to no incentive to act on behalf of the taxpayers. The benefits received are immediate and relatively concentrated, while the costs are widely dispersed. Further, while some of the cost is beginning to be felt today, the lion’s share can be delayed for future generations, a demographic that has been traditionally ignored by today’s politician.

It is imperative that Californians recognize the true value, and cost, of a CalPERS pension, and recognize the urgent need for reform measures such as those that have been discussed exhaustively elsewhere.

*   *   *

About the Author:  Robert Fellner is Research Director for TransparentCalifornia.com, a joint project of the California Policy Center and the Nevada Policy Research Institute.

California's Most Financially Stressed Cities and Counties

Introduction:  Due to the healthy response generated by this study, and justifiable expressions of concern by many whose cities we found to be financially stressed, we would like to state that the rankings developed herein are based on information contained in 2013 financial statements, that is, financial statements for the fiscal year ended June 30, 2013. Therefore the data we used is nearly 18 months old. In a few cases, we couldn’t find 6-30-2013 financial statements and had to rely on 6-30-2012 financial statements. Therefore it is important to emphasize the rankings we have produced are based on the financial condition of California cities then, not now. It is possible that many of these cities have improved their financial condition. If we were able to assess the financial health of California’s cities as of 6-30-2014, these rankings would inevitably have changed.

It is also important to acknowledge that any attempt to rank the financial health of a city, or any financial entity, will rely on criteria and formulas that are debatable. How much emphasis to place on historical performance, debt, unfunded liabilities, cash flow, general fund balance, budget deficits vs surpluses, interest and pension expense, and a host of other relevant data will cause differing results. Nonetheless we believe the rankings we have come up with, based on the information we had to work with, would not have been substantially different if we had used alternative but credible systems of analyses.

If there is anything factually inaccurate in this study, pending review by our lead authors, we will insert a corrective note into the text of this study where the inaccuracy appears. If an official representing any of the cities that have come up high on the list of financially distressed cities wishes to post a rebuttal to our findings, even if it refers to activities that occurred after the period we analyzed, they are welcome to post them in the comments section of this study. It was impossible for us to contact every city in California when preparing this study, for obvious reasons. But our goal is not to issue these findings and stifle any subsequent dialogue, quite the contrary. 
Ed Ring  –  November 11, 2014

*   *   *

Over two years have passed since the cities of Mammoth Lakes, San Bernardino and Stockton filed for municipal bankruptcy. While this quiet period reminds us that municipal insolvency is a rare event, some cities and counties are more vulnerable than others. If the economy enters another recession, some of these at-risk municipalities could be compelled to enter bankruptcy.  And even without an economic downturn, these distressed municipalities will be challenged to provide adequate services, avoid tax increases, pay vendors on time and continue operating without imposing unpaid furloughs on their workers.

Working with Civic Partner, a firm that collects and analyzes municipal finance data, the California Policy Center has ranked over 490 California cities and counties with respect to their bankruptcy risk. This report contains the complete list as well as brief reports on the most vulnerable local governments.

To compile the ranking, we collected and analyzed audited financial statements published by approximately most cities and counties in California. Local governments typically produce audited financial statements if they issue municipal bonds or if they receive more than $500,000 in federal grants annually.

Governments are usually required to produce audited financial statements within six to nine months after their fiscal year end, which, in California, is generally June 30. Many governments miss the filing deadline. For our study, we used 2013 financial statements where available, but, in some cases used 2012 statements when we could not obtain a more recent filing.

Our data is distinct from that published by the State Controller’s Office (SCO) in its Cities Annual Report and Counties Annual Report documents. The controller reports contain unaudited data and do not conform to US Governmental Accounting Standards. We have found multiple large discrepancies and omissions in this data set, and believe that the state would be better served if SCO relied on the financial audits we have used.  More recently, SCO has started to publish local government financial statistics in a more user-friendly form at https://bythenumbers.sco.ca.gov/. The source of the data for the new SCO web site is the same unaudited information used in the annual reports mentioned above.

Once we located the audited reports, we extracted general fund revenue, expense and balance data, along with pension and interest expenses and total revenue for all governmental funds.  We entered this data into a scoring model created last year by Public Sector Credit Solutions in a research project funded by the California Debt and Investment Advisory Commission (CDIAC) – a unit of the State Treasurer’s Office. Although the research was supported by a state entity, the model itself and the findings reported here are not endorsed by any official entity. They are a product of the California Policy Center, Civic Partner and Public Sector Credit Solutions.

The scoring model uses a composite of four financial metrics derived from the information we collected.  These metrics are:

  • General Fund Balance / General Fund Expenditures – This is a measure of the cushion present in the government’s key fund – essentially its checking account.  General fund balance depletion was associated with the Vallejo, Stockton and San Bernardino bankruptcies – as well as those of Detroit and Harrisburg.
  • General Fund Surplus or Deficit / General Fund Revenues – This ratio indicates whether the general fund balance is improving or deteriorating – and at what rate.
  • Change in Annual Revenues (Total Governmental Funds) – Declining revenues were strongly associated with the Vallejo and Stockton bankruptcies, as both cities faced falling real estate values. We broaden the scope to include funds other than the general fund since many cities and counties divert large proportions of their revenue to special funds.
  • Interest and Pension Expenses / Total Governmental Fund Revenues – This is a measure of “uncontrollable” costs which cannot be avoided even if the city or county implements layoffs. During the Depression, cities with high interest burdens defaulted on their municipal bonds at much higher rates than those with more moderate debt burdens. A high interest burden was also associated with Desert Hot Springs insolvency at the turn of the millennium.

We then calculate a default probability score based on a weighted average of these four metrics. The scores are calibrated to reflect the estimated probability that a local government will either declare bankruptcy or default on its general obligation bond issues within one year. The calibration reflects the low historic incidence of bankruptcy and default by US cities and counties. In an average year, about one in 1000 of these entities declares bankruptcies and/or defaults on general obligation bond issues. This historic default rate of 1/1000 = 0.10% is close to the median default probability in our universe.

Cities and counties with default probability scores much higher than 0.1% have substantially elevated risk. The highest default probability among the California local governments we evaluated is 4.01% for the City of Compton – reflecting forty times the bankruptcy risk of a typical US city or county.

*   *   *

LOCAL GOVERNMENTS MOST AT RISK – THE UNLUCKY 13

This section includes brief descriptions of the most vulnerable cities and counties as measured by our model. We excluded Stockton and San Bernardino both of which continue to operate under bankruptcy protection.  Mammoth Lakes emerged from bankruptcy without having to adjust its debts and is not among the most distressed municipalities according to our model.

(1)  COMPTON  –  Default Probability, 4.01%

In July of 2012, Standard and Poor’s downgraded Compton’s bond rating after an independent auditor refused to express an opinion on the city’s 2011 financial statements amid allegations of corruption and fraud. At the time, the city’s bank account was $2 million short of the $5 million in notes it had due, and officials were unable to secure short-term financing. Bankruptcy seemed inevitable for the city of 93,000 with high poverty and an unemployment rate of 20 percent. City council faced scrutiny for recklessly overspending revenues by $10 million for four consecutive years and draining a $22 million surplus. General fund shortages were routinely covered with cash from restricted funds resulting in a $43 million deficit. After hiring more than 100 new employees between 2007 and 2011, the city was forced to make deep cuts, laying off 15 percent of its workforce and dramatically reducing services – bad news for a city where the unemployment rate has grown to 13 percent and the median income hovers at $21,832.

At the height of the crisis, council members abandoned plans to establish a $19.5 million police force. Instead the city continues to contract its police services with Los Angeles County Sheriff’s Department for $17.5 million annually. Through 2011, the city fell behind on its monthly payments to the county and accumulated $369,000 in late fees. Additional cuts and layoffs followed. Despite the fiscal emergency, Compton has continued to issue bonds through efforts by the county to divert city tax revenues to a bank-controlled reserve fund. Officials have worked hard to bring the city back from the brink of bankruptcy, and Compton has begun to rebuild reserves. But the city’s recovery is progressing at a painfully slow pace. City council has implemented a long-term, 15-year repayment plan to address past debt, and the 2014-2015 balanced budget passed without furloughs or layoffs. However, the city maintains a negative general fund balance in excess of $40 million, and services remain at a minimum.

View press release from City of Compton in response to study, posted Nov. 12th: “City of Compton’s Rebuttal…
View City of Compton’s Financial Transparency Page.

Sources:

Compton Financial Crisis Worsens, More Cuts Loom, Nov. 1, 2011, myfoxla.com
http://www.myfoxla.com/story/18391615/compton-financial-crisis-worsens-more-cuts-loom

City of Compton Annual Financial Report for the Year Ended June 30, 2012
http://www.comptoncity.org/images/stories/dept/cm/72538461823648162385483457.pdf

Compton on Brink of Bankruptcy, July 18, 2012, Los Angeles Times
http://articles.latimes.com/2012/jul/18/local/la-me-0719-compton-bankruptcy-20120719

Ten California Cities in Distress, May 15, 2013, USA Today
http://www.usatoday.com/story/news/nation/2013/05/15/ten-california-cities-in-distress/207621http://www.usacityfacts.com/ca/los-angeles/compton/economy/

Compton, CA Income and Economy, USA City Facts
http://www.usacityfacts.com/ca/los-angeles/compton/economy/

FY 2014-2015 City of Compton Budget Review, June 3, 2014
http://www.comptoncity.org/images/stories/dept/cm/376458234689579834652436774.pdf

(2)  KING CITY  –  Default Probability, 3.38%

King City’s efforts to contain the flow of cash started back in 2011, when a $150,000 hole opened in the budget as a result of dwindling property and sales tax revenues. Budget cuts and layoffs followed. To complicate matters, the city became embroiled in scandal when six city police officers, including two high-ranking officials, were charged with bribery and embezzlement early in 2014. With one-third of the police force on leave, the sheriff’s department has been contracted to patrol the city. Further jeopardizing the city’s finances is its participation in a joint powers worker’s compensation fund, MBASIA, which, according to the latest city audit, has $10 million in liabilities and a negative net position. All of this has come at a time when the city, where citizens earn a median salary of $18,885, is most in need of strong leadership to stabilize its finances. Current officials are working hard to get the city back on track. Looking forward, King City’s finances may benefit from a one-half cent tax increase scheduled to go into effect in April 2015. Funds from the tax increase will be used to rebuild the city’s reserves and police force.

Sources:
City Prepares to Make Budget Cuts, Considers Layoffs, Jan 26, 2011, King City Rustler
http://www.kingcityrustler.com/v2_news_articles.php?heading=0&story_id=600&page=72

City Continues to Work Toward Closing $150,000 Budget Gap, March 30, 2011, King City Rustler
http://www.kingcityrustler.com/v2_news_articles.php?heading=0&page=72&story_id=673

King City Police Officers Arrested in corruption scandal, Feb. 25, 2014
http://www.montereyherald.com/news/ci_25223763/king-city-police-officers-arrested-corruption-scandal

City of King 2013 Comprehensive Audited Statement, June 30, 2014
http://rpt.civicpartner.com:90/cafr/490DC870-C2FF-4BAC-8A81-DED72E264E31.pdf

City of King, CA Income an Economics, USA City Facts, 2013
http://www.usacityfacts.com/ca/monterey/king-city/

King City Makes Most Financially Distressed City List, The Salinas Californian, Nov. 6, 2014
http://www.thecalifornian.com/story/news/local/2014/11/06/king-city-makes-financially-distressed-city-list/18595461/

(3)  SUTTER CREEK  –  Default Probability, 2.79%

Once a bustling mining boomtown, Sutter Creek has settled into a quaint, historic town where citizens make ends meet on a modest median income of $25,510. When the city’s general fund deficit ballooned from $150,000 in 2008 to more than $1 million in 2010 and 2011, auditors raised doubts about its ability to continue as a going concern. They also made note of the city’s incomplete financial records, as well as weaknesses in financial reporting procedures. Council members took corrective action to simplify the budgeting process and trim down costs for Fiscal Year 2012-2013. Cost-cutting strategies included steep program and expense reductions, and outsourcing functions when possible. Unfortunately, these actions may not be enough to keep the general fund afloat as the city faces a calPERS increase from 28 percent to 33 percent, and an increase in health benefit costs of $200 monthly per SEIU 1021 member. These increases, coupled with the city’s $100,000 general fund repayment obligation leave Sutter Creek’s fund balance in a vulnerable financial position for the foreseeable future.

Sources:

Sutter Creek City Council, Aug. 5, 2009, tspntv.com
http://webcache.googleusercontent.com/search?q=cache:12LDPkg7MFcJ:www.tspntv.com/item/7143-sutter-creek-city-council+&cd=1&hl=en&ct=clnk&gl=us

City of Sutter Creek 2010 Audit
http://www.cityofsuttercreek.org/docs/063010-COSC-AuditedFinancialStatement.pdf

City of Sutter Creek 2011 Audit
http://cityofsuttercreek.org/agendasminnutes2013.html

City of Sutter Creek 2012 Audit
http://www.cityofsuttercreek.org/docs/2012%20Audited%20Financials.pdf

City of Sutter Creek 2013-2014 Final Budget, June 17, 2013
http://www.cityofsuttercreek.org/docs/031814-FinalBudget-2013-2014.pdf

City of Sutter Creek, CA Income and Economy, USA City Facts, 2013
http://www.usacityfacts.com/ca/amador/sutter-creek/

(4)  IONE  –  Default Probability, 2.17%

Officials in historic Ione have struggled to get a firm grip on the city’s finances for years, depleting reserves and making cuts to balance the budget. On numerous occasions, auditors have commented on the city’s inconsistent accounting methods and habitual inter-fund borrowing. In 2011, miscalculations and erroneous revenue projections left a $500,000 hole in the city’s budget. A 2011-2012 Amador County Grand Jury Report revealed multiple instances of mismanagement and questionable fiscal practices. The city has since made efforts to rectify its past issues. However, citizens of Ione, who enjoy a relatively high median income of $34,514, remain apprehensive about the future of their close-knit community.

According to recent public records, Ione’s current budget priorities include building a reserve fund and paying down principal and interest on inter-fund loans, but both will present an ongoing challenge as the city struggles to keep pace with rising pension liabilities. While the city expects to see a modest five percent increase in tax revenues over the current fiscal year, grant funds are expected to decrease. Under the circumstances reducing the city’s structural deficit will be a long-term undertaking.

Sources:

Lone Faces Massive Budget Shortfall, Oct. 12, 2011, CBS Sacramento
http://sacramento.cbslocal.com/2011/10/12/ione-faces-massive-budget-shortfall/

2011-12 Amador County Grand Jury Report: City Administration City of Ione, Sept. 4, 2012
http://www.voiceinione.com/Documents/GrandJuryReports/2011-2012/2011-2012GJR-Response.pdf

City of Ione Finance Workshop FY 2012-2013 Mid-Year Review, Jan. 31, 2013
http://ione-ca.com/home/ione/MyMedia/audits/20120131%20Finance%20Workshop_MY%20Budget%20Review.pdf

City of Ione 2012 Audit Report, June 30, 2013
http://ione-ca.com/home/ione/financials.htm

City of Ione, CA Income and Economy, 2013, USA City Facts
http://www.usacityfacts.com/ca/amador/ione/

Ione Continues to Wrestle with Budget Issues, April 16, 2014, kvgcradio.com
http://www.kvgcradio.com/local-daily-headlines/2997-ione-continues-to-wrestle-with-budget-issues

Ione Council Sees 2014-15 Budget – Enjoys Surplus from Last Year, June 5, 2014, Amador Ledger Dispatch
http://www.ledger-dispatch.com/news/ione-council-sees-2014-15-budget-enjoys-surplus-from-last-year

(5) MAYWOOD  –  Default Probability, 1.46%

By the time the 2008 recession hit Maywood, the city had already been operating with a deficit for several years and had been dipping into reserves to balance the general fund.  A significant part of the problem has been traced back to an underpriced 2003 police contract that cost the city millions annually. By 2010, the Maywood’s financial situation had spiraled into chaos, and the city lost its worker’s compensation insurance coverage and was quickly running out of cash. Following a unanimous vote by city council, the police department was dismantled and replaced by the Los Angeles County Sheriff’s Department, all 100 city workers were laid off and municipal services were outsourced to the neighboring city of Bell for a monthly fee of $50,833. At first, becoming a 100 percent contracted city (the first in the country) appeared to be a brilliant solution to Maywood’s financial problems, but the plan fell apart when evidence of payroll corruption were uncovered in Bell. In the wake of the scandal and resulting criminal investigations, Bell canceled its management agreement. Maywood was left to operate without an official budget for nine months while a brand new mayor tried to pick up the pieces.

Maywood’s 2011 financial statements show that an auditor expressed doubts about the city’s ability to continue as a going concern. At the close of 2013, the city had accumulated a $500,000 deficit. Moderate revenue increases and surpluses are projected for Fiscal Years 2015 and 2016. Nevertheless, the city’s ability to remain solvent remains in jeopardy.

Sources:

City of Maywood 2008-2009 Budget Report
http://www.cityofmaywood.com/index.php?option=com_content&view=article&id=144&Itemid=145

Maywood to Lay off all City Employees, Dismantle Police Department, June 22, 2010, Los Angeles Times
http://latimesblogs.latimes.com/lanow/2010/06/sheriffs-dept-to-patrol-maywood-while-city-employees-now-face-lay-offs.html

Maywood, CA Plans to Disband ALL City Services, June 23, 2010, Huffington Post
http://articles.latimes.com/2011/may/14/local/la-me-05-14-maywood-20110514

California City That Outsourced Everyone is Snarled by Pay Scandal in Bell, Aug. 3, 2010, Bloomberg
http://www.bloomberg.com/news/2010-08-03/california-city-that-outsourced-everyone-is-snared-by-pay-scandal-in-bell.html

Maywood Strives to Bring Order to Financial Chaos, May 14, 2011, Los Angeles Times
http://articles.latimes.com/2011/may/14/local/la-me-05-14-maywood-20110514

Maywood passes Budget for 2014-15, Oct. 17, 2014, Los Angeles Wave

Maywood, CA Income and Economics, USA City Facts, 2013
http://www.usacityfacts.com/ca/los-angeles/maywood/economy/

(6)  ATWATER  –  Default Probability, 1.22%

Atwater city council declared a fiscal emergency in October of 2012. The city cited ongoing structural deficits and negative fiscal impacts from the state’s elimination of redevelopment agencies for its financial hardships. Since the beginning of the recession the city’s revenues failed to keep pace with expenses, leading to mounting debts and a negative general fund balance in 2011. Reserve funds were depleted to help finance an $85 million waste water treatment plant. By 2013, the city faced structural deficits of more than $4 million in the general fund and enterprise funds. During the months following the emergency declaration, the city responded to these economic challenges by dramatically reducing its workforce, cutting employee wages by five-percent and passing the Measure H half-cent sales tax increase to fund public safety.

With a relatively high unemployment rate of 14.7-percent and a median income of $23,083, Atwater citizens are in no position to shoulder the city’s financial problems. Unfortunately, city officials had to balance the current budget through a combination of utility rate increases and continued reductions in operating expenses. City services remain at a minimum, and staffing levels are down from 134 positions in 2008 to just 78 in 2014, a total reduction of 42-percent. Though workers have continued to absorb a significant part of the burden through mandatory 10-percent furloughs and increased health costs, the city’s financial condition remains weak. Significant increases to calPERS retirement costs loom on the horizon, and the city continues to operate without the cushion of reserve funds. The local economy suffered another setback when Mi Pueblo Foods, which served as the anchor store of the Bellevue Road Shopping Center, closed its doors in August 2014 and laid off 91 employees. With no additional revenue increases projected over the next five years and little left to cut from the budget, the city’s solvency remains doubtful.

Sources:

Ten California Cities in Distress, May 15, 2013, USA Today
http://www.usatoday.com/story/news/nation/2013/05/15/ten-california-cities-in-distress/2076217/

City of Atwater Comprehensive Audited Financial Report, June 30, 2013
http://www.atwater.org/doc_files/Atwater%20Fin%20Stmts%206-30-13.pdf

Atwater Hires a New Finance Chief, Sept. 9, 2014, Merced Sun Star
http://www.mercedsunstar.com/2014/09/09/3839325/atwater-hires-a-new-finance-chief.html

Atwater Adopts Barely Balanced Budget, May 6, 2014, Merced Sun Star
http://www.mercedsunstar.com/2014/06/24/3716140/atwater-adopts-barely-balanced.html

Mi Pueblo Foods Closing in Atwater, June 16, 2014, Modesto Bee
http://www.modbee.com/incoming/article3166434.html

Atwater, CA Income and Economy, USA City Facts
http://www.usacityfacts.com/ca/merced/atwater/economy/

(7)  HURON  –  Default Probability, 1.08%

 When the majority of cities started feeling the impacts of the recession in 2008, the farming economy of Huron had already reached a low point. Miles of fields that produced Huron’s agribusiness economy dried up as increasing federal restrictions reduced water allocations to a trickle. Huron’s “cash driven” migrant economy also dried up as workers left in droves for employment in neighboring cities, taking their money with them. The city’s annual budget provides for only the most basic services; there is no fire department, no hospital and no high school. In a city where the median household income is $21,041 and nearly half of the citizens live below the poverty line, crime is a persistent issue. On Nov. 5, 2013, voters passed Measure P, a one-cent sales tax increase to fund additional police services. Nevertheless, the city’s budget remains inadequate to meet the basic needs of the community. Auditors expressed a negative opinion of the city’s 2013 financial statements, citing a general fund deficit of $494,911 and a cash balance of $0. Despite a significant decrease in expenditures over a three-year period, the city has also been cited for using restricted funds to subsidize the general fund. With unresolved deficits and no reserves, the Huron’s financial situation truly appears to be on the verge of collapse.

Sources:

California’s Disappearing Towns – Huron May Not Be Here a Year from Now, July 13, 2009, New American Media
http://news.newamericamedia.org/news/view_article.html?article_id=fe824636288f2231f5e75d0e0b6d7ca3

City of Huron Police Services Sales Tax Increase, Measure P (November 2013), Ballotopedia
http://ballotpedia.org/City_of_Huron_Police_Services_Sales_Tax_Increase,_Measure_P_(November_2013)

City of Huron 2013 Comprehensive Audited financial Report
Huron city_CAFR_2013.pdf

City of Huron Fast Facts, 2014, Fresno Council of Governments
City of Huron – Fast Facts | Fresno Council of Governments

(8)  CHICO  –  Default Probability, 0.88%

In 2013, questions raised by concerned city officials and third-party auditors exposed a $15 million deficit that had accumulated between 2007 and 2012. During those years, negligent auditors allowed the city’s eroding fiscal condition to slide while city council made empty promises to enforce stricter budgetary controls. As Chico’s revenues dwindled, the council reduced personnel costs through attrition, early retirements and layoffs, eventually cutting 70 positions including 19.5 positions in public safety. When workforce cuts failed to produce the savings needed to balance the budget, officials depleted reserves and relied heavily on inter-fund transfers to subsidize yearly general fund shortfalls, accumulating debts of $13.5 million in the capital and enterprise funds. By the end of 2013, officials were pressed to enact an aggressive debt repayment plan to prevent auditors from stating a negative opinion of the city’s 2012 financial statements. The 10-year deficit reduction plan, passed by city council in December of 2013, prioritized reducing existing deficits and restricted the use of new revenue sources. Fiscal Year 2013-2014 budget balancing measures included a five-percent reduction in wages and benefits, an additional workforce reduction of 50 positions (13%), $5 million in general fund cuts, and $13.1 million in debt reimbursements to restore the city’s depleted funds.

As Chico recovers, new development projects have been downsized to reflect the city’s long-term financial reality. It has been estimated that it will take the city 15 years to pay off current debts and restore reserve funds. The city’s struggle to catch up despite flat revenues reflects the hardship felt by Chico citizens who face an unemployment rate of 10.9 percent and scrape by with a median income of $17,847. The city experienced another setback with the 2012 defeat of Measure J, a tax on electronic communications, which leaves a $900,000 hole in the yearly general fund budget. Covering the loss will be a challenge as the city begins to make debt payments in Fiscal Year 2015-2016. The initial payment of $800,000 is scheduled to increase to $1.5 million, and yearly payments will continue until 2030 when the city’s debts are paid and $13.4 million is restored to its reserve funds.

Sources:

City of Chico 2012-2013 Annual Proposed Budget
http://www.chico.ca.us/finance/documents/2012-13CityAnnualPROPOSEDBudget.pdf

City of Chico Utility Users Tax, Measure J, Nov, 12, 2012, Ballotopedia
http://ballotpedia.org/City_of_Chico_Utility_Users_Tax,_Measure_J_(November_2012)

City of Chico 2013 Comprehensive Annual Report, June 30, 2013
http://www.chico.ca.us/finance/documents/CAFRFinal_000.pdf

Debt Catches up to Chico City Government, March 20, 2014, Chico ER News
http://www.chicoer.com/news/ci_25382327/debt-catches-up-chico-city-government

Chico Council Adopts $42.6 Million General Fund Budget, June 17, 2014, Chico ER News
http://www.chicoer.com/news/ci_25984458/chico-council-adopts-42-6-million-general-fund

Chico City Councilors React to Grand Jury Report, June 26, 2014, Chico ER News
http://www.chicoer.com/news/ci_26042532/chico-city-councilors-react-grand-jury-report

Chico, CA Income and Economy, 2013, USA City Facts
http://www.usacityfacts.com/ca/butte/chico/economy/

(9)  CALIPATRIA  –  Default Probability, 0.84%

The city of Calipatria has been running a deficit, with no reserves, since 2009. As revenues tanked, the council increasingly relied on inter-fund loans to supplement the general fund. By 2012, the city enacted across-the-board furloughs and eliminated council members’ monthly stipend to close the growing $112,000 gap. When the deficit grew to more than $400,000 in 2013, with nothing left to trim from the budget, city council considered the option of consolidation but could not reach a reasonable compromise on the issue. Citizens of Calipatria have maintained a median income of roughly $24,000, but without political consensus or a reserve fund, Calipatria’s future prosperity is in doubt.

Sources:

Calipatria Staff Looking Where to Make Cuts, July 1, 2011, Imperial Valley Press
http://articles.ivpressonline.com/2011-07-01/mayor-raul-navarro_29728998

Furlough Approval in Calipatria, June 26, 2012, Imperial Valley Press
http://articles.ivpressonline.com/2012-06-26/furlough_32445379

Calipatria Reviews Consolidation Options, May 30, 2013, Imperial Valley Press
http://articles.ivpressonline.com/2013-05-30/mayor-raul-navarro_39636628

Calpatria, CA Income and Economy, 2013 USA City Facts
http://www.usacityfacts.com/ca/imperial/calipatria/economy/

(10)  RIDGECREST  –  Default Probability, 0.76%

The state’s dissolution of redevelopment agencies in February 2012 created a ripple effect that forced Ridgecrest to declare a fiscal emergency on Jan. 11, 2012. For Ridgecrest, the loss of its redevelopment agency meant the city also lost money on investments, funding for key staff positions and additional property tax revenue. And it came at a time when the city could not afford to sustain any more losses. The general fund was already $4.25 million in debt to the wastewater fund for a cash flow advance city council approved in September of 2011. Measures implemented to address the city’s declining financial condition, including furloughs, layoffs, deferred maintenance and severe cuts to non-essential services, were insufficient to compensate for ongoing losses. At the close of 2012, the general fund had only $7,600 in cash.

Following the declaration of a fiscal emergency, Ridgecrest citizens passed Measure L, a 75 percent sales tax increase to fund public safety and essential services for five years, effective Oct. 1, 2012. Original Measure L revenue estimates of $1.8 million were adjusted down to $1.5 million – then down again to $1.3 million. After passing a shoestring budget for Fiscal Year 2013-2014, the city ran out of money mid-year and had to approve budget increases in December to pay for services rendered as it struggles to restore services and rebuild its workforce after a cumulative reduction of 22.5 percent.

Sources:

City of Ridgecrest Resolution Declaring a Fiscal Emergency, Jan. 11, 2012
http://ridgecrest-ca.gov/uploadedfiles/Government/RESO%2012-04%20-%20FISCAL%20EMERGENCY.pdf

City of Ridgecrest Sales Tax, Measure L, June 2012
http://ballotpedia.org/City_of_Ridgecrest_Sales_Tax,_Measure_L_(June_2012)

City of Ridgecrest 2012-2013 Approved Budget
http://ridgecrest-ca.gov/uploadedfiles/Departments/Finance/Budget_2012-13_with_Reso_attached.pdf

City Presents Draft Budget, July 4, 2012, News Review
http://www.newsreviewiwv.com/zarchives/2012-05-23/2012-05-23-story-01.html

Audit Presents Sobering Financial Outlook, Feb. 8, 2013, Ridgecrest Daily Independent
http://www.ridgecrestca.com/article/20130208/NEWS/130209805?refresh=true

City of Ridgecrest 2012 Comprehensive Audited Financial Report, June 30, 2013
https://ridgecrest-ca.gov/uploadedfiles/Departments/Finance/Ridgecrest_CAFR2012FINAL_LetterheadSecured.pdf

City’s Obligations Mainly Lie in Wastewater Fund, March 27, 2013, Ridgecrest Daily Independent
http://www.ridgecrestca.com/article/20130327/News/130329790

Council to Hear Budget Increase Requests, Dec. 3, 2013, Ridgecrest Daily Independent
http://www.ridgecrestca.com/article/20131203/News/131209920

City of Ridgecrest 2013 Comprehensive Audited Financial Report, June 30, 2014
https://ridgecrest-ca.gov/uploadedfiles/Departments/Finance/Ridgecrest_CAFR_2013_-_Final.pdf

(11)  SAN FERNANDO  –  Default Probability, 0.75%

San Fernando’s budget reflects the city’s history of extreme highs and lows. During high times in 2008, the city opened a $14.5 million aquatics center with an Olympic-sized pool, paid in part by property taxes. Shortly thereafter, the City’s economy began a steady decline, and by 2009 it was clear that aquatics center revenues could not keep pace with the cost of running the facility. In 2009 city council closed the center to the public for nine months out of the year to reduce costs. As the economy slumped, San Fernando’s median income dipped to $22,838 and unemployment grew to 12 percent. The city’s financial condition continued to slide as council members found themselves mired in scandal. In 2012 citizens pushed back in an election to recall corrupt council members, and under new leadership the city has begun the process of stabilizing its finances. Drastic cost-saving cuts, including layoffs and furloughs, have been made to address the city’s deficits. While unemployment has dropped to eight percent and the local retail outlook has improved, revenues remain relatively flat.

In 2013, auditors expressed doubts about the city’s fund’s ability to continue as a going concern, citing lack of liquidity in the general fund and the grants special revenue fund. Facing $4.2 million in obligations to the enterprise funds and no general fund reserves, city council declared a fiscal emergency, followed by passage of the Measure A one-half cent tax increase in June of 2013. Revenues from the tax increase will be used to pay off existing debt and build reserves. Despite higher than projected Measure A revenues, the general fund ended 2013 with a negative balance and a growing unfunded pension liability. In an effort to alleviate some of the hardship, city council recently reached an agreement transferring financial and operational responsibility of the Aquatic Center to Los Angeles County. A modest general fund surplus is projected for 2014 and will be used to reduce deficits in the general fund and self-insurance fund, but ongoing annual surpluses will be required to eliminate structural deficits, build reserves and meet growing expenses.

View rebuttal, posted Nov. 11th: “City of San Fernando Responds to CPC Study

Sources:

San Fernando Voters Recall Mayor Brenda Esqueda, Councilwoman Maribel De La Torre, November 6, 2012, Daily News
http://www.dailynews.com/government-and-politics/20121107/san-fernando-voters-recall-mayor-brenda-esqueda-councilwoman-maribel-de-la-torre

City of San Fernando City Council Agenda, March 4, 2013
http://www.ci.san-fernando.ca.us/city_government/city_council/agendas_minutes/2013/3-4-13%20CC%20Packet.pdf

City of San Fernando 2013 Comprehensive Annual Financial Report, June 30, 2013
http://www.ci.san-fernando.ca.us/city_government/departments/finance/divisions/cafr.shtml

San Fernando, CA Income and Economy, USA City Facts, 2013
http://www.usacityfacts.com/ca/los-angeles/san-fernando/economy/

San Fernando Annual Report – Measure A: ½ Cent Transaction & Use Tax, September 15, 2014
http://www.ci.san-fernando.ca.us/city_government/departments/finance/forms_docs/Measure%20A%20Annual%20Report%202014.pdf

City Council Appears Ready to Hand Over Aquatic Center to Los Angeles County, October 4, 2014, San Fernando Sun
http://www.sanfernandosun.com/news/article_618dfbfa-4a4e-11e4-a7f1-332869db1ff8.html

(12)  BLYTHE  –  Default Probability, 0.74%

When city council attempted to declare a fiscal emergency on March 2, 2009, the general fund had been operating with structural deficits for 10 consecutive years – by 2008 the negative balance was close to $3.4 million. The city’s golf course and airport funds were also running deficits in excess of $1 million. The measure failed to pass by one vote. Auditors raised doubts about the city’s ability to continue as a going concern. City council narrowly reduced the deficit, shaving off $1 million through efforts including layoffs, drastic cuts to expenditures and essential services, and the sale of unneeded city assets. However, an end to the city’s financial instability was nowhere in sight. In 2012, the council rejected the proposed budget due to disputes about future funding of the Joe Wine Rec Center, and a continuing resolution was passed to allow the city to continue to operate for 45 days while the council drafted a new budget. Despite conflicts, council members reluctantly passed a “bare bones, keep the lights on budget” by the end of July.

The 2014-2015 budget has a balanced spending plan, but negative fund balances persist. The city’s workforce remains staggeringly low – down from 135 full-time positions in 2008 to just 69 in 2014. City infrastructure suffers from years of deferred maintenance, and the fire department is overdue for new protective gear. On July 29, 2014, city council passed a resolution declaring a fiscal emergency through June 30, 2015, and the Nov. 4, 2014 ballot will include measures to increase the sales tax by one-half cent and TOT by 3%. Citizens, who face an unemployment rate of 9% and struggle to pay their own bills on a median income of $16,877, remain skeptical of the city council’s ability to manage a successful financial recovery.

Sources:

Blythe City Council Continuing Meeting Agenda, March 2, 2009

City Deficit Nears $3.4 Million, June 12, 2009, Palo Verde Valley Times
http://paloverdevalleytimes.com/main.asp?TypeID=1&ArticleID=11146&SectionID=167&SubSectionID=468&Page=2

Blythe City Council Rejects Proposed Budget, June 28, 2012, Palo Verde Valley Times
http://paloverdevalleytimes.com/main.asp?SectionID=1&SubSectionID=1&ArticleID=17343

Council Approves Fiscal Year Budget after Contentious Debate, July 26, 2012
http://paloverdevalleytimes.com/main.asp?SectionID=1&SubSectionID=1&ArticleID=17441

Blythe City Council Special Meeting Agenda, June 29, 2014
http://www.cityofblythe.ca.gov/ArchiveCenter/ViewFile/Item/620

City of Blythe Demographics
http://www.cityofblythe.ca.gov/ArchiveCenter/ViewFile/Item/620

(13)  FIREBAUGH  –  Default Probability, 0.74%

The farming community of Firebaugh in Fresno County has been hit hard by the economic impacts of regional droughts. Since 2007, the agricultural industry that propped up Firebaugh’s economy has felt the squeeze of increasingly reduced federal water allocations from the Central Valley Project. Firebaugh’s hardships were compounded by the recession, and the city began enforcing mandatory furlough days for all employees when tax revenues bottomed out in 2009. Things went from bad to worse as local businesses closed or downsized operations – in 2010 Gargluilo Inc., one of the city’s top employers, cut its workforce by 33%, laying off 262 workers. The city’s unemployment rate spiked to 28%, and per capita incomes dwindled to $10,133. As revenues sagged, local businesses called in overdue bills for years of unpaid utility tax refunds, pushing the city into a $1 million deficit. With no relief in sight, officials began balancing general fund deficits with money transferred from water, sewer and airport funds. Of the $815,000 in debts incurred by the city’s funds through 2012, an estimated $230,000 remains unpaid as of June 2013 – the total amount is expected to be repaid by 2016.

City council declared a fiscal emergency on February 4, 2013, citing a negative cash balance of $834,695.00 and $0 cash reserves. In July of 2013, the city held a stand-alone election to reduce utility user tax rates and eliminate the $500 service cap that allowed businesses to receive yearly refunds. The tax reforms will provide an estimated $240,000 in annual revenue. Unfortunately that revenue increase was undercut by the closure of Westside Ford in July 2013. According to the city manager, the closure of the dealership – one of the city’s top revenue sources – equates to a loss of $77,000 in general fund revenue. Crippling economic challenges continue to hinder a full recovery as Firebaugh officials work to restore reserve funds, end mandatory furloughs, and reinstate two police positions that were cut from previous budgets.

Sources:

With Little Water Coming, Small Town Faces Extinction, May 14, 2009, Contra Costa Times
http://www.contracostatimes.com/bay-area-drought/ci_12302104

Major Employer in Firebaugh Announces Layoffs, May 23, 2010, ksby6 News

Firebaugh Ford Dealership Prepares to Close, Jan. 30, 2013, abc30 News
http://abc30.com/archive/8971769/

The City Council/Successor Agency of the City of Firebaugh Meeting Minutes, Feb. 4, 2013
http://www.ci.firebaugh.ca.us/pdf/Minutes13-02-04.pdf

Firebaugh Hopes Utility Tax Tweak Will Lead to Better Budget, Aug. 5, 2013, TMC News
http://www.tmcnet.com/usubmit/2013/08/05/7327837.htm

City of Firebaugh 2014-2015 Budget
http://www.ci.firebaugh.ca.us/pdf/budget_fy14-15.pdf

City of Firebaugh Demographics
http://firebaugh.org/demographics/

*   *   *

COMPLETE CITY AND COUNTY RANKINGS

The following table shows all the cities and counties we analyzed in order from most to least vulnerable. We also show the estimated default probability calculated by the model.  This is our measure of the probability that the local government will file for bankruptcy within one year.  Because municipal bankruptcy is a rare event, all the probabilities are quite low.  Readers focusing on any given city may be more interested in the ranking and the distance between its default probability score and those of others.

The table also shows the latest year for which audited financials were available when we finished data collection earlier this month.  The unavailability of financial statements fifteen months after the end of the fiscal year is, in itself, a cause for concern.  The State Controller’s Office publishes the filing status of local agency financial audits every two weeks. The latest version of this report, including a complete list of delinquent filers, is available at http://www.sco.ca.gov/Files-AUD/SingleAud/sa_10_15_2014.pdf.

Details behind the default probability scores shown in the table below are available at Civic Partner’s web site:  http://www.publicsectorcredit.org/ca. This web site is currently in a testing phase – we welcome reader feedback on this tool.

*   *   *

20141029-2_Joffe

*   *   *

CONCLUSION

Elected officials, financial managers and concerned citizens are generally aware of their municipality’s financial condition. But due to the unavailability of good data, they are less aware of how their city or county compares with its peers.

By systematically collecting and analyzing audited financial statements from California local governments, CPC and Civic Partner have provided this missing context. We look forward to analyzing these reports each year and sharing our findings with policymakers and the general public.

For the cities on our distressed list, we hope this report serves as a wake-up call.  While officials in these cities were generally aware that they were facing fiscal challenges, they now know that their issues are particularly acute compared with peer municipalities. Also for cities and counties just below our “top ten”, we hope the report serves as a warning to take corrective action before they take their place at the top of future ranking.

*   *   *

About the Authors:

Julie Lark is an AmeriCorps VISA alumni who has spent several years working with non-profits to build stronger, more prosperous communities. Her most recent projects include working on a research study for Public Sector Credit Solutions. She has a BA in English/Communications from Shippensburg University and is pursuing her MPA. In her spare time, Julie enjoys traveling and spending time with family.

Marc 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.

Ed Ring is the executive director for the California Policy Center. Previously, as a consultant and full-time employee primarily for start-up companies in the Silicon Valley, Ring has done financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

Estimating America's Total Unfunded State and Local Government Pension Liability

Summary:  The total state and local government pensions in the United States at the end of 2013 had an estimated $3.6 trillion in assets. They were 74% funded, with liabilities totaling an estimated $4.86 trillion, and an unfunded liability of $1.26 trillion. These funds, in aggregate, project annual returns of 7.75%. If you apply a 6.2% average annual return to recalculate the liability, using formulas provided by Moody’s Investor Services, the liability increases to $5.87 trillion and the unfunded liability increases to $2.27 trillion. Using the 4.33% discount rate recommended by Moody’s for valuing pension liabilities, the Citibank Pension Liability Index for July 2014, increases the estimated liability to $7.39 trillion and the unfunded liability to $3.79 trillion. That is, if America’s state and local pension funds were to no longer make aggressive market investments but were to return to relatively risk free investments, the payment required just to return these funds to solvency would be more than $12,000 per American.

This study concludes with four recommendations to ensure the ongoing solvency of public sector pensions. Based on the principals governing Social Security benefits, they are (1) Increase employee contributions, (2) Lower benefit formulas, (3) Increase the age of eligibility, (4) Calculate the benefit based on lifetime average earnings instead of the final few years, and (5) Structure progressive formulas so the more participants make, the lower their actual return on investment is in the form of a pension benefit. Finally, the study recommends all active public employees immediately be enrolled in Social Security, which would not only improve the financial health of the Social Security System, but would begin to realign public and private workers so they share the same sets of incentives and formulas when earning government administered retirement benefits.

*   *   *

Introduction and Methodology:

This study relies on the most recent data compiled by the U.S. Census Bureau, combined with recent analysis performed by Wilshire Associates, an investment advisory firm, to estimate America’s total state and local government pension fund assets, liabilities, earnings, contributions and payments to retirees. This study then applies formulas provided by Moody’s Investor Services to estimate how much the unfunded liability deviates from the Census Bureau’s estimate, based on using lower rate of return projections. This study is limited to state and local government pension funds and does not include analysis of the federal retirement pension systems. In most cases, instead of footnotes, citations and links to sources are included within the text. This report concludes with some recommendations intended to stimulate discussion and debate.

*   *   *

Total Assets – All U.S. State and Local Government Pension Systems:

The most recent compilation of total assets, contributions and payments for America’s state and local government pension funds is the “Summary of the Quarterly Survey of Public Pensions for 2014: Q1,” released on June 26, 2014 by the U.S. Census Bureau. It provides data for the quarter ended March 31, 2014.

In the introduction, the report states “total holdings and investments of major public pension systems increased to over $3.2 trillion, reaching the highest level since the survey began in 1968.” In the footnotes, the report provides clarification that they are only referring to state and local pension systems. They also estimate these “major public pension systems” to only represent 89.4% of all state/local pension system assets, which allows the means to reasonably extrapolate an estimate representing 100% of the total state/local pension system assets, contributions, and payments. They write:

“This summary is based on the Quarterly Survey of Public Pensions, which consists of a panel of the 100 largest state and local government pension systems, as determined by their total cash and security holdings reported in the 2007 Census of Governments. These 100 systems comprised 89.4% of financial activity among such entities, based on the 2007 Census of Governments.”

In table 1, below, the total pension assets are determined by taking the Census Bureau’s reported $3.218 trillion representing the 100 largest state/local pension funds, and dividing by 89.4%, yielding an estimated total assets for all state/local pension systems in the United States of $3.6 trillion.

Similarly, in table 1, using Census Bureau data, the most recent reported quarterly total employer and employee contributions for the 100 largest state/local pension funds are multiplied by four, with the product then divided by 89.4%. The resulting estimates are that during the 12 month period through March 31, 2014, $163.8 billion was contributed into these funds by employers and employees, and $251.6 billion was paid out to state and local government retirees. Presumably the cash flow deficit, $87.8 billion, was covered by investment returns.

Table 1 – State/Local Pension Systems as of 3-31-2014
Estimated Assets, Contributions, and Payments ($=B)
20140910_Ring_Pensions-T1b

*   *   *

Official Funding Status  – All U.S. State and Local Government Pension Systems:

At face value, it would appear that the funding status of these pension systems is quite healthy, since the deficit implied by payments to retirees exceeding contributions by employers and employees, $87.8 billion, represents only 2.4% of the estimated $3.6 trillion in assets. It isn’t nearly so simple, however.

The funding status of a pension system is determined by comparing the value of the invested assets to the present value of the estimated future payments to retirees. These future payments include estimates for people who have not yet retired. Since most state and local government employee participants in their pension systems are still working, the fact that current investment returns easily cover the deficit between contributions and payments to retirees is irrelevant. For a pension system to be 100% funded, payments into the fund, combined with investment returns earned by the fund, need to ensure that the total assets invested by the fund are equal to the present value of the liability. More on this later.

Wilshire Associates, a global investment advisory firm, performs in-depth analysis of America’s public employee pension systems through research papers that are updated annually. Their most recent reports are a “2014 Report on State Retirement Systems,” which primarily discusses data for the fiscal year ended 6-30-2013, and a “2013 Report on City and County Retirement Systems,” which primarily discusses data for the fiscal year ended 6-30-2012. Taking into account the improvement in the investment markets between June 2012 and June 2013, the weighted average funding ratio of the state and city/county pension systems combined, in accordance with the estimates provided by Wilshire Associates, at the end of June 2013 was 74%.

As previously discussed, the estimated total assets for all state/local pension systems in the United States is $3.6 trillion. Assuming that $3.6 trillion in assets represents 74% of the total pension liability carried by these same pension systems, then the estimated total liabilities for all state/local pension systems in the United States is $4.86 trillion. This means the total unfunded liability for these systems is estimated to be $1.26 trillion.

Table 2 – State/Local Pension Systems as of 3-31-2014
Estimated Assets, Liabilities, and Unfunded Liability ($=B)
20140910_Ring_Pensions-T2b

*   *   *

Funding Status Scenarios – All U.S. State and Local Government Pension Systems:

As part of their analysis of America’s state/local pension systems, Wilshire Associates compiles a “median actuarial interest rate assumption,” representing both the average annual rate of return these systems expect to earn over the next 20-30 years, as well as the discount rate they use to derive a present value for the estimated stream of payments they expect to make to current and future retirees. For both state and local systems, in their “Summary of Findings” in both of their reports, Wilshire Associates estimates this median interest rate assumption to be 7.75%.

As alluded to earlier, to be 100% funded, a pension plan must have invested assets equal to the present value of all future pension payments. For every participating employee, whether they are active or retired, actuaries estimate their salary growth, their year of retirement, their initial pension, their subsequent pension payouts based on COLAs, and their life expectancy. The present value of all these future payments is how much a fully funded pension plan’s assets must be worth.

The rate at which these future payments are discounted per year must be equivalent to whatever rate the pension fund managers believe they will earn interest, on average, over the life of the fund. The theory is that if no future work were performed, and therefore no additional future pension benefits were earned and no additional money was contributed to the fund, the assets currently invested in a fully funded plan would earn enough interest to support every future pension payment until the last participant died of old age.

Since the amount of assets in a pension plan is a known, objective quantity, the debate over how much unfunded liability a plan may have centers on what assumptions are used to estimate the present value of the future payments, i.e., the “Actuarial accrued liability (AAL),” which, as discussed and noted on table 2, is estimated as of 6-30-2013 at $4.86 trillion. In order to assess whether or not that amount is overstated or understated, we can use a short-cut formulated by Moody’s Investor Services in their July 2012 proposal, “Moody’s Adjustments to US State and Local Government Reported Pension Data.”

In order to revalue a pension fund’s liabilities without having access to every actuarial calculation from every fund, what Moody’s does is estimate the midpoint of the future payments stream. They select 13 years into the future, which is quite conservative. Using a longer duration than 13 years will greatly increase the sensitivity of the liability to changes in the projected rate-of-return. As discussed in their July 2012 proposal, here is their rationale:

“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate. For example, a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.

We recognize this duration estimate may be higher than warranted for some plans and lower than warranted for others. Each pension plan has a unique benefit structure and demographic profile that affects the time-weighted profile (duration) of future benefit payment liabilities. However, plan durations are not reported, and calculating duration individually for each plan is not feasible. Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.”

Here is the formula that governs this recalculation of the present value of the liability (“PV”):

Adj PV = [ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years

As made explicit in the above formula, along with duration (years), the other key variable in order to use Moody’s formula to evaluate funding status scenarios, of course, is the “%i,” the discount rate, which is also the rate of return projection. It is worth noting that the discount rate and the rate of return projection don’t have to be the same number. In private sector pension plans, the discount rate is required to differ from the rate of return projection. Private sector pension plans are required to use a lower, more conservative discount rate in order to calculate the present value of their future liabilities in order to avoid understating the present value of the liability. Public sector pension plans have not yet been subjected to this reform regulation, and the rate used to project interest is invariably the same as the rate used to discount future liabilities. This puts enormous pressure on these funds to adopt an aggressively high rate of return projection.

Here are explanations for the various alternative rate of return projections applied in Table 3.

Case 1, 6.2%  –  here is the rationale for this rate-of-return, excerpted from the report “Pension Math: How California’s Retirement Spending is Squeezing The State Budget” authored by Joe Nation, a Ph.D., Stanford Institute for Economic Policy Research, and former California Democratic assemblyman: “This 6.0 to 6.5 percent figure is based on the performance of a hypothetical fund containing 80 percent equity and 20 percent income instruments between 1900 and 1999. It assumes an equity rate based on the 20th-century Dow Jones industrial annual average of 5.3 percent, plus 2 percent in dividends, less 0.5 percent in fees. Combined with income instruments with a net rate of return of 4.5 percent, this hypothetical fund would have earned an average annual rate of 6.2 percent.”

Case 2, 4.33%  –  the rationale for this rate-of-return comes from Moody’s Investor Services “Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013: “For adjustments to pension data, Moody’s will use the Citibank Pension Liability Index (Index) posted on the date of the valuation instead of its original proposal to apply a single rate for all plans each year.” Citigroup Pension Discount rate as posted by the Society of Actuaries in July 2014 was 4.33%.

Table 3, below, shows how much the unfunded liability for all of America’s state/local pension systems will increase based on various alternative rate-of-return projections, all of which are lower than the official composite rate of 7.75% currently used by America’s state/local pension funds. As can be seen, if a rate of 6.20% is used, reflecting the historical performance of U.S. equities, the total liability for America’s state/local pension systems rises from $4.86 trillion to $5.87 trillion; the unfunded liability rises from $1.26 trillion to $2.27 trillion; the funding status declines from 74% to 61%.

If the relatively risk-free rate of 4.33% is used, reflecting Moody’s recommendation to adhere to the Citibank pension liability index rate, the total liability for America’s state/local pension systems rises from $4.86 trillion to $7.39 trillion; the unfunded liability rises from $1.26 trillion to $3.79 trillion; the funding status declines from 74% to 49%.

Table 3 – State/Local Pension Systems as of 3-31-2014
Estimated Unfunded Liability Using Various Discount Rate Projections ($=T)
20140910_Ring_Pensions-T3c

Please note the above table can be downloaded here [1]. It is a useful tool for quickly estimating how much the unfunded liability may increase for any pension fund if the projected rate of return is lowered from the official rate. In this table, and on the spreadsheet, the yellow highlighted cells represent assumptions, and require input from the user. The green highlighted cells depict key results from the calculations.

*   *   *

Observations and Recommendations

The data gathered for this study, combined with reasonable assumptions, allows one to estimate the pension fund assets for the total state and local government pension systems, combined, to equal $3.6 trillion, with an attendant liability of $4.86 trillion. In turn this means the total unfunded liability for these pension systems is estimated at $1.26 trillion. Using formulas provided by Moody’s investor services, one may apply lower rate-of-return assumptions to the official total liability estimate, and calculate how much the liability – and unfunded liability – will increase based on lower projected returns. While none of these various estimates can be considered precise and indisputable, the credibility of the source data and formulas strongly suggest they are reasonably accurate.

Not beyond serious debate, however, are financial questions and policy issues relating to pensions that are of critical importance to the solvency of America’s state and local governments. For example, even if the 74% funded ratio is accurate, it is a best case scenario that still raises troubling questions. Because the $183 billion in reported annual contributions must include not only the “normal contribution,” representing the present value of future pensions earned by workers in the most recent fiscal year, but also the “unfunded contribution,” the catch-up payment designed to pay down the unfunded liability. Even if the total unfunded liability for all of America’s state/local government pension systems is only $1.26 trillion, to eliminate the underfunding over 20 years at 7.75% interest would require annual payments of $126 billion per year. That would leave only $63 billion to cover the normal payment.

Although consolidated contribution data that breaks out the normal and unfunded contributions separately is not readily available for America’s state/local government pension systems, it is possible to impute the normal contribution – an exercise that leaves wide latitude for interpretation. Nonetheless, in a 2013 study, “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County,” the California Policy Center did just that. The worksheet showing the assumptions and formulas can be downloaded here, ref. the tab “normal contribution (imputed).” As it is, assuming 16 million full-time equivalent active state/local government workers, accruing pension benefits at an aggregate rate of 2.0% of final payroll per year worked – keeping the rate-of-return assumption at 20 years, the imputed normal contribution is $120 billion per year. [2] By this logic, the total contribution of $183 billion is inadequate. The normal contribution of $120 billion plus the unfunded contribution of $126 billion suggests an adequate contribution should be $246 billion per year.

To summarize the immediately preceding paragraphs, if one continues to assume these funds will earn 7.75% per year, annual contributions were $67 billion short of the $246 billion total necessary to pay not only the normal contribution, but enough of a catch-up “unfunded contribution” to restore 100% funded status within 20 years. Aspiring to at least do this much is crucial, because the 7.75% rate-of-return projection may not be achieved. As already shown, the amount of a pension system’s liability is highly sensitive to the assumed rate of return. So are the normal and unfunded contributions. Here is the impact of lower rates of return on those payment estimates:

On Table 3, above, the impact of a 6.2% rate-of-return projection is shown to increase the unfunded liability from $1.26 trillion to $2.27 trillion, and lower the funded ratio from 74% to 61%. Using the tools and assumptions summarized in the preceding paragraphs, the impact of a 6.2% rate of return – representing the historical performance of U.S. equities over the past 60 years – on the unfunded contribution is to increase it from $126 billion to $201 billion; the normal contribution increases from $120 billion to $176 billion. Put another way, if realistic repayment terms are adopted for the unfunded liability, at a rate-of-return of 6.2% the total required contribution for America’s state/local government pension systems could rise from the current $183 billion to $377 billion.

Similarly, at a hopefully risk-free rate-of-return of 4.33% (the July 2014 Citibank Pension Liability Index Rate recommended by Moody’s), the normal contribution estimate rises to $281 billion and the unfunded contribution estimate rises to $287 billion – a total of $586 billion vs. $183 billion being actually contributed today.

These figures are not outlandishly inflated. They merely indicate how extraordinarily sensitive pension fund solvency is to rate-of-return projections, and how perilously dependent pension funds are on investment returns.

This, again, brings up the most salient question of all: What rate of return is truly achievable over the next 2-3 decades?

To at least recap this economic debate is necessary because this one assumption is central to policy decisions of extraordinary significance. If the optimists are right, rates-of-return will rise into the high single-digits and stay there, rendering pensions financially sustainable. The states and locales who offer them can therefore keep their contributions flat and allow a few more good years in the market to wipe out their unfunded liabilities. If the pessimists are correct, rates-of-return are going to shrink into the low single digits and stay there, making aggressive paydowns of a swollen unfunded liability a mandatory proposition. Required contributions will rise to untenable levels, crowding out other government services, causing taxpayer revolts, union lawsuits, and a string of bankruptcies.

The case for pessimism – or realism – is strong. Economic growth over the past 30 years has been fueled by debt accumulation; economic growth creates profits, profits create stock appreciation. Debt accumulation stimulates consumption, low interest rates stimulate purchases of real estate and durable goods, driving prices up. Debt accumulation and easy credit causes an asset bubble, and asset bubbles create collateral for additional debt. Total market debt in the U.S. is now higher than it was in 1929, immediately before the great depression. We are at the point now where there is no precedent in economic history that enables us to assume we can continue to use debt to stimulate economic growth.

The other economic headwind facing investments is the aging population. In 1980, 11% of the U.S. population was over 65. By 2030, over 22% of the U.S. population will be over 65. This means that compared to 1980, when America’s current era of of debt accumulation began, by 2030 there will be twice as many people, as a percentage of the U.S. population, selling assets to finance their retirements. The impact of so many sellers in the markets, combined with interest rates having now fallen to near zero – meaning a primary method to stimulate debt formation has been exhausted – will at the very least take the growth out of asset bubbles, if not cause their collapse. The state/local pension funds, based on current data as presented here, are already net sellers in the markets. All of this augers poorly for returns-on-investment. And while, as noted in the next paragraph, America’s economy remains extraordinarily resilient, especially compared to the rest of the world, a collapse of collateral values would trigger a global financial meltdown, and that would take America down with it.

The case for optimism is not unfounded. To stave off recession, or worse, the U.S. has pursued a policy in recent years of injecting trillions of dollars of new money into the system through massive Federal Reserve Bank intervention. But the only way this impetuous gambit can backfire is via a global loss of confidence in the U.S. currency. Despite wails of panic from predictable quarters, that isn’t likely, since every other central bank in the world is playing the same game, with less success. The largest currency group apart from the U.S. dollar is the Euro, and the Eurozone, unlike the U.S., faces a demographic crisis that is genuinely alarming, and their debt burden combined with their level of structural entitlements is much worse than in the U.S. China’s economy is far more dependent on trade, they face a demographic crisis similar to Europe’s, their society is the most likely among the major economies to experience social upheaval in the future, their real estate bubble is worse than in the U.S., and despite the opacity of their banking system, their debt burden is quite likely more severe than in the U.S. Japan is still reeling from a generation of deflation and crippling debt. No other currencies are supported by economies that are big enough to matter. Especially since the energy boom began in the U.S., no other country has anywhere near America’s capacity to domestically source raw materials and manufactured goods for export. The U.S. is basically daring the world to depreciate the dollar, because currency depreciation might actually help the U.S. economy more than it would hurt.

And so the debate over realistic rates of return rages on.

There is another question, however, which considers not the economic issues, but the issue of equity and fairness. A recently published book “Capital in the Twenty-First Century,” by Thomas Piketty, has become a favorite among leftist intellectuals who provide thought leadership for, among others, the public sector unions who control most public sector pension fund boards and who advocate tenaciously for keeping pension benefits as they are. Piketty makes the following claim:

“The rate of capital return in developed countries is persistently greater than the rate of economic growth, and that this will cause wealth inequality to increase in the future.”

Piketty is certainly correct that the rate of capital return exceeds the rate of economic growth. But his moral arguments fail when it comes to public sector pensions. Because public sector pensions have provided the means whereby public sector employees are granted immunity from the very forces that Piketty is arguing have empowered the oligarchy at the expense of ordinary workers. Public sector pensions have essentially creating a common cause between government workers and the oligarchy they allege is exploiting ordinary workers. This point cannot be emphasized enough. Government workers, through their pension funds, benefit from all policies designed to elevate asset values, including bubble levels of asset appreciation, because that is essential to the solvency of their funds. Their interests are aligned with those of central bankers, international corporations, and individual billionaires, whose self-interests impel them to support policies to keep interest rates artificially low, heap additional levels of debt onto the economy despite diminishing returns, and push asset values to even higher, more unsustainable levels. Because to stop doing that will crash these pension funds.

Is it equitable for government sponsored investment entities to control over $3.6 trillion in market investments, investments made in an economic environment which, if successful, perpetuates the gains of productivity flowing disproportionately to the wealthy elite, yet which, when unsuccessful, hits up taxpayers to cover the losses?

When considering solutions to both the financial challenges and issues of equity and fairness surrounding public sector pensions, it is important to understand that even if these systems are able to recover fully funded status based on surprisingly good and sustained market performance, it does not follow that their performance is something that can be extended to the entire population, because if so, instead of 20% of the retired population funding their retirement income through selling assets on the markets, 100% of the retirement population would be doing so, exerting far more downward pressure on asset values.

A relevant question to ask is therefore whether or not pension systems that are funded by taxpayers and bailed out by taxpayers should be investing in the market at all – why aren’t government employee pensions funded through a combination of low risk investments such as T-Bills and contributions from current workers?

The example of Social Security provides several instructive points which should be considered in any discussions of pension reform, or the larger question of what the government’s role should be in providing financially sustainable retirement security to Americans. Social Security, unlike state/local government worker pensions, has a positive cash flow. As seen here from this table on their website “Fiscal Year Trust Fund Operations,” during 2013 Social Security collected $851 billion from active workers and paid out $813 billion, primarily to retirees. The so-called Social Security “Trust Fund” had a balance at the end of 2013 of $2.76 billion.

If public sector pensions are indeed facing serious, potentially fatal financial challenges, they should consider adopting five elements from Social Security:

(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 (tied up in court by the unions) 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.

These suggested reforms are meant to be taken to evolve defined benefit pensions into a plan that provides a minimal level of retirement security. The government should not be in the business of providing retirement benefits to anyone, private or within government, that go beyond providing a minimal safety net. The government certainly shouldn’t be in the business of providing pensions to government employees that are many times better than what they provide to private citizens in the form of Social Security. And the government, or government employees through their union controlled pension funds, should not be playing the market with $3.6 trillion of taxpayer sourced dollars, then forcing taxpayers to bail out these funds when they don’t meet projections.

A unique and elegant way to provide equitable, minimal, government administered and financially sustainable retirement security to all American’s would be to immediately require all active government workers to join Social Security. These workers, and retirees, would keep whatever pension benefits they’d qualified for so far, subject to reductions per the five options just noted in order to preserve solvency for the fund. They would begin to pay into the Social Security system, with the employer contribution into their pension funds proportionally reduced to make it an expense-neutral proposition. Since government workers are relatively highly compensated compared to private sector workers, the participation, for example, of 16 million active state/local government workers would immediately improve the solvency of the Social Security Fund. The five options available to preserve Social Security, as noted above, would be far less onerous in their implementation over the coming decades if tens of millions of highly compensated government workers were to participate. And since their unions purportedly speak for the common man, they should have no objection to the highly compensated among them getting less back in retirement than those less fortunate.

Who knows, maybe the much vaunted, potentially real Social Security “Trust Fund” assets could be used to purchase Treasury Bills. Such a policy would have the twin virtues of taking pressure off the federal reserve, and augmenting Social Security collections with modest investment returns.

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

*   *   *

FOOTNOTES

(1) The tables in this study are all found on this spreadsheet, State-and-Local-Pension-Liability.xlsx. The spreadsheet also contains additional notes on the assumptions used, as well as links to the source data.

(2)  To estimate a fund’s required normal pension contribution using the Impact-of-Returns-and-Amortization-Assumptions-on-Pension-Contributions.xlsx spreadsheet, “normal contribution (imputed)” spreadsheet, the assumptions used and referenced above were as follows:
–  Average Salary = $70,000
–  % cola growth/yr = 2.0%
–  % merit growth/yr = 1.0%
–  avg years till retire = 17
–  proj % discount (fund’s assumed annual rate of return) = 7.75%
–  base year 2000+ = 11
–  avg years retired = 20
–  pension formula/yr = 2.00%
–  pension cola % = 2.0%
–  elig # workers = 16,000,000
Please note this spreadsheet does not default to these values. They have to be entered in the yellow highlighted input cells. The spreadsheet is designed to calculate results for whatever set of assumptions the user wishes to enter. This spreadsheet also contains tabs, similarly highlighted with yellow to denote cells to input user assumptions, to recalculate estimates for the unfunded liability and the unfunded contribution. On this spreadsheet, as noted above, there are tools to recalculate the normal contribution based on having that information, or imputing it if that information is not available.

The Case for Adjustable Defined Benefits

Notwithstanding the fact that “adjustable defined benefits” might constitute an oxymoron, as a concept it represents the only way that defined benefit plans can be sustained. Rather than throwing new employees into individual 401K plans, while they effectively subsidize legacy defined benefits for veteran employees and retirees, why not adjust defined benefits down to a financially sustainable level and let everyone participate?

Let’s set aside for a moment the debate over whether or not defined benefit plans are just fine the way they are, and can survive with merely incremental refinements – eliminating spiking, raising contributions a bit, bumping the retirement age a few years. Those solutions buy time, but unless the investment market roars for another 30 years, they will not solve the problem. And in the context of equitable policy, that debate is moot, because if these plans are just fine, than nobody should object to reforms that will make benefits adjustable if and when they are no longer fine.

Three good examples of how adjustable defined benefits can be implemented are the proposed “Government Employee Pension Reform Act of 2012,” an California citizen’s initiative proposed by pension reformer Dan Pellissier that failed to qualify for the ballot, the City of San Jose’s “Measure B, Public Employee Pension Plan Amendments,” passed overwhelmingly by voters in 2011 and currently deadlocked by union court challenges, and the “Fifth Amended Plan for the Adjustment of Debts of the City of Detroit,” submitted to the court on July 25, 2014.

Here are summaries of what these plans do:

California’s proposed 2012 initiative, the Government Employee Pension Reform Act of 2012, would have allowed emergency changes – adjustments – to pension benefits if the pension system was deemed to be less than 80% funded. It would limit employer contributions to 6.0% of payroll for non-safety and 9.0% for safety, then add an additional employer contribution (approx. another 6.0%) to match what an employer would be required to contribute to social security. It then would have required employees to either contribute through withholding the balance of necessary funding required to maintain pension fund solvency, or participate in a new benefit plan as defined for new hires if they didn’t want to increase their pension contributions.

San Jose’s 2011 Measure B would gradually increase current employee pension contributions to 16% of pay, and offer “Voluntary election plan” (VEP) for current employees who don’t want to pay 16% for their pension. This plan limits – adjusts – an employee’s pension accrual for future years of service to 2.0% of final compensation times years worked and gradually raises age of retirement eligibility to 57 for safety and 62 for non-safety personnel. Measure B also revised the defined benefits for new employees to cap city contribution to 50% of plan cost or 9%, whichever is less, raised the retirement age to 60 for safety and 65 for non-safety personnel, and capped pension benefits at 65% of final compensation. It then authorized the city to suspend cost of living adjustments if the city declares a “fiscal emergency.”

Detroit’s proposed solution to their pension challenges takes place against a dire backdrop of economic and demographic implosions decades in the making and unlikely to ever confront a major California city. But the “triggers” they built into their revived plan, which retains defined benefits, provide useful ideas for Californians. Reviewing the “New GRS Active Pension Plan – Material Terms” (above link, page 58-59, item 12), the plan calls for implementing “risk shifting levers” at any time the funding level goes below 100%. They include, in order of application, and for as long as necessary, (1) no COLAs will be paid, (2) employee contributions will increase by 1% to 5% of base compensation, (3) most recently awarded COLAs will be rescinded, and (4) the benefit accrual rate will be decreased from 1.5% to 1%.

To reiterate: If defenders of California’s 83 public employee defined benefit systems are confident that incremental reforms as previously noted are sufficient to guarantee the financial solvency of these plans, then they should make no objection to permitting more drastic means – that effectively make defined benefits adjustable – should incremental reforms be insufficient.

Saving the defined benefit by introducing flexibility to the formulas accomplishes important goals. It protects taxpayers. It allows new employees to also have a defined benefit plan. It ensures veteran employees and retirees that the plan will never collapse completely in a financial downturn, leaving them with nothing. As an element of retirement security, a defined benefit system, because it pools the ongoing investments of thousands of participants, provides insurance against market downturns, as well as against unanticipated individual longevity. Anyone relying on an individual 401K must live with the dismal hope there will not be a severe bear market during their retirement, and that they die before they run out of money. The most compelling reason to advocate individual 401K plans for government workers is to protect the taxpayer. Making defined benefit plans modest and adjustable solves that problem in a more elegant way, but it may be naive to hope stakeholders can negotiate the necessary adjustment triggers in good faith, and implement them with integrity in the long run.

The best retirement security plan of all, implemented already for federal employees, and originally advocated by Gov. Brown before he settled for the decidedly incremental AB 340, is the “three legged stool.” That is (1) a modest – and adjustable – defined benefit, (2) a contributory 401K, and (3) Social Security. Requiring high income government workers participate in Social Security, because of its progressive benefit formulas that penalize higher income workers vs. lower income participants, would go a long way towards further stabilizing that system.

*   *   *

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

Evaluating Total Unfunded Public Employee Retirement Liabilities in 20 California Counties

Summary:  Using officially reported figures from the most recent financial statements available, this report calculates the total unfunded employee retirement liabilities for the 20 California counties with their own independent retirement systems. This study is the first of its kind to compile for these counties not only reported pension fund assets and liabilities, but also retirement health care assets, if any, and their corresponding liabilities, as well as the outstanding balances for any pension obligation bonds.

This composite data, reported for each county both as a funding ratio and as a numerical value for the net liability, incorporates all assets and liabilities associated with retirement obligations to public employees. To-date, most reports focus on the unfunded pension liability, ignoring the amount of the unfunded healthcare liability and the outstanding balance owed on pension obligation bonds. But these other liabilities are of comparable value, and are offset with far fewer invested assets, if any. For taxpayers and policymakers to properly understand and cope with the financial challenges facing their counties, this information is vital.

As it is, these 20 counties combined have a population of 29.3 million, constituting 77% of Californians. Their total unfunded pension liability, based on their most recent financials, is $37.2 billion. Their total unfunded retirement liabilities, also based on officially reported amounts in their most recent financial statements, but also including pension obligations bonds and unfunded healthcare liabilities, is $72.3 billion. As a percentage, their total funded ratio just for pensions (assets as a percent of liabilities) is 74%. Their total retirement funding percentage, taking into account pensions, healthcare, and pension obligation bonds, is only 60%.

This total obligation, $7,369 per household vs. $3,932 if you only include pension funds, is a daunting amount. But it is based on official rates of return of 7.5%, which as explained further in this study, if not attained, will result in far higher calculations of underfunding for pensions – at a 5.5% discount rate, for example, the funded ratio for these 20 counties drops to 49%. And, of course, it only represents the costs for county workers – within these counties, taxpayers are also responsible for the unfunded pension and healthcare liabilities – and retirement related bond debt – for those working for the local cities, as well as all workers within their counties who are employed by public schools, local colleges and universities, other public agencies, and the state.

*   *   *

INTRODUCTION

The concept of “total compensation” has become increasingly recognized as the only accurate way to assess whether or not public employee compensation is either affordable or equitable. Instead of just reporting base pay, total compensation calculations look at all types of direct pay including “credential pay,” “specialty pay,” “bilingual pay,” “advanced degree pay,” “tuition reimbursement,” etc., along with overtime pay, and along with the costs for all employer paid benefits including current health insurance coverage. “Total compensation” calculations also include current year contributions made by an employer towards an employee’s retirement benefits – namely, health insurance and pensions.

“Total compensation,” as it turns out, often exceeds “base pay” by a factor of 100% to 200%.

Discussions of unfunded liabilities for retirement benefits must undergo a similar examination. To-date, the primary topic of debates and discussion over the size of unfunded liabilities regards pensions, and on what discount rate to use to calculate the present value of the employer’s future retirement pension obligations.

This debate is ongoing and of critical importance – to use very rough numbers, each 1.0% drop in the projected rate-of-return for a typical pension fund can increase the required annual contribution by roughly 10% of payroll. Similarly, using very rough numbers, as documented in a February 2013 CPC study entitled “How Lower Earnings Will Impact California’s Total Unfunded Pension Liability” – using formulas provided by Moody’s Investors Services for this purpose, and data provided by the California State Controller. Bearing in mind that a relatively small change to the total liability may result in a very large change to the net unfunded liability – here is the impact of changes to the projected rate of return on the total unfunded liability for all of California’s public employee pension systems combined using annual report data from 6-30-2012:

Official total unfunded pension liability at assumed rate-of-return of 7.5% = $128 billion.

Official total unfunded pension liability at assumed rate-of-return of 6.2% = $252 billion.

Official total unfunded pension liability at assumed rate-of-return of 5.5% = $329 billion.

Official total unfunded pension liability at assumed rate-of-return of 4.5% = $450 billion.

*   *   *

TOTAL UNFUNDED PUBLIC EMPLOYEE RETIREMENT LIABILITY

The purpose of this study is not to present the consequences of lower rates of return, but instead to calculate – using the officially recognized composite rate of return of 7.5% – what the total unfunded public employee retirement liability is, using information provided by independent pension systems serving select California counties. There are 20 counties that administer their own independent pension systems under the “County Employee Retirement Law;” this study draws on information provided in the Consolidated Annual Financial Reports for these counties, as well as in the County Employee Retirement Systems annual Actuarial Valuation reports.

Using official numbers has the virtue of being relatively beyond debate – when using the official projections, the only question anyone should be asking is how much higher these numbers may be using lower estimated rates-of-return. But total public unfunded employee retirement liabilities do not just include unfunded pension liabilities, they also include unfunded retirement health insurance liabilities – the so-called “OPEB” (Other Post-Employment Benefits). Total unfunded public employee retirement obligations must also include the outstanding balances on Pension Obligation Bonds – balance sheet debt, usually long-term that was entered into by cities and counties in order to raise cash to make their required employer pension contributions to their pension funds.

By combining all three sources of liability for retirement obligations, a far more accurate picture of just how much taxpayers owe – even at the official rate-of-return projections which may turn out to be far too optimistic. By matching these liabilities against the assets on hand – pension fund assets and in some cases OPEB fund assets – the next table shows the true “unfunded” ratio for the 20 CERL counties.

Table 1 – Total Unfunded Retirement Liability per CERL Counties ($=Millions)

20140506_Churchill-Monnett_1

Showing this number adds a sobering perspective to the discussion of unfunded retirement liabilities. The counties on the above table are ranked with those counties having the worst funded ratios appearing first. As can be seen, there is a wide variation between the worst, Merced, where less than half the necessary amount to fund already earned pension and retirement healthcare benefits has actually been set aside, and Tulare, which is has a healthy 87% funded ratio.

It is important to emphasize that all these numbers reflect officially recognized liabilities. It would be instructive to provide data on just how much these unfunded liabilities will swell if any sort of projection is made based on lower rates of return. Here’s the formula that Moody’s Investor Services provided to revalue the present value of pension liabilities from the common 7.5% rate of return projection based on using a more conservative rate of 5.5%:

[ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years  =  Adj PV

Here, plugging into the formula the official total pension liability for all 20 CERL counties of $143 billion, is how much it grows at the lower discount rate of 5.5%:

[ 143.2 x ( 1 + 7.5% ) ^ 13 ]  /  ( 1 + 5.5% ) ^ 13  =  182.8

Collectively, for the CERL counties, using this formula to apply the more conservative discount rate of 5.5%, their estimated pension liabilities grow from $143.2 billion to $182.8 billion, which means their estimated funded ratio for pensions (not including pension obligation bonds) drops from 74% to 58%. Put another way, since the unfunded pension liability is equal to the total assets less the estimated pension liabilities, by using the more conservative discount rate of 5.5%, they more than double, from $37.3 billion to $76.8 billion. The 20 CERL pension systems have had similar earnings rate during this period. The potential for surprises like this should not be lightly dismissed. In spite of recently reported good results, note that 5.5% is in fact the cumulative investment rate of return earned by CalPERS during the 13 years from 2001 to 2013.

[Note: This recent CPC study “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County,” provides a tutorial, including a downloadable spreadsheet, explaining how use Moody’s pension analysis formulas to analyze any typical public sector pension fund.] 

*   *   *

PAYING DOWN THE TOTAL UNFUNDED RETIREMENT LIABILITY

Another way to explain the significance of the total unfunded retirement liability would be to describe what repayments would be based on the goal to achieve 100% funded status in 20 years. The next table shows these payments as a percent of their respective county budgets, using 2012 budget data compiled from publicly available information by the website PublicSectorCredit.org.

The order of the counties on this table are ranked with the worst counties, i.e., those with the highest payments on their unfunded liability as a percent of revenue listed first. Even though Los Angeles County has only the 2nd lowest unfunded liability, at 51%, 2nd to Merced County at 47%, Los Angeles County’s unfunded liability as a percent of their annual budget is actually greater.

As shown in the 3rd column “Liability as Multiple of Revenue,” Los Angeles County’s officially recognized total retirement liability is 2.37 times their entire annual revenue. As a payment calculated to bring the county to 100% funding by 2034, they would have to make an unfunded “catch-up” payment each year equivalent to 23% of their annual revenue.

Table 2 – Unfunded Payment as Percent of Revenue per CERL Counties ($=Millions)

20140506_Churchill-Monnett_2b

As can be seen in the above table, these so-called “unfunded payments,” for which reforms to-date do not require public employees to bear any share of payment on via payroll withholding, will themselves consume a significant portion of the entire budget of many counties – if serious attempts are made to actually achieve 100% funding. And without 100% funding, the pool of invested assets is too small to prevent the unfunded liability from growing further even if rate-of-return projections are fulfilled. Here’s why:

In the projections shown on the above table, a 7.5% rate of interest is used – this rate represents the opportunity cost of not having 100% funding. For example, Ventura County has a funded ratio of nearly 80%, purportedly the threshold for a “healthy” fund. But because they are earning money on invested assets that only amount to 80% of the present value of their estimated retirement liabilities, if all they do is earn 7.5% in a given year, their unfunded liability will grow. Because to 7.5% earnings on a 100% funded plan is equivalent to 9.4% earnings on an 80% funded plan. And so it goes.

While the math behind all of this may only seem obvious to those who understand financial concepts and are proficient at algebra, the point of it all should be obvious to everyone: For the CERL counties to improve their funded ratio for their total retirement obligations, which collectively – using officially reported numbers – is already only 60%, they will have to make annual unfunded payments that will by themselves consume a significant portion of their budgets, in addition to the normal funding contributions for new benefits earned in any given year.

*   *   *

THE IMPACT OF THE TOTAL UNFUNDED RETIREMENT LIABILITY ON INDIVIDUAL TAXPAYERS

The next chart lists the number of households and the population of each of the 20 CERL counties, using estimated 2013 figures provided by the U.S. Census Bureau. The ranking again finds Los Angeles County at the top of the list. The officially recognized unfunded liability per household for Los Angeles County is a whopping $12,123; the payment per household to eliminate this unfunded liability by 2034 is $1,190 – one may reliably surmise that the payment per taxpaying household to be considerably higher. As noted already, this liability refers only to the county workers – every resident and taxpayer also carries the prorated burden of unfunded liabilities for the local and state government employees who work in their cities, their schools, and state agencies.

Table 3 – Unfunded Liability and Payment per Household per CERL Counties ($=Millions)

20140506_Churchill-Monnett_3

Properly calculating the entire unfunded retirement liability for California’s citizens, or performing what-if analysis based on what may happen to that liability if rate-of-return projections are lowered, was not the intention of this study, but bears a final point: As shown on Table 1, the total unfunded liability for all retirement obligations is only 60% funded using official discount rates. If the pension liability is revalued at the lower 5.5% discount rate, the estimated total retirement liability swells from $179 billion to $218 billion, the estimated unfunded liability grows from $72 billion to $112 billion, and the funded ratio drops from 60% to 49%.

The CERL counties, with their independent pension systems, provide an excellent means to distill the nature of the problem to very specific and easily documented numbers and calculations. The concept of total retirement obligations, incorporating not only unfunded pension liabilities, but also debt outstanding on pension obligation bonds, and unfunded retirement healthcare obligations, yields a far more ominous profile of financial ill health than merely focusing on pensions. But it is the only accurate way to assess the cost taxpayers truly face.

*   *   *

About the Authors:

Ken Churchill is 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. 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, Churchill 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. Churchill is currently running for supervisor, 4th district, in Sonoma County.

Bill Monnet is a board member of Citizens for Sustainable Pension Plans in Marin County.   He has an MA in Political Science from UC Davis and an MBA in Finance from UC Berkeley. Monnet was briefly an adjunct Professor of Public Administration and then spent 24 years in Silicon Valley in various management positions at IBM, Siemens and Cisco Systems. His work experience includes positions in finance, service & manufacturing operations, demand forecasting and failure analysis. He says that his varied experiences have proved surprisingly effective in understanding the counterintuitive world of public finance.

Ed Ring is the executive director for the California Policy Center. Previously, as a consultant and full-time employee primarily for start-up companies in the Silicon Valley, Ring has done financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

*   *   *

FOOTNOTES

(source data for counties listed in alphabetical order)

Alameda County

Pension Assets and Liabilities:
Alameda County CAFR 6-30-2013, Liabilities and Actuarial Value of Assets see page 64.
http://www.acgov.org/auditor/financial/cafr12-13.pdf
Alameda Employee Retirement Association Actuarial Valuation Report for 12-31-2012, Market Value of Assets see page viii.
http://www.acera.org/post/actuarial-reports

Pension Obligation Bonds (balance as of 6-30-2013):
Alameda County CAFR 6-30-2013, Outstanding Long-Term Obligations, pages 17 & 56.
http://www.acgov.org/auditor/financial/cafr12-13.pdf

Retirement Healthcare Assets and Liabilities (actuarial valuation  as of 12-31-2012):
Alameda County CAFR 6-30-2013, Outstanding Long-Term Obligations, pages 67, 70.  Alameda County has 2 separate OPEB programs:  retiree medical benefits program and a COLA + death benefit program.  The assets & liabitlies reported here are for both programs.
http://www.acgov.org/auditor/financial/cafr12-13.pdf

Contra Costa County

Pension Assets and Liabilities:
Contra Costa County CAFR 6-30-2013, Actuarial Value of assets & liabilities page 95.
http://www.co.contra-costa.ca.us/DocumentCenter/View/28970
Contra Costa County Employee Retirement Association Actuarial Valuation 12-31-2012, Actuarial & Market value of assets page 5.
http://www.cccera.org/actuarial/Actuarial Val Report 2012.pdf

Pension Obligation Bonds (actuarial valuation as of 6-30-2013):
Contra Costa County CAFR 6-30-2013, 10. Long-Term Obligations, “Pension Bonds Payable,” page 80
http://www.co.contra-costa.ca.us/DocumentCenter/View/28970

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 01-01-2012):
Contra Costa County CAFR 6-30-2013, Schedule of Funding Progress, Other Postemployment benefits “Actuarial Accrued Liability,” pages 98 and 106. Note the CAFR reports the value of OPEB Assets as $114,599 as of 06-30-2013 but does not report the corresponding liability on that date. In order to have a fair matching of assets with liabilities at the same point in time I have reported the 01-01-2012 numbers.
http://www.co.contra-costa.ca.us/DocumentCenter/View/28970 

Fresno County

Pension Assets and Liabilities:
Fresno County Employees Retirement Association Actuarial Valuation 6-30-2013 [actuary = Segal], page vi.
http://www2.co.fresno.ca.us/9200/Attachments/Agendas/2014/011514/Item 27 011514 Actuarial Valuation Report as of June 30 2013.pdf 

Pension Obligation Bonds (balance as of 6-30-2013):
Fresno County CAFR 6-30-2012, POBs outstanding page 117.
http://www2.co.fresno.ca.us/0410/CAFR/CAFR2013.pdf 

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):
No OPEB liabilities, assets or program is reported in the CAFR.

Imperial County

Pension Assets and Liabilities:
Imperial County Employees Retirement System Actuarial Valuation 6-30-2013, page v.

Pension Obligation Bonds (balance as of 6-30-2013):
Imperial County CAFR 6-30-2012, Note 8: Long Term Debt, page 41.
http://www.co.imperial.ca.us/Budget/GeneralPurposeFinancialStatements/2013Financials.pdf

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):
Imperial County CAFR 6-30-2012, Note 11: OPEB, page 46.
http://www.co.imperial.ca.us/Budget/GeneralPurposeFinancialStatements/2013Financials.pdf

Kern County
Pension Assets and Liabilities:
Kern County Employees Retirement Association Actuarial Valuation 6-30-2012, page vi.
http://www.kcera.org/pdf/Actuary/2012_valuation_report.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
Kern County CAFR 6-30-2013, page 61.
http://www.co.kern.ca.us/auditor/cafr/13cafr.PDF

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2012):
Kern County CAFR 6-30-2013, page 107. This includes the liabilities for both the Retiree Health Premium Supplement Program and the Retiree Health Stipend.
http://www.co.kern.ca.us/auditor/cafr/13cafr.PDF 

Los Angeles County

Pension Assets and Liabilities:
Los Angeles County Employee Retirement Association Actuarial Valuation 6-30-13 [actuary = Milliman], page 11.
http://www.lacera.com/investments/inv_pdf/actuarial_valuation.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
Los Angeles County CAFR 6-30-2013. No POBs are reported in the CAFR.

Retirement Healthcare Assets and Liabilities (balance as of 7-1-2012):
Los Angeles County CAFR 6-30-2013, Other Postemployment Benefits, Retiree Health Care, page 122
http://file.lacounty.gov/auditor/portal/cms1_208825.pdf  

Marin County

Pension Assets and Liabilities:
Marin County Employees Retirement Association Actuarial Valuation 6-30-13, page 5.
http://egovwebprod.marincounty.org/depts/RT/main/reports/valuations/actuarialvaluationreport2013-06-30.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
Marin County CAFR 6-30-2013, Note 8, Long-Term Obligations, Pension Obligation Bonds, page 54
http://www.marincounty.org/depts/df/~/media/Files/Departments/DF/2013_Marin%20CAFR.pdf

Retirement Healthcare Assets and Liabilities (balance as of 7-1-2013):
Marin County CAFR 6-30-2013, Schedule of Funding Progress Postemployment Healthcare, “AVA,” “AAL,” page 64
http://www.marincounty.org/depts/df/~/media/Files/Departments/DF/2013_Marin%20CAFR.pdf

Mendocino County

Pension Assets and Liabilities:
Mendocino County Employees Retirement Association Actuarial Valuation 6-30-2013, page vi.
http://www.co.mendocino.ca.us/retirement/pdf/063013Valuation.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
Mendocino County CAFR 6-30-2013, Note 8: Long Term Liabilities, page 41.
http://www.co.mendocino.ca.us/auditor/pdf/2013_Mendocino_afs_-_FINAL.pdf

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):
Mendocino County CAFR 6-30-2013, Note 12: OPEB, page 48.
http://www.co.mendocino.ca.us/auditor/pdf/2013_Mendocino_afs_-_FINAL.pdf

Merced County

Pension Assets and Liabilities:
Merced County Employees Retirement Association Actuarial Valuation 6-30-2013, pages 2 & 5. http://www.co.merced.ca.us/documents/Retirement/Annual Reports/Valuation 2013 6 30.PDF

Pension Obligation Bonds (balance as of 6-30-2013):
Merced County CAFR 6-30-2013, Outstanding Long-Term Debt, Pension Obligation Bonds, page 14

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):
Merced County CAFR 6-30-2013, page 68.
http://www.co.merced.ca.us/ArchiveCenter/ViewFile/Item/456

Orange County

Pension Assets and Liabilities:
Orange County sponsors a defined benefit pension through OCERS. The OCERS plans are multi-employer plans which include sponsors not related to Orange County (e.g. City of San Juan Capistrano.) Neither the Orange County CAFR nor the OCERS Acturial Valuation separately report pension assets & liabilities by employer. However, Orange County does report that it is the largest employer in OCERS and pays 88% of sponsor payments into the plan. So, Orange County’s pension assets & liabilities are estimated as 88% of total OCERS assets & liabilities.
Orange County CAFR 6-30-2013, pages 145-146.
http://ac.ocgov.com/civicax/filebank/blobdload.aspx?BlobID=33067 
Orange County Employee Retirement Association Actuarial Valuation 12-31-12. Assets & liabilities page viii.
http://www.ocers.org/pdf/finance/actuarial/valuation/2012actuarialvaluation.pdf 

Pension Obligation Bonds (balance as of 6-30-2013):
Orange County CAFR 6-30-2013, short term POBs pages 110-111, long term POBs page 117.
http://ac.ocgov.com/civicax/filebank/blobdload.aspx?BlobID=33067 

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2011):
Orange County CAFR 6-30-2013, OPEB liability pages 155 & 159.
http://ac.ocgov.com/civicax/filebank/blobdload.aspx?BlobID=33067 

Sacramento County

Pension Assets and Liabilities:
Sacramento County CAFR 6-30-2013, Actuarial value of assets & liabilities page 100.
http://www.finance.saccounty.net/AuditorController/Documents/CAFR2013.pdf 
Sacramento County Employees Retirement Association Actuarial Valuation 6-30-2013, Actuarial & Market value of assets pages viii & 6.
http://www.retirement.saccounty.net/Documents/ActualInfo/Actuarial Valuation 2013.pdf

Pension Obligation Bonds (balance as of 6-30-2013 including accreted interest):
Sacramento County CAFR 6-30-2013, Note 9 – Long-Term Obligations, page 74
http://www.finance.saccounty.net/AuditorController/Documents/CAFR2013.pdf 

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2011):
Sacramento County CAFR 6-30-2013, OPEB assets and unfunded liabilities page 102.
http://www.finance.saccounty.net/AuditorController/Documents/CAFR2013.pdf  

San Bernardino County

Pension Assets and Liabilities:

San Bernardino County Employees Retirement Association Actuarial Valuation 6-30-2013, Market value of assets page 5, Actuarial Value of assets & liabilities page 70.
http://www.sbcera.org/Portals/0/PDFs/Actuarial Valuation and Review/2013/13_Actuarial_Valuation_Review.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
San Bernardino County CAFR 6-30-2013, Direct and Overlapping General Fund Obligation Debt, pages 84 & 192.
http://www.sbcounty.gov/atc/pdf/Documents/0000_00_00_178_2012-2013%20CAFR.pdf

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):

San Diego County

Pension Assets and Liabilities:
San Diego County Employees Retirement Association CAFR 6-30-2013. SDCERA is a multi-employer plan. There are 5 participating employers. Separate pension and OPEB results are not reported for each employer. However, it is reported that San Diego County employees represent 95.5% and the Superior Court employees represent anothyer 4.3% of SDCERA members. So, the County owns practically all of SDCERA assets & liabilities and all are attributed here to the County. Pension liabilities and Actuarial Value of Assets page 48. Market Value of Assets page 77.
http://www.sdcera.org/investments_report.htm 
These numbers are also reported in the SDCERA Actuarial Valuation 6-30-13 on page v.
http://www.sdcera.org/PDF/June_2013_valuation.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
San Diego County CAFR 6-30-2013, Taxable Pension Obligation Bonds, page 82, Table 27
http://www.sdcounty.ca.gov/auditor/annual_report13/pdf/cafr1213.pdf 

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2012):
San Diego County Employees Retirement Association CAFR 6-30-2013, page 49.
http://www.sdcera.org/investments_report.htm 

San Joaquin County

Pension Assets and Liabilities:
San Joaquin County Employees Retirement Association Actuarial Valuation 01-01-2013, pages 3 & 16.
http://www.sjcera.org/Pages/index.htm

Pension Obligation Bonds (balance as of 6-30-2013):
No POBs are reported in the CAFR.

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):
San Joaquin County CAFR 6-30-2013, pages 73 & 81.
http://www.sjgov.org/uploadedFiles/SJC/Departments/Auditor/Services/2012-13 SJC Financial Statements Final.pdf

San Mateo County

Pension Assets and Liabilities:
San Mateo County CAFR 6-30-2013, Actuarial Value of assets & liabilities pages 69 & 80. Balances as of 6-30-2013.
http://www.co.sanmateo.ca.us/Attachments/controller/Files/CAFR/2013CAFR.pdf
San Mateo County Employee Retirement Association Actuarial Valuation 6-30-2013 [actuary = Milliman], Market Value of assets page 11. Balance as of 6-30-2013.
http://www.samcera.org/pdf/2013valuation.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
No outstanding POBs are reported in the San Mateo County CAFR.

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):
San Mateo County CAFR 6-30-2013, Funded Status and Funding Progress, “AAL” and “UAAL.” page 71
http://www.co.sanmateo.ca.us/Attachments/controller/Files/CAFR/2013CAFR.pdf

Santa Barbara County

Pension Assets and Liabilities:
Santa Barbara County Employees Retirement Association Actuarial Valuation 6-30-13, page 5.
http://www.countyofsb.org/uploadedFiles/sbcers/benefits/2013 Valuation.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
No POBs are reported in the CAFR.

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2012):
Santa Barbara County CAFR 6-30-2013, OPEb Schedule of Funding Progress, “Actuarial Value of Assets,” “AAL,” page 106
http://countyofsb.org/uploadedFiles/auditor/Publications/1213%20CAFR.pdf

Sonoma County

Pension Assets and Liabilities:
Sonoma County Employees Retirement Association Actuarial Valuation 12-31-2012, pave viii.
http://scretire.org/uploadedFiles/SCERA/Resource_Center/News_and_Updates/2013/ActuarialValuationAsOf12-31-12.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
Sonoma County CAFR 6-30-2013, Long-Term Liabilities, Pension Obligation Bonds, page 20
http://www.sonoma-county.org/auditor/financial_reports.htm
(Click on “2012-2013 Comprehensive Annual Financial Report”)

Retirement Healthcare Assets and Liabilities (balance as of 6-30-2013):
Sonoma County CAFR 6-30-2013, Schedule of Funding Progress, “AVA,” “AAL,” page 111
http://www.sonoma-county.org/auditor/financial_reports.htm
(Click on “2012-2013 Comprehensive Annual Financial Report”)

Stanislaus County

Pension Assets and Liabilities:
Stanislaus County Employees Retirement Association Actuarial Valuation 6-30-2013, page 5.
http://www.stancera.org/sites/default/files/Financials/20130630_Actuarial_Report.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
Stanislaus County CAFR 6-30-2013, Note 11: Summary of Long Term Debt page 74.
http://www.stancounty.com/auditor/pdf/AFR2013.PDF

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 7-1-2012):
Stanislaus County CAFR 6-30-2013, Note 19: OPEB page 91
http://www.stancounty.com/auditor/pdf/AFR2013.PDF

Tulare County

Pension Assets and Liabilities:
Tulare County Employees Retirement Association Actuarial Valuation 6-30-2013, page 1.
http://www.tcera.org/Publications.php

Pension Obligation Bonds (balance as of 6-30-2013):
Tulare County CAFR 6-30-2013. There was no balance due on any POB as of 6-30-2013.
http://tularecounty.ca.gov/auditorcontroller/index.cfm/auditor-controller/financial-reports1/comprehensive-annual-financial-report-cafr/cafr-2012-2013/

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2012):
Tulare County CAFR 6-30-2013, pages 71 & 78.
http://tularecounty.ca.gov/auditorcontroller/index.cfm/auditor-controller/financial-reports1/comprehensive-annual-financial-report-cafr/cafr-2012-2013/ 

Ventura County

Pension Assets and Liabilities:
Ventura County Employees Retirement Association Actuarial Valuation 6-30-13, page vi
http://vcportal.ventura.org/VCERA/docs/publications/Actuarial_Valuation_as_of_June_30_2013.pdf

Pension Obligation Bonds (balance as of 6-30-2013):
No POBs are reported in the CAFR.

Retirement Healthcare Assets and Liabilities (actuarial valuation as of 6-30-2013):
Ventura County CAFR 6-30-2013, page 100
http://www.ventura.org/auditor-controller/comprehensive-annual-financial-report-2013

Evaluating Public Safety Pensions in California

Summary: To accurately assess how much pension obligations for current workers are going to cost, it is necessary to calculate average pensions for retirees who retired after 1999 when pension benefits were enhanced.

Because public safety employees represent about 15% of California’s total state and local government workforce [1], but an estimated 25% of the total pension costs [2], this study focuses on the average pensions for public safety employees.

Public safety retirees who retired after 1999 after working for the city of San Jose, Los Angeles, or the many state and local governments participating in CalPERS, if they worked 25 years or longer, collected pensions and retirement benefits in excess of $90,000 in the most recent fiscal year for which records were available.

Among the three pension systems analyzed, San Jose had the most generous pensions; retired police and fire personnel who retired in the last 10 years, and who worked at least 25 years, earned an average base pension of $100,175 in 2012. Added to this was employer paid health insurance of worth about $10,000 per year. 

In Los Angeles, factoring in the value of the employer provided health insurance, the average post-1999 retiree with 30+ years of service collects a pension and benefit package in excess of $100,000.

In addition to pension and health insurance benefits, Los Angeles, San Diego, and other California cities offer their public safety retirees the “DROP” program, which enables qualifying participants to collect a lump sum payout upon retirement that – at least in Los Angeles – is so substantial it increases the average pension amount of all retirees by over $50,000, despite only being received by less than 3% of LAFFP members during the 2013 year.

*   *   * 

INTRODUCTION

The topic of public sector pensions quite rightly emphasizes the issue of financial sustainability, given the inherent long term nature of pension benefits. Typically these discussions center on a pensions system’s “funding ratio,” which represents the percentage of the fund’s liabilities that are offset by the value of their assets. A funding ratio of 100% means that a pension fund’s total assets equal their liabilities, that is, the assets are equal to the present value of the estimated future payment obligations to retirees. Any funding ratio below 80% calls into question the eventual solvency of a pension fund, and according to the American Academy of actuaries, even an 80% funding ratio should not be considered adequate. [3]

Debates over whether or not California’s public sector pension funds are solvent quickly boil down to debates over fundamental assumptions regarding future events, that, depending on how optimistic or pessimistic they are, can have exponential consequences.

Perhaps the most consequential of these projections is the assumed rate of investment return the fund expects to achieve, as most pension funds rely on investment returns to generate a substantial amount of their funding. Another key projection necessary for the fund’s long term fiscal solvency pertains to the expected average amount of time a retiree is eligible to receive their benefits.

Consequently, the fund must correctly forecast the expected age at which participants will retire and how long they will live. Understanding the effects caused by changes in these forecasts is crucial for anyone managing pensions, regulating them, or advocating a set of reforms.

Along with assumptions regarding future events, the solvency of public sector pensions have been affected by so-called “pension holidays” taken in the past, which refers to those years when the participating employers did not make their full contributions. Often these regular contributions were missed because the pension funds themselves waived the requirement during years when the investment markets were delivering excellent returns. [4]

The solvency of pensions is also affected whenever benefit formulas are increased. In California, starting in 1999 with the passage of SB 400, pensions for virtually all public workers were increased by approximately 50%. [5]

This benefit enhancement necessitated higher annual contributions by the employer, but in most cases the amount of additional cost presented to the employers by the pension funds was underestimated, because of optimistic rate-of-return expectations for the funds. So optimistic, in fact, that most all of the benefit enhancements implemented starting around 1999 were awarded retroactively. Needless to say, applying a 50% pension enhancement to an employee’s entire career – even for those employees about to retire – exacerbated whatever unfunded challenges may have existed anyway in the pension funds.

The purpose of this study isn’t to delve further into the causes or potential remedies for the financial challenges facing California’s public sector pension funds. But at a time when virtually every public sector pension system in California is increasing required employer contributions in order to preserve solvency, year after year, with no end in sight, it is relevant to report as comprehensively as possible on just how much current retirees are receiving in retirement pensions and benefits. [6]

To that end, the California Policy Center, in partnership with the Nevada Policy Research Institute, has acquired data directly from dozens of public sector pension funds in California, including CalPERS, CalSTRS, and about 25 other independent California-based pension systems. This information is available to the public at the website TransparentCalifornia.com.

Using this data, it is possible to construct an accurate and detailed look at what pension funds are paying current retirees. In this study, the focus is on public safety pensions, using recent data acquired from the California Public Employee Retirement System (CalPERS), the Los Angeles Fire and Police Pension system, and the City of San Jose Police and Fire Department’s Retirement Plan.

One important observation stand out: Public sector pensions are not applied equally in California. As will be shown, retirees who left state or local government service after 1999 are collecting far larger pensions than those retiring before the late 1999.

Additionally, retirees with less than 20 years of service credit are collecting pensions that are disproportionately smaller than those with 25 years or more.  Also, the so-called “base pension” paid retirees can be quite misleading. As we will show, public safety officers receive benefits and supplemental payments that result in much greater total benefits than the base pension amount indicates. Most pension plans offer health insurance coverage of significant value, supplemental payments, annuities, or payments associated with DROP (deferred retirement option plan) that are not reflected in the base pension amount.

Understanding the real value of the pension benefits a full-career safety officer can expect to receive in retirement is critical to addressing the issue of whether or pension benefits might be equitably reduced as part of a comprehensive plan for pension reform.

If pension fund contributions are becoming such a burden on city and county budgets that they have the potential to throw these public employers into bankruptcy, then either in negotiations to avoid bankruptcy, or through a bankruptcy, one way to restore the solvency and reduce the financial demands of a pension fund is to lower the amount retirees receive as a benefit. The more participants are affected by benefit cuts, the more modest the effect these cuts may have on any specific individual.

*   *   *

METHOD AND ASSUMPTIONS

The focus of this study is public safety pensions, which are typically calculated using a “3% at 50” or “3% at 55” formula. The formula works as follows: “3% is multiplied by the number of years worked, times final salary.” Sometimes the pensionable salary is simply the final salary of the employee at time of retirement. It can also be formulated as an average of the final three years of salary.

In some cases, pensionable salary may still include the value, or a percentage of the value, of, for example, unused sick time that is cashed in at the time of retirement. Many of these so-called “spiking” tactics were deemed abusive of the system and eliminated with the passage of SB 400 in 2012. In any case, public safety retirees, on average, collect the largest pensions of any class of state or local government employees in California. According to the U.S. Census Bureau, active police, firefighters and corrections officers represent about 15% of California’s approximately 1.5 million full-time state and local government employees. [7]

In order to provide information on average public safety pensions that can provide insight into what currently active employees will be collecting, it is important to evaluate how much average pensions and benefits are for retirees who worked full careers and who retired in recent years. It is essential to break this information out separately from more general averages that include retirees who left service decades ago, because the pension formulas currently in effect for nearly all active personnel are the same as the ones used to calculate recent retiree pensions. To-date, pension reforms have only affected the benefit formulas earned by new employees, not existing employees. This means that any savings gained from pension reforms to-date will not be realized for 20 years or more.

Similarly, it is important to show pension benefits for employees who worked full careers, since this, again, is the only way to help foster accurate insight into how much pensions cost. Because these vital positions must be permanently filled, for every retiree who only worked a few years, earning a proportionately smaller pension, there must be additional hires who will also be collecting a partial pension. For this reason, normalizing pensions to “full-career equivalents” is necessary.

In order to highlight the effects of legislative actions such as SB 400 that retroactively enhanced pension benefits, as well as the disproportionally greater benefits of those who have accrued a full-career of service credit, the tables used in this study provide data that breaks out averages accordingly.

These tables, while intricate, follow a uniform format throughout the study:

– The vertical axis is the amount of the annual pension benefit. In all cases, the bars of data refer to average pensions received in their plan’s respective reporting year, including participants who retired decades ago. For CalPERS the data analyzed is the most recent available, calendar year 2012. For San Jose the data is from the 2013 fiscal year. Finally, the data from the LAFPP is for the 2013 calendar year.

– The horizontal axis has six blocks of data. Each block represents a five year range of retirement years, starting with 1984-1988, and proceeding in five year increments to the three columns on the far right, representing participants who retired in the years 2009-2013. Each of these sets of data have three vertical bars, representing participants who worked 20-25 years, 25-30 years, and over 30 years.

Finally, it is necessary to include benefits in addition to pensions in order to get a truly accurate impression of how much retired public safety employees in California receive in retirement benefits each year. Unfortunately, among the three pension systems being analyzed, only the Los Angeles Fire and Police Pension system provided this data. But while not disclosed elsewhere, they are present in virtually all retirement benefit plans for public safety retirees in California.

These benefits primarily include two types of compensation in addition to base pensions – they are payments towards health insurance and “Medigap” coverage or supplemental coverage to Medicare. In addition to health benefits, many safety officer plans offer supplemental pension benefits in the form of quarterly or annual payments in addition to their monthly benefit amount.

The LAFPP and other local safety pension plans such as the San Diego City Employees Retirement System (SDCERS) offer one of the most substantial forms of these additional benefits through a program known as a deferred retirement option plan, also known as DROP. In aggregate these distinctions are not relevant. However, the inclusions of these benefits are vital to any comprehensive analysis that wishes to accurately represent the true value of these benefits.

*   *   *

PUBLIC SAFETY PENSIONS – CalPERS

Of the 483,902 individual retiree records provided by CalPERS, 48,863 were designated as “Public Safety” participants who retired between 1984 and 2013 with 20 years or more of service. Public safety retirees participating in CalPERS include California Highway Patrol, Correctional Officers, as well as police and fire department personnel from throughout the State of California that do not have, or are not members of, a local plan such as the LAFFP or San Jose plan.

The table below only shows base pension as that was the only data made available by CalPERS for the 2012 year. Naturally, any additional supplemental payments as well as health benefits received will increase these values.

There are six blocks of data, corresponding to year of retirement ranging from those who retired in 1984-1988 on the far left, to recent entrants on the right who retired in 2009-2013. In all cases, the amounts reported are the average pension paid last year. As can be seen, the amounts go up every year, that is, the more recently a participant retired, the bigger their pension. This is clearly the result of pension benefit enhancements that rolled through virtually all state and local government agencies – retroactively – starting in 1999.

As can also be seen from the six blocks of data, the longer a participant worked, the higher their pension. For example, participants who retired in 2009-2013 are depicted in three bars. Those who worked 20-25 years are shown in the lightest bar on the left side of the block; their average pension is $55,861 per year. In the medium shaded bar in the middle are those who retired after 25-30 years of service; their average pension is $82,926 per year. In the dark shaded bar on the right are those who retired after 30 years or more of service; their average pension is $99,908 per year.

CalPERS Safety Officers
Average Base Pension by 
Years of Service and Year of Retirement

20140404_Ring-Fellner_CalPERS-by-Svc-and-Ret_1

 *   *   *

 PUBLIC SAFETY PENSIONS – SAN JOSE

The San Jose Police and Fire Retirement Plan reported 1,953 individuals receiving a pension benefit for the 2013 fiscal year; the data analyzed here are for the 1,571 participants who retired between 1984 and 2013 with 20 years or more of service.

The table below only shows base pension because the San Jose Police and Fire Retirement Plan did not release information on health benefits or any other potential supplemental benefits. Again, there are six blocks of data, corresponding to year of retirement ranging from those who retired in 1984-1988 on the far left, to recent entrants on the right who retired in 2009-2013. In all cases, the amounts reported are the average pension paid last year. Also as seen with the CalPERS data, the amounts go up every year, that is, the more recently a participant retired, the bigger their pension, and the longer a participant worked, the higher their pension.

The differences shown between retirees before and after 1999 are striking. Almost all retirees post 1999 who have 25 years of experience or more are collecting pensions in excess of $100,000 per year, with the sole exception of retirees between 1999-2003 with 25-30 years experience who collected, on average, a pension of $90,108 in fiscal year 2013.

City of San Jose Safety Officers
Average Base Pension by 
Years of Service and Year of Retirement

20140404_Ring-Fellner_SJ-by-Svc-and-Ret

*   *   *

PUBLIC SAFETY PENSIONS – LOS ANGELES

The Los Angeles Fire and Police Employees’ Pension plan reported 10,040 individuals receiving a pension benefit for 2013 [8]; the data analyzed here are for the 8,717 participants who retired between 1984 and 2013 with 20 years or more of service.

The table below only shows base pension, even though the LAFPP has provided benefits and DROP data that will be summarized in the table following this one. Again, there are six blocks of data, corresponding to year of retirement ranging from those who retired in 1984-1988 on the far left, to recent entrants on the right who retired in 2009-2013. In all cases, the amounts reported are the average pension paid last year. Also as already seen, the amounts go up for post-1999 retirees, although the variation isn’t nearly as striking with the LAFPP data compared with the CalSTRS and San Jose data.

City of Los Angeles Safety Officers
Average Base Pension by 
Years of Service and Year of Retirement

20140404_Ring-Fellner_LA-by-Svc-and-Ret

*   *   *

TOTAL RETIREMENT BENEFITS – LOS ANGELES

The next table provides a more complete picture of public safety retirement benefits because it includes the amount of employer provided health insurance, which adds approximately another $10,000 to the actual retirement compensation received by LA Police and Fire retirees. As can be seen, when including the value of the employer provided health insurance, the average post-1999 retiree with 30 years of service collects a pensions and benefit package in excess of $100,000.

What the complete data from Los Angeles reveals is an additional program of astonishing value, referred to as “DROP,” which stands for “Deferred Retirement Option Plan.” Conceived as a method to retain skilled public safety personnel who would otherwise be eligible to retire, the DROP program permits the participant to “retire” but continue to work. During the time they continue to work, they collect their normal pay, but the amount they would have been collecting as a pension is deposited in an account bearing 5% interest. They no longer accrue pension benefits. The potential savings of this program – similar in rationale to pension obligation bonds – is that the pension fund returns during the same period will exceed 5% earnings guaranteed the pensioner. In practice the DROP program results in very large final year payouts to retirees in their first year of retirement – enough to skew the average annual total retirement payouts per retirees with 25+ years of experience over the past 10 years to over $150,000.

Due to the incomplete data received from many – if not most – of California’s pension systems to-date, it isn’t clear how many agencies offer DROP to their public safety personnel. It is apparently not offered in San Jose, but definitely is offered in San Diego. It isn’t clear whether or not some of the many cities and counties who participate in CalPERS offer DROP to their public safety retirees. But the DROP program is a striking example of how reports that only reference base pensions are not representative of what total retirement benefits often will include. Another example of this, not strictly a retirement benefit, but nonetheless a sum paid upon retirement, is the common practice of cashing out accrued sick and vacation time, something which can and often does add tens, if not hundreds of thousands of dollars to a public employee’s final year of compensation.

City of Los Angeles Safety Officers
Average Total Retirement Benefits by 
Years of Service and Year of Retirement

20140404_Ring-Fellner_LA-w-DROP-by-Svc-and-Ret_RFver3

*   *   *

CONCLUSION

In recognition of the specialized skills required, and in order to attract and retain a workforce of the highest quality, it is certainly appropriate to pay a premium to active and retired public safety employees. But in the face of ballooning costs to California’s taxpayers to maintain pension solvency, it is also appropriate that anyone involved in discussions regarding reform be aware of just how much public safety officers currently receive in total retirement benefits. Here are some highlights:

  • CalPERS, with the largest and hence probably the most representative dataset, reports base pensions to average $99,908 for public safety officers retiring in the last five years with 30+ years experience; for retirees with 25-30 years experience, the average base pension was $82,926 if they retired in the last five years.
  • CalPERS retirees make far more if they retired after 1999, regardless of years of experience, because of the pension benefit enhancements that were awarded – retroactively – starting in that year. For all public safety participants retiring before 1999 with at least 20 years service, the average base pension is $52,179; for all participants retiring in 1999 or later, with at least 20 years service, the average base pension is $77,878.
  • When including the value of other benefits, primarily employer paid health insurance, the estimated value of the average CalPERS public safety retirement compensation increases by about $10,000 per year.
  • San Jose’s retired police and fire personnel who retired in the last 10 years, and who worked at least 25 years, earned an average base pension of $100,175 in 2012. Add to this at least the average value of employer paid health insurance of about $10,000 per year.
  • While Los Angeles does not report their public safety retiree pension benefits, on average, as generous as CalPERS or San Jose, when including the value of the employer provided health insurance, the average post-1999 retiree with 30+ years of service collects a pension and benefit package in excess of $100,000.
  • Los Angeles, San Diego, and other cities offer the “DROP” program, which in practice enables retirees to leave public service with a lump sum payout that – at least in Los Angeles – is substantial enough to increase the average pension amount by over $50,000 per participant.

To speculate as to whether or not this level of pay and benefits in retirement is appropriate or fair, even for former public safety personnel, is well beyond the scope of this study. But it should be observed that employer pension contributions in San Jose, for example, are on track to consume 25% of that city’s entire general fund within a few years. [9] And yet efforts are currently in progress to repeal portions of San Jose’s pension reform measure. Similarly, in Los Angeles, pension costs jumped to 18% of the budget in 2012-13. [10]

Another question that should be asked is why public safety employees are incentivized to retire after 25 or 30 years. While it is probably not wise to require officers in their 50’s or 60’s to occupy front-line roles in fighting crime or fighting fires, these veteran officers possess a great deal of experience that would be of significant value to their departments. Skilled officers can participate in training, management, administration, intelligence work, investigations, and logistical support – they might even oversee and operate the many automated systems such as micro drones that are inevitably going to become a vital resource for public safety agencies. There is no reason these individuals, with the skills they have acquired and talents they offer, to have to retire any earlier than anyone else.

In any case, the primary aim of this study was to put out accurate data regarding just how much public safety retirees in California receive in retirement pensions and other benefits. We have found that on average, a public safety retiree in California – working at least 25 years and retiring in the last ten years – earns a pension and benefit package in excess of $90,000 per year.

 *   *   *

 FOOTNOTES

(1)  U.S. Census Bureau, California Local Government Payroll 2012California State Government Payroll 2011

(2)  Brown and Whitman duel over public pensions, Marin Independent Journal, October 12, 2010

(3)  The 80% Pension Funding Standard Myth, American Academy of Actuaries, Issue Brief, July 2012

(4)  State pension funds: what went wrong, Cal Pensions, January 10, 2011

(5)  How California’s Public Pension System Broke, Reason Policy Brief, June 2010, page 5 “California Standard Pension Benefit Formulas Before and After SB 400”

(6)  California pension rate hikes loom after Calpers vote, Reuters, February 18, 2014

(7)  U.S. Census Bureau, California Local Government Payroll 2012, California State Government Payroll 2011

(8)  The data provided on the TransparentCalifornia website for LAFPP pensions is for 2012. This study used 2013 data, also received from LAFPP, but not yet posted.

(9)  Can San Jose cut pensions of current workers?, Cal Pensions, August 5, 2013

(10)  Los Angeles City Pension Costs Grew 25% Annually Over Last Decade, Public CEO, March 6, 2013

*   *   *

About the Authors:

Robert Fellner is a researcher at the Nevada Policy Research Institute (NPRI) and joined the Institute in December 2013. Robert is currently working on the largest privately funded state and local government payroll and pensions records project in California history, TransparentCalifornia, a joint venture of the California Policy Center and NPRI. Robert has lived in Las Vegas since 2005 when he moved to Nevada to become a professional poker player. Robert has had a remarkably successfully poker career including two top 10 World Series of Poker finishes. Additionally, his economic analysis on the minimum wage law won first place in a 2011 essay contest hosted by George Mason University.

Ed Ring is the executive director for the California Policy Center. Previously, as a consultant and full-time employee primarily for start-up companies in the Silicon Valley, Ring has done financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

The Benefits and Costs of Oil and Gas Development in California

Summary: California is the nation’s third largest producer of crude oil and has considerable potential to expand production. This report assesses this potential by quantifying scenarios for crude oil and natural gas production both onshore and offshore and the associated economic and environmental impacts.

The oil production possibilities of the Monterey Shale recently have attracted considerable attention. If Monterey shale development remains at currently low levels, additional future production would be at most 50 thousand barrels per day. If producers solve the complex geology and engineering associated with this formation, production levels could reach 500 thousand barrels per day after 15 years. Finally, higher well productivity could boost production to slightly less than 1 million barrels per day by 2035. There are also substantial offshore reserves with considerably less production risk and a larger upside than the Monterey Shale.

The combined development scenarios would generate significant economic benefits that are summarized in Table ES1. The average annual increase in employment ranges from 67 to 557 thousand. Average annual gains in state and local taxes are between $1.1 and $8.2 billion per year as value added or state domestic product increases from $8.5 to $63.8 billion depending upon the production scenario. The environmental impacts include greenhouse gas emissions associated with higher consumption of petroleum products and natural gas, the expected value of oil spill costs, and costs associated other environmental events, such as well blow–outs and breaches of well bores. Using mid-range estimates of carbon emission costs and other environmental damage estimates produced by the federal government and the peer reviewed literature, the average annual economic value of these environmental damages are from $1.4 to $12.8 billion per year (see Table ES1). These impacts are between 12 and 20 percent of value added, roughly on par with many royalty rates, which perhaps is a means to assuage environmental concerns. The net economic benefits defined as value added less the expected environmental impact costs are between $7 and $51 billion per year. Developing California’s oil and gas resources, therefore, provides significant net economic benefits to society.

Table ES1: Economic Contribution of Oil and Gas to California Economy in 2011

20140320_Considine_01_TableES1

*   *   *

1.  INTRODUCTION

New technologies have transformed the oil and gas sector in the U.S. economy from a sunset to a growth industry. Three-dimensional seismic technology, directional drilling, and multi-stage hydraulic fracturing have dramatically lowered the cost of extracting crude oil, natural gas, and natural gas liquids from previously inaccessible shale rock and other tight geological formations. Crude oil production is up considerably in several states, including North Dakota, Texas, Wyoming, Colorado, Utah, and New Mexico. Moreover, Pennsylvania, West Virginia, and Ohio are emerging as major producers of natural gas and associated liquids, such as propane, ethane, and butane.

The application of these technologies has led to dramatic increases in oil and gas production in the United States and a significant reduction in our nation’s trade deficit. In 2008, the US produced 6.78 million barrels per day of crude oil and natural gas liquids. Four years later, production averaged 8.91 million barrels per day, an increase of over 31 percent. Over this period, North America provided 75% of world oil production growth, which has been pivotal in keeping world oil prices from going any higher than they already are. Depending upon prices, oil and petroleum products comprise roughly half of our nation’s trade deficit. From 2007 through the first quarter of 2013, the trade deficit in crude oil and petroleum products had declined by almost 45 percent, which directly translated to higher gross domestic product here at home.

California is now the third largest oil producing state in the US, behind Texas and North Dakota. In contrast to many other major oil and gas producing states, California’s crude oil production had been declining prior to 2012. A slight uptick in production last year suggests that the technological innovations discussed above are being applied to the significant oil and gas resources remaining in California. Directional drilling offers the possibility of safely accessing a significant portion of the estimated 10 billion barrels of offshore oil and gas from land-based drilling rigs. Another opportunity is to develop the Monterey shale in the Central Valley region, which may hold up to 15 billion barrels of crude oil. At current market prices, these assets are worth $2.5 trillion, which, if monetized, could generate hundreds of billions in tax and royalty revenues to fund pensions, education, health, and other government programs. Developing oil and gas resources, however, involves environmental impacts on air, land, and water resources that impose costs on society. The central question of this study is whether the economic benefits of oil and gas development in California exceed the associated environmental costs.

The next section of this study defines the current state of the oil and gas industry in California and its contribution to the state’s economy. The third section describes future development scenarios for additional oil and gas production in California with a specific focus on state offshore resources and on the Monterey Shale. The fourth section estimates the economic impacts from these development scenarios. While a recent study from the University of Southern California estimates the economic impacts from developing the Monterey Shale, there are a number of problems with this study that require additional analysis. The fifth section of this study identifies the environmental impacts associated with these development scenarios, addressing two questions: 1.) Whether these impacts are manageable in terms of minimization of occurrence and implementation of remediation procedures, and 2.) Whether the remaining unmitigated impacts impose significant costs on the economy. The final section compares these costs and benefits, addressing whether accelerated development of oil and gas reserves is in the best interest of California and discussing how the state could achieve a balance between environmental quality, economic growth, and energy independence.

*   *   *

2.  OIL AND GAS RESOURCES IN CALIFORNIA

California has a large and diverse economy, generating more than $1.9 trillion in value added, which is also known as gross domestic product. Over 19.5 million people are employed in the state. Since the economic recovery began in 2009, California’s economy has struggled. The unemployment rate is at 8.5 percent, well above the national average of 7.0 percent in December of 2013. Significant tax increases have been enacted to fund state pensions, schools, health care and other public expenditures. State policy makers have begun to look at the oil and gas sector as a potential source of future income to fund these public expenditures.

There are several ways to define the oil and gas sector. Some studies, such as Avalos and Vera (2013) define the oil and gas industry from wells to final consumers, including the refining sector and transportation of petroleum products. This study focuses on the upstream segment of the industry – drilling, support, and extraction – because the possible expansion of production discussed in the next section specifically involves these segments of the industry, not the refining and transportation of products. While expansion of the refining sector is possible from expansion of oil and gas extraction, displacement of imported crude oil without significant expansion of refining sector is the most likely outcome.

The economic contribution of the oil and gas sector is summarized in Table 1. Direct employment was 49,582, which was 0.3 percent of total employment in the state. Gross output, which includes purchases of goods and services from other sectors as well as the net contribution to the economy in terms of value added, came to $23.4 billion in 2011. Value added, which is the best measure of net economic contribution of an industry, was $12.6 billion in 2011, or 0.7 percent of total value added or gross state product. Oil and gas generated $1.9 billion in indirect business taxes, constituting 1.6 percent of total tax collections. While these statistics indicate that the oil and gas sector is a small component of the California economy, there are other ways in which additional oil and gas production can provide significant contributions to the economy.

California spent $104.7 billion on oil and natural gas during 2011. The gross output of oil and gas during 2011 was $23.4 billion (see Table 1). Hence, roughly $81.3 billion or slightly over 4 percent of gross state product flowed out of the California economy to pay for imported oil and natural gas to meet domestic needs. If these expenditures flowed to California oil and gas producers who hired workers and paid taxes within the state, California employment, gross state product, and tax revenues would be higher. Hence, increasing oil and gas production in California can cut the state’s energy trade deficit that would provide a direct stimulus to employment, income, and government revenues.

Table 1: Economic Contribution of Oil and Gas to California Economy in 2011
20140320_Considine_02_Table01a

What are the prospects for increasing oil and gas production in California? The potential future production possibilities are significant. Humphries and Pirog (2012) report that California offshore areas contain 10.13 billion barrels of oil and 11.73 trillion cubic feet of natural gas. While oil and gas production offshore California continues, significant expansion is prevented by federal and state drilling moratoriums. Onshore there is the Monterey shale that may contain upwards of another 15 billion barrels of oil, according to the U.S. Energy Information Administration (2011). The development of this resource is just getting underway and faces significant technical challenges.

So while there is significant potential for expanded output, production of oil and gas has steadily declined as illustrated in Figure 1. Production of crude oil peaked in 1985 at 1.079 million barrels per day. Natural gas production also peaked in the same year at 1.6 trillion cubic feet. Like Texas and many other states, technological innovations could reverse these declines. Accordingly, the analysis in the next section develops some possible scenarios for future onshore and offshore oil and gas development.

Figure 1: Oil and Gas Production in California, 1981-2012
20140320_Considine_03_Figure01

*   *   *

3.  DEVELOPMENT SCENARIOS

The first stage of oil and gas development involves investment to drill wells and construct gathering lines and oil and gas processing facilities other than refineries. This investment spending increases gross output of the drilling sector and depends upon the number of wells drilled each year. Once production begins, oil and gas revenues are generated and payments are made to investors, landowners, and governments. In this second stage , gross output from the oil and gas extraction sector increases in line with oil and gas production. Drilling support services are tied to each of these two sectors. Accordingly, this study models the economic impacts from oil and gas development in two steps; first by increasing gross output in the drilling sector by the amount of investments in the drilling and completion of wells and second by increasing gross output in the oil and gas extraction sector by the amount of gross revenues generated from oil and gas sales. This approach requires the specification of a drilling plan and estimates for the production of oil and gas resulting from current and past wells both offshore and onshore.

3.1  Offshore Development

The development and production plans for offshore development are built upon a scenario developed by Schniepp (2009) for the production of oil offshore Santa Barbara using slant-drilling techniques from land-based rigs. These rigs would drill wells extending several miles offshore. The oil project envisioned by Schniepp (2009) involves developing roughly 1.5 billion barrels of oil reserves offshore Santa Barbara.

Three scenarios for offshore California oil development are considered in this study. These scenarios are intended to bracket the range of possible future outcomes, reflecting considerable geologic, technological, and economic uncertainties.

The low scenario is the one presented by Schniepp (2009), which involves investment outlays of $10.6 billion over a 16-year period, with annual investment spending peaking at about $1.5 billion (see Figure 2). Under this development plan, production rises by 400,000 barrels per day and tracks down to slightly over 50,000 barrels per day after 20 years (see Figure 3).

The medium scenario involves developing these reserves plus those offshore Los Angles and Long Beach with a three-year lag from the low scenario. The total reserves under this scenario are estimated to be 5 billion barrels. Under this case, total investment outlays are $34.4 billion (Figure 2). Production peaks at nearly 1.3 million barrels per day and remains above 150,000 barrels per day after 20 years (Figure 3).

The high scenario assumes all 10 billion barrels of estimated oil reserves offshore California are developed. Given the infrastructure requirements, production in this scenario begins in 2021. This would require total investment outlays of $68.6 billion reaching nearly $10 billion in the early years (see Figure 2) and resulting in annual production peaking at roughly 2.6 million barrels per day and remaining well above 300,000 barrels per day after 20 years (Figure 3). While these cases may be dismissed as unlikely given the opinion in California of some people that is highly critical of offshore drilling, these scenarios provide a basis for estimating the opportunity costs of these views.

Figure 2: Offshore Oil and Gas Investment Outlay Scenarios, 2015-2035
20140320_Considine_04_Figure02

Figure 3: Offshore Oil and Gas Production Scenarios, 2015-2035
20140320_Considine_05_Figure03

3.2  Development of Monterey Shale

Despite its significant potential, oil production offshore amounted to only 36 thousand barrels per day in 2012. Onshore production in 2012 was 504.9 thousand barrels per day. Nearly 80 percent of this output comes from the southern San Joaquin Valley resting above Monterey Shale, which is considered the source rock for conventional oil production in the region. The active area for the Monterey Shale is approximately 1,752 square miles. Assuming 16 wells per square mile and 550 thousand barrels of estimated recoverable reserves (EUR) of oil per well, the US Energy Information Administration (2011) estimates that this shale play contains 15.42 billion barrels of technically recoverable oil.

Currently there is considerable uncertainty about whether this oil can be produced. Some geologists believe most of the oil has already migrated to conventional reservoirs. Hughes (2013) argues that the potential of the Monterey has been overstated, citing historical production statistics that only 145 thousand barrels of oil have been recovered from producing wells. Occidental Petroleum, which holds 78 percent of the net leasehold acreage, however, is optimistic about the future production potential of the Monterey. The reason for their optimism most likely is based upon the promise of applying more advanced oil recovery technology, which was not employed for the wells covered by the data sample that Hughes (2013) collected.

A crucial unknown in projecting possible future production profiles for the Monterey shale is the amount of oil recoverable per well. Since there is little doubt that technology has improved considerably since the samples collected by Hughes (2013), this study assumes that Monterey wells drilled beginning in 2015 will average 250 thousand barrels EUR, less than half the EIA estimate but significantly above the average computed by Hughes (2013). Based upon experience in other shale plays reported by Considine et al (2011), technological innovations and learning by operators likely would increase recoverable reserves.

This study assumes three scenarios for the track of recoverable reserves per well over the forecast period summarized below in Figure 4. Under the low scenario, average EUR increases from 250 thousand barrels to 300 thousand after 20 years in 2035. Under the medium scenario, operators crack the code and average EUR increases to 350 thousand barrels by 2020 and then grows one percent per annum, reaching 400 thousand barrels by 2035. The high scenario envisions an even faster ramp-up in EUR to 450 thousand barrels by 2020 and then a gradual increase to 500 thousand barrels per well. Allowing for technical progress that improves well productivity is a reasonable approach based upon experience from other shale plays around the US, such as the Eagle Ford and Marcellus.

The next critical assumption for building a production forecast involves the production decline curve, which is presented below in Figure 5. The area under this curve is the estimated recoverable reserves, which in the base year 2015 is 250 thousand barrels. During the first three years of production, wells are assumed to average 134, 75, and 52 barrels of crude oil production per day. Production in subsequent years then gradually declines (see Figure 5).

Figure 4: Assumptions for Estimated Recoverable Reserves
20140320_Considine_06_Figure04

Figure 5: Hypothetical Monterey Shale Oil Production Decline Curve
20140320_Considine_07_Figure05

Given assumptions on EUR per well and the production decline curve, this study posits three drilling scenarios. The first or low case assumes only 90 wells are drilled per year under the low EUR scenario (see Figure 6). Under this scenario, the number of producing wells reaches 1,890 by 2035, which represents 6.7 percent of the 28,032 wells that EIA estimates could be drilled in the Monterey shale region. The medium scenario assumed 300 wells drilled in 2015, increasing by 85 each year to 2020, increasing by 8 per year between 2021 and 2025, then declining by 25 wells per year as productivity growth reduces the need to drill as many wells (see Figure 6). At the end of the forecast period in 2035, there are 14,575 Monterey wells producing, which is 52 percent of the maximum number possible. The high drilling scenario assumes the high EUR scenario and, therefore, a faster pace of drilling that reaches over a thousand in 2020, a gradual increase to 1,100 wells in 2025 and then a decline to 810 wells drilled in 2035 (see Figure 6). The number of producing wells in this scenario is 19,205, which is 68.5 percent of the maximum possible wells that could be drilled.

Figure 6: Monterey Shale Oil and Gas Drilling Scenarios, 2015-2035
20140320_Considine_08_Figure06

Since well productivity and the number of wells changes change each year, each class of wells or vintage produces crude oil according to its production decline curve, the number of years since initial production, and the number of wells producing from that vintage. Accordingly, production of crude oil in each year going forward is computed by adding production across all well vintages. Associated natural gas production is assumed to be 0.859 thousand cubic feet per barrel of oil produced, which is the California state average from 2008 to 2012.
The results from these calculations are presented in Figure 7. Under the low scenario production gradually increases from 25 to 50 thousand barrels per day. The medium scenario has production rising to over 50 thousand barrels per day in 2015, 250 thousand barrels per day in 2020, and over 500 thousand barrels per day in 2035. The high scenario has production rising to over 470 thousand barrels per day by 2020 and approaching 1 million barrels per day by 2035.

Figure 7: Monterey Shale Oil Production Scenarios, 2015-2035
20140320_Considine_09_Figure07

These production scenarios are considerably lower than the projections by Gordon et al (2013) that had production increasing from between 1.7 and 3.3 million barrels per day. Our findings support the contention by Hughes (2013) that the production forecasts by the team at the University of Southern California reported by Gordon et al (2013) are somewhat on the high side. Given that Gordon et al (2013) do not clearly describe their methods of production forecasting, it is difficult to determine the source of the differences between the two projections. In contrast to their analysis, this study makes explicit assumptions concerning EUR, employs a possibly more realistic production decline curve, and computes oil and gas output from a vintage production model. While advocates and opponents of oil and gas development can take exception to some of the assumptions made here, at least there is an explicit statement of the assumptions and a model supporting the analysis that allows a transparent quantification of the range of possible outcomes given technical and economic uncertainties.

3.3  Total Development Potential

The above results suggest that there is considerable potential for additional oil and gas production in California. Under the low scenario, Monterey Shale development shows modest productivity improvements and with development of oil reserves offshore Santa Barbara from onshore slant-drilling rigs, California would increase its oil production by 400 thousand barrels per day by 2020 (see Table 2). So even under modest development, California could increase its oil production by 75 percent over a short period of time.

Table 2: Potential Additional California Oil and Gas Production, 2015-2035
20140320_Considine_10_Table02a

With a technological breakthrough in deciphering the complex geology of the Monterey Shale along with expansion of oil production offshore Southern California, oil production could soar by over 1.6 million barrels per day. Such an increase would rival the production gains witnessed recently in Texas and North Dakota. The high resource scenario would involve developing all of California’s offshore oil resources along with successful and relatively intensive development of the Monterey Shale. Under this scenario, California oil production could increase by over 3.3 million barrels per day. Combined with oil production already in place, California would emerge as one of the largest oil producing regions in the world. Although the resources are in place and the technology is in a position to monetize these resources, the central question is whether the California people and their elected officials would ever allow such development. Cynics would be quick to respond that such development is unlikely for political reasons, but public opinion can change, especially when the economic benefits of additional oil and gas production become apparent and environmental management policies are in place to assure responsible development.

To determine the economic impacts of the production potential of California’s oil and gas sector, forecasts of prices for crude oil and natural gas are required. This study uses forecasts produced from the US Energy Information Administration (2013), which are plotted in Figure 8. Real oil prices rise from slightly under $100 per barrel in 2015 to over $140 per barrel by 2035. Similarly, natural gas prices increase from $3.5 per thousand cubic feet to over $6 per thousand cubic feet over the forecast horizon.

Figure 8: Oil and Natural Gas Prices, 2015-2035
20140320_Considine_11_Figure08

Given these price forecasts, incremental revenues from the three production scenarios appear in the last three columns of Table 3. The low scenario has incremental oil and gas revenues increasing by over $17 billion and then gradually declining to $6 billion by 2035. The medium scenario has a sharper increase in revenues to over $40 billion in 2020 peaking at over $73 billion three years later and then declining but remaining above $40 billion by 2035. The high scenario has revenues peaking over $150 billion in the early 2020s and then remaining well above $90 billion per year out to the end of the forecast horizon.

Also reported below in Table 3, are capital expenditures by the oil and gas industry to develop the Monterey Shale and offshore resources, if drilling moratoriums are lifted. These projections assume that each well costs $6 million to drill and complete. Capital spending begins at 540 million per year initially under the low scenario and ramps up to over $1 billion per year between 2020 and 2033. In total, oil and gas producers would invest over $21 billion over the entire period under this scenario. Capital expenditures are significantly higher under the medium scenario, amounting to over $120 billion from 2015 to 2035. Under the high scenario, capital spending is over $180 billion.

Since most of these expenditures would come from outside the state, they can be viewed as direct foreign investment in California’s energy production sector. As is well known in macroeconomics, a dollar of investment spending generates considerably more dollars as other business sectors supply the labor, raw materials, fuels, and materials to build these capital assets. Estimating these multiplier effects is the subject of the next section.

Table 3: Capital Spending & Oil & Gas Revenues in millions of 2013 dollars
20140320_Considine_12_Table03

*   *   *

4.  ECONOMIC IMPACTS

The economic impacts of energy resource development involve two stages. First, there are the impacts on value added, jobs, and tax revenues during the construction of the energy producing facilities. During the second phase, economic impacts arise during the operation of these facilities as the income generated from these facilities is spent.

The spending during the construction and operation of energy production facilities will have several economic impacts. The direct capital expenditures will directly stimulate support industries. For example, capital expenditures for construction of oil and gas wells involve direct purchases from companies that provide capital equipment, engineering and construction services, and other goods and services. These companies in turn acquire equipment and supplies from other companies, stimulating several rounds of indirect spending throughout the supply chain. The direct and indirect outlays generate additional employment and income, which induce households to spend their income on additional goods and services. Together, these direct, indirect, and induced impacts during construction and operation constitute the total economic impacts of the energy investments.

Regional economic impact analysis using input-output (IO) tables and related IO models provides a means for measuring these economic impacts. Input-output analysis provides a quantitative model of the inter-industry transactions between various sectors of the economy. This framework provides a means for estimating how spending in one sector affects other sectors of the economy. This re-spending through the economy initiating from an exogenous increase in investment spending or production generates multiplied impacts on value added, employment, and tax revenues. IO tables are available from Minnesota IMPLAN Group, Inc. (2011) based upon data from the Bureau of Economic Analysis in the U.S. Department of Commerce. This study uses these tables to estimate the direct, indirect, and induced economic impacts from spending for the mineral development and eventual operation, which are summarized for California oil and gas in Table 4.

Table 4: Economic Multipliers for Drilling and Extraction in California
20140320_Considine_13_Table04

The multipliers in table 4 were computed by solving the IMPLAN model for California for a $1 million dollar increase in the gross output of the drilling sector and for a $1 million increase in the gross output of oil and gas extraction sector. Under the former solution, 5.83 jobs are required to support that $1 million increase in drilling activity. Likewise, value added increases by $857,942 and state and local taxes and federal taxes rise by $69,420 and $99,421, respectively. These multiplier impacts arise as industries supplying inputs to oil and gas drilling hire workers, pay taxes, and purchase supplies from other sectors to support this higher level of drilling activity. The multipliers for oil and gas extraction are similar in magnitude (see Table 4).

A more detailed look at the multiplied effects of the oil and gas sector on the economy is presented below in Table 5, which estimates the impact on value added by sector from a $2 million increase in oil and gas drilling and extraction. For the $2 million increase in oil and gas drilling and extraction, value added, which again is a measure of gross domestic product, increases by $960,904 (see Table 5). The next five largest impacts by sector include those affecting real estate, professional scientific and technical services, manufacturing, finance and insurance, and construction. Notice that for four of these top five sectors the total effects in the last column are dominated by the indirect impacts in column 3, reflecting the supply-chain linkages of these sectors with the oil and gas sector. In contrast, induced effects dominate the impacts on health and social services and retail trade as workers employed from the new activity in oil and gas and the related supply-chain industries purchase these services. Overall, the $2 million of additional oil and gas drilling and extraction increases total value added by $1.8 million.

Table 5: Impacts on Value Added by Sector
20140320_Considine_14_Table05

4.1   Economic Impacts of Offshore Development

Applying the multipliers in Table 4 to the capital spending and oil and gas revenues generated under the offshore development scenarios results in the estimated economic impacts presented in Table 6. The low development scenario that involves developing the 1.5 billion barrels of oil offshore Santa Barbara generates a peak of $16.5 billion in value added and slightly over 96 thousand jobs in 2020. This development generates $24 billion in state and local taxes and slightly over $20 billion in federal taxes over the 20-year period. After peak production, these economic benefits decline but remain significant with state and local tax revenue generation above $400 million in 2035.

Table 6: Economic Impacts of Offshore California Oil & Gas Development
20140320_Considine_15_Table06a

The medium development scenario that involves significant additional production offshore southern California generates substantially more value added and employment than the low scenario. Incremental value added exceeds $50 billion in 2025 and job gains are nearly 300,000. Given this higher economic activity, state and local tax collections increase by $80 billion over the twenty-year projection period. Under the high scenario, state and local taxes increase by $158 billion. Employment and value added gains are roughly double the gains achievable under the medium growth scenario.

While there has been focus recently on the potential of the Monterey Shale, the economic gains from developing the offshore resources are significant and probably entail relatively less technological uncertainties. On the other hand, the perceived threat from oil spills remains an ongoing concern but these risks can be substantially mitigated with onshore slant drilling to access these offshore reserves.

4.2  Economic Impacts from Developing the Monterey Shale

While fraught with considerable uncertainties arising from geology and petroleum engineering technology, if developed, the Monterey Shale could generate significant economic gains for the State of California. Even under the low development scenario at slightly increased levels of drilling and production from current activity, developing this resource would generate annual gains in value added of between $1 and $4 billion while supporting between 8 and 22 thousand jobs per year (see Table 7).

Table 7: Economic Impacts of Monterey Shale Oil & Gas Development
20140320_Considine_16_Table07

If producers developed cost effective methods for extracting oil from this particular shale represented under the medium scenario, the annual economic gains in terms of value added would be between $15 and $30 billion after five years (see Table 7). Cumulative state and local tax revenues would increase by $56 billion . Value added and employment also increases significantly under the medium scenario.

Under the high scenario, annual gains in value added exceed $24 billion by 2020 and rise to well over $50 billion in 2035. Also after 2020, employment gains are between 150 and 350 thousand. State and local tax revenues would increase by almost $100 billion over the entire 20-year forecast horizon.

These economic impacts are considerably smaller than those estimated by Park and Gordon (2013). The economic impact analysis in their study is driven by statistical regressions. A simple sensibility check using the data reported on page 55 of their report reveals that the net per capita GDP increase is $259.4 and the assumed per capita GDP increase in the oil and gas industry is $35.32. The total effect is 35.32 plus 259.4, which equals 294.72. This implies that the multiplier is 8.34 (294.72 / 35.32), which is well more than seven times larger than multipliers derived from IMPLAN or the Bureau of Economic Analysis for the oil and gas sector. So not only are the projections for oil and gas production from the study by Gordon et al. (2013) somewhat on the high side, so are the estimated economic impacts.

4.3  Total Potential Economic Impacts

The combined economic impacts from developing both the Monterey Shale and offshore oil and gas resources are summarized in Table 8. Near term, gains in value added, employment and tax revenues are relatively modest as technical uncertainties are resolved and infrastructure is constructed. Once these investments are completed, these projects could generate substantial benefits to the State of California. For example, under the medium development plan, value added or gross state product increases by $75 billion generating more than 440 thousand jobs, again via direct, indirect, and induced multipliers. Accumulated state and local tax revenues are $136 billion.

Table 8: Total Economic Impacts of California Oil & Gas Development
20140320_Considine_17_Table08a

The high resource scenario generates substantially more incremental value added, employment, and tax revenues (see Table 8). Employment peaks at slightly more than 958 thousand in 2025, considerably smaller than the 2.8 million in job gains reported by Gordon et al. (2013) just for the Monterey Shale. State and local tax revenues increase by over $250 million over the entire projection period from 2015 to 2035. While the economic gains reported in this study are smaller than Gordon et al. (2013), they remain significant.

However unlikely this high resource scenario may be, this projection does point to the possibility that America could indeed become completely self-sufficient in oil, perhaps even a net exporter of crude oil in coming years. The high resource scenario in California combined with additional tight oil production from Texas to North Dakota, higher oil output from the Gulf of Mexico, an opening of the eastern seaboard of the US for drilling, and full development of oil reserves on the North slope of Alaska is a path to oil independence for the United States. Political interests, however, have blocked these pathways arguing that potential environmental impacts outweigh the economic benefits. To assess the reality of this proposition, the discussion now shifts to environmental concerns with developing oil resources in California, which provides a microcosm of the national debate surrounding oil and natural gas resource development.

*   *   *

5.  ENVIRONMENTAL IMPACTS

The oil and gas production scenarios developed above will have a range of environmental impacts. The key question is whether the economic costs associated with these impacts are commensurate with the economic benefits estimated above. Producing and consuming oil and natural gas affect the natural environment, including air, land, and water resources. These impacts directly affect society by reducing the flow of services from these natural resources. For example, offshore oil production involves the risk of oil spills, which incurs cleanup costs and degrades water resources that would affect related economic activities, such as fishing and recreation. Likewise, additional oil production and consumption would increase emissions of greenhouse gases that contribute to global climate change.

Indeed one of the more cogent arguments against developing the untapped oil and gas in California is that additional production would add to greenhouse gas emissions when the world is trying to combat the impacts of global climate change. The extent of this increase, however, is somewhat tempered because higher California production would be partially offset by reductions in oil and gas production elsewhere. In other words, not all of the increase in California oil and gas production represents an increase in world consumption of these products. The extent of this offset depends upon how world supply and demand for oil and gas adjust to California production. Higher oil and gas production in California displaces imports and depending upon the size of the production increase reduces market prices, which discourages production outside California and increases world consumption. This study uses estimates for these market adjustments reported in the literature to estimate the net increase in world oil and gas consumption resulting from changes in oil and gas production in California. The methods used for these computations are reported in Appendix A that describes the changes in prices, demand, and production by region.

The associated changes in greenhouse gas emissions are directly proportional to these changes in net oil and gas consumption. In addition to greenhouse gas emissions, offshore crude oil production would incur costs associated with the risks of oil spills. Finally, there are costs associated with other environmental impacts from oil and gas production, such as land and water contamination from onshore spills and well blowouts.

5.1  Greenhouse Gas Emissions

As the analysis above demonstrates, higher oil and gas production in California will increase value added, employment, and tax revenues. These gains, however, will come at the price of additional greenhouse gas emissions. The size of these emissions will depend upon how oil and natural gas markets adjust to higher California production. Given the market responses reported in the literature, roughly 50 percent of the increase in California oil production offsets production elsewhere in the world. Figure 9 summarizes the gross and net increases in world crude oil production for the three scenarios for onshore and offshore California production. Under the high production scenario, the gross increase in world production is 3.3 million barrels per day in 2024 but after accounting for reduced production elsewhere, the net increase in world production and consumption is 1.7 million barrels per day.

Figure 9: Gross and Net Increases in World Oil Consumption, 2015-2035
20140320_Considine_18_Figure09

Corresponding with these increases in net world oil consumption are higher greenhouse gas emissions. Assuming 21.2 pounds of CO2 per gallon of crude oil consumed plus another 20 percent to reflect emissions during the production, refining, and transportation of petroleum products, results in the estimates for greenhouse gas emissions from higher California oil production illustrated in Figure 10.

Under the low production scenario, greenhouse gas emissions peak at over 40 million tons by 2020 and then track downward to roughly 11 million tons by 2035. Under the medium scenario, emissions peak at over 160 million tons by the early 2020s and then track down to 75 million tons by 2035. The high production scenario shows a sharp increase in emissions to over 330 million tons per year that like the other two scenarios declines with production but ends up with over 160 million tons per year. While these increases may seem large in an absolute sense, they are between 3 and 6 percent of the 5.279 million tons of total U.S. carbon dioxide emissions from energy consumption during 2012.

Figure 10: Greenhouse Gas Emissions from Higher Oil Production, 2015-2035
20140320_Considine_19_Figure10

To place an economic value on these emissions and, thereby, compare the environmental impacts with the economic benefits, estimates of the costs of greenhouse gas emissions are required. For this, the Interagency Working Group on the Social Cost of Carbon (2013) provides the latest estimates that are summarized in the Figure 11. Under the low cost scenario, greenhouse gas emission costs slowly rise from $13 to $21 per ton. The medium scenario has emission costs rising from $42 in 2015 to $63 per ton in 2035. Finally, under the high cost scenario in which significant damages occur from global climate change, emission costs are $121 per ton and rise to nearly $200 per ton by 2035.

Figure 11: Prices for Greenhouse Gas Emissions, 2015-2035
20140320_Considine_20_Figure11

These emission costs per ton in Figure 11 and the estimated net emissions reported in Figure 10 allow an estimation of the valuation of the environmental impacts from higher California crude oil production. The low carbon cost or price scenario shows environmental impacts valued between $33 million and $5.178 billion dollars per year. These environmental impacts increase more than three-fold under the medium carbon cost scenario. The high carbon price scenario increases the value of carbon emissions to $23.842 billion in 2025 for the medium production scenario and considerably more than that for the high output scenario.

Table 9: Value of Carbon Emissions from Higher California Oil Production
20140320_Considine_21_Table09a

A similar set of calculations for carbon emissions associated with incremental natural gas production is undertaken. The study by Jaramillo (2007) provides estimates of the life cycle emissions of greenhouse gas emissions in the natural gas industry. Given the widespread concern about methane leaks during natural gas production, this study includes these emissions based upon a recent study by Allen et al. (2013).

The estimated values of these environmental impacts are summarized in Table 10 across the three carbon price and production scenarios. Given the smaller volume of natural gas production relative to oil, the environmental costs are considerably smaller than those estimated for crude oil production. Environmental impacts range from $4 million to $592 million under the low carbon price scenario. The medium output and carbon price scenarios have environmental impacts from natural gas production increasing from $25 million in 2015 to slightly more than $900 million in 2025 before tracking down to $533 million in 2035 (see Table 10). The high carbon price and high production scenario has environmental impacts from higher gas production starting at $72 million in 2015, peaking at over $6 billion in 2025 and then declining with production to $3.6 billion in 2035. Overall, while significant, these environmental impacts are considerably smaller than those associated with crude oil production.

Table 10: Value of Carbon Emissions from Higher California Gas Production
20140320_Considine_22_Table10

5.2  Oil Spills

Another significant concern with expanding oil production in California involves oil spills. In fact, the present-day moratorium on offshore drilling off the eastern and western coasts of the United States originates with the 1968 well blowout off the Santa Barbara coast. This policy has become a fixture of U.S. energy policy despite the likelihood of billions of barrels of recoverable oil under continental coastal waters.

Unlike the environmental impacts from additional oil and natural gas consumption, the environmental impacts of oil spills are inherently probabilistic in nature. In other words, they can occur but with low frequency. The environmental impacts, therefore, should be viewed in a probabilistic context. The best measure of occurrence of oil spills in this situation is the expected value or the most likely outcome given the distribution of possible outcomes.

Using records of actual oil spills Anderson et al. (2012) find that 32,329 barrels of oil are spilled for every billion barrels produced. Harper et al. (1995) find that offshore and onshore costs of cleanup are between $30 thousand and $107 thousand dollars per barrel spilled. Using these values for the three production scenarios provides estimates of the expected value of oil spill costs from higher oil production offshore California.

The results appear in Table 11. Compared with the other environmental impacts, the expected value of the environmental impacts from oil spills is small due to their relatively low frequency and size. For example, in the peak year of production in 2025 across all three offshore scenarios, the expected environmental damages range from $81 million to $3.166 billion (see Table 11). The latter is considerably smaller than the comparable estimates of $53.26 billion and $6.094 billion for environmental impacts from greenhouse gas emissions for oil and gas respectively. Nevertheless, oil spills are serious problems and these estimates provide a basis for establishing a contingency fund to mitigate their impacts if additional offshore production was allowed.

Table 11: Value of Expected Oil Spill Costs from Higher California Oil Production
20140320_Considine_23_Table11

5.3  Impacts on Land and Water

There are additional environmental impacts that would arise primarily from developing the Monterey Shale. Hydraulic fracturing uses large volumes of water to liberate oil and natural gas from tight rock formations, such as the Monterey Shale. Handling these large volumes of water inevitably involves spills on land or in local waterways. In addition, there are environmental impacts that arise from well blowouts, which occur in less than one percent of wells drilled, see Considine (2013). Environmental contamination also occurs when there are defects in the construction of wells that allows methane and flow-back water to enter local aquifers. Like well blowouts, these events occur with low frequency, see Considine (2013). This study uses the findings reported by Considine et al. (2013) to measure the frequency of these events and by Considine et al. (2011) to estimate the value of the associated environmental impacts.

The estimates reported in Table 12 include the value of air, land, and water impacts from diesel use during hydraulic fracturing, impacts from blowouts and other accidents, and the impacts from water contamination from well bore failures. Like the oil spill estimates above, these estimates should be viewed as expected values. As Table 12 illustrates, these values range from $108 to $349 thousand per well. These values use the value of water damages implicit in the Dimock case in Pennsylvania discussed by Considne et al. (2011). Multiplying these values by the number of wells drilled yields the total expected value of these environmental impacts under the three production scenarios for onshore development of the Monterey Shale. As the table illustrates, the expected values range from $10 to $387 million.

Table 12: Expected Value of Other Environmental Impacts
20140320_Considine_24_Table12

5.4  Total Environmental Impacts

The total environmental impacts – greenhouse gas emissions from oil and gas production and consumption, oil spills, and other environmental impacts, such as well blowouts and water contamination – are summarized below in Table 13. With relatively low prices for carbon emissions, oil spill costs, and water damage assessments, the total value of environmental impacts range from $46 million to $6.8 billion. The medium cost scenario in the second panel in Table 13 has vales ranging from $134 million to $21.5 billion. Finally, in the high cost scenario the three production scenarios generate environmental impacts that range in value from $362 million to $62.9 billion.

Table 13: Total Expected Value of Environmental Impacts
20140320_Considine_25_Table13

 

*   *   *

6.  CONCLUSION

The resource and economic impact assessment conducted above finds significant economic benefits from developing California’s oil and natural gas resources. These developments, however, entail environmental impacts, which the previous section estimated. The key question is how the economic benefits compare with the value of the environmental impacts. To address this question, Table 14 presents the value of environmental impacts as a percent of value added from additional oil and gas production in California. With low environmental resource costs, the estimated values for environmental impacts are roughly 4 percent of value added. Under the medium cost scenario, the percentage rises to between 9 and 12 percent. Incidentally, most royalty rates are around 12 percent, suggesting that some form of taxation in that range could be used to endow environmental contingency funds. The high cost scenario has environmental impacts between 23 and 38 percent of value added. Overall, these findings suggest that the economic benefits from developing California’s oil and natural gas resources substantially exceed the value of the associated environmental impacts.

Table 14: Environmental Impacts as a Percent of Value Added
20140320_Considine_26_Table14

The above analysis demonstrates that California citizens pay a rather steep price in terms of foregone opportunities from restricting access to oil and gas development. In other words, the strategy of leaving the resources in the ground passes up billions in value added and tax revenues at the cost of avoiding environmental impacts that are worth far less. Even under the worst-case scenario with high carbon prices and environmental damage cost assessments, the “leave-it-in-the-ground” strategy foregoes $2.5 in economic gains for every dollar of avoided environmental impact. Under the medium environmental cost scenario, the ratio is close to ten-to-one. The implication is that if California is willing to pay for these environmental impacts, the returns would be significant in terms of employment, value added, and tax revenues.

*   *   *

Appendix A: Analysis of Supply and Demand Adjustments

Consider the equilibrium condition for the crude oil or natural gas market:

20140320_Considine_27_Equation1

where Qd is the total demand for crude oil or natural gas, Qo is production of crude oil or natural gas from California, and Qc is crude oil or natural gas supply from other regions.

Recognizing that each quantity in (1) is a function of price, taking the total differential of (1) and re-arranging terms yields:

20140320_Considine_28_Equation2

Factoring equation (2) and transforming to express in terms of elasticities provides:

20140320_Considine_29_Equation3

where is the elasticity of total market demand and is the elasticity of supply from other regions. The change in incremental demand is given by:

20140320_Considine_30_Equation4

The change in production from other regions can be computed as follows:

20140320_Considine_31_Equation5

The elasticities of supply and demand for natural gas and crude oil are determined based upon a review of the literature. The crude oil supply elasticity is 0.58 based upon a survey conducted by Dahl and Dugan (1996). The elasticity of crude oil demand is -0.58, which is an average of long-run price elasticities of demand reported by Hamilton (2009). The natural gas price elasticity of demand is -0.236, which is a sector weighted average of demand elasticities estimated following the model specifications developed by Considine et al. (2011b). The natural gas supply elasticity is 0.345, which is computed based upon a comparison of simulations from the National Energy Modeling System developed by the Energy Information Administration described by Considine (2013).

As an illustration of these calculations, consider the high production scenario for California crude oil. The base world oil consumption forecast is from the Annual Energy Outlook for 2013. Demand for oil outside California is determined by subtracting base California oil production assuming a 3 percent depletion rate plus the incremental change for each scenario from total world consumption projected by EIA. The percentage change in demand is computed using equations (4). Production outside California is computed using equation (5).

An example of the results appear below in Table A1 indicating that the 3.3 million barrels of additional oil production in 2025 under the high production scenario would reduce world prices by 2.79 percent, which would increase world consumption by 1.7 million barrels per day and reduce production outside California by 1.6 million barrels per day.

Table A1: Oil Market Adjustments to California High Production Scenario
20140320_Considine_32_TableA1

*   *   *

REFERENCES

Allen, David, V.M Torres, J. Thomas, D. Sullican, M. Harrison, A. Hendler, S. Herndon, C. Kolb, M. Fraser, A. Hill, B. Lamb (2013) “Measurements of Methane Emissions at Natural Gas Production Sites in the United States,” Proceedings of the National Academies of Science, 110. 44, 17768-17773, http://www.pnas.org/content/110/44/17768.

Anderson C., M. Mayes, and R. LaBelle (2012) “Update of Occurrence rates for Offshore Oil Spills,” U.S. Department of Interior, Bureau of Ocean Energy Management, http://www.boem.gov/uploadedFiles/BOEM/Environmental_Stewardship/Environmental_Assessment/Oil_Spill_Modeling/AndersonMayesLabelle2012.pdf.

Avalos, A. and D. Vera (2013) “The Petroleum Industry and the Monterey Shale: Current Economic Impact and the Economic Future of the San Joaquin Valley,” California State University, Western State Petroleum Association, http://www.wspa.org/sites/default/files/uploads/The%20Petroleum%20Industry%20and%20the%20Monterey%20Shale%20-%20Fresno%20State%20Study.pdf, 38 pages.

Considine. T.J., R. Watson, N. Considine, and J. Martin  (2013) “Environmental Regulation and Compliance in Marcellus Shale Gas Drilling,” Environmental Geosciences, 20, 1, 1-16.

Considine, T.J. R. Watson, and N. Considine, (2011a) “The Economic Opportunities of Shale Energy Development,” The Manhattan Institute, June 2011, http://www.manhattan-institute.org/pdf/eper_09.pdf, 28 pages.

Considine, T.J., R. Watson, and S. Blumsack (2011b) “The Economic Impacts of the Pennsylvania Marcellus Shale Natural Gas Play: An Update,” Energy and Mineral Engineering, May 2010, 59 pages,

Considine, T.J. (2013) “Powder River Basin Coal: Powering America,” Natural Resources, 4, 8 (2013), 514-533.

Dahl, C. and T. Duggan (1996) “U.S. Energy Product Supply Elasticities: A Survey and Application to the U.S. Oil Market,” Resource and Energy Economics, Vol. 18, No. 3, 243-263.

Humphries, M. and R. Pirog (2012) “U.S. Offshore Oil and Gas Resources: Prospects and Processes,” Congressional Research Service, http://assets.opencrs.com/rpts/R40645_20120210.pdf, 31 pages.

Gordon, P., J. Park, A. Khodabakshnejad, K. Hopkins, D. Wei, and A, Rose (2013) “Economic Modeling Scenarios,” Appendix K, “The Monterey Shale & California’s Economic Future,” University of Southern California, http://gen.usc.edu/assets/001/84955.pdf, pages 62-68.

Hamilton, James (2009) “Understanding Crude Oil Prices,” The Energy Journal, International Association for Energy Economics, vol. 30, No. 2, pages 179-206.

Harper, J. A. Godon, and A. Allen (1995) “Costs Associated with the Cleanup of Marine Oil Spills,” http://ioscproceedings.org/doi/pdf/10.7901/2169-3358-1995-1-27.

Hughes, J. D. (2013) “Drilling California: A Reality Check on the Monterey Shale,” Post Carbon Institute, http://www.postcarbon.org/report/1977481-drilling-california-a-reality-check-on, 49 pages.

Interagency Working Group on Social Cost of Carbon (2013) “United States Government Technical Support Document: Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis – Under Executive Order 12866, https://selectra.co.uk/sites/default/files/pdf/cost%20of%20carbon.pdf

Jaramillo, Paulina (2007) “A Life Cycle Comparison of Coal and Natural Gas for Electricity Generation and the Production of Transportation Fuels, “ Ph.D. Dissertation, Carnegie Mellon University.

Minnesota IMPLAN Group (2011) .

Park, J. and P. Gordon (2013) “Macroeconomic Impacts of Developing the Monterey Shale Using Advanced Extraction Technology,” Chapter 3 in, “The Monterey Shale & California’s Economic Future,” University of Southern California, http://gen.usc.edu/assets/001/84955.pdf, pages 25-40.

Schniepp, M. ( 2009) “Economic Benefits of Future Oil and Gas Production in Santa Barbara County,” California Economic Forecast, Santa Barbara Industrial Association Economic Conference, Santa Barbara, California.

U.S. Energy Information Administration (2011) “Review of Emerging Resources: U.S. Shale Gas and Shale Oil Plays,” http://www.eia.gov/analysis/studies/usshalegas/ pdf/usshaleplays.pdf, 82 pages.

U.S. Energy Information Administration (2013) “Annual Energy Outlook for 2013,” http://www.eia.gov/forecasts/aeo/pdf/0383(2013).pdf.

*   *   *

About the Author:  Dr. Timothy Considine is a School of Energy Resources Professor of Economics in the Department of Economics and Finance at the University of Wyoming. He received his Ph.D. from Cornell University. His research on petroleum market analysis has been published in the top economics journals. Recently, The Cato Institute published his paper exploring management policy issues facing the U.S. Strategic Petroleum Reserve, and the U.S. Department of Energy’s Office of the Strategic Petroleum Reserve currently uses his econometric model of world crude oil markets to estimate the market impacts of various management policies. Dr. Considine also worked as an economist at Bank of America, and as the lead analyst for natural gas deregulation on the U.S. Congressional Budget Office.

Is the Stock Market Over-Stimulated and Overpriced?

At the end of 2013 Wall Street appeared to be convinced that the markets were enjoying the best of all possible worlds. In an interview with CNBC on Dec. 31 famed finance professor Jeremy Siegel stated that stocks would build on the great gains of 2013 with an additional 27% increase this year. So far 2014 hasn’t gone according to script. In contrast to the prevailing optimism I maintain a high degree of skepticism regarding the current rally in U.S. stocks. But opinions are cheap. To back up my gut feeling, here are six very diverse indicators that suggest U.S. stocks are overvalued.

1) U.S. STOCK PRICES VS. LONG-TERM EARNINGS

Currently market bulls will tell you that price to earnings ratios are well within their historic range. But they fail to mention that this statement is based on projected 2014 those earnings that won’t be known exactly until 2015. More sophisticated investors tend to rely on the Shiller S&P 500 P/E Ratio which compares U.S. stock prices to average 10 year inflation-adjusted earnings. This takes a lot of the guess work out of the equation. Today the Shiller S&P 500 PE Ratio is at 26.4. But going back 100+ years, the historic mean of the index is 16.5. This means the current ratio is 61% higher than its long term average.

20140325_Chaudhary-1

Past performance does not guarantee future results.

There are only four occasions in the past 100+ years in which the Shiller S&P 500 PE Ratio was higher than it is now: 1929, 1999, 2002, and 2007. In 3 of these 4 instances, U.S. stock prices saw major declines over the ensuing two years.

But even if we were to agree with the bullish pundits who argue that today’s low interest rates have created a new plateau of valuations, (and therefore can’t be compared fairly to generations-old metrics) today’s short term P/E ratio is still high. Based on the most recent year’s trailing 12-month earnings, the S&P 500 PE Ratio is at 20.14.

At first glance, this does not appear to be extremely high. However, there is an important caveat. Currently, corporate profits as a percentage of GDP are the highest they have ever been since the World War II era.

20140325_Chaudhary-2

Currently profits are coming in at 11% of GDP, a level that is around 60% higher than the average of around 6% that has been seen since 1952. (It is even significantly higher than the average of the past 10 years – a period during which low interest rates pushed up financial ratios past their traditional levels). To return to a more normalized ratio either GDP would have to expand rapidly or profits would have to diminish. Given our view of the current economic prospects, we believe the latter outcome is more likely.

2) U.S. STOCK PRICES VS. CORPORATE ASSETS: TOBIN’S Q RATIO

Maybe earnings just aren’t as important as they used to be. Given all the cash that is on company balance sheets, maybe assets are more detreminative. Tobin’s Q Ratio is a popular measure that compares a company’s market value (which is a function of share price) to the amount it would cost to replace the company’s assets.

So if a company owned a factory, and the market capitalization of the company was $1 million, but the factory would cost $2 million to build today, Tobin’s Q Ratio would be 0.5. The lower the ratio, the less the investor is theoretically paying for the company’s assets.

20140325_Chaudhary-3

At greater than 1, Tobin’s Q Ratio implies that stocks are overvalued. From the chart above, you can see that the Tobin’s Q Ratio for the U.S corporate sector was at 1.05 at the end of last year, which is approaching the level associated with past market declines. The historic mean over more than 100 years for the ratio is just .68 and there are only a few occasions over that time when the ratio passed 1.0. The late 1990’s was the only instance in which the ratio passed 1.1. At that time it shot up to 1.63, before eventually plunging. But should we really hold up the dotcom mania as a benchmark for sound valuations?

3) U.S. STOCK PRICES VS. GDP

The chart below compares the total market capitalization of all publicly traded U.S. companies with U.S. GDP.

20140325_Chaudhary-4

Since 1950 the median figure of this ratio is .65, meaning that all public companies together were worth 65% of that year’s GDP. Currently, the ratio is nearly double that at 1.25. The only times U.S. stocks were valued higher relative to GDP were in 1999 and 2000.You know how that ended.

4) U.S. STOCK PRICES VS. MARGIN DEBT

Just as it’s possible to buy houses with debt (mortgages), people can buy stocks with debt (it’s called margin). As stocks go higher, an increased number of investors may become tempted to use credit to buy appreciating assets. This is particularly true when low interest rates push down the cost of borrowing. Not surprisingly, the chart below from the New York Times shows that stock margin debt as a percentage of GDP is approaching the higher end of its historic range:

20140325_Chaudhary-5

As we have seen in so many of the other metrics, the chart shows large spikes in 1999 and 2007. And while it’s certainly possible that margin debt could go higher from current levels of 2.27% (it reached 2.85% in 1999), it is also possible that margin debt will decrease sharply soon thereafter. When margin equity falls below a certain percentage, many investors are forced to sell stock to repay the loans, which brings downward pressure on share prices. We have seen this movie before, and it’s not a comedy.

5) U.S. STOCK PRICES VS. DIVIDEND YIELD

Of all the ways to measure stock valuations, dividend yield may be the most tangible. Dividends are what investors are paid directly to own stocks. By that metric, U.S. stocks are looking historically expensive.

20140325_Chaudhary-6

As you can see in the chart above, the dividend yield on the S&P 500 at the end of 2013 was the lowest it’s ever been (with the exception of the period around 1999 – there’s that year again).

6) U.S. STOCK PRICES VS. INTEREST RATES

Low interest rates have been the Holy Grail of stock market bulls. By definition, the present value of stocks is higher when interest rates are anticipated to be lower in the future (meaning that investors are willing to pay more for well-established income streams today in anticipation of lower rates).

20140325_Chaudhary-7

As seen in the chart above, yields on the 10-year Treasury bond were cut in half between 1981 and 1989They were halved again by 2002, and again by 2011. From there they decline another 25% before bottoming in May 2013, at 1.5%. These historic declines helped fuel an historic rally in stocks.

Low interest rates also tend to keep corporate costs down and profits up (low rates are one of the main factors in the current profit boom), and make stocks more attractive relative to bonds. The Fed’s current open-ended commitment to zero interest rates has inspired many investors to  adopt a “Don’t Fight the Fed” rallying cry. (A new variant on this may be “As long as it’s Yellen, don’t think of sellin.”)

But here’s the problem…although interest rates remain in historically low territory they have been trending upward slowly for the past year and a half. It’s unreasonable to expect this trend to reverse and interest rates to fall once again into record low territory. If the Fed goes through with its tapering campaign and diminishes the amount of Treasury bonds it buys on a monthly basis (purchases that have helped keep rates low), they are much more likely to rise.

In the first weeks of 2014, yields on 10-year Treasuries flirted with three percent for the first time since July 2011, a time in which the Dow Jones Industrial Average was about 23% below current levels.

IN CONCLUSION

While our analysis at Euro Pacific Capital is in no way exhaustive, I believe that the above metrics make a fairly solid case that U.S. stocks are likely overvalued. I believe that the current optimism is based solely on confidence in monetary policy and the belief that the U.S. has embarked on a period of sustained expansion. However, as Peter Schiff has explained many times, the economy now shows many of the over-leveraged and delusional characteristics that existed before the recessions of 2000 and 2008. Perhaps that helps to explain why today’s markets so closely resemble those periods.

About the Author:  Neeraj Chaudhary is an Investment Consultant in the Los Angeles branch of Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff. This commentary originally appeared in the Winter 2014 EPC Global Investor Newsletter and appears here with permission from the author.

How Much Do CalSTRS Retirees Really Make?

Summary:  The California State Teacher’s Retirement System (CalSTRS) is California’s 2nd largest public employee pension fund, serving roughly 2% of California’s population. At present, its unfunded liability is officially estimated at $71 billion. While much of the discussion over pension reform focuses on projected rates of investment returns, which greatly affects the required annual contributions to the fund, too often the actual amount of the average CalSTRS pension is omitted from these discussions. Even worse, the average pension amounts frequently cited for CalSTRS retirees are often misleading because they fail to take into account years of service, or the impact of pension benefit enhancements in recent years.

In this study, we analyze data from CalSTRS 2012 pension records to assess the true value of the average CalSTRS pension. We do so by factoring in years of service data to extrapolate an average “full career” amount, represented by both 30 and 43 year terms. We find that the average CalSTRS retiree can presently expect to receive a $51,500 pension for having worked a 30 year career, and a $73,817 pension for a 43 year career.

This study also analyzes 2012 pension averages broken out by the retiree’s retirement date and finds a significant disparity between the amount received by those who have retired more recently as compared to those who have retired earlier. For example, if a CalSTRS participant had retired in 2012 after working 30 years, they could expect an initial annual pension of $57,645; after 43 years, $82,625. The average 2012 pension for a CalSTRS participant who retired 20 years ago, in 1992, is much lower; $38,517 if they had worked 30 years; after 43 years, $55,207.

When discussing how much public employees receive in pension benefits, in order to make accurate comparisons and avoid misleading the public, it is vital to adjust the data to reflect averages based on full careers in public service. It is also vital to provide averages that reflect current benefit formulas, since the more generous formulas currently in effect are what inform the scale of pension liabilities in the future. This study addresses these concerns.

INTRODUCTION

The pay and benefits of public employees is a discussion of increasing relevance to taxpayers. As noted in a CPPC study published on February 1st, 2014, “How Much Do California’s State, City and County Workers Really Make?,” in California, personnel costs are estimated to consume 40% of total city budgets, 41% of the state budget for direct operations, and 52% of county budgets. In many cities and counties the percentage is much higher. And these averages don’t include personnel costs for outside contractors, nor do they include payments on debt that is directly related to personnel costs, such as pension obligation bonds.

Meanwhile, even when budgets are balanced, as may be the case this fiscal year at least for the State government, there is an overhang of debt obligations facing California’s state and local governments that are only manageable as long as interest rates remain relatively low. Another CPPC study published in April 2013 entitled “Calculating California’s Total State and Local Government Debt,” estimated California’s total state and local bond debt at $382.9 billion as of June 30, 2012. That same study reported California’s officially recognized state and local unfunded obligations for retirement health insurance and pension obligations at $265.1 billion. Using more conservative assumptions regarding pension fund performance, the study estimated these retirement obligations on the part of California’s state and local governments could increase by an additional $389.8 billion. In all, it is quite likely that California’s taxpayers currently owe over $1.0 trillion in total debt and unfunded retirement obligations incurred by state and local government, and most of that is for retirement benefits for state and local government employees.

In this environment it is important to present factual information relating to public sector compensation. With respect to retirement benefits, it is helpful to present complete and accurate aggregate data, in order for policymakers and taxpayers to determine whether or not current benefit formulas are fair and financially sustainable. This study analyzes data from CalSTRS, using nearly a quarter-million records obtained from CalSTRS for 2012. In particular, this study presents data showing, by year of retirement, what the average pension benefits were in 2012. The study then normalizes these benefits to account for full careers using two benchmarks – the public sector “full career” expectation of 30 years, and the private sector “full career” expectation of 43 years.

*   *   *

METHODS AND ASSUMPTIONS TO ACQUIRE DATA

This study precisely replicates the methods used in a CPPC study released on February 14th, 2014, “How Much Do CalPERS Retirees Really Make?”  The analysis and charts developed for this study can be evaluated by downloading the following spreadsheet. Please note the file size is 23 MB.

CalSTRS-2012_Analysis_normalized-pensions-by-year-of-retirement.xlxs

The source data was acquired from the website www.TransparentCalifornia.com, an online resource produced through a joint-venture involving the California Policy Center and the Nevada Policy Research Institute. The data on the Transparent California website, in this case, was acquired directly from CalSTRS, and has not been altered. Since the focus in this study involves aggregate data, the names of individual participants have been removed from the downloadable spreadsheet that accompanies this analysis.

Because the information provided by CalSTRS included “year of retirement” and “years of service,” it is possible to normalize the information to produce “full career” equivalent pensions. It is vital to make this analysis, because no statistic representing average pensions can be evaluated apart from knowing how long most participants actually worked. It would be analogous to saying that an active worker only was paid $100 for a day’s work, without knowing how many hours they worked. Did they work ten hours and earn $10 per hour, or did they only work one hour and earn $100 per hour? Without looking at how many years participants worked to earn their pensions, we cannot even begin to have a productive discussion as to whether or these pensions are fair and appropriate or not.

From a standpoint of financial sustainability it is also vital to know how many years of service the average pensioner logged. Using the payroll analogy again, if a person only worked one hour in a day and made $100, and the employer needed someone at that post for ten hours, than the employer cost was actually $1,000 per day, whereas if that person worked a ten hour day and made $100, then the employer cost was only $100. This is precisely what is at stake when evaluating the overall cost to taxpayers of public sector pensions. For example, if the average years of service for a pensioner is only 20 years, and a private sector career is actually 40 years, then the taxpayer is essentially paying for two pensions for each position that would have been filled by one person working 40 years.

*   *   *

AVERAGE LENGTH OF SERVICE AND AVERAGE PENSION – TOTAL POOL OF PARTICIPANTS

In Table 1 it can be seen that nearly a quarter-million retirees collected pension benefits through CalSTRS during 2012, and that the average pension was $43,821 during that year. Inexplicably, this average is considerably higher than the averages frequently cited by spokespersons for CalSTRS and public sector unions representing CalSTRS participants. But the average CalSTRS retiree worked for 25.53 years. It is not reasonable to suggest that someone who has only worked perhaps two-thirds the duration of a normal career should expect a retirement benefit that might be more appropriate for a full career. And it is impossible to discuss, much less determine, whether or not CalSTRS retirement benefits are appropriate, without taking into account how long a retiree has worked in order to earn their retirement benefit.

Table 1  –  Basic CalSTRS Data, 2012

20140228_CalSTRS_normalized-pensions_Table01

The next table, below, depicts how much these overall average pension amounts would increase if the retiree pool had turned in an average “years of service” of 30 years, which is a typical duration to use when considering public sector careers, as well as 43 years, which is typical for any private sector worker who hopes to receive the full Social Security benefit.

These calculations are made by dividing the average annual pension for a CalSTRS participant in 2012, $43,821, by the average years of service, 25.53. The result, $1,717, is the amount the average CalSTRS retiree accrued in annual pension benefits for each year they worked during their careers. This amount is multiplied by 30 to show what a current CalSTRS retiree could expect, on average, if they had worked 30 years; $51,500.  This amount is multiplied by 43 to show what a current CalSTRS retiree could expect, on average, if they had worked 43 years; $73,817.

Table 2  –  CalSTRS Average Pensions Assuming Full Careers

20140228_CalSTRS_normalized-pensions_Table02

Just as when considering current compensation for public employees, total compensation – direct pay plus employer paid benefits – is the only truly accurate measurement of how much they make, when considering retirement pensions for retired public employees, pensions adjusted to show what they would have been if the recipient had spent their entire career working and paying into the pension system, i.e., “full career equivalent pensions,” are the only accurate measurements of how much they are really getting in retirement. But there is another crucial variable that must be considered to complete this analysis, which is how much full career equivalent pensions are paying to CalSTRS retirees who retired in recent years.

*   *   *

AVERAGE PENSION ADJUSTED FOR FULL-CAREER – SHOWN BY YEAR OF RETIREMENT

Because the data provided by CalSTRS includes not only years of service for each participant, but also the year they retired, it is possible to calculate average “full-career” pension benefits based on the year they retired. It is important to do this because pension benefits for California’s state and local government workers were steadily enhanced over the past decades, especially after 1999 when SB 400 was passed by the California state legislature. In general, pension formulas have been altered to bestow pension benefits that are approximately 50% better today than they were 20 years ago. At the same time, pension benefits are calculated on rates of pay, which themselves have increased at a rate exceeding inflation for at least the last 20 years.

Table 3 depicts the unambiguous impact of these trends. The last column to the right on the table, “Avg Pension, 43 Years Svc” shows what retirees would be really getting in pension benefits if they had worked 43 years – from age 25 through age 67 (one may substitute age 22 through age 64, or whatever, of course). As seen, the 14,247 retirees in 2012, had they worked 43 years, would have collected average annual pensions of $82,625.

In general, pensions adjusted to reflect a full career in the private sector exceeded $80,000 per year starting with those CalSTRS participants retiring in 2001. They decrease sharply for participants who retired prior to 2001. In 1999 and 2000 they were less than less than $70,000 but more than $60,000. Participants who retired between the years 1986 and 1998 collect pensions today – again, had they worked a full private sector career – greater than $50,000 and less than $60,000. Participants who retired before 1986 collect pensions today that are less than $50,000.

It is hard to find a data set that shows a greater correlation than this one: The earlier you retired, the less you’re going to get in your pension today. That is because pension formulas were enhanced for California’s state and local government workers over the past 10-20 years – especially starting around 1999. Not only were they enhanced, but they were enhanced retroactively, meaning that someone nearing retirement who had been accruing pension benefits at a rate of 2.0% per year, for example, suddenly began accruing pension benefits at a rate of 3.0% per year not only for the years remaining in their career, but for every year they worked.

To speculate as to why it was possible to retroactively enhance pension formulas through legislative action, yet it is purportedly unconstitutional and therefore impossible to merely reduce these formulas for active workers from now on, would go beyond the scope of this modest analysis.

 Table 3  –  CalSTRS Average “Full Career” Pensions By Year of Retirement

20140228_CalSTRS_normalized-pensions_Table01-bar-chart

Table 3 (Data)  –  CalSTRS Average “Full Career” Pensions By Year of Retirement

20140228_CalSTRS_normalized-pensions_Table03

It is probably necessary to reiterate as to why full-career equivalent pensions are the only accurate measurement to use when discussing whether or not today’s public sector pension benefits are appropriate or financially sustainable. The reason is simple and bears repeating:  Defenders of pensions as they are use “averages” that don’t seem terribly alarming. Notwithstanding the fact that a self-employed person in the private sector would have to earn over $100,000 per year and contribute 12.4% of their lifetime earnings in order to collect the maximum Social Security benefit of $31,704 at age 68, which is considerably less than the average CalSTRS pension of $43,821, that average CalSTRS pension is based on an average years of service of 25.53 years. Somebody who has only worked for 25 years should not have an expectation of a pension that exceeds the maximum Social Security benefit that requires 12.4% of a six-figure annual income and 43 years of work. Few, if any participants in CalSTRS are contributing more than 12.4% of their pay into their pension account. The taxpayers make up the difference.

When debating the financial sustainability of CalSTRS and the other pension funds serving California’s state and local government workers, there are many issues. How the unfunded liability is estimated is the topic of intense debate, focusing primarily on what rate-of-return these funds believe they will average over the next few decades. That rate-of-return estimate also is a primary determinant of how the “normal contribution” is calculated. There are myriad aspects to the debate over how to adequately fund public sector pensions. But missing from that debate far too frequently is an honest assessment of just how much, on average, these pensions are really worth to the recipients.

This study has presented a calculation of what CalSTRS’s average pension benefit is based on years worked as well as year of retirement. It has normalized that data to show that a retiree who worked 30 years and retired last year, on average, can expect a pension of over $57,000 per year, and if they worked 43 years and retired last year, on average, can expect a pension of over $82,000 per year.

About the Authors:

Robert Fellner is a researcher at the Nevada Policy Research Institute (NPRI) and joined the Institute in December 2013. Robert is currently working on the largest privately funded state and local government payroll and pensions records project in California history, TransparentCalifornia, a joint venture of the California Policy Center and NPRI. Robert has lived in Las Vegas since 2005 when he moved to Nevada to become a professional poker player. Robert has had a remarkably successfully poker career including two top 10 World Series of Poker finishes. Additionally, his economic analysis on the minimum wage law won first place in a 2011 essay contest hosted by the George Mason University.

Ed Ring is the executive director for the California Policy Center. As a consultant and full-time employee primarily for start-up companies in the Silicon Valley, Ring has done financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

Comparing CalSTRS Pensions to Social Security Retirement Benefits

Summary:  This study compares Social Security retirement benefits to CalSTRS pension benefits and finds a significant disparity between the plans, despite the employee contributions being relatively similar.

For example, the average CalSTRS participant retires at age 62, which is the current earliest age one may collect Social Security retirement benefits. At age 62, the average CalSTRS retiree collects 56% of their final salary in the form of a pension, whereas, depending on their income, the average Social Security recipient collects between 29% and 36% of their final salary in the form of a retirement benefit. At age 65, the oldest age necessary to collect the full CalSTRS benefit, a CalSTRS retiree with 35 years experience will collect a retirement benefit equal to 84% of their final salary. At age 65 a Social Security recipient will collect a retirement benefit between 30% and 35% of their final salary.

The study then examined how much more a CalSTRS participant might have accumulated based on having 8.0% of their paycheck withheld vs. only 6.2% for a Social Security participant. For a CalSTRS paticipant retiring at age 65 with a final income of $80,000, the study estimated the value of this extra 1.8% in annual contributions to equal $155,814 after 35 years of withholding. This is equal to 3.6 years of the difference in the amount of a typical annual CalSTRS pension and a typical Social Security annual retirement benefit, i.e., it does not come close to closing the gap between the typical Social Security benefit vs the typical CalSTRS benefit. A more in-depth analysis of contribution comparisions between CalSTRS and Social Security will be the topic of a subsequent study.

In general, the study calculated the average annual CalSTRS pension to exceed the average annual Social Security benefit by between 1.5 and 1.9 times for those retiring at age 62, and by between 2.4 and 2.8 times for those retiring at age 65.

*   *   *

INTRODUCTION

“California’s educators do not participate in Social Security, retire on average around age 62, and earn a retirement income that replaces only about 56 percent of their salary.
CalSTRS Statement on Proposed Pension Reform Act of 2014 Ballot Measure, October 17, 2013

A frequent objection to public sector pension reforms is that pension benefits are received in place of Social Security. While many public employees do earn Social Security benefits along with pensions, in the case of public school teachers they do not. So how does a pension from the California Teachers Retirement System (CalSTRS) compare to a Social Security benefit?

There are various ways to make valid comparisons between a CalSTRS pension and a Social Security retirement benefit, and this article will explore some of them. In order to make these comparisons, we will rely on statements from CalSTRS or information available on their website, along with information available online from the Social Security Administration. All source data will be linked to within the text. For each of the cases to follow, we will summarize the baseline assumptions, then present the comparisons.

*   *   *

(1)  How much will a person retiring at age 62, with a final income of of $80,000, receive via a CalSTRS pension vs. a Social Security retirement benefit?

A 62 year old CalSTRS retiree, based on the average presented in the above-referenced October 2013 press release, will earn an annual pension of $44,800.

A 62 year old private sector retiree working through 2013 with a final income of $80,000 will receive a Social Security retirement benefit of $23, 544 per year. This is based on inputting into the Social Security Administration’s online “Quick Calculator” a birth date o f 1-1-1952, a benefit start date of 2-1-2014, and a final annual pay of $80,000 in 2013.

As can be seen, in this first, admittedly simplistic analysis, the average CalSTRS retiree will collect a pension 90% greater than a Social Security recipient fitting the same profile, nearly twice as much. Put another way, in this example the CalSTRS particpant receives a pension equivalent to 56% of their final $80,000 salary, and the Social Security participant receives a pension equivalent to 29% of their final $80,000 salary.

Social Security, unlike pensions, however, has the characteristic of being progressive, in the sense that lower income participants will collect a greater percentage of their earnings in the form of a Social Security benefit than higher income participants. Since information on the average teacher salary earned by 62 year old retirees is not readily available, here are the same comparisons made with lower final annual earnings:

Case 1:  CalSTRS Pension vs. Social Security
Retirement Age 62, Various Final Year Earnings

20140228_SocSec_vs_CalSTRS_Case1As can be seen from the above chart, there is a considerable improvement on the amount a Social Security beneficiary will earn at lower levels of income. But even at a $40,000 annual salary, which it is reasonable to assume virtually all veteran CalSTRS participants will collect if they are still working into their early sixties, the Social Security benefit is only 36% of final salary, whereas the CalSTRS pension remains at 56% of final salary. Since CalSTRS formulas are applied regardless of income levels, it is accurate to apply this assumption to make this comparison.

*   *   *

(2) CalSTRS benefits for employees hired after January 1st 2013 have had their benefit formulas reduced. How does this affect the comparison between a CalSTRS retiree and a Social Security retiree?

To answer this question it is necessary to make some assumptions regarding length of service, since the averages used by CalSTRS spokespersons are calculated based on existing retirees. From the “Retirement Benefits” section of their website, CalSTRS retirement benefits are calculated according to the following formula (readers may click on each variable for more detailed information from CalSTRS):

 Service Credit x Age Factor x Final Compensation = Retirement Benefit

Here’s how this works: “Service Credit” refers to years of full time employment (there are ways employees can increase their service credit, such as through converting unused sick time into additional service credits, but we will set that aside). The “Age Factor” is a multiplier which increases the older a beneficiary is when they retire, and the “Final Compensation” is how much they earned in their final year of full-time work. In some cases final compensation is calculated using the average of salary earned during the final three years worked.

In practice, this formula would work as follows: If someone worked 30 years, their service credit is 30. If they are 65 years old, their age factor is determined according to a table; for a 65 year old under the new benefit formula, the age factor is 2.4%. So if their final salary was $80,000, their initial annual pension would be 30 (service credit) x 2.4% (age factor) x $80,000 (final salary) =  $57,600.

Since new employees hired after January 1st 2013 are the only ones affected by the recent reductions to benefit formulas, they won’t have any significant impact on pension averages for decades. But to ensure this analysis avoids any overstatement, all comparisons used will be based on the new formulas, the so-called “2% at 62” employee pool – all of whom are new hires. Here is the statement on the benefit changes from CalSTRS, found on the first page of their 2013 Member Handbook:

“Of special note, the California Public Employees’ Pension Reform Act of 2013 made significant changes to the benefits for members first hired on or after January 1, 2013, to perform CalSTRS creditable activities, and other changes that affect both new and existing members. As a result, CalSTRS now has two benefit structures:

• Members first hired on or before December 31, 2012, are under CalSTRS 2% at 60.

• Members first hired on or after January 1, 2013, are under CalSTRS 2% at 62.”

Under CalSTRS’s new pension benefit formulas, which are marginally less generous than their old pension benefit formulas, if you retire at age 65, you are entitled to an “Age Factor” of 2.4% (ref. column 4 in the table on CalSTRS “Age Factor” information page).

Immediately one may see that earning a pension equivalent to the amount CalSTRS represents as “average,” 56% of final salary, would require a participant to work for 23.3 years, since 23.3 x 2.5% = 56%. Referring to the table depicting Case 1, above, this means that to earn a pension that exceeds the Social Security benefit by the amounts pertaining to various levels of final salary between $40,000 and $80,000 – all quite significant – one would only have to work 23 years.

For the sake of a fair comparison, however, it is necessary to examine the Social Security benefit at age 65, since that is how old a CalSTRS participant now must be before they can earn the maximum multiplier (or “Age Factor”) or 2.4%. This, in turn, requires one to speculate as to how many years a Social Security recipient would have to work in order to get the amount calculated by the “Quick Calculator” benefit estimator provided by the Social Security Administration.

Fortunately, in the “Frequently Asked Questions” section of the Social Security website, this can be found:

“8. How does the Quick Calculator estimate my past covered earnings? Answer: The calculator bases your estimated past earnings on the latest earnings figure you provide, the national average wage indexing series, and a relative growth factor that is initially set to 2 percent.”

Digging deeper, it can be seen from the Social Security website’s page “Benefit Calculation Examples For Workers Retiring In 2014,” that in these “Quick Calculator” estimates, as they put it, “We use the highest 35 years of indexed earnings in a benefit computation.” This is helpful for validating the assumptions necessary for a proper comparison at age 65. The Social Security estimates assume at least 35 years of work.

Here then, are the benefits one may expect from the revised, reformed and diminished CalSTRS benefit formulas, compared to the current Social Security retirement benefit formulas, for a 65 year old retiree who has worked for 35 years. This shows the same final annual income variants as case 1, ranging from $40,000 to $80,000.

Case 2:  CalSTRS Pension vs. Social Security
Retirement Age 65, Various Final Year Earnings

20140228_SocSec_vs_CalSTRS_Case2 As is readily apparent on the above table, working for 35 years creates a major improvement in the pension benefits enjoyed by a CalSTRS participant; instead of collecting the average 56% of final salary at an average age of 62, by age 65 – if they have worked 35 years – they will collect a pension equivalent to 84% of their final salary. For a Social Security participant, waiting an extra three years to retire scarcely makes a difference. Depending on their income, they will collect at retirement benefit equivalent to somewhere between 30% and 35% of their final year of earnings.

*   *   *

(3) But CalSTRS participants contribute 8.0% of their salary into the pension fund, and Social Security participants only contribute 6.2% of their salary into the Social Security fund. What’s that worth?

Before answering this question, it should be intuitively obvious that contributing 1.8% more into a fund will not fund a lifetime retirement annuity that is between 1.5 and 2.8 times greater than if one had retained the 1.8% asZ take-home pay.

The table below shows in detail exactly how much more money someone might be able to save over the course of a 35 year career by putting 1.8% of their paycheck into a fund that yielded 7.5% annual interest.

Case 3:  CalSTRS Pension vs. Social Security
Additional Savings Possible By Contributing 1.8% More Per Year

20140228_SocSec_vs_CalSTRS_Case3-REVISED-a

As shown above, after 35 years, putting an extra 1.8% of earnings per year into an investment fund will only increase the total savings by $155,814 (contributions of $37,438 plus investment earnings of $118,376). At age 65, as shown in Case 2, a CalSTRS participant who worked 35 years and retired at a final salary of $80,000 (also used in this case) will earn an initial annual pension of $67,200. A Social Security participant, using identical assumptions, can expect an initial annual retirement benefit of $23,940, a difference of $43,260 per year. This means the extra withholding made by the CalSTRS participant earns an extra amount, $155,814, that is used up in 3.6 years.

According to the online Life Expectancy Calculator provided by the Social Security Administration, in 2014 a 65 year old American may expect to live, on average, for another 20 years. This means that contributing another 1.8% on the part of CalSTRS participants compared to Social Security participants will still leave, on average, a gap of $709,386 in lower benefits earned by the Social Security recipient (16.4 x $43,260).

Because much has been made of the extra amount CalSTRS participants have withheld, it is important to emphasize that every assumption used in this analysis is conservative. The “growth factor on past earnings” is only 2%, matching the one used by the Social Security Administration in their estimates. This low percentage is unlikely to accurately reflect earnings growth, especially in the public sector, where in general over the past three decades earnings growth has kept pace with inflation. Using a lower than representative growth factor of 2.0%, working backwards from the present into the past, results in early career pay estimates that are higher than what probably was the case. This causes the early career contributions to be overstated, causing compound interest to accrue on larger amounts, resulting in a larger ending fund balance than would have actually been achieved.

Similarly, this example uses a 7.5% earnings estimate throughout. While CalSTRS claims to have achieved this result historically, it is not clear they will be able to achieve it in the future, for a variety of macroeconomic reasons that are the topic of ongoing debate.

*   *   *

About the Author:

Ed Ring is the executive director for the California Policy Center where he oversees execution of the Center’s strategic plan. He is also the editor of ProsperityCalifornia.org and UnionWatch.org. Previously as a consultant and full-time employee primarily for start-up companies in the Silicon Valley, Ring has done financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

 

 

How Much Do CalPERS Retirees Really Make?

INTRODUCTION

The pay and benefits of public employees is a discussion of increasing relevance to taxpayers. As noted in a CPPC study published earlier this month “How Much Do California’s State, City and County Workers Really Make?,” in California, personnel costs are estimated to consume 40% of total city budgets, 41% of the state budget for direct operations, and 52% of county budgets. In many cities and counties the percentage is much higher. And these averages don’t include personnel costs for outside contractors, nor do they include payments on debt that is directly related to personnel costs, such as pension obligation bonds.

Meanwhile, even when budgets are balanced, as may be the case this fiscal year at least for the State government, there is an overhang of debt obligations facing California’s state and local governments that are only manageable as long as interest rates remain relatively low. Another CPPC study published in 2013 entitled “Calculating California’s Total State and Local Government Debt,” estimated California’s total state and local bond debt at $382.9 billion as of June 30, 2012. That same study reported California’s officially recognized state and local unfunded obligations for retirement health insurance and pension obligations at $265.1 billion. Using more conservative assumptions regarding pension fund performance, the study estimated these retirement obligations on the part of California’s state and local governments could increase by an additional $389.8 billion. In all, it is quite likely that California’s taxpayers currently owe over $1.0 trillion in total debt and unfunded retirement obligations incurred by state and local government, and most of that is for retirement benefits for state and local government employees.

In this environment it is important to present factual information relating to public sector compensation. With respect to retirement benefits, it is helpful to present complete and accurate aggregate data, in order for policymakers and taxpayers to determine whether or not current benefit formulas are fair and financially sustainable. This study analyzes data from CalPERS, using nearly a half-million records obtained from CalPERS for 2012. In particular, this study presents data showing, by year of retirement, what the average pension benefits were in 2012. The study then normalizes these benefits to account for full careers using two benchmarks – the public sector “full career” expectation of 30 years, and the private sector “full career” expectation of 43 years.

*   *   *

METHODS AND ASSUMPTIONS TO ACQUIRE DATA

The analysis and charts developed for this study can be evaluated by downloading the following spreadsheet. Please note the file size is 23 MB.

CalPERS-2012_Analysis_normalized-pensions-by-year-of-retirement.xlxs

The source data was acquired from the website www.TransparentCalifornia.com, an online resource produced through a joint-venture involving the California Policy Center and the Nevada Policy Research Institute. Since the focus in this study involves aggregate data, the names of individual participants have been removed from the spreadsheet.

Because the information provided by CalPERS included “year of retirement” and “years of service,” it is possible to normalize the information to produce “full career” equivalent pensions. It is vital to make this analysis, because no statistic representing average pensions can be evaluated apart from knowing how long most participants actually worked. It would be analogous to saying that an active worker only was paid $100 for a day’s work, without knowing how many hours they worked. Did they work ten hours and earn $10 per hour, or did they only work one hour and earn $100 per hour? Without looking at how many years participants worked to earn their pensions, we cannot even begin to have a productive discussion as to whether or these pensions are fair and appropriate or not.

From a standpoint of financial sustainability it is also vital to know how many years of service the average pensioner logged. Using the payroll analogy again, if a person only worked one hour in a day and made $100, and the employer needed someone at that post for ten hours, than the employer cost was actually $1,000 per day, whereas if that person worked a ten hour day and made $100, then the employer cost was only $100. This is precisely what is at stake when evaluating the overall cost to taxpayers of public sector pensions. For example, if the average years of service for a pensioner is only 20 years, and a private sector career is actually 40 years, then the taxpayer is essentially paying for two pensions for each position that would have been filled by one person working 40 years.

*   *   *

AVERAGE LENGTH OF SERVICE AND AVERAGE PENSION – TOTAL POOL OF PARTICIPANTS

In Table 1 it can be seen that nearly a half-million retirees collected pension benefits through CalPERS during 2012, and that the average pension was $30,456 during that year. This average is consistent with the averages frequently cited by spokespersons for CalPERS and public sector unions representing CalPERS participants. But the average CalPERS retiree worked for 19.93 years. It is not reasonable to suggest that someone who has only worked half the duration of a normal career should expect a retirement benefit that might be more appropriate for a full career. And it is impossible to discuss, much less determine, whether or not CalPERS retirement benefits are appropriate, without taking into account how long a retiree has worked in order to earn their retirement benefit.

Table 1  –  Basic CalPERS Data, 2012

20140212_CalPERS_normalized-pensions_Table01The next table, below, depicts how much these overall average pension amounts would increase if the retiree pool had turned in an average “years of service” of 30 years, which is a typical duration to use when considering public sector careers, as well as 43 years, which is typical for any private sector worker who hopes to receive the full Social Security benefit.

These calculations are made by dividing the average annual pension for a CalPERS participant in 2012, $30,456, by the average years of service, 19.93. The result, $1,528, is the amount the average CalPERS retiree accrued in annual pension benefits for each year they worked during their careers. This amount is multiplied by 30 to show what a current CalPERS retiree could expect, on average, if they had worked 30 years; $45,841.  This amount is multiplied by 43 to show what a current CalPERS retiree could expect, on average, if they had worked 43 years; $65,705.

Table 2  –  CalPERS Average Pensions Assuming Full Careers

20140212_CalPERS_normalized-pensions_Table02Just as when considering current compensation for public employees, total compensation – direct pay plus employer paid benefits – is the only truly accurate measurement of how much they make, when considering retirement pensions for retired public employees, pensions adjusted to show what they would have been if the recipient had spent their entire career working and paying into the pension system, i.e., “full career equivalent pensions,” are the only accurate measurements of how much they are really getting in retirement. But there is another crucial variable that must be considered to complete this analysis, which is how much full career equivalent pensions are paying to CalPERS retirees who retired in recent years.

*   *   *

AVERAGE PENSION ADJUSTED FOR FULL-CAREER – SHOWN BY YEAR OF RETIREMENT

Because the data provided by CalPERS includes not only years of service for each participant, but also the year they retired, it is possible to calculate average “full-career” pension benefits based on the year they retired. It is important to do this because pension benefits for California’s state and local government workers were steadily enhanced over the past decades, especially after 1999 when SB 400 was passed by the California state legislature. In general, pension formulas have been altered to bestow pension benefits that are approximately 50% better today than they were 20 years ago. At the same time, pension benefits are calculated on rates of pay, which themselves have increased at a rate exceeding inflation for at least the last 20 years.

Table 3 depicts the unambiguous impact of these trends. The last column to the right on the table, “Avg Pension, 43 Years Svc” shows what retirees would be really getting in pension benefits if they had worked 43 years – from age 25 through age 67 (one may substitute age 22 through age 64, or whatever, of course). As seen, the 21,590 retirees in 2012, had they worked 43 years, would have collected average annual pensions of $73,040.

In general, pensions adjusted to reflect a full career in the private sector exceeded $70,000 per year starting with those CalPERS participants retiring in 2002. They exceeded $60,000 but were less than $70,000 for CalPERS participants retiring in 2003, 2001, and 2000. Participants who retired between the years 1990 and 1999 collect pensions today – again, had they worked a full private sector career – greater than $50,000 and less than $60,000. Participants who retired between 1984 and 1989 collect pensions today greater than $40,000 and less than $50,000. And participants who retired prior to 1984 collect pensions today that are less than $40,000.

It is hard to find a data set that shows a greater correlation than this one: The earlier you retired, the less you’re going to get in your pension today. That is because pension formulas were enhanced over the past 10-20 years. Not only were they enhanced, but they were enhanced retroactively, meaning that someone nearing retirement who had been accruing pension benefits at a rate of 2.0% per year, for example, suddenly began accruing pension benefits at a rate of 3.0% per year not only for the years remaining in their career, but for every year they worked.

To speculate as to why it was possible to retroactively enhance pension formulas through legislative action, yet it is purportedly unconstitutional and therefore impossible to merely reduce these formulas for active workers from now on, would go beyond the scope of this modest analysis.

Table 3  –  CalPERS Average “Full Career” Pensions By Year of Retirement

20140212_CalPERS_normalized-pensions_Table03-a

It is probably necessary to reiterate as to why full-career equivalent pensions are the only accurate measurement to use when discussing whether or not today’s public sector pension benefits are appropriate or financially sustainable. The reason is simple and bears repeating:  Defenders of pensions as they are use “averages” that don’t seem terribly alarming. Notwithstanding the fact that a self-employed person in the private sector would have to earn over $100,000 per year and contribute 12.4% of their lifetime earnings in order to collect the maximum Social Security benefit of $31,704 at age 68, which barely exceeds the average CalPERS pension of $30,546, that average CalPERS pension is based on an average years of service of 19 years. Somebody who has only worked for 19 years should not have an expectation of a pension that exceeds the maximum Social Security benefit that requires 12.4% of a six-figure annual income and 43 years of work. Few, if any participants in CalPERS are contributing more than 12.4% of their pay into their pension account. The taxpayers make up the difference.

When debating the financial sustainability of CalPERS and the other pension funds serving California’s state and local government workers, there are many issues. How the unfunded liability is estimated is the topic of intense debate, focusing primarily on what rate-of-return these funds believe they will average over the next few decades. That rate-of-return estimate also is a primary determinant of how the “normal contribution” is calculated. There are myriad aspects to the debate over how to adequately fund public sector pensions. But missing from that debate far too frequently is an honest assessment of just how much, on average, these pensions are really worth to the recipients.

This study has presented a calculation of what CalPERS’s average pension benefit is based on years worked as well as year of retirement. It has normalized that data to show that a retiree who worked 30 years and retired last year, on average, can expect a pension of over $50,000 per year, and if they worked 43 years and retired last year, on average, can expect a pension of over $70,000 per year. Those millions of private sector taxpayers in California who have already worked well over 30 years, with no end in sight, should think carefully about these facts about pensions, when considering what sort of reforms to preserve solvency might be equitable for all workers, public and private.

About the Author:

Ed Ring is the executive director for the California Policy Center where he oversees execution of the Center’s strategic plan. He is also the editor of ProsperityCalifornia.org and UnionWatch.org. Previously as a consultant and full-time employee primarily for start-up companies in the Silicon Valley, Ring has done financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

How Much Do California's State, City and County Workers Really Make?

INTRODUCTION

What level of public employee pay and benefits are affordable and appropriate is a difficult but necessary discussion. And missing too often from this discussion is good data on just how much, on average, public employees are currently making. In California, the State controller has made available a database of public employee compensation, organized by agency, that includes every city, county and state worker. The analysis to follow represents the first attempt we know of to extract from the raw data the average pay and benefits for full-time employees of California’s cities, counties, and the state government.

One of the biggest weaknesses inherent in the State controller’s “Government Compensation in California” database is that the summary information provides averages that take into account positions that were part-time, or only occupied by the employee for part of the fiscal year. But the State controller’s compensation website provides downloadable Excel spreadsheets on their “raw export” page that yield sufficient additional information to estimate averages limited to full-time employees. Table 1 shows the difference between averages compiled for all employees, including part-time workers (left three columns) vs. averages compiled for full-time employees, excluding part-time workers (right three columns).

Table 1:  Average Compensation, All Employees vs. Full-Time – 2012

20140131_CA-Gov-Pay_Table1-bAs can clearly be seen on the above table, it is extremely misleading to rely on average pay and benefit data that includes part-time and partial-year employees. For example, if a researcher were to click on the State controller’s “Data at a Glance” for Redondo Beach, the “average wages” for a city employee are reported as $47,879 per year, and the “average benefits” (comprised primarily of the employer contribution to pension and health insurance) are reported as $18,203 per year. But if the averages are recalculated to only include full-time employees – a far more representative indication of how much city employees actually make – the average wages increase to $93,809 per year and the average employer-paid benefits increase to $38,197 per year. This results in a total average compensation for full-time employees of $132,006 per year, more than twice as much as the average total compensation of $66,082 as reported on the State Controller’s “Data at a Glance” page for Redondo Beach.

In general, and as shown in the examples provided in Table 1, when limiting the pool of records under analysis to full-time employees, nearly 50% of the records are eliminated and the average pay and benefits increases by nearly 100%.

*   *   *

METHODS AND ASSUMPTIONS TO ISOLATE FULL-TIME EMPLOYEE RECORDS

The method to remove part-time records from the denominator, in order to develop compensation averages for full-time employees of California’s cities, counties, and state government, using the State controller’s raw data, rests on three assumptions. They are:

(1) A full-time employee would participate in a health insurance plan to which the employer would contribute some portion of the required payment, however minimal.

(2) A full-time employee would participate in a retirement benefit plan, usually a pension, to which the employer would contribute some portion of the required payment, however minimal.

(3) A full time employee would earn an amount in “regular pay” at least equal to the amount specified as the “minimum pay for job classification.”

It is important to note that the pool of full time employees that is isolated using this analysis does not necessarily include all records of full-time employees. The third condition that must be met, for example, that requires a “full time” employee to have earned an amount in “regular pay” at least equal to the amount specified as the “minimum pay for job classification,” will exclude employees who only worked a partial year (typically because during the year they either were hired, retired, or transferred into or out of that job) and therefore earned less than the minimum. But “partial-year” employees must be excluded from the analysis because their lower earnings are not representative of what they would have earned if they’d been in the position the full year.

Another factor worth explaining are end of career payouts of, for example, accrued sick time, which could potentially skew averages upwards. In reality the opposite is probably true, because (1) this deferred compensation that occurs whenever an employee retires is an accurate reflection of what they were earning throughout their career, and so unless a disproportionate number of employees retire and collect payouts in the year under analysis, these payouts belong in the averages, and (2) a significant number of retirees do not work the full year and are therefore screened out based on condition #3 because their “regular pay” did not equal or exceed the “minimum pay for [their] job classification.”

Another potentially distorting factor in these calculations, that, if anything, lowers the averages yielded, is the failure of the three conditions to screen out, for example, City Council members who do not work full time. Most of them have pension contributions and health insurance contributions made by the cities, and their “regular pay” matches or exceeds the “minimum pay for job classification.” But they work part time and their “regular pay” is typically only around $12,000 per year, if that. The presence of these records probably slightly lowers the full-time averages that are calculated.

Because of the sheer size of the pool, even with the weaknesses noted, it is unlikely the results generated are not accurate. They draw from a database that literally includes every single employee under the payroll of any city, county, or state agency in California. In all, 291,011 city employee records were analyzed, 350,150 county employee records, and 239,860 state agency employee records. To verify the methods and the data, the reader is invited to download each of these Excel files, which were created by downloading the State controller’s raw data files and modifying them:

2012_Payroll_All-CA-Cities_CA-Controller-Data_CPPC-ANALYSIS.xlsx (44 MB)

2012_Payroll_All-CA-Counties_CA-Controller-Data_CPPC-ANALYSIS.xlsx (52 MB)

2012_Payroll_All-CA-State-Agencies_CA-Controller-Data_CPPC-ANALYSIS.xlsx (35 MB)

*   *   *

AVERAGE TOTAL COMPENSATION, FULL-TIME EMPLOYEES

Using this method for several cities in California (ref. Table 1) has validated the accuracy of this method. While a surprising number of employees are excluded from the averages as part-time – usually about half of them – a review of their job descriptions indicates they clearly are not full-time workers: “recreation leaders,” “school crossing guards,” “lifeguards,” “library clerks,” “library pages,” “theater technicians,” “maintenance trainees,” “custodians,” “swim instructors,” “theater arts aides,” and so on.

Table 2, Average Compensation by Entity – 2012

20140131_CA-Gov-Pay_Table2-b

In producing this information, because department classifications are not standardized among cities and counties, it is difficult if not impossible to compile compensation data by type of job. This is possible with individual cities and counties, and yields interesting results. Anyone interested in developing this data for a particular city or county is encouraged to download and study the spreadsheets provided in the CPPC analyses prepared for the following cities.

Download Spreadsheet:  Irvine_Total_Employee_Cost_2012.xlsx
Discussion/Tutorial:  City of Irvine 2012 Compensation Analysis

Download Spreadsheet:  Orange_County_Fire Authority_Total_Employee_Cost_2011.xlsx
Discussion/Commentary:    The Average Orange County Firefighter’s Total Compensation is $234,000 per Year

Download Spreadsheet:  Costa_Mesa_Total_Employee_Cost_2011.xlsx
Discussion/Tutorial:  City of Costa Mesa 2011 Compensation Analysis

Download Spreadsheet:  Anaheim_Total_Employee_Cost_2011.xlsx
Discussion/Tutorial:  City of Anaheim 2011 Compensation Analysis

Download Spreadsheet:  San_Jose_Total_Employee_Cost_2011.xlsx
Discussion/Tutorial:  City of San Jose 2011 Compensation Analysis

Download Spreadsheet:  Desert_Hot_Springs_Total_Employee_Cost_2011.xlsx
Discussion/Commentary:  Desert Hot Springs, California – Average City Employee Makes $144,329 Per Year

Download Spreadsheet:  Palo Alto_Total_Employee_Cost_2012.xlsx
Discussion/Commentary:  City of Palo Alto Faces Strike

Download Spreadsheet:  Redondo Beach_Total_Employee_Cost_2012.xlsx
Discussion/Commentary:  City of Redondo Beach Fights Unions

The methods, assumptions, formats and formulas used are the same in all of these analyses; the more recent ones (Palo Alto, Redondo Beach) provide a refined template that is relatively easy to copy and adapt to evaluate any body of Excel data downloaded from the State controller’s website.

*   *   *

AVERAGE TOTAL COMPENSATION, PUBLIC SAFETY VS. MISC. EMPLOYEES

When evaluating State controller payroll records to isolate full-time employees and develop averages, while it is not practical – because of the size of the databases and the non-standard terminology employed – to develop per-department averages, it is possible to estimate averages for public safety personnel compared to miscellaneous personnel. This can be accomplished by sorting the records to move the full-time records into a single block of data, while doing a secondary sort of the field “pension formula.” It is reasonable to assume that virtually all records showing either “3% at 50” or “3% at 55” pension formulas are for public safety employees. Since very few public safety employees, apart from a still statistically inconsequential pool of new hires in some locales, are on any pension formulas other than “3 at 50” or “3 at 55,” and since very few, if any, employees who are not in public safety are under those pension formulas, this is a reasonably accurate way to separate the records. Doing so yields the results showing on Table 3:

Table 3:  Average Compensation, Public Safety vs. Miscellaneous Employees – 2012

20140131_CA-Gov-Pay_Table3-b

*   *   *

PERSONNEL COSTS AS A PERCENT OF TOTAL BUDGETS

Finally, using the State Controller’s data, one may add all of the employee records, full-time and part-time, to calculate the total personnel expense for all of California’s cities, counties, and state agencies. By comparing the results to data compiled by the California Policy Center in an earlier study “How Big Are California’s State and Local Governments Combined?,” it is possible to estimate what percentage of total government spending is comprised of personnel costs, as shown on Table 4. The amounts reported in the first row of data, “Total Budget,” may be surprising to readers familiar with the numbers, but the basis for them are explained fully in the afore mentioned CPPC study. For example, the direct state budget, once pass-throughs to cities and counties are eliminated, was only $48 billion in 2012. This smaller amount is the appropriate number to use, since the other approximately $50 billion in the state budget are funds that are passed through to cities, counties, school districts and special districts, and are not part of direct state operations.

Table 4:  Personnel Costs as a Percent of Total Budgets – 2012  ($=M)

20140131_CA-Gov-Pay_Table4-b

CONCLUSIONS

The purpose of this study is primarily to make publicly available a set of compensation averages for California’s state and local government full-time workers. Merely having this benchmark, built from officially reported data, using transparent assumptions, may provide a credible benchmark that can be useful in discussions of what level of pay and benefits is appropriate for California’s public servants.

The data clearly indicates that personnel costs do not, on average, consume 60% to 70% of local budgets, even though in many cities they do consume that much of the budget. On the other hand, at an average equaling 40% of city and 52% of county budgets, personnel costs consume far more than the 8% that has been cited as a reason taxpayers should be unconcerned about public employee compensation. And many cities and counties are now using outside contractors to perform services that are essentially part of normal operations and could be considered personnel costs.

A related observation is that the employer’s share of pension costs, while shown as still consuming less than 10% of total budgets – despite consuming far more than that in many cities and counties – do not include payments on pension obligation bonds. These numbers also don’t reflect how much payments are already scheduled to increase – for example, last year CalPERS announced it would phase in a 50% increase to required pension contributions over the next few years. When one takes this into account, unless all of this increase is borne through increased employee contributions – unlikely – it is necessary to consider the true average compensation for public servants in California’s cities, counties, and state agencies to be at least 10% greater than these estimates.

Finally, total compensation estimates here are skewed downwards because they don’t reflect accruals for the employer’s future retirement healthcare obligations beyond Medicare coverage, which are common for state and local government workers. It is common for these costs to currently range as high as $12,000 per year in retirement, and in most cases they are not pre-funded at all by California’s cities and counties. The present value of these future retirement healthcare obligations constitute an unfunded liability on precisely the same terms as unfunded pension obligations. That is, they represent an accrued cost each year these employees work, which ultimately is translated into cash payments. Appropriate pre-funding of retirement health care obligations probably adds another 3-5% to these estimates of average total compensation.

To reiterate, however, these numbers speak for themselves without requiring embellishment or copious observations. In California, during 2012 the average miscellaneous full-time employee collected total compensation as follows: Cities, $111K; Counties, $98K; State, $90K. Also during 2012, the average full-time public safety employee collected total compensation of: Cities, $170K, Counties, $140K; State, $129K. Add at least 12% to these numbers to reflect unfunded retirement healthcare and pension obligations, and you have an accurate representation of what California’s public servants earn, built from the ground up using the actual payroll records.

Sonoma County's Pension Crisis – Analysis and Recommendations

INTRODUCTION

New Sonoma, a volunteer organization of financial experts and citizens concerned about the finances and governance of the County has just completed an extensive study of the County’s pension crisis.

In addition to describing how the County has incurred over a billion dollars in unfunded pension and retiree health care liabilities, how the County ignored the requirements to notify the citizens of cost of the benefit increase and failed to follow the Board of Supervisor’s resolution requiring the employees to pay for the increase, this report also provides a first-of-its-kind comparison of Sonoma County’s pension system with neighboring counties.

The following is a summary of the study’s findings.

(1) Sonoma County is approaching balance sheet insolvency, which means the County’s liabilities will exceed their net assets when the GASB’s new accounting standards take effect. These will require the County to list their pension liabilities on their balance sheet in 2014, and unfunded retiree medical liabilities by 2016.

(2) The key driver of the pension problem was the retroactive increases which took effect in 2003 and 2006 for Safety and 2004 for General employees. The increases lead to higher pensions, accelerated retirement rates and reduced the average retirement age by 5 years.

(3) The retroactive increases combined with a new definition of pensionable compensation increased pensions by 66% for General Employees and 69% for Safety Employees after the increases were enacted.

(4) Even though the Board of Supervisors Resolutions authorizing the new formula required the General Employees to pay the entire past and future cost of the increase and Safety Employees to pay the past cost, the resolutions were never enforced. In fact, in the 2008 contract negotiations the County picked up all but 1% of the employee contributions.

(5) The County’s pension costs have climbed from $24 million in 2001 to $122 million in 2012. Even with these increased costs, the system has $1.3 billion dollars in unfunded pension, retiree health care and pension obligation bond liabilities.

(6) When comparing Sonoma County’s pension costs with Tulare, Mendocino, Alameda, San Mateo, Marin and Contra Costa counties the study found that their average pension costs were 16% of the General Fund while Sonoma’s were more than double at 36%. As a percent of the general fund, no other county in California has pension costs as high as Sonoma County.

(7) When adding payroll costs, the total climbs to 120% of the General Fund. The average for the other six counties analyzed is 60%.

(8) The County currently has a funding ratio of 60% for pension and retiree health care benefits. That means there is only 60 cents available for every dollar for benefits already earned. This ratio assumes a 7.5% return on investments. If a more conservative 5.5% return is used, the funded ratio drops to 50%.

(9) Sonoma County employees receive on average $110,000 per year in salary and pension benefits, plus health insurance for life after 10 years of service. This is double the average salary and retirement benefits of Sonoma County residents.

(10) Increased pension costs in the years ahead have far reaching implications for the all Sonoma County residents, including; (a) unsustainable annual costs for taxpayers, (b) burden on active County employees, (c) threats to vital public services, and (d) the potential for the County to run out of money and go bankrupt resulting in loss of health care and a reduction of pensions for retirees as has happened in Stockton and Detroit.

This report is a call to action on the part of all stakeholders to work together to solve this deepening crisis, which threatens the quality of life and economic prosperity of all Sonoma County residents.

*   *   *

SONOMA COUNTY’S PENSION CRISIS – ANALYSIS AND RECOMMENDATIONS

Newly mandated financial reporting requirements by the General Accounting Standards Board indicate that Sonoma County will be required to recognize a $1 billion reduction in net assets next year, reducing them from $1.2 billion to about $200 million.  After adding on the $297 million in unfunded liability for retiree healthcare, the new rules will wipe out the net assets of the County.

A fair and sustainable retirement system plays a critical role in recruiting and retaining talented employees on whom we depend for quality public services, such as taking care of our fellow citizens in need, maintaining our roads, protecting our environment, policing our streets and highways, and prosecuting lawbreakers. The system is also designed to provide a level of secure income to these employees, once they retire. To be viable, the County’s retirement system must be affordable for both the employees and the taxpayers who support it.

This report was published by New Sonoma, a nonpartisan, volunteer group of financial experts and concerned citizens.  All the financial information in this report is taken from publically available documents. This report provides the first-of-its kind rating and assessment of the financial impacts of hundreds of millions of dollars in unfunded retiree debt owed by the County. It also compares Sonoma County with our neighboring counties and Tulare County, a county with a sound retirement system to demonstrate how our retirement system compares with others.

Ensuring a common understanding of the current pension situation and how we got here is critical to fostering a lively and informed debate among all stakeholders, including; employees, retirees, taxpayers, and elected officials.

Prior to 2002 we had a sustainable pension system. From the 1940’s until 2002, Sonoma County provided its employees with sustainable pension levels that provided career employees with 60% of their salary upon retirement combined with social security and health care benefits. It was a sustainable, affordable system that required the County to contribute 7% of the payroll and employees 7% of their salary to properly fund the system. From 1994 to 2001 the County’s pension costs averaged $20 to $25 million per year.

Today, this is not the case. Sonoma County’s retiree pension and health care system provides neither retirement security nor financial sustainability and it is in dire need of re-design. At the end of 2012 the retirement fund had unfunded liabilities of $527 million and unfunded retiree health care liabilities of $297 million. In addition, the pension fund has consumed $600 million in pension obligation bond funds that taxpayers will pay principal and interest on for the next 20 years. At its simplest, an unfunded liability is the additional amount of money required to be infused into the system today, to fully support the promises made to retirees and current employees for service already rendered. It does not include amounts required to fund benefits for future service. In fact, most of the money going into the system today is to pay off these unfunded liabilities.

This challenge is not unique to Sonoma County, but as the County’s financial statements and the pension funds annual actuarial valuations indicate, our pension costs as a percentage of the General Fund are double those of our surrounding counties and when payroll is added, the pension and salary costs exceed the County’s General Fund, leaving limited funding for the services citizens expect and deserve for their tax dollars.

Each year that the County delays action to address its fundamental structural pension issues, the more risk the system faces and the harder and more painful it will be to fix. Recently in Stockton, the retirees lost their medical benefits in the bankruptcy settlement and in Detroit, the bankruptcy judge ruled that pensions can be impaired, meaning retirees will see their benefits significantly reduced.

This report is a call to action on the part of our elected leaders, County employees, employee unions, and citizens to work together to create a sustainable pension system that will provide retirement security for our valued employees and enable the County to continue to provide the services we need to maintain our quality of life and a thriving economy.

The Key Drivers of the Problem – Retroactive Increases and Accelerated Retirements

In 2002, the Sonoma County Board of Supervisors enacted pension increases for both General and Safety Employees and adopted the highest allowable formulas, 3% of salary per year of service at 50 years of age for Safety Employees and 3% at 60 for General Employees. The increased benefits were combined with a court settlement called the Ventura Decision, which also added 46 special pay items to what was considered pensionable compensation.

All of these benefit increases were applied retroactively back to the date people were hired. This means that many employees were able to retire at younger ages with richer benefits. Since employee and taxpayer contributions needed to fund these improved benefits during prior periods of service were never collected the unfunded liability increased substantially.

After the increase, the average retirement age for General Employees dropped from 62 to 57 and for Safety Employees from 56 to 51. The increases also resulted in a 69% increase in pensions for new retirees from an average cost of $35,803 in 2002 to $60,697 in 2006. This had a huge impact on the funding status and created additional unfunded liabilities because pensions were funded for 5 fewer years and retirees received benefits for 5 more years.

Currently, the funding ratio is at 50% to 60%, meaning there is only 50 to 60 cents on the dollar available to pay for retiree pension and health care benefits already earned.

How the Increase Was Supposed to Have Been Paid For

The County Supervisors were told by the Sonoma County Retirement Association before pension increases were enacted that the costs of these benefit increases could be covered with an additional 3% of payroll contribution to the pension fund by the employees.  Based upon these numbers, the Supervisors passed the increase. What the Plan Administrators of the retirement board did not tell the supervisors was the cost they presented for General Employees did not include the impact of accelerated retirements. Those accelerated retirements have cost the County tens of millions in additional pension costs each year as more and more employees started drawing their pensions instead of contributing to them.

The costs of the benefit increases were also magnified by the lower than anticipated stock market returns. The pension fund’s actuary used an assumed rate of investment return of 8% when calculating the cost of the increase. Since the increase, the investment fund has fallen $570 million short of its assumed rate of return. As a result of increased retirements and investment shortfalls, the actual cost of the increase is approximately three times the cost that was provided to the Supervisors.

The Failure to Provide Required Public Notification of the Benefit Increase

After sending out letters requesting information under the Freedom of Information Act, New Sonoma received and reviewed the County documents surrounding the benefit increase. We discovered that when they were enacted, the Supervisors did not follow the requirements to perform their own actuarial study of the costs, nor did they notify the public of the increase as required by Section 7507 of the California Government Code. Some legal experts believe this should void the increase back to the date it was enacted.

Understanding the Consequences of Further Inaction

Increased pension costs in the years ahead have far reaching implications for the all County residents, including; (1) unsustainable annual costs for taxpayers, (2) burden on active County employees, (3) threats to vital public services, and (4) the potential for the County to run out of money and go bankrupt.

So far, additional pension costs have caused deep cuts to services and have greatly reduced the County’s ability to maintain its roads and infrastructure.  According to the Supervisor’s Ad Hoc Committee Report on Roads, 86% of the County’s roads are not receiving pavement preservation and we now have the worst roads in the state according to the state’s Pavement Condition Index’s (CPI) report.

In addition to service insolvency, the County is approaching balance sheet insolvency. New government accounting standards have been enacted that will have a drastic effect on the County’s balance sheet. Currently the County lists $1.2 billion in net assets in their most recent financial statements. After the new reporting requirements, the County will need to write off $472 million in pension assets and post about $527 million in new pension liabilities on the balance sheet for a $1 billion reduction in net assets. And if the $297 million in unfunded liability for employee health care is added, the County’s liabilities will exceed its assets.

Employees Breached the Agreement to Pay for the Increase  

Upon reviewing the 2002 Board Resolutions approving the benefit increase we found the resolutions stated the General Employees were required to pay for 100% of the past service and prospective cost of the increase and Safety Employees were required to pay for just the past service cost, estimated to be 50% of the cost of the increase.

The initial cost estimates for the increase provided by the County’s Actuary Rick Roeder to the Sonoma County Employee Retirement Association Plan Administrator in 2002 stated that if employees contributed an additional 3% of salary for 20 years, the $93 million cost would be offset by the employees.

In his 2002 Annual Actuarial Report Mr. Roeder came up with a completely different cost for the increase. The new, more detailed cost analysis concluded that increasing the General Employee formula to 3% at 60 and Safety Employees to 3% at 55 would increase the unfunded liability of the plan by $152 million, even after adding in the new employee contributions.

Even though the employees had agreed to pay the 3% of salary estimated cost of the increase the Supervisors agreed to pick up more of their contribution. The employee MOU’s indicate that when the County negotiated the 3% of salary additional contribution with the Safety employees the County agreed to pick up 2% of their previous contributions so the net Safety Employee contribution was 1% of salary.

In 2008, after paying the 3% of salary for 4 years, SEIU employees received a 2.25% pickup of their previous contribution so their net contribution was .75% of salary.

Even though the employee contributions were falling significantly short of paying for the increase, the Board of Supervisors negotiated for the employees to pay even less.

The Current Supervisors Have Ignored Their Own Pension Report

The Board of Supervisors has ignored its own Ad Hoc Committee Pension Report dated November 3, 2011, which included the following text on Page 18 identifying the failure of employees to pay their share and the recommendation to address this in labor negotiations. Here is the text from the report:

“In 2002, Sonoma County agreed to retroactive increases which became effective in 2004 for general members and 2006 for safety members. This decision while part of a legal settlement and negotiations was made with the understanding that employees would bear the full cost of the enhanced retroactive benefit. At the time, the long term cost was actuarially estimated and labor negotiations provided for contract provisions to pay for the cost over the course of 20 years. However, those initial estimates and stock market volatility caused an increased cost to the County to cover pension costs”.

“The Ad Hoc Committee recommends staff commission a new calculation to identify the shortfall, if any, and to work with the labor organizations through negotiations to meet the intent of the prior agreements regarding the enhanced benefit formulas costs”.

We have asked the Supervisors for the results of this calculation and were informed it has never been performed. As a result, we believe the citizens of Sonoma County deserve a full accounting and explanation of what went wrong and what corrective actions should be taken to bring the County into compliance with their own Board Resolution.

Because of the numerous problems with the increase process including: (1) not notifying the public, (2) not presenting accurate cost estimates to the Board of Supervisors, and (3) ignoring the Board Resolutions requiring the employees to pay for the increase, New Sonoma believes an independent committee of experts should be hired by the County to evaluate the situation and propose corrective actions to bring the fund into compliance with the law and the Board Resolutions.

We also believe that a Pension Advisory Committee made up of experts, union and retiree representatives should be formed to develop a plan for paying off the pension’s unfunded liabilities over the next decade and to ensure that the County complies with governance issues in the future. It is evident that there are too many conflicts of interest between staff and the supervisors over pensions and an independent committee needs to be formed.

The charts on the following pages demonstrate the problems faced by all stakeholders including; taxpayers, employees and retirees. These include:

  • The unaffordable impact of the benefit increases on retirement rates and payments
  • Evidence that Sonoma County’s salaries and pension benefits are significantly richer than those of surrounding counties,
  • County employees receive compensation that is double the average for county residents,
  • The County’s pension fund costs are soaring and unsustainable, and
  • The pension and health care funds are significantly underfunded.

The chart below demonstrates how the number of new retirees jumped significantly after the increase. In addition, the average age of new retirees dropped 5 years from 62 to 57. This meant people paid into the retirement system for 5 fewer years and will receive retirement funds for 5 additional years. As previously discussed, the retirement association did not have their actuary include the impact of accelerated retirements in their cost analysis, as was recommended.

2014_Sonoma_Churchill_1

In addition to lowering the retirement age, the increase to 3% at 60 also resulted in an immediate jump in pensions for new retirees of 66% from an average cost of $22,468 in 2003 to $37,715 the following year.

2014_Sonoma_Churchill_2

The Sonoma County Board of Supervisors adopted two new pension formulas for Safety Employees. A 3% at 55 formula took effect in 2003 and a 3% at 50 formula took effect in 2006. As a result, the average age of new retirees dropped from 56 to 51 resulting in 5 fewer years of employee contributions and 5 more years of retirement.

2014_Sonoma_Churchill_3

The increases also resulted in a 69% increase in pensions for new retirees from an average cost of $35,803 in 2002 to $60,697 in 2006.

2014_Sonoma_Churchill_4 

This graph demonstrates how the cost for pensions has soared for the County, now reaching 40% of payroll. However, the cost that employees pay,  has stayed flat at 12% of payroll or less than the amount shown because the graph does not account for the County’s pickup of employee contributions, which is difficult information to obtain from County reports.

2014_Sonoma_Churchill_5

This chart provides the total annual cost of pensions each year. Pension costs were stable at about $25 million per year from 1994 to 2000 and from 2001 to 2012 the average annual cost jumped 600% to an average of $155 million per year.

2014_Sonoma_Churchill_6

This chart shows the growth of the unfunded liability, which is money owed to current employees and retirees for work already performed. It is the difference between what they are owed and the assets in the fund. Bond funds used to buy down the debt are added back in to provide the true unfunded liability the County faces. The pension bond debt is currently at $495 million. It will end up costing the County $856 million when interest is added. In addition, the County had $527 million in unfunded pension liabilities at the end of 2012 as well as $297 million in unfunded medical liabilities.  These amounts assume the County will receive a 7.5% return on its investment earnings. If they receive less, the unfunded liability increases dramatically.
2014_Sonoma_Churchill_7

This graph shows the disbursements to retirees and disabled workers. The payments have increased 600% over the past 12 years from $28 million in 2000 to $122 million in 2012. From 2000 to 2004 payments to retirees increased by about $4.2 million per year. After the increase in benefits, payments to retirees increased an average of $9.4 million per year.
2014_Sonoma_Churchill_8

Comparing Sonoma County Pension Costs with its Neighboring Counties

Sonoma County’s annual pension costs as a percentage of the General Fund are more than double neighboring counties and 7 times the cost of Tulare County.  In addition, Sonoma County expects its pension costs to climb to $209 million per year by 2020, an amount equal to 50% of today’s General Fund.  We have not seen any other city or county with a ratio as high as Sonoma County’s.

2014_Sonoma_Churchill_9But it even gets worse. When Sonoma County’s $300 million in payroll costs is added onto its pension and social security costs, the total reaches 119% of the General Fund, double the average of the other counties.

2014_Sonoma_Churchill_10The Earned Retiree Benefits Funding Ratio is the present value of pension and other post employment benefits earned by retirees and employees to date. Generally 80% funded is considered a healthy plan and 60% is a plan in significant financial stress and risk of insolvency. We calculated the funded ratio based upon three rates of investment return of 7.5%. 5.5% and 4.8%. Tulare and Alameda County did not retroactively increase benefits and therefore have a funded ratio of almost 90%.

2014_Sonoma_Churchill_11

Average county employee salary and pension costs are now $110,000 per year, double the salary and retirement costs of the average county resident. A 3% employer contribution to a 401k account was added to the non-government employee salary for comparison purposes. That is the most typical amount contributed by employers.

2014_Sonoma_Churchill_12

Comparison of Sonoma with Tulare County

Tulare County has about the same population as Sonoma County, but their finances are in great shape because they never retroactively increased pensions and they controlled salaries. Their payroll is 37% less than Sonoma County’s even thought they have 577 or 15% more employees. This data is from the 2012 Annual Actuarial Valuations of both counties.

2014_Sonoma_Churchill_13

PROVIDING A FRAMEWORK FOR SOLUTIONS

With a clear understanding of the nature and extent of the challenges we face as a County, we must find a workable solution. Indeed, only by addressing and solving this urgent financial challenge can we move to a healthy local economy and provide retirement security for employees and retirees.

To begin this process New Sonoma believes a Citizens Advisory Board made up of union, retiree and taxpayer representatives along with independent legal, actuarial, and financial experts needs to be formed to develop a long term solution to this growing crisis. It is our intent to ask the Supervisors to form this Board and if they refuse, to place an initiative on the ballot that will let the voters decide. The initiative would also include other measures, such as reducing pension formulas going forward if the Reed Initiative slated for the 2014 election passes.

The path to comprehensive pension reform should begin with agreement on a definition of retirement security – once we have agreement on a level of post-retirement income that ensures security and that the County can afford, we can design a sustainable system to provide that security.

Sonoma County residents, retirees and employees should share the following goals in creating a secure, sustainable retirement system that:

  • Attracts and retains quality employees
  • Provides a level of benefits that retirees can plan on being there
  • Accumulates assets to cover 80% or more of its projected liabilities
  • Allows the County to continue to invest in public services
  • Eliminates the need for piecemeal reform by instituting self-correcting mechanisms that are triggered when funding levels dip below acceptable thresholds.

Any comprehensive solution should be informed by the following:

1. Accurate and transparent assumptions: Today’s system was largely built by policymakers using little accurate data. Retirees, employees and taxpayers rely on government leaders to be honest about the system’s liabilities and to have safeguards in place that require accurate accounting. Public employees should depend upon their union leadership to insist on conservative, realistic assumptions. Using overly optimistic assumptions hurts everyone because these assumptions underestimate the true cost of pensions and increase the risk that not enough money will be set aside to pay for granted pension benefits.

2. Equitable and reasonable changes: Fair and balanced eligibility rules, benefit levels and contributions for all members must be required of any retirement system reform. This report underscores the truth that any reform impacting only new employees will not affect the existing $1 billion in unfunded pension and medical liability for past service. This problem is over a decade in the making and all stakeholders must now share in the solution. The following, among many other ideas, should be analyzed as possible areas of reform:

  • Increasing the retirement age
  • Lowering the accrual rate of benefits
  • Cost of living adjustments
  • Hybrid plans and portability
  • Eliminating the ability to spike pensions and purchase Service Credits

As we analyze the various options for fixing our retirement system, we must again remind ourselves that real people and real families are connected to every change we consider. While all stakeholders must be prepared to collaborate in achieving a fair and sustainable system, we must also consider possible hardships that these changes may impose.

Therefore, reforms could be structured so that they have a smaller impact on plan members at lower income and lower benefit levels. One of the principal purposes of a public retirement system is to sustain public workers during their retirement years. Reforms that provide protection to sustenance level benefits must be part of any reform.

3. Intergenerational fairness: New County employees are receiving a lower pension formula (2% at 62), but are required to pay the additional 3% of pay for an enhanced formula their predecessors’ received. In addition, they shoulder the greatest risk that money will not be there in 20 to 30 years when it is time for them to retire.

And when there are budget cuts today that result in lower wages and furlough days, it is the current employees that endure these challenges. Any solution needs to ensure fairness between newer and more veteran employees and retirees.

4. Comprehensive and self-correcting processes: As the collaboration on reform begins, it is important that any solutions protect the County from ever again facing the massively underfunded system that it has today. To maintain a defined benefit system at all, it is critical that the County adopt structures that provide for automatic self corrections.

5.  Unfunded liability is the lion’s share of the problem: A real challenge in reforming the pension system is that it is extremely underfunded today and any solution must address the unfunded liability, the bill for past service. It is likely that any solution will require a change to benefits to both retirees and current employees in order to address this problem.

THE TIME TO ACT IS NOW

The Board of Supervisors have enacted some reforms to limit spiking of pensions and have changed benefit levels for new hires. However, these reforms will not provide substantial savings for decades. It is time to take a different approach to solving this problem. We must begin this time by defining retirement security and designing a system that provides security in retirement for our valued public employees.

This new system will necessarily also address budgetary concerns because no one is secure if they are promised a benefit that the County cannot afford. Each day the County avoids comprehensive reform, the liability grows. It is unfair to ask taxpayers to pay for the growing level of required contributions and it is dishonest to let County employees and retirees believe that full benefits will be there for their retirement.

The time to act is now because it is in the interest of everyone to solve this problem, once and for all.

*   *   *

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.

How to Think About Debt

Summary:  Balancing the budget is a good idea and receives a lot of press. However, the budget is far less important than the steady growth of debts, unfunded obligations, and entitlements. These items are stealthy future deficits. To really understand whether or not we have financially sustainable government budgets, we have to go to the balance sheet, where debt is recorded. There are a lot of misconceptions about debt. In the interest of simplifying a complex subject, this report focuses on government debt, but the primary concepts discussed apply to all debt, public and private. They are all claims against future income.

What about California’s debts, state and local, and unfunded obligations? Are they large enough to affect the state’s growth rate? It’s hard to tell. Our recent study for the California Policy Center, “Calculating California’s Total State and Local Government Debt” (April 2013) summarized the state’s debts and unfunded pension and retiree healthcare obligations as follows:

Estimated Total California State and Local Government Debt
As of June 30, 2012   ($=B)

Fletcher_20121210_CA-Debt

California’s total state and local government debts and unfunded obligations are about $18,000 to $23,000 per citizen depending upon what investment return assumption you use in valuing unfunded pension obligations. This data is for 2011 and 2012 and debts and unfunded obligations are higher today. This only refers to California’s state and local debt and does not include any estimate of entitlement obligations for welfare and Medicaid, or the private debts of companies and individuals. U.S. federal debt now exceeds $17.0 trillion or about $54,000 per citizen. This doesn’t include unfunded liabilities for Medicare, Social Security, or Medicaid.

When do these debt and other obligations become a serious problem?

The Debt Supercycle

We are at the end of a 30-year debt supercycle. How will it end? All debts and entitlements can’t be paid. Who gets stuck with the bill? So far, we’re leaving the check on the table and pretending the dinner was free.

Will all this debt come due with a bang one day or will it dissipate slowly over time?

Fletcher-20121210-2

The debt cycle begins when debt levels are fairly low. The government determines that they can stimulate economic growth by adopting policies to encourage people to borrow to increase consumption and investment. The Federal Reserve facilitates this process by keeping interest rates low and taking other actions to avoid slowdowns in the economy. As debts increase, so does the cost of servicing these debts, interest and principal payments. At some point it becomes crucial to maintain low interest rates to make it easier for private and public debtors to service their debts and avoid bankruptcies.

Low interest rates and easy credit further stimulates economic growth as well as excessive speculation such as in housing and the stock market. These assets increase in value beyond what they would be worth without easily available credit at low interest rates.

These overvalued assets are used as collateral to secure additional borrowing that increases debt burdens even more. As debt levels grow, it takes more and more borrowing and other stimulus to keep the economy growing, and to maintain asset prices.

At some point, debt burdens become unsustainable in spite of low interest rates and easy credit, and investors lose confidence that future growth of the economy and asset prices can be sustained. We then have a market correction or recession such as the 2008 mortgage bubble collapse. The triggering event may be the collapse of the Lehman Brothers investment bank or some other event. However, the house of cards that collapsed was assembled over many years.

When the economy contracts in a recession and incomes fall, the debts and other obligations remain.

Shouldn’t we be mainly concerned about the deficit, and balancing the budget? Who looks at balance sheet entries anyway?

Balancing the budget is a good idea and receives a lot of press. However, the budget is far less important than the steady growth of debts, unfunded obligations, and entitlements. These items are stealthy future deficits.

To really understand whether or not we have financially sustainable government budgets, we have to go to the balance sheet, where debt is recorded. That is where the bodies are buried. This is further complicated by the fact that some obligations aren’t reported at all and are largely ignored on official government financial statements.

The real problem is the steady under reported growth of debt at the federal, state, and local level, the growth of unfunded pension and retiree healthcare obligations at the state and local level, and the seemingly out of control growth of entitlement obligations for welfare, Social Security, and government provided medical care, Medicare and Medicaid.

These are balance sheet items and can’t be fully grasped by looking at annual budgets. GASB, the Government Accounting Standards Board, will improve reporting of unfunded pension obligations starting with the fiscal year beginning in June 2014. However, this is only a start in honestly reporting these obligations. Reporting of unfunded pension obligations is inadequate in that pension funds such as CalPERS are still free to use optimistic investment return assumptions in calculating unfunded obligations. They assume an average investment return of 7.5% per year. If actual returns average less than 7.5%, unfunded pension obligations will be larger than reported under the new GASB regulations. For example, as shown on the first table above, if average returns to the pension funds are 5.5% instead of 7.5%, the unfunded liability increases by over $200 billion, from the officially recognized $128.3 billion to $328.6 billion. For much more on how changes in rates-of-return affect California’s total state and local unfunded pension obligation, refer to the CPPC study “How Lower Earnings Will Impact California’s Total Unfunded Pension Liability.”

Retiree healthcare expenses are largely unfunded and must be fully paid out of future tax revenues. GASB doesn’t currently require this future obligation to be reported.

Why can’t we just write off debts we can’t pay?

Debt forgiveness is a fiction. Someone always pays in full.

According to the economist Michael Pettis, author of “The Great Rebalancing,” “Debt always matters because it must always be paid for by someone –even if the borrower defaults, of course, the debt is simply “paid” by the lender… It must cause a reduction in demand elsewhere, most probably in household consumption. This reduction in demand implies slower growth in the future and, of course, a more difficult rebalancing process.”

What’s the relationship between debt and growth?

Borrowing increases the rate of GDP growth (gross domestic product) on the way up and reduces GDP growth on the way down. Debt stimulates growth when it’s spent and depresses future growth when it is paid back. Debt is essentially borrowing future consumption.

Over-indebtedness is probably the main reason that the world’s major economies are growing slowly. This is in spite of massive efforts by the U.S. Federal Reserve and other central banks to stimulate their economies by keeping interest rates very low and adding to bank reserves to stimulate borrowing.

When we were adding to our debts, borrowed money allows a higher level of consumption than could have been supported based on the earnings of individuals and corporations alone. This effect may have added as much as 0.5%/year to GDP growth over many years. However, this is stealing consumption from the future when the debt has to be serviced (make the principal and interest payments).

So, on the way up, if we assume that the economy would grow about 3.0%/year without increasing debt, we’d get 3.5%/year growth instead. On the way down, we’d have to subtract the negative effects of servicing high debt loads and deleveraging (paying off debts) to reduce debt burdens. A guess is that we’d see growth of 2.5%/year or so (3.0%/year normal growth less something like 0.5%/year due to debt service and deleveraging). Interestingly, the U.S. real GDP growth rate was 3.4%/year on average until the 2008 recession, and an average of 2.3%/year since the recovery started in mid-2009. This could be a coincidence.

According to the economist Gary Shilling, the U.S. economy is likely to have low growth for another five years or so before deleveraging reduces debt loads enough to allow the economy to grow at its normal long-term average rate. So far, all the deleveraging has occurred in the private sector, companies and individuals reducing what they owe, while government debts continue to grow.

Is there good debt and bad debt?

There are several broad types of debt, some good and some bad. The form of the debt is less important than what it is used for. The California Policy Center’s debt study listed several broad categories of debt:

Good debt is:

1. Debt that is an investment in an asset that generates a future income by way of taxes or fees sufficient to pay the interest and principle on the debt. A toll road or water treatment plant would be examples.

Debt to fund investments that grow the economy with a corresponding growth in tax revenues sufficient to service the debt also qualifies as good debt. However, not all debt-financed investments qualify. Government debt requires tax increases or fees to service the debt and these tax increases and fees reduce funds available for consumption and investment in the private sector, the source of tax revenues. Both of these effects need to be considered in deciding if a government expenditure funded by debt is worthwhile.

2. Debt that is an investment in a long-lived asset such as a new highway or government building that would be used by the future taxpayers who are responsible for paying the interest and principle on the debt by way of taxes or fees.

Bad debt (and unfunded obligations) is debt that is used to cover current expenses but paid for by future taxpayers. This form of debt is essentially deferred taxation and passes a current expense to future taxpayers, inter-generational theft.

Are growing unfunded obligations the same as debt?

They are similar with some differences.

The growing future cost of paying for unfunded obligations takes funds that could have been used for future consumption and investment and has the same effect as servicing or paying down debts.

Some entitlements are responsible and desirable transfers to those who need help from those who can afford to help. This can include publicly funded K-12 education to welfare and Medicaid payments. However, we shouldn’t spend more than the economy can support.

All entitlements, current and future are different from debt in that changes in laws and regulations might be able to reduce these future costs while the cost of debt service can’t be altered without a bankruptcy or mutually agreed restructuring of debt. Future entitlements, because they aren’t funded, qualify as debt to the extent we are not setting aside enough money today to pay for them in the future. These unfunded liabilities for future entitlements are particularly troubling with respect to pension benefits that are difficult to modify even in bankruptcy.

In some ways, entitlements and unfunded pension and retiree healthcare obligations are a bigger problem than debt. Debt typically is for a fixed amount to be repaid at a specific interest rate over a specific time period. Entitlements are open-ended obligations such as for unemployment, welfare, or medical care for low-income families. The taxpayer, via the government, is obligated to pay whatever the formula for the entitlement says is due without regard to ability to pay. Timing can also be a problem. In a recession, unemployment and welfare payments go up as more people lose their jobs at a time when tax revenues are declining.

The future cost of underfunded pension obligations and retiree healthcare expenses are hard to predict. If pension funds suffer investment losses such as during the 2008 recession, or if investment returns are less than assumed, the taxpayer is responsible for any shortfall. Retiree healthcare expenses are largely unfunded and have to be paid out of future tax revenue.

It’s the authors’ opinion that post retirement benefits should be fully funded while the employee is working and providing a public service to taxpayers. To the extent that these benefits aren’t fully funded, we are asking future taxpayers to pay for current expenditures that they are not gaining any benefit from, the equivalent of bad debt.

Entitlements such as Social Security, Medicare, and Medicaid are promises of future payments that are totally the responsibility of future taxpayers since these entitlements are not funded. Even Social Security is not funded even though there is a Social Security trust fund. Social Security payments in excess of current benefit payouts are spent by the federal government. The government deposits an IOU in the trust fund to offset the amount taken. When these IOUs are due in the future, they will have to be paid for out of future taxes or by additional borrowing by the government.

What’s the relationship between debt, inflation, and deflation?

Debt is future consumption denied as taxes have to be increased and other spending has to be cut to service the debt. Ditto for entitlements and unfunded obligations. Servicing debt is deflationary. It depresses future consumption by the amount of the debt service.

The cost of servicing a high level of debt or paying down your debts takes funds that could have gone to consumption, the major portion of GDP, or private sector investments needed to grow the economy. In the U.S., consumption makes up almost 70 percent of GDP. This loss of consumption leads to lower prices and slower GDP growth. Lower prices, overall, constitutes deflation.

If the cost of servicing debt is high enough, demand is so depressed that the economy could experience a depression, chronic negative growth with falling prices, high unemployment, and ongoing budget deficits – possibly a deflationary spiral that is very hard to break out of to get the economy growing again. This is Japan today, and possibly countries such as Greece, Spain, and Italy.

Why is growth so important?

By far, the best way to reduce indebtedness is to increase tax revenues by growing the economy faster. However, high levels of debt work in the opposite direction as we’ve seen and lead to lower, not higher growth of the economy. If debts are too high, one can enter a death spiral where debts are growing faster than tax revenues so that debt service costs continue to grow as a percent of GDP. This could also be caused by interest rates increasing to exceed the rate of revenue growth, or by having to add to already high levels of debt to fund a budget deficit or increasing entitlements.

When lenders lose confidence in the ability of a government to service its debts, they can stop lending or increase the interest rate they charge to account for the risk of non-payment. If the interest rate exceeds the country’s growth rate, their debts will continue to grow faster than their economy and tax revenues and become an ever-increasing burden.

Can’t governments avoid repaying their debts or reduce what’s owed?

Governments, national, state, or local can take steps to reduce their debt burdens. However, they can’t make their debts disappear. They can only transfer part or all of their debts to others either publicly or secretly if they can get away with it. Special interests such as large financial institutions also try to transfer their debts to others, often with government help.

Not surprisingly, the prime target to receive the unpaid government debt is the taxpayer who is not well represented in the transaction. Savers and high-income taxpayers are best because they at least have some money.

Growing the economy faster to increase tax revenues would be a positive way to reduce debt burdens. However, governments that have high debt levels usually have other problems that prevent them from being able to grow their economies faster, or lack the political will to make hard choices in favor of policies that promote growth.

Some favorite alternatives to transfer debts to others are:

1. Financial repression:  This is underway in the U.S., Europe, Japan, and China. The central bank takes actions to keep interest rates below their normal long-term averages to make it easier for debtors to service their debts. Savers pay the difference via lost income between normal interest rates and the lower repressed rates they are earning on their savings. These low interest rates also make it more difficult for pension funds to meet investment targets.

Financial repression and inflation are essentially hidden taxes on savers and bondholders. It’s estimated that financial repression is costing savers about $400 billion/year in lost interest income. This discourages savings and reduces the amount that people can save making them more dependent on the government in old age. This is not a policy objective of financial repression but is an unintended consequence.

2. Inflation:  Inflation reduces the value of a currency and makes it easier for governments to repay their debts in cheaper currency. Who pays? The saver whose savings and interest and dividend payments lose value due to inflation. Also, consumers who have to pay higher prices for goods and services.

3. Default:  This isn’t very practical for major economies. However, it’s not inconceivable that countries such as Greece or even Italy could be forced to default at some point. Banks and other lenders will get stuck with the bill and will have to be bailed out by their governments if their losses are large enough to threaten their solvency.

4. Restructuring:  Under the threat of default, sometimes a borrower can convince lenders to revise the terms of the debt to stretch out payments and reduce the interest rate. Again, the lender pays the difference between what they would have received in interest and principal payments and what they get under the new terms.

5. Devaluation:  An outright default can be replaced by efforts to devalue, lower the value, of a county’s currency. This doesn’t work for those countries using the Euro because they don’t control the value of their currency. Other countries such as Argentina frequently resort to devaluations to pass on their debts to foreign lenders.

6. A wealth tax:  Why not tax wealthy persons’ assets, not just their income? Why not, for example, impose a one-time tax of 5 to 10% of a person’s net worth in excess of $1.0 million? It would all be “applied” to debt reduction and the government would promise to do this only once. This would be a very destructive and unfair tax in that a persons’ wealth was already taxed when the money was earned or inherited. However, this idea was suggested recently by the International Monetary Fund (IMF) and could have some appeal to desperate politicians and voters who would be in favor of more taxes on those with substantial savings.

What did Keynes really say?

Shouldn’t the government increase spending during recessions even if that leads to deficits and increases debt? They have to make up for the slack in the private sector.

People forget what Keynes said. They remember that, according to Keynes, during recessions you should increase government spending even if that results in deficits and increased debt. What they forget is that during good times you need to run a surplus and pay off the debt.

Unfortunately, it’s easy for politicians and others to agree to run deficits (such as for “stimulus” spending) and increase debts during recessions but impossible for them to agree to run a surplus in good times. During recessions we run deficits, during good times we spend it all and sometimes a lot more.

Another crucial point made by Keynes was the importance of incurring “good debt” when stimulating the economy during recessions. Good debt, well exemplified by the many projects undertaken by the U.S. government in the 1930’s – dams, highways, rural electrification – is investment in infrastructure that yields long-term economic returns to society.

“Keynes, as opposed to some of his interpreters and predecessors, did not recommend constant budget deficits. Instead, he advocated cyclical deficits, counterbalanced by cyclical budget surpluses. Under such a system, government debt in bad times would be retired in good times. However, Keynes’ original proposition was bastardized in support of perpetual deficits, something Keynes himself never advocated.”  –  Hoisington Investment Management report

Can you solve your debt problem by taking on more debt?

Many governments are trying to solve their problems by adding debt to fund budget deficits, and entitlement spending, and public works projects. They are using deficit spending to attempt to stimulate their economy to grow faster. They are digging a bigger hole on the assumption that their economies will eventually grow fast enough to service their growing debts. Some are probably cynically assuming that they will be able to default or devalue their currency sometime in the future and never have to repay what was borrowed. It won’t work.

What if the borrower can’t pay, defaults?

The borrowed funds have already been spent and will never be recovered. The lender can wait forever to get paid. It will not happen. In this case the lender can pay off the bad debt slowly over time via lost income or recognize this loss immediately and write down the bad debt, taking the loss all at once. Some may avoid a write down hoping for a government bailout or are waiting to leave the problem to a successor.

Can’t we sell assets to pay off debts?

This works if there sufficient valuable to assets sell. Examples could be drilling permits for oil and gas, or public land. This can work for some countries that, for example, have state owned companies that can be sold to the public or to a private company. However, this is usually not a practical solution since what can be sold is greatly exceeded by what’s owed.

How will it end?

Nobody knows for sure.

Will we have inflation or deflation? It is quite possible we will experience deflation over the next several years as debt burdens become unsustainable and as some defaults become inevitable. This could be followed by inflation if central banks can’t unwind the massive bank reserves they’ve created, and if governments remain addicted to deficits and growing debts, unfunded benefits, and expanding entitlements.

Have central bank actions actually done some good following the 2008 mortgage bubble collapse and given economies time to heal? Or, are they just postponing inevitable harsh adjustments when governments are forced to live within their means? It is generally agreed that aggressive action by the Federal Reserve following the collapse of the Lehman Brothers investment bank in 2008 prevented a credit crisis and an even more severe recession.

A concern is what are the practical limits of what the Federal Reserve and other central banks can do to stimulate growth. Will the Federal Reserve be out of bullets when the next recession hits?

In the U.S., fiscal policy, the use of budgets, taxes, and spending to deal with the situation is not available due to gridlock in Washington D.C. We don’t need another stimulus bill anyway. The last one, The American Recovery and Reinvestment Act of 2009, was sold as being for “shovel ready” projects but was later determined to be primarily for entitlements and aid to state governments. The full burden of dealing with the situation falls on the central bank, the Federal Reserve, and their tools to influence money supply, borrowing, and interest rates.

Will fiscal or monetary stimulus help much anyway? Are we just avoiding the real work associated with real reforms that make a difference? Are we trying to get an out of shape athlete to run faster by loading him up with Red Bull? To grow the economy faster and create more jobs and tax revenue, we need to make changes to taxes and regulations at all levels of government to lower the cost of doing business, to promote private sector investment in the economy, and to encourage business growth and new business formation. We also need reforms to improve job training and education. We are in competition with workers, companies, and governments around the globe. There isn’t any place to hide.

Genuine investments in public infrastructure could help. These investments would qualify as good debt if they made real improvements that lowered costs and improved productivity, or were for essential public works projects such as rebuilding levees to avoid flooding. However, our ability to add debt has already been compromised and we’d need to carefully consider any additions even if it is good debt.

Politicians are in denial when it comes to dealing with deficits, debts, and unfunded pension benefits and entitlements.

*   *   *

About the Authors:

William Fletcher is an experienced 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.

Ed Ring is the executive director for the California Policy Center. Before joining the CPPC, he worked in finance and media, primarily for start-up companies in the Silicon Valley. As a consultant and full-time employee for private companies, Ring has done financial modeling and financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

Are Annual Contributions Into CalSTRS Adequate?

Preface: Earlier this year the California Policy Center published a study evaluating the Orange County Employee Retirement System (OCERS) to explore this same question: Are Annual Contributions into OCERS Adequate? That study adopted a unique focus, evaluating contributions into OCERS not based on percent of payroll, but by looking at the actual amount of cash being contributed each year. In particular, the study evaluated how much cash each year was being contributed to reduce the unfunded liability. This report performs the exact same analysis, using the exact same template. Different numbers; same story. Pension analysts and pension activists are encouraged to download the spreadsheets (CalSTRSOCERS) used in both of these studies, and use them to perform similar analysis for whatever pension systems they are concerned about. For whatever pension fund they choose to analyze, it is quite likely they will find that the amount of money being contributed to reduce the unfunded liability is alarmingly low.

Summary: For the fiscal year ended 6-30-2012 the California State Teachers Retirement System, CalSTRS, collected $5.8 billion from employees and employers to invest in their pension fund. Of this $5.82 billion, $4.7 billion was the so-called “normal contribution,” which was a payment to cover the present value of future pensions earned during FYE 6-30-2012 by actively employed participants. The other $1.1 billion that was collected and invested in the fund was a “catch-up” payment to reduce the unfunded liability, which as of 6-30-2012 was officially estimated to be $71.0 billion.

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the “catch-up” payment is calculated based on a level payment, 20 year amortization of the $71.0 billion unfunded liability – still assuming a 7.5% rate-of-return projection – this catch-up payment should be $7.0 billion per year. The study also shows that if the CalSTRS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $107.8 billion and the catch-up payment increases to $9.6 billion per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $154.9 billion and the catch-up payment increases to $12.2 billion per year.

This study also finds that the $4.7 billion normal contribution into CalSTRS for FYE 6-30-2012 was based on a rate-of-return assumption of 7.5%. The study shows that lowering the rate-of-return projection from 7.50% to 6.20% would require the normal contribution to increase by another $1.1 billion; lowering it from 7.50% to 4.81% would require the normal contribution to increase by another $2.5 billion. The rate of 6.2% represents the historical performance of U.S. equity investments (including dividends) between 1900 and 1999. The rate of 4.81% is the Citibank Pension Liability Index rate as of July 2013, which is the lower risk rate recommended by Moody’s Investor Services for pension liability forecasting.

The conclusion of this study is that CalSTRS relies on optimistic long-term earnings projections and very aggressive unfunded liability repayment schedules in order to pay the absolute minimum into their pension fund. If CalSTRS is required to even incrementally lower their rate-of-return projections – something that market conditions may eventually dictate – their funded ratio which is already only 67.0% will fall precipitously. Unless extremely favorable market conditions occur for the next several years without interruption, in order for CalSTRS to remain solvent, they need to dramatically cut retirement benefits, or increase their annual contributions by 50% or more per year.

*   *   *

INTRODUCTION

The purpose of this brief study is to assess whether or not the $5.82 billion contributed during the fiscal year ended 6-30-2012 into the CalSTRS pension fund was sufficient to ensure the long-term solvency of the fund. Using methods recommended in July 2012 and finalized in April 2013 by Moody’s Investor Services, and elucidated in a recent CPPC study “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County,” this study will perform what-if scenarios, estimating the size of the CalSTRS unfunded liability at various rates of return.

This study will also discuss whether or not the current contributions, both normal and catch-up, add sufficient assets to the CalSTRS fund to ensure solvency, and how much contributions would need to increase using more conservative assumptions regarding return on investment and payback periods. Finally, throughout this study an attempt will be made to discuss and explain key concepts of pension finance, in keeping with the CPPC’s mission to inform and involve more people in discussions of sustainable public finance. The tables in this study were produced on an Excel spreadsheet that can be downloaded here:

DOWNLOAD SPREADSHEET:  Analysis-of-CalSTRS-Pension-Liability-and-Contributions.xlsx

The officially recognized amounts for key variables used in this study, including the total contribution to the pension fund, normal contribution, “catch-up” contribution to reduce the unfunded liability, as well as the total assets, total liabilities, and unfunded pension fund liability, were all drawn from publicly available CalSTRS financial reports.

*   *   *

HOW MUCH WAS CalSTRS UNDERFUNDED AS OF 6-30-2012?

The underfunding of any pension fund is calculated by subtracting from the amount of the total invested assets the present value of the liability to pay pensions in the future. Because these future pension obligations are intended to be paid sometime between next year and 50-60 years from now, the liability today is calculated by adding up the net present values of the estimated payments to be made for each year in the future. If the total value of the pension fund’s invested assets is equal to the present value of all future pension payments, the fund is said to be 100% funded.

Using data from the CalSTRS “Defined Benefit Program Actuarial Valuation as of June 30, 2012,” here are the officially recognized amounts for CalSTRS assets, liabilities, and underfunding at the end of last year [1]:

  • Actuarial accrued liability (AAL) = $215.19 billion
  • Valuation value of assets (VVA) = $144.23 billion
  • Unfunded Actuarial Accrued Liability = $70.96 billion

*   *   *

HOW MUCH WAS CONTRIBUTED INTO CalSTRS IN FYE 6-30-2012?

Again using data from CalSTRS “Comprehensive Annual Financial Report, FYE 6-30-2012,” the total contribution into the pension fund in 2012, via direct payments by participating employers and withholding from participating employee paychecks, was $5.82 billion [2].

Annual pension fund contributions have two components, the “normal contribution,” and the “unfunded contribution,” which is the amount paid towards reducing the plan’s unfunded liability. The “normal contribution,” simply stated, needs to be an amount equal to the present value of future pension payment obligations earned in the current year.

Normal Contribution: The total employer and employee normal cost for FYE 6-30-2012 was $4.69 billion as documented on page 15 of the Milliman actuarial report for CalSTRS, “Defined Benefit Program Actuarial Valuation.” [3].

Unfunded Contribution: The amount paid into the CalSTRS pension fund during their FYE 6-30-2012 to reduce their unfunded liability is not explicitly disclosed on official documents. But logic dictates the total unfunded contribution to be the difference between the total contribution, $5.82 billion, and the normal contribution, $4.69 billion, or $1.13 billion.

  • Total contribution = $5.82 billion
  • Normal contribution = $4.69 billion
  • Unfunded contribution = $1.13 billion

The remainder of this report will consider whether or not this level of contributions is adequate by estimating required contributions based on more aggressive payback terms, as well as more conservative rate-of-return projections. The first step is performing these what-ifs is to estimate how the unfunded liability is affected by changes to the rate-of-return projections.

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT CalSTRS UNFUNDED PENSION LIABILITY?

To be 100% funded, a pension plan must have invested assets equal to the present value of all future pension payments. For every participating employee, whether they are active or retired, actuaries estimate their salary growth, their year of retirement, their initial pension, their subsequent pension payouts based on COLAs, and their life expectancy. The present value of all these future payments is how much a fully funded pension plan’s assets must be worth.

The rate at which these future payments are discounted per year must be equivalent to whatever rate the pension fund managers believe they will earn interest, on average, over the life of the fund. The theory is that if no future work were performed, and no future pension benefits were earned, and no additional money were contributed to the fund, the assets currently invested in a fully funded plan would earn enough interest to support every future pension payment until the last participant died of old age.

Since the amount of assets in a pension plan is a known, objective quantity, the debate over how much unfunded liability a plan may have centers on what assumptions are used to estimate the present value of the future payments, i.e., the “Actuarial accrued liability (AAL),” which CalSTRS valued as of 6-30-2013 at $215.2 billion. In order to assess whether or not that amount is overstated or understated, we can use a short-cut formulated by Moody’s Investor Services in their July 2012, “Moody’s Adjustments to US State and Local Government Reported Pension Data.”

In order to revalue a pension fund’s liabilities without having access to every actuarial calculation from every fund, what Moody’s does is estimate the midpoint of the future payments stream. They select 13 years into the future, which is quite conservative. Using a longer duration than 13 years will greatly increase the sensitivity of the liability to changes in the projected rate-of-return. Here is their rationale [4]:

“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate. For example, a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.

We recognize this duration estimate may be higher than warranted for some plans and lower than warranted for others. Each pension plan has a unique benefit structure and demographic profile that affects the time-weighted profile (duration) of future benefit payment liabilities. However, plan durations are not reported, and calculating duration individually for each plan is not feasible. Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.”

Here is the formula that governs this readjustment:

Adj PV = [ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years

Table 1, below, shows how much the CalSTRS unfunded liability will increase based on two alternative rate-of-return projections, both of which are lower than the official rate of 7.50% currently used by CalSTRS. Here they are:

Case 1, 6.2%  –  here is the rationale for this rate-of-return, excerpted from the report “Pension Math: How California’s Retirement Spending is Squeezing The State Budget” [5] authored by Joe Nation, a Ph.D., Stanford Institute for Economic Policy Research, and former California Democratic assemblyman: “This 6.0 to 6.5 percent figure is based on the performance of a hypothetical fund containing 80 percent equity and 20 percent income instruments between 1900 and 1999. It assumes an equity rate based on the 20th-century Dow Jones industrial annual average of 5.3 percent, plus 2 percent in dividends, less 0.5 percent in fees. Combined with income instruments with a net rate of return of 4.5 percent, this hypothetical fund would have earned an average annual rate of 6.2 percent.”

Case 2, 4.81%  –  the rationale for this rate-of-return comes from Moody’s Investor Services “Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013 [6]“For adjustments to pension data, Moody’s will use the Citibank Pension Liability Index (Index) posted on the date of the valuation instead of its original proposal to apply a single rate for all plans each year.” Citigroup Pension Discount rate as posted by the Society of Actuaries in July 2013 was 4.81% [7].

Table 1 makes the revaluation method specified by Moody’s transparent. To download the spreadsheet that contains all of these tables, click here:  Analysis-of-CalSTRS-Pension-Liability-and-Contributions.xlsx, and refer to the first tab “unfunded liability.” To make the logic of these calculations as plain as possible, the spreadsheet cells where assumptions are input are shaded in yellow, and the result cells at the bottom are shaded in green. Column 1 shows the baseline case, using the official projected interest rate of 7.50%, meaning the end result is unchanged. Column two uses the “case 1″ lower rate of 6.20%, column three uses the “case 2″ rate of 4.81%. The first three rows show how the officially reported unfunded liability is calculated. The first four rows of the second second section, “Revaluation of Unfunded Pension Liability,” projects the liability forward 13 years to develop a future value at the official rate of return, 7.50%. The final three rows of the second section then calculate the present value using the baseline rate of 7.50%, the case 1 rate of 6.20%, and the case 2 rate of 4.81%.

As can be seen, even with what is probably an unrepresentative duration of only 13 years, if the pension fund is only projected to earn 6.2% instead of 7.50%, the unfunded liability estimate jumps from $70.0 billion to $107.8 billion, and at a projection of 4.81%, more than doubles to $154.93 billion. These are not implausible scenarios.

TABLE 1  –  RECALCULATING CalSTRS UNFUNDED PENSION LIABILITY

CalSTRS_solvency_analysis_Nov2013_table01a

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT CalSTRS UNFUNDED CONTRIBUTION?

Table 2, below, shows how much CalSTRS should be paying back each year to reduce their unfunded liability if they were to pay it back using the terms of a conventional amortized loan with level payments each year. And this “level payment” method is what has been adopted by Moody’s Investor Services in their Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data, “Moody’s adjusted net pension liability will be amortized over a 20-year period on a level-dollar basis using the interest rate provided by the Index.” [8]

When reviewing Table 2, bear in mind that the payment made in FYE 6-30-2012 into the CalSTRS pension fund towards reducing their unfunded liability was $1.13 billion. As the baseline case in column 1 shows, if this payment were calculated using a level payment, 20 year term as recommended by Moody’s Investor Services, they would have had to pay $6.96 billion during 2012, more than six times as much. This observation merits repetition: By applying repayment terms that Moody’s Investor Services – the largest credit ratings agency in the world – has recommended public sector pension funds adopt, and without changing the return-on-investment assumptions that many analysts (including Moody’s who recommend using the Citibank Pension Index rate which typically is under 5.0%), CalSTRS is underpaying their unfunded contribution by a factor of more than six times.

Columns 2 and 3 in Table 2 help illustrate why it isn’t excessive to specify a 20 year, level payment plan to eliminate a pension plan’s unfunded liability. Because the amount of the unfunded pension liability, the principle being repaid, will fluctuate according to how much fund managers think the invested assets are going to earn. And as Table 1 shows, the amount of the unfunded liability is extremely sensitive to these changes.

In column 2, case 1 shows the impact of a 6.20% rate of return projection for the CalSTRS pension fund. The unfunded pension liability increases from the official $70.0 billion to $107.8 billion, which more than offsets the using the lower 6.20% rate to calculate the required payments. In case 1, a 6.20% projected rate of return for the CalSTRS pension assets will equate a $9.55 billion annual payment to reduce their unfunded liability. In case 2, a 4.81% projected rate of return for the CalSTRS pension assets will equate a $12.2 billion annual payment to reduce their unfunded liability.

Note: The first table in the Appendix to this report shows more detail on how CalSTRS is currently incurring negative amortization, i.e., how the unfunded pension liability will increase each year if only $1.13 billion is paid annually toward reducing that liability, as well as how the unfunded pension can be eliminated within 20 years using the higher payments calculated using the level payment method.

TABLE 2  –  RECALCULATING CalSTRS UNFUNDED CONTRIBUTION

CalSTRS_solvency_analysis_Nov2013_table02a

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT CalSTRS NORMAL CONTRIBUTION?

No discussion of whether or not sufficient funds were contributed to CalSTRS during FYE 6-30-2012 would be complete without considering the “normal contribution,” which was $4.69 billion. The normal contribution is defined as how much future pension obligations were earned by actively employed participants during the current year, in this case, during the 12 month period ended 6-30-2012. If a pension plan is considered to be 100% funded, the normal contribution is the only payment necessary.

Table 3, below, revalues the normal contribution using methods recommended by Moody’s Investor Services. Again, a shortcut of this type is necessary because it is impossible with publicly available information to apply various rates of return to estimated future annual pension payments accrued during 2012 according to the actuarial profile for every actively employed participant in CalSTRS. Instead, the normal payment, representing the present value of the entire stream of future pension payments earned by actively working participants in the most recent year, is recalculated, using the official rate-of-return projection, 7.50%, at a future value set 17 years from now, representing the average remaining service life of active employees. This future value is then discounted back to present value using the lower rate-of-return, in our cases, at 6.20% and 4.81%. This process will yield a higher required normal contribution. Here’s how Moody’s describes this method in their July 2012 proposal “Moody’s Adjustments to US State and Local Government Reported Pension Data.” [9]

“The ENC [employer’s normal cost] adjustment reflects the lower assumed discount rate and the use of a 17-year active employee duration estimate for all plans – i.e., each plan’s normal cost is projected forward for 17 years at the plan’s reported discount rate, and then discounted back at 5.5% [based on the Citibank Pension Liability Index, as Moody’s specifies, which has dropped subsequently dropped to 4.81% – this study uses two lower rate scenarios, 6.20% and 4.81%], after which employee contributions are deducted to determine the adjusted ENC. The 17-year duration assumption reflects our estimate of the average remaining service life of employees based on a sample of public pension plans. We acknowledge that this is a simplifying assumption that may be too long or too short for different plans. Using this approach, a reported ENC payment of $100 million based on an 8% discount rate would grow to $149 million based on a 5.5% discount rate.”

As case 1 and 2 show on Table 3, lowering the CalSTRS pension fund’s rate-of-return projection from 7.50% to 6.20% increases the normal contribution by $1.1 billion; if it is lowered from 7.50% to 4.81% the normal contribution increases by $2.5 billion.

TABLE 3  –  RECALCULATING CalSTRS NORMAL PENSION CONTRIBUTION

CalSTRS_solvency_analysis_Nov2013_table03b

*   *   *

CONCLUSION

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the CalSTRS “catch-up” payment is calculated based on a level payment, 20 year amortization of the $70.0 billion unfunded liability – still assuming a 7.50% rate-of-return projection – this catch-up payment should be $6.96 billion per year, rather than the $1.1 billion unfunded payment that was actually made. The study also estimates that if the CalSTRS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $107.8 billion and the catch-up payment increases to $9.6 billion per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $154.9 billion and the catch-up payment increases to $12.2 billion per year.

This study also estimates that the $4.7 billion normal contribution into CalSTRS for FYE 6-30-2012, based on a rate-of-return assumption of 7.50%, would have to increase to $5.5 billion based on lowering the rate-of-return assumption to 6.20%. Further, the study shows that by lowering the rate-of-return assumption from 7.50% to 4.81% would require the normal contribution to increase to $6.9 billion.

The 2nd table in the appendix, “Required rate-of-return at various levels of underfunding,” shows why underfunding is a slippery slope by illustrating how much higher rates have to be just to keep the underfunding from getting worse. Pension spokespersons have consistently stated that annual earnings in any mature fund will always greatly exceed annual contributions. On the table, the 5th column “baseline” shows how much earnings have to increase at CalSTRS current official level of 67.02% funded. At that level of funding, as can be seen, just in order for the unfunded liability to not increase, CalSTRS currently has to earn an annual return of 11.2%. At that sustained rate-of-return, the surplus earnings beyond the projected 7.50% do not reduce the unfunded liability at all, they merely prevent it from getting larger.

To recap, for the fiscal year ended 6-30-2012, here are some CalSTRS financial highlights as determined in this study:

  • Lowering the earnings projection to 6.20% increases the normal contribution by $1.1 billion per year; lowering it to 4.81% increases the normal contribution by $2.5 billion per year.
  • The unfunded “catch-up” contribution of $1.1 billion did not lower the officially recognized unfunded liability of $71.0 billion, in fact, it grew by $4.2 billion (ref. Appendix 1, baseline case).
  • If the earnings projection is lowered from 7.50% to 6.20% the unfunded liability increases from $71.0 billion to $107.8 billion; if it is lowered to 4.81% the unfunded liability increases to $154.9 billion.
  • At the official return projection of 7.50%, if the unfunded liability is paid back according to 20 year level payment amortization terms, the annual catch-up payment would have been $6.9 billion.
  • Using 20 year level payment amortization terms, at a return projection of 6.20% the annual catch-up payment should have been $9.6 billion; at 4.81%, it should have been $12.2 billion.
  • An annual return projection of 6.20% represents the long-term appreciation of equities [5], an annual return projection of 4.81% represents the Citibank pension liability index rate as of July 2013 [7].

The conclusion of this study is that CalSTRS relies on optimistic long-term earnings projections and very aggressive unfunded liability repayment schedules in order to contribute the absolute minimum each year into their pension fund. As a result, their unfunded liability increased during FYE 6-30-2012 by over $4.0 billion. If CalSTRS is required to even incrementally lower their rate-of-return projections further – something that market conditions may eventually dictate – their funded ratio which is already only 67.0% will fall precipitously. Unless extremely favorable market conditions occur for the next several years without interruption, in order for CalSTRS to remain solvent, they need to dramatically cut retirement benefits, or increase their annual contributions by 50% or more per year.

*   *   *

FOOTNOTES

(1)  CalSTRS Defined Benefit Program Actuarial Valuation as of June 30, 2012, page 32, Table 8

(2)  CalSTRS “Comprehensive Annual Financial Report, FYE 6-30-2012, page 41, “Statement of Changes in Fiduciary Net Assets.”

(3)  Milliman: Defined Benefit Program Actuarial Valuation, as of June 30, 2012, page 15, Section 4 “Actuarial Obligation, Normal Cost.”

(4)  Moody’s Adjustments to US State and Local Government Reported Pension Data, request for comment, July 2nd, 2012, page 6.

(5)  Pension Math: How California’s Retirement Spending is Squeezing The State Budget, Stanford Institute for Economic Policy Research, page 13, December 2011.

(6)  Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” ref. “The Adjustments,” item 1, April 2013.

(7)  Citigroup Pension Discount Curve, Society of Actuaries, July 2013

(8)  Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data, ref. “The Adjustments,” item 3, April 2013.

(9)  Moody’s Adjustments to US State and Local Government Reported Pension Data, ref. page 8, section four, part one “New discount rate applied to normal cost.”

*   *   *

APPENDIX  –  TABLE 1  –  UNFUNDED LIABILITY AMORTIZATION SCENARIOS

CalSTRS_solvency_analysis_Nov2013_appendix01a

APPENDIX  –  TABLE 2  –  REQUIRED RETURN AT VARIOUS LEVELS OF UNDERFUNDING

CalSTRS_solvency_analysis_Nov2013_appendix02a

Are Annual Contributions Into Orange County's Employee Pension Plan Adequate?

By Ed Ring, August 30, 2013

Summary: During 2012 the Orange County Employee Retirement System, OCERS, collected $628 million from employees and employers to invest in their pension fund. Of this $628 million, $410 million was the so-called “normal contribution,” which was a payment to cover the present value of future pensions earned during 2012 by actively employed participants. The other $218 million that was collected and invested in the fund was a “catch-up” payment to reduce the unfunded liability, which at the end of 2012 was officially estimated to be $5.6 billion.

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the “catch-up” payment is calculated based on a level payment, 20 year amortization of the $5.6 billion unfunded liability – still assuming a 7.25% rate-of-return projection – this catch-up payment should be $546 million per year. The study also shows that if the OCERS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $7.74 billion and the catch-up payment increases to $685 million per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $10.95 billion and the catch-up payment increases to $865 million per year.

This study also finds that the $410 million normal contribution into OCERS for 2012 was based on a rate-of-return assumption of 7.75%, which was lowered during 2012 to 7.25%. At that lower rate the normal contribution should have been $460 million. Further, the study shows that lowering the rate-of-return projection from 7.25% to 6.20% would require the normal contribution to increase by another $75 million; lowering it from 7.25% to 4.81% would require the normal contribution to increase by another $196 million. The rate of 6.2% not only represents the historical performance of U.S. equity investments, but actually reflects the returns earned by OCERS since Segal took over the actuarial duties in 2004. The rate of 4.81% is the Citibank Pension Liability Index rate as of July 2013, which is the lower risk rate recommended by Moody’s Investor Services for pension liability forecasting.

The inescapable conclusion of this study is that OCERS relied on optimistic long-term earnings projections and adopted very aggressive unfunded liability repayment schedules in order to pay the absolute minimum into their pension fund in 2012. As a result, their unfunded liability increased during 2012 by over $100 million. If OCERS is required to even incrementally lower their rate-of-return projections further – something that market conditions may eventually dictate – their funded ratio which is already only 62.52% will fall precipitously. Unless extremely favorable market conditions occur for the next several years without interruption, in order for OCERS to remain even marginally solvent, they need to either cut retirement benefits across the board, or increase their annual contributions by 50% or more per year.

 *   *   *

INTRODUCTION

The purpose of this brief study is to assess whether or not the $628 million contributed during 2012 in to the OCERS pension fund was sufficient to ensure the long-term solvency of the fund. Using methods recommended in July 2012 and finalized in April 2013 by Moody’s Investor Services, and elucidated in a recent CPPC study “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County,” this study will perform what-if scenarios, estimating the size of the OCERS unfunded liability at various rates of return.

This study will also discuss whether or not the current contributions, both normal and catch-up, add sufficient assets to the OCERS fund to ensure solvency, and how much contributions would need to increase using more conservative assumptions regarding return on investment and payback periods. Finally, throughout this study an attempt will be made to discuss and explain key concepts of pension finance, in keeping with the CPPC’s mission to inform and involve more people in discussions of sustainable public finance. The tables in this study were produced on an Excel spreadsheet that can be downloaded here:

DOWNLOAD SPREADSHEET:  Analysis-of-Orange-County-Pension-Liability-and-Contributions.xlsx

The officially recognized amounts for key variables used in this study, including the total contribution to the pension fund, normal contribution, “catch-up” contribution to reduce the unfunded liability, as well as the total assets, total liabilities, and unfunded pension fund liability, were all drawn from OCERS financial reports and verified with experts employed at OCERS.

*   *   *

HOW MUCH WAS ORANGE COUNTY’S PENSION FUND UNDERFUNDED AS OF 12-31-2012?

The underfunding of any pension fund is calculated by subtracting from the amount of the total invested assets the present value of the liability to pay pensions in the future. Because these future pension obligations are intended to be paid sometime between next year and 50-60 years from now, the liability today is calculated by adding up the net present values of the estimated payments to be made for each year in the future. If the total value of the pension fund’s invested assets is equal to the present value of all future pension payments, the fund is said to be 100% funded.

Using data from the OCERS “Actuarial Valuation and Review as of 12-31-2012,” here are the officially recognized amounts for OCERS assets, liabilities, and underfunding at the end of last year [1]:

  • Actuarial accrued liability (AAL) = $15.14 billion
  • Valuation value of assets (VVA) = $9.47 billion
  • Unfunded Actuarial Accrued Liability = $5.67 billion

Here’s how OCERS management describes the funding status of their pension plan in the “Management Discussion and Analysis” section of OCERS Comprehensive Annual Financial Report for the fiscal year ended 12-31-2012:

“Based upon the most recent actuarial valuation as of December 31, 2012, prepared by the System’s independent actuary, OCERS’ funding status for the pension plan, as measured by the ratio of the actuarial value of assets (which smooths market gains and losses over five years) to the actuarial value of liabilities, decreased from 67.03% at December 31, 2011 to 62.52% at December 31, 2012 due primarily to the impact of decreasing the investment assumed rate of return from 7.75% to 7.25%.” [2]

*   *   *

HOW MUCH WAS CONTRIBUTED INTO ORANGE COUNTY’S PENSION FUND IN 2012?

Again using data from OCERS “Actuarial Valuation and Review as of 12-31-2012,” the total contribution into the pension fund in 2012, via direct payments by participating employers and withholding from participating employee paychecks, was $628 million [3].

Annual pension fund contributions have two components, the “normal contribution,” and the “unfunded contribution,” which is the amount paid towards reducing the plan’s unfunded liability. The “normal contribution,” simply stated, needs to be an amount equal to the present value of future pension payment obligations earned in the current year.

Normal Contribution: The total employer and employee normal cost for calendar year 2012 was $410 million as documented on page 62 of the OCERS Actuarial Valuation and Review [4]. Of note is that that amount was calculated using the assumptions from the 12/31/2011 valuation; in particular, the 7.75% investment return assumption used in that valuation.

Unfunded Contribution: The amount paid into the OCERS pension fund during 2012 to reduce their unfunded liability is not explicitly disclosed on official documents. But logic dictates the total unfunded contribution to be the difference between the total contribution, $628 million, and the normal contribution, $410 million, or $218 million. We verified this is correct in discussions with OCERS management. To summarize:

  • Total contribution = $628 million
  • Normal contribution = $410 million
  • Unfunded contribution = $218 million

The remainder of this report will consider whether or not this level of contributions is adequate by estimating required contributions based on more aggressive payback terms, as well as more conservative rate-of-return projections. The first step is performing these what-ifs is to estimate how the unfunded liability is affected by changes to the rate-of-return projections.

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT ORANGE COUNTY’S UNFUNDED PENSION LIABILITY?

To be 100% funded, a pension plan must have invested assets equal to the present value of all future pension payments. For every participating employee, whether they are active or retired, actuaries estimate their salary growth, their year of retirement, their initial pension, their subsequent pension payouts based on COLAs, and their life expectancy. The present value of all these future payments is how much a fully funded pension plan’s assets must be worth.

The rate at which these future payments are discounted per year must be equivalent to whatever rate the pension fund managers believe they will earn interest, on average, over the life of the fund. The theory is that if no future work were performed, and no future pension benefits were earned, and no additional money were contributed to the fund, the assets currently invested in a fully funded plan would earn enough interest to support every future pension payment until the last participant died of old age.

Since the amount of assets in a pension plan is a known, objective quantity, the debate over how much unfunded liability a plan may have centers on what assumptions are used to estimate present value of the future payments, i.e., the “Actuarial accrued liability (AAL),” which OCERS valued as of 12-31-2013 at $15.14 billion. In order to assess whether or not that amount is overstated or understated, we can use a short-cut formulated by Moody’s Investor Services in their July 2012, “Moody’s Adjustments to US State and Local Government Reported Pension Data.”

In order to revalue a pension fund’s liabilities without having access to every actuarial calculation from every fund, what Moody’s does is estimate the midpoint of the future payments stream. They select 13 years into the future, which is quite conservative. Using a longer duration than 13 years will greatly increase the sensitivity of the liability to changes in the projected rate-of-return. Here is their rationale [5]:

“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate. For example, a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.

We recognize this duration estimate may be higher than warranted for some plans and lower than warranted for others. Each pension plan has a unique benefit structure and demographic profile that affects the time-weighted profile (duration) of future benefit payment liabilities. However, plan durations are not reported, and calculating duration individually for each plan is not feasible. Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.”

Here is the formula that governs this readjustment:

Adj PV = [ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years

Table 1, below, shows how much the OCERS unfunded liability will increase based on two alternative rate-of-return projections, both of which are lower than the official rate of 7.25% currently used by OCERS. Here they are:

Case 1, 6.2%  –  here is the rationale for this rate-of-return, excerpted from the report “Pension Math: How California’s Retirement Spending is Squeezing The State Budget” [6] authored  Joe Nation, a Ph.D., Stanford Institute for Economic Policy Research, and former California Democratic assemblyman: “This 6.0 to 6.5 percent figure is based on the performance of a hypothetical fund containing 80 percent equity and 20 percent income instruments between 1900 and 1999. It assumes an equity rate based on the 20th-century Dow Jones industrial annual average of 5.3 percent, plus 2 percent in dividends, less 0.5 percent in fees. Combined with income instruments with a net rate of return of 4.5 percent, this hypothetical fund would have earned an average annual rate of 6.2 percent.”

Case 2, 4.81%  –  the rationale for this rate-of-return comes from Moody’s Investor Services “Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013 [7]: “For adjustments to pension data, Moody’s will use the Citibank Pension Liability Index (Index) posted on the date of the valuation instead of its original proposal to apply a single rate for all plans each year.” The Citibank Pension Liability Index rate as posted by the Society of Actuaries in July 2013 was 4.81% [8].

Table 1 makes the revaluation method specified by Moody’s transparent. To download the spreadsheet that contains all of these tables, click here:  Analysis-of-Orange-County-Pension-Liability-and-Contributions.xlsx, and refer to the first tab “unfunded liability.” To make the logic of these calculations as plain as possible, the spreadsheet cells where assumptions are input are shaded in yellow, and the result cells at the bottom are shaded in green. Column 1 shows the baseline case, using the official projected interest rate of 7.25%, meaning the end result is unchanged. Column two uses the “case 1” lower rate of 6.20%, column three uses the “case 2” rate of 4.81%. The first three rows show how the officially reported unfunded liability is calculated. The first four rows of the second second section, “Revaluation of Unfunded Pension Liability,” projects the liability forward 13 years to develop a future value at the official rate of return, 7.25%. The final three rows of the second section then calculate the present value using the baseline rate of 7.75%, the case 1 rate of 6.20%, and the case 2 rate of 4.81%.

As can be seen, even with what is probably an unrepresentative duration of only 13 years, if the pension fund is only projected to earn 6.2% instead of 7.25%, the unfunded liability estimate jumps from $5.67 billion to $7.74 billion, and at a projection of 4.81%, nearly doubles to $10.95 billion. These are not implausible scenarios.

TABLE 1  –  RECALCULATING ORANGE COUNTY’S UNFUNDED PENSION LIABILITY

OCERS_solvency_analysis_Aug2013_table1rev1

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT ORANGE COUNTY’S UNFUNDED CONTRIBUTION?

When discussing what amount constitutes a prudent amount to pay each year towards reducing Orange County’s unfunded pension liability, it is important to emphasize that not only is the rate of return a key variable, but also the payment terms. A valid analogy to describe how pension funds typically attempt to pay down their unfunded liabilities might be to compare them to how subprime loans were structured. They offered features such as interest only payments for the first several years, “resetting” after several years to become fully amortized loans. They offered floating interest rates, usually set at very low “teaser” rates in the first years, only elevating to market rates after 3 to 5 years. They even offered “negative amortization,” whereby borrowers would pay less than the minimum interest-only payment, allowing the amount owed to actually increase each year.

What OCERS has done, and this is quite typical for underfunded public sector pension plans in California, is extend the term of the repayment and adopt a so-called “level percent of payroll” method of repayment. What “level percent of payroll” does is calculate each year’s payment towards reducing the unfunded liability as a percent of projected payroll, which is assumed to increase each year. This translates into a payment stream that is relatively small in the early years of the payback term, increasing every year. It sounds reasonable, but the practical effect is negative amortization, that is, the unfunded liability actually grows each year for the first several years of the payback term.

Table 2, below, shows how much OCERS should be paying back each year to reduce their unfunded liability if they were to pay it back using the terms of a conventional amortized loan with level payments each year. And this “level payment” method is what has been adopted by Moody’s Investor Services in their Revised New Approach to Adjusting Reported State and Local Government Pension Data, “Moody’s adjusted net pension liability will be amortized over a 20-year period on a level-dollar basis using the interest rate provided by the Index.[9]

When reviewing Table 2, bear in mind that the payment made in 2012 into the OCERS pension fund towards reducing their unfunded liability was $218 million. As the baseline case in column 1 shows, if this payment were calculated using a level payment, 20 year term as recommended by Moody’s Investor Services, they would have had to pay $548 million during 2012, 2.5 times as much. They would have had to find an additional $328 million from employees or taxpayers – or cut services.

Columns 2 and 3 in Table 2 dramatically illustrate why it isn’t excessive to specify a 20 year, level payment plan to eliminate a pension plan’s unfunded liability. Because the amount of the unfunded pension liability, the principle being repaid, will fluctuate according to how much fund managers think the invested assets are going to earn. And as Table 1 shows, the amount of the unfunded liability is extremely sensitive to these changes.

In column 2, case 1 shows the impact of a 6.20% rate of return projection for the OCERS pension fund. The unfunded pension liability increases from the official $5.67 billion to $7.74 billion, which more than offsets the using the lower 6.20% rate to calculate the required payments. In case 1, a 6.20% projected rate of return for the OCERS pension assets will equate a $685 million annual payment to reduce their unfunded liability. In case 2, a 4.81% projected rate of return for the OCERS pension assets will equate a $865 million annual payment to reduce their unfunded liability.

Note: The first table in the Appendix to this report shows more detail on how OCERS is currently incurring negative amortization, i.e., how the unfunded pension liability will increase each year if only $218 million is paid annually toward reducing that liability, as well as how the unfunded pension can be eliminated within 20 years using the higher payments calculated using the level payment method.

TABLE 2  –  RECALCULATING ORANGE COUNTY’S UNFUNDED CONTRIBUTION

OCERS_solvency_analysis_Aug2013_table3rev1

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT ORANGE COUNTY’S NORMAL CONTRIBUTION?

No discussion of whether or not sufficient funds were contributed to Orange County’s Employee Retirement System during 2012 would be complete without considering the “normal contribution,” which was $410 million. The normal contribution is defined as how much future pension obligations were earned by actively employed participants during the current year, in this case, during 2012. If a pension plan is considered to be 100% funded, the normal contribution is the only payment necessary.

Table 3, below, revalues the normal contribution using methods recommended by Moody’s Investor Services. Again, a shortcut of this type is necessary because it is impossible with publicly available information to apply various rates of return to estimated future annual pension payments accrued during 2012 according to the actuarial profile for every actively employed participant in OCERS. Instead, the normal payment, representing the present value of the entire stream of future pension payments earned by actively working participants in the most recent year, is recalculated, using the official rate-of-return projection, 7.25%, at a future value set 17 years from now, representing the average remaining service life of active employees. This future value is then discounted back to present value using the lower rate-of-return, in our cases, at 6.20% and 4.81%. This process will yield a higher required normal contribution. Here’s how Moody’s describes this method in their July 2012 proposal “Adjustments to US State and Local Government Reported Pension Data.” [10]

“The ENC [employer’s normal cost] adjustment reflects the lower assumed discount rate and the use of a 17-year active employee duration estimate for all plans – i.e., each plan’s normal cost is projected forward for 17 years at the plan’s reported discount rate, and then discounted back at 5.5% [based on the Citibank Pension Liability Index, as Moody’s specifies, which has dropped subsequently dropped to 4.81% – this study uses two lower rate scenarios, 6.20% and 4.81%], after which employee contributions are deducted to determine the adjusted ENC. The 17-year duration assumption reflects our estimate of the average remaining service life of employees based on a sample of public pension plans. We acknowledge that this is a simplifying assumption that may be too long or too short for different plans. Using this approach, a reported ENC payment of $100 million based on an 8% discount rate would grow to $149 million based on a 5.5% discount rate.”

To put this theory into sharp focus, the impact of the change during 2012 by OCERS of their rate-of-return projection down from 7.75% to 7.25% had a significant impact on their required normal contribution. From the OCERS Actuarial Valuation and Review as 0f 12-31-2012, on page 62 [11] they reference the “”Normal Cost at Middle of Year” reported by OCERS for 2012 was $410 million. From that same report, on page 66 [12], they state “The actuarial factors as of the valuation date [12-31-2012] are as follows (amounts in 000s): 1. Normal cost. $460 [million].” Since not much else changed in six months, lowering the assumed rate-of-return from 7.75% to 7.25% caused the normal contribution into OCERS to increase by $50 million. For this reason, Table 3 probably is conservatively estimating the impact of further lowerings of the rate-of-return, since the baseline case starts at a normal contribution of $410 million based on a 7.25%, when in reality the normal cost at that rate of return should probably already be $460 million.

In any event, as case 1 and 2 show on Table 3, lowering the OCERS pension fund’s rate-of-return projection from 7.25% to 6.20% increases the normal contribution by $75 million; if it is lowered from 7.25% to 4.81% the normal contribution increases by $194 million.

TABLE 3  –  RECALCULATING ORANGE COUNTY’S NORMAL PENSION CONTRIBUTION

OCERS_solvency_analysis_Aug2013_table2rev1

*   *   *

CONCLUSION

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the “catch-up” payment is calculated based on a level payment, 20 year amortization of the $5.6 billion unfunded liability – still assuming a 7.25% rate-of-return projection – this catch-up payment should be $546 million per year. The study also shows that if the OCERS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $7.74 billion and the catch-up payment increases to $685 million per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $10.95 billion and the catch-up payment increases to $865 million per year.

This study also finds that the $410 million normal contribution into OCERS for 2012 was based on a rate-of-return assumption of 7.75%, which was lowered during 2012 to 7.25%. At that lower rate the normal contribution should have been $460 million. Further, the study shows that lowering the rate-of-return projection from 7.25% to 6.20% would require the normal contribution to increase by another $75 million; lowering it from 7.25% to 4.81% would require the normal contribution to increase by another $196 million.

The 2nd table in the appendix, “Required rate-of-return at various levels of underfunding,” shows why underfunding is a slippery slope by illustrating how much higher rates have to be just to keep the underfunding from getting worse. Recall that when pension benefits were being enhanced, retroactively at that, the pension bankers said funds wouldn’t require any contributions to pay for these enhancements. Pension spokespersons have consistently stated that annual earnings in any mature fund will always greatly exceed annual contributions. On the table, the 5th column “baseline” shows how much earnings have to increase at OCERS current official level of 62.52% funded. At that level of funding, as can be seen, just in order for the unfunded liability to not increase, OCERS currently has to earn an annual return of 11.6%. At that level of earnings, the surplus earnings beyond the projected 7.25% do not reduce the unfunded liability at all, they merely prevent it from getting larger.

To recap, here are some OCERS financial highlights as determined in this study:

  • Their normal contribution in 2012 should have been $460 million instead of $410 million, based on the earnings projection of 7.25% which was adopted that year.
  • Lowering the earnings projection to 6.20% increases the normal contribution by $75 million per year; lowering it to 4.81% increases the normal contribution $196 million per year.
  • The unfunded “catch-up” contribution of $218 million in 2012 did not lower the officially recognized unfunded liability of $5.67 billion, in fact, it grew by over $100 million.
  • If the earnings projection is lowered from 7.25% to 6.20% the unfunded liability increases from $5.67 billion to $7.74 billion; if it is lowered to 4.81% the unfunded liability increases to $10.95 billion.
  • At the official return projection of 7.25%, if the unfunded liability is paid back according to 20 year level payment amortization terms, the annual catch-up payment would have been $546 million in 2012.
  • Using 20 year level payment amortization terms, at a return projection of 6.20% the annual catch-up payment should have been $685 million in 2012; at 4.81%, it should have been $865 million in 2012.
  • An annual return projection of 6.20% represents the long-term appreciation of equities [6], an annual return projection of 4.81% represents the Citibank pension liability index rate as of July 2013 [7].

The inescapable conclusion of this study is that OCERS relied on optimistic long-term earnings projections and adopted very aggressive unfunded liability repayment schedules in order to pay the absolute minimum into their pension fund in 2012. As a result, their unfunded liability increased during 2012 by over $100 million. If OCERS is required to even incrementally lower their rate-of-return projections further – something that market conditions may eventually dictate – their funded ratio which is already only 62.52% will fall precipitously. Unless extremely favorable market conditions occur for the next several years without interruption, in order for OCERS to remain even marginally solvent, they need to either cut retirement benefits across the board, or increase their annual contributions by 50% or more per year.

*   *   *

FOOTNOTES

(1)  OCERS Actuarial Valuation and Review as of 12-31-2012, page viii.

(2)  OCERS Comprehensive Annual Financial Report for the fiscal year ended 12-31-2012, page 18.

(3)  OCERS Actuarial Valuation and Review as of 12-31-2012, page 62, Section 3, Exhibit H, line 3, “Actual Employer and Member Contribution [2012].”

(4)  OCERS Actuarial Valuation and Review as of 12-31-2012, page 62, Section 3, Exhibit H, line 2, “Normal Cost at Middle of Year [2012].”

(5)  Moody’s Adjustments to US State and Local Government Reported Pension Data, request for comment, July 2nd, 2012, page 6.

(6)  Pension Math: How California’s Retirement Spending is Squeezing The State Budget, Stanford Institute for Economic Policy Research, page 13, December 2011.

(7)  Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” ref. “The Adjustments,” item 1, April 2013.

(8)  Citigroup Pension Discount Curve, Society of Actuaries, July 2013

(9)  Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data, ref. “The Adjustments,” item 3, April 2013.

(10)  Moody’s Adjustments to US State and Local Government Reported Pension Data, ref. page 8, section four, part one “New discount rate applied to normal cost.”

(11)  OCERS Actuarial Valuation and Review as of 12-31-2012, page 62, Section 3, Exhibit H, line 2, “Normal Cost at Middle of Year [2012].”

(12)  OCERS Actuarial Valuation and Review as of 12-31-2012, page 66, Section 4, Exhibit I, part 2, line 1, “The actuarial factors as of the valuation date [12-31-2012] are as follows (amounts in 000s): 1. Normal cost.”

*   *   *

APPENDIX  –  TABLE 1  –  UNFUNDED LIABILITY AMORTIZATION SCENARIOS

OCERS_solvency_analysis_Aug2013_appendix4rev1

APPENDIX  –  TABLE 2  –  REQUIRED RETURN AT VARIOUS LEVELS OF UNDERFUNDING

OCERS_solvency_analysis_Aug2013_appendix5rev1

State Pension Litigation Update

By Joe Luppino-Esposito, August 9, 2013

About the Author:  Joe Luppino-Esposito is an editor and author at State Budget Solutions, focusing on public employee pensions, labor law, and state budget reforms. Prior to joining SBS, Joe was a researcher at the Center for Union Facts, and previously served as a Visiting Legal Fellow at the Heritage Foundation. He is a graduate of Seton Hall University School of Law and the College of William and Mary. Joe is a licensed Virginia attorney. He is a New Jersey native and currently resides in Virginia. This study originally was published by State Budget Solutions and is republished here with permission. 

*   *   *

STATE-BY-STATE ANALYSIS

ALABAMA

Taylor v. City of Gadsden
Facts: The retirement system for firefighters for the city of Gadsden, Alabama, was folded into the state pension system in 2002. In 2011, the Alabama Legislature passed a law that increased employee contributions to the state retirement fund. For firefighters, the contribution rates increased from 6 percent to 8.5 percent by 2012. Plaintiff Taylor, a Gadsden firefighter, sued the city for violating his contract.
Issue: Does a city’s implementation of state law increasing pension contributions of covered state employees violated state and/or federal contract law when the city had a prior contract with the now-covered state employee?
Status: Pending; Motion to dismiss denied on 02/23/2012.
SourceLaura and John Arnold Foundation Quarterly Pension Litigation Summary, April 2013

Wood v. Retirement System of Alabama
Facts: In 2011, the Alabama Legislature passed a law that increased employee contributions to the state retirement fund. For judges, the contribution rates increased from 6 percent to to 8.5 percent. Mobile County Circuit Judge James Wood sued the state alleging that the pension reform violated the state constitution by decreasing the pay of a judge during his time in office.
Issue: Is a pension reform that increases pension contribution rates of state judges lower their compensation in a way violative of the Alabama constitution?
Status: Pending; filed 06/01/2012.
Sources: Laura and John Arnold Foundation Quarterly Pension Litigation Summary, April 2013AlabamaNews.net

CALIFORNIA

San Jose Police Officers’ Association v. City of San Jose
Facts: While negotiating with the police officer union in early 2012, San Jose City Council approved a ballot measure put before city voters in June 2012 that gives current city employees a choice to contribute more to their pension plan or take a lower pension and requires any new hires to contribute half of their pension costs. The measure passed with 70 percent voter approval.
Issue: Did the city sufficiently bargain with the union, as required by labor law, before putting the issue before the voters?
Status: Filed in state Superior Court in Santa Clare County on 4/29/2013.
SourceCBS NewsSan Jose Inside

[Multiple suits]
Facts: Governor Jerry Brown signed the State’s Public Employees Pension Reform Act into law in September 2012. The law, effective January 1, 2013, requires that all new government employees pay 50 percent of their pension costs and the retirement age was raised. The law also altered the pension calculation for current employees.
Issue: Can the state alter collective bargaining agreements with government employees? Does the relationship that exists between current employees and the state regarding employee pensions constitute a contract?
Status: Several suits were filed in multiple jurisdictions in late 2012 and early 2013. We will report on the individual cases and issues as they are adjudicated.
SourceLos Angeles Times

CalPERS sues the city of Compton, Californiafiled October 30, 2012 in Superior Court in Sacramento County ISSUE: Whether the city of Compton is required to make $1.99 million in pension contributions and $674,000 in health benefit contributions after failing to make these payments since September 21, 2012.

ILLINOIS

State can charge retirees premiums for their health care benefits according to 7th Judicial Circuit in Illinois. PLANSPONSOR.com. March 22, 2013.

SEC Charges Illinois for Misleading Pension Disclosures. Filed 3.11.13. The Securities Exchange (SEC) has charged Illinois with securities fraud. The SEC alleges that the state misled municipal bond investors by failing to disclose that its plans “significantly underfunded” the state pension plan and increased risk. The SEC order instituting settled administrative proceedings against Illinois shows that the pension contribution schedule was insufficient to cover all costs and severely backloaded payments to a future date. In particular, the effects of pension holidays and other changes made to the funding plan in 2005 were not properly disclosed to investors. March 11, 2013.

The Chicago Teachers Pension Fund notified teachers who retired between June 2000 and August 2004, who were paid on a regular school calendar, that they may have been overpaid because their pensions were calculated differently than the Chicago Board of Education felt they should be. After seven years of litigation following a suit filed in 2004, CTPF accepted a settlement agreement on December 6, 2012 allowing for the recalculation of pensions. In addition to recalculations, the Board of Education will not seek overpayments from anyone who retired in 2000 to 2012.

Chicago Teachers Union v. Chicago Public Schools filed Wednesday, 10.31.12 ISSUE: Whether the a law passed by the Illinois General Assembly barring Chicago Public School teachers from participating in the public pension plan after going on leave to work for the Chicago Teachers Union is unconstitutional. The effect of the law prior to appeal was to allow labor union leaders to collect public pension benefits based on significantly higher union salaries.

Illinois reported that it owes $83 billion to its five public pension funds. Under new Governmental Account Standards Board and Moody’s Investment Services requirements, the state’s pension debt will more than double.

Board of Education of Chicago v. Public School Teachers’ Pension & Retirement Fund filed January 2005 ISSUE: Whether the Board of Education violated its legal duty under the Illinois Pension Code submitting a contribution that was $40,635,883 short of the requirement with unilateral authority. PENDING: Currently in procedural battle over whether the Board must redraft its complaint to name all 3,400 teachers as defendants, meaning they must find and serve each one with a copy of the suit. (10.12.11). Oral arguments are scheduled August 2, 2012.

LOUISIANA

Retired State Employees Association v. State
Facts:  House Bill No. 61 created a cash balance retirement plan for new state employees. The bill was passed by a majority vote on the House floor after the Speaker of the House determined that only a majority vote was required. The Louisiana constitution requires a two-thirds supermajority vote for changes to the “[b]enefit provisions for members of any public retirement system, plan, or fund” that have an “actuarial cost.” The State argues that the bill created a new plan for new members and did not alter the current plan for the current “retirees” (as opposed to “members”) and therefore, did not require a two-thirds supermajority. Furthermore, the state argues that the actuarial note of the legislative auditor is not the sole fiscal advisor for the state.
Issues: Did House Bill No. 61 create a new plan that is separate from the current retirement system, such that passing the plan by less than a supermajority does not violate the Louisiana Constitution? Is the legislative auditor the only valid determiner of actual cost of a piece of legislation? [N.B.: This is not a question of the legality of the cash balance plan itself, but rather a legislative procedural question.]
Holding: House Bill No. 61 was never enacted because the House did not have the required two-thirds votes to pass the bill. The cash-balance plan, because it alters the current retirement system and has an actuarial cost, as determined by the legislative auditor, can only become law if it receives two-thirds of all votes in both houses of the legislature.
Status: State Supreme Court struck down House Bill No. 61 on 6/28/2013.
Sources: Supreme Court of LouisianaTimes-Picayune

MAINE

Maine Association of Retirees v. Maine Public Employee Retirement System
Facts: In June 2011 the state legislature approved a pension reform measure that would eliminate cost-of-living (COLA) adjustments for retired state employees and public school teachers for three years and thereafter reduce the adjustments to three percent on the first $20,000 of a retirees’ pension. Prior to the change, the retirement system was authorized to grant COLA of up to four percent per year. The retiree association plaintiff, later joined by three public employee unions, sued the retirement system to stop the adjustments and to pay COLA retroactively.
Issue: Was there a contract between the state retirement system and retirees regarding their retirement benefits, and if there is, has the state violated that contract by altering COLA? Alternatively, is the elimination of COLA an unlawful taking without just compensation?
Holding: Federal District Court Judge George Z. Singal dismissed the case in summary judgment, determining that plaintiffs were unable to show a violation of a contract.
Status: Dismissed by summary judgment 6/23/2013.
Sources: U.S. District CourtBangor Daily News

MICHIGAN

In re City of Detroit, Michigan
Facts: With the power granted under Michigan’s emergency manager law, Governor Rick Snyder authorized Kevyn Orr to file for Chapter 9 federal bankruptcy protection on behalf of the city of Detroit. Detroit claims it is $18 billion in debt that it cannot repay. Among the city’s creditors are the city employees’ pension boards.
Procedural History: Prior to the federal bankruptcy filing, the pension boards filed for a restraining order in state court against Governor Snyder to stop him from authorizing Detroit’s bankruptcy filing. The state Circuit Court granted the temporary restraining order and ruled that the federal bankruptcy filing was improper because it violates the Michigan constitution provision which prohibits the reduction of pension benefits. The Michigan Attorney General appealed the case on behalf of the state to the Michigan Court of Appeals. The Michigan Court of Appeals granted a stay on the lower court ruling that would have blocked the bankruptcy filing. The Attorney General also moved in bankruptcy court for a confirmation of protection, which would stay all state suits against Detroit.
Issue: Can state lawsuits against the debtor city continue after the city has filed for Chapter 9 bankruptcy protection?
Holding: The federal bankruptcy court ordered a stay of all suits against Detroit and claimed jurisdiction over all debtor claims. In turn, the Michigan Court of Appeals closed the suits against Detroit, pending the lifting of the federal bankruptcy court’s stay.
Status: 
All state suits dismissed and ordered under federal bankruptcy court jurisdiction 07/25/2013. Case ongoing.
Note: State Budget Solutions estimates the city’s pension funding gap to be even larger than the bankruptcy filing states. For more information, click here.
Sources:
  Bankruptcy Court’s Detroit Bankruptcy Site; All other sources are in-line for better references.

MISSOURI

Firemen’s Retirement System of St. Louis Board of Trustees v. City of St. Louis
Facts: The St. Louis Board of Aldermen passed several reforms of the city’s firefighter pension plan, some of which were halted by preliminary injunction. The city government eventually amended the earlier changes, based on the court’s preliminary injunction orders. The amendment at issue restored some benefits to vested firefighters, but also created another retirement system with fewer benefits that would apply to new firefighters and firefighters with less than 20 years on the job. The new system would also have a new board of trustees which would give city government the majority of members on the board, rather than a majority of current and retired firefighters of the current trustee board.
Issues: Can the city of St. Louis adopt a pension system without enabling legislation? Can St. Louis, rather than the State of Missouri, terminate the current trustee system and replace it, and if yes, with what level of discretion? Per the latest amendment, can the city, instead, create a dual-plan system? Finally, does a change to the current system for non-vested firefighters constitute an impairment of vested right or violation of contract law?
Holding: The court determined that the St. Louis Board of Aldermen are permitted to change the pension plans of city employees without additional enacting legislation, since it is a chartered city with “home rule,” but that the city does not have absolute discretion. The enacting legislation establishing the pension plan allows for alterations without further enacting legislation being necessary. Putting aside the issues of the earlier reforms, the currently-established ordinance regarding the dual plan system is permissible. The earlier reforms that reduced benefits for vested retirees and their families were a violation of contract law principles. The current reform does not suffer the same flaw.
Status: Order in favor of city upholding pension reforms 6/3/2013.
Notes: For a full review of the lucrative firefighter benefits, please read this special report from the St. Louis Post-Dispatch.
Sources: Missouri Circuit CourtSt. Louis Post-DispatchDannna McKitrick, P.C.

NEW HAMPSHIRE

Professional Firefighters of New Hampshire et. al. v. State, et. al. (Hillsborough County)
Facts: The New Hampshire Retirement System (NHRS) has two classes of employees and pays out pension benefits calculated by standards written into state statute RSA 100-A. In 2011, the state legislature passed HB 2 which made several changes to the state employee pension system: 1) redefining “earnable compensation”; 2) increasing the number of years to calculate “average final compensation”; 3) adding a cap on benefits; 4) altered minimum age requirements of Group II members; and 5) repealed accidental disability exception for Group II members who already retired. Plaintiffs firefighters union and other others public employee unions sued the state and the state retirement system alleging a contract violation for those members of NHRS who had permanent employment or had retired by January 1, 2012.
Issue: Does RSA 100-A create a contract between the state and public employees, and if it does, when does that contract vest, and has that contract been violated by HB 2?
Holding: RSA 100-A creates a contract that vests upon reaching permanent employee status, so long as the state employee reaches the minimum requirements for age and service. Summary judgment granted on this issue. The court did not reach a decision on the claims of contract impairment or violation of the Takings Clause.
Status: Partial Summary judgment reached 05/24/2013. Parties will continue litigation on the outstanding claims.
Note: This ruling creates a county court split with the Merrimack County Superior Court, though a state Supreme Court case was decided between these two Superior Court decisions.
SourcesSeacoast OnlineMolan, Milner & Krupski, PLLC: Cases to Follow

American Federation of Teachers v. State of New Hampshire filed 7.30.12. ISSUE: Whether the legislature violated the Contracts Clause, Takings Clause, Due Process Clause, and the state’s Contracts Clause in HB 653 and 1645 recalculating cost of living adjustments and redefined compensation. DECLINED INTERLOCUTORY TRANSFER on 9.26.2012. The parties’ briefs were due on December 14, 2012. Supplemental briefs were due April 5, 2013. Federal claims dropped on March 15, 2013, pending the outcome of a similar case before the state supreme court.

Professional Firefighters of NH, et. al., v. state of New Hampshire filed 2.13.12 ISSUE: Whether the legislature may withdraw more from the paychecks of veteran public employees to support pension reform. HOLDING: Merrimack County Superior Court held that it is illegal for the legislature to increase contributions for all employees who had worked for at least 10 years. The ruling declared legal the Legislature’s ability to affect new hires, including increasing the retirement age and reducing their ability to pad the future pension amounts. At this point, it is unclear whether the Attorney General will appeal.

NEW YORK

Empire Center for New York State Policy v. New York State Teachers’ Retirement System
Facts: The Empire Center, a non-profit group, filed a Freedom of Information Law (FOIL) request for the names of all retirees in the State Teachers’ Retirement System, along with the corresponding information for each retiree. Respondent argues that it is not required to provide that information under the exemptions of Public Officers Law § 89 (7). Empire Center argues that the respondent may hold back the addresses and other exempt information but furnish the remainder.
Issue: Must a state retirement system disclose the retiree names and corresponding information under FOIL, or is that information exempt under Public Officers Law § 89 (7)?
Holding: The Supreme Court, Appellate Division held that lower courts were correct in allowing the retirement system respondent to claim the FOIL exemption.
Status: The Court of Appeals granted Empire Center a review of its FOIL cases on 6/27/2013.
Additional Notes: This is one of a series of FOIL cases by Empire Center to obtain this information.
The Empire Center has been supported by amici Albany Times UnionAuburn CitizenBuffalo News, Gannett Co. Inc., Hearst Corp., New York Daily News, New York News Publishers Association, New York Post, New York Press Association, New York Times Co., Newsday LLC and the Observer-Dispatch.
Sources: Empire Center; Appellate Division; Appellate Division;

OHIO

Sunyak v. City of Cincinnati, consolidated with Harmon et al. v. City of Cincinnati filed 07.01.11. ISSUE: Plaintiffs contended the changes violated the U.S. Contracts Clause, substantive due process, procedural due process, the Takings Clause, the Ohio Contracts Clause, and Ohio common law causes of action for breach of contract and breach of fiduciary duty. CONSOLIDATED: Amended complaint due by October 1, 2012. Discovery is due by March 1, 2013. Motions due by April 1, 2013. Final pretrial conference is scheduled for September 2013 and jury trial in October 2013.

RHODE ISLAND

State of Rhode Island and Rhode Island Public Employees’ Retiree Coalition, et. al., v. Lincoln Chafee and Gina Raimondo filed June 22, 2012 ISSUE: Whether the Rhode Island Retirement Security Act violates the state Constitution by suspending COLAs until the pension system is 80% funding and by moving most employees to a hybrid pension plan. The Plaintiffs also allege that State Treasurer, Gina Raimondo, created a “manufactured crisis” in 2011 by dropping the pension fund’s investment outlook from 8.25% to 7.5%, sharply raising the contribution made by taxpayers. In an effort to stop pension reform beginning July 1, 2012, unions sued in Superior Court for a temporary restraining order to suspend the cessation of cost-of-living adjustments, raising of the retirement age, lowering the assumed rate of return on pension funds to 7.5% from 8.25%, and moving state employees onto a hybrid pension benefit plan. HOLDING: Superior Court Judge Sarah Taft-Carter denied the request just hours after unions launched three coordinated lawsuits on behalf of 30,000 state employees, retirees, and emergency responders. Defendants filed OBJECTION TO MOTION TO P’S CONSOLIDATE July 16, 2012, in to object to Plaintiff’s Motion to Consolidate. Defendant’s asked the Court to consolidate for purposes of discovery only and reserve judgment on whether the case should be consolidated for purposes of trial because consolidation is premature and therefore inappropriate. RECUSAL CONCERNS: On October 22, 2012, Judge Taft-Carter held a conference with all attorneys to address the State’s concerns that there was a conflict of interest. The Judge issued a bench decision finding that she is not recusing herself and that all of the pension cases are assigned to her. The State’s MOTION TO DISMISS scheduled for October 30, 2012 was moved to December 7, 2012. STATE REQUESTS HEARING BEFORE SUPREME COURT on November 19, 2012, to make a decision on whether to let Judge Taft-Carter to continue hearing the pension case, based on claims of conflict of interest because her son is a state trooper and mother receives benefits as the widow of the former Mayor of Cranston. SUPREME COURT DENIED REMOVAL of Judge Taft-Carter from presiding over the case, noting a substantial public interest in the pension case “requiring the resolution of complex questions of constitutional law, the speedy, effective, and efficient determination of which is of incalculable importance to all of the state’s citizens.” December 6, 2012. Both parties to the lawsuit agreed to MEDIATION to attempt to resolve issue and reach a settlement. The parties were referred to the Federal Mediation and Conciliation Service in Washington, D.C.; A progress report is due to Judge Taft-Carter by February 1, 2013. December 18, 2012.

TEXAS

U.S. District Judge John McBryde sent litigation over the city of Fort Worth’s pension changes back to State District Court in Fort Worth, where the city initiated it. Two officers representing the interests of the Fort Worth Police Officers Association had filed suit in U.S. District Court. On Oct. 23, the City Council approved significant cuts in employees’ pension benefits in an effort to close the plan’s fast-growing $748 million unfunded gap. The same day, the city filed its own suit in state District Court, asking a judge to declare the pension cuts legal under the state constitution.
The city’s suit also asked the judge to declare that a Police Officers Association vote – in which members voted overwhelmingly to raise their pension contributions and leave more money in the retirement fund in exchange for retaining their benefits formula, was illegal because it didn’t include firefighters and general employees. The council later approved the payment of $100,000 to the Fort Worth law firm Kelly, Hart & Hallman to represent it in the litigation. Under the pension changes, the city will reduce the multiplier used in calculating benefits, raise the number of years used in figuring base retirement pay, and eliminate overtime in pension calculations.

WASHINGTON

Washington Federation of State Employees v. state of Washington & Governor Christine Gregoire filed 10.12.11 ISSUE: Whether the legislature violated constitutional rights of equal protection and freedom from contract impairment when it ended automatic COLA for retirees in two of Washington’s older pension plans in HB 2021. The bill also raised the minimum benefit for older retirees if they meet certain service and year requirements. FINAL DECISION, PENDING FINAL ORDER: Thurston County Superior Court Judge Chris Wickham ruled that the legislature acted illegally when it eliminated annual increases in benefits to retirees in the PERS 1 and TRS 1 systems. The decision effects current and future retirees, but excludes workers who left government service before 1995. The law was intended to save the general fund $415 million from 2012-13 and another $525 million in 2013-15. It was also expected to reduce the pension plans’ unfunded liability by $3.8 billion.

*   *   *

RESOURCES:

Williams Report: Pension News Update

Protection of Past and Future Accruals

Wikipension

Courts and Public Pension Change

Unfunded Pension Obligations and Chapter 9 Remedy

Laura and John Arnold Foundation Quarterly Pension Litigation Summary, April 2013

 *   *   *

RECOMMENDED READING

Understanding the Legal Limits on Public Pension Reform, Amy Monahan, American Enterprise Institute, May 2013.

 *   *   *

PENSION BACKGROUND

State Budget Solutions released a report in August 2012 finding that state pension liabilities represent trillions of dollars of unfunded state debt. The U.S. Census Bureau, Government Accountability Office, Federal Reserve Bank of Cleveland, and Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School detail the long-term chance of failure of the public pension system and the resulting state government fiscal crisis in a May 2012 report. Additional resources are available at the end of this update.

In attempts to reign in the costs of pensions, state lawmakers legislate pension reform. Challengers to those reforms often bring suit, alleging violations of state law, contracts, and the Constitution. Lawsuits also arise regarding the investment of pension funds, involving fiduciary duties of private investment firms as well as oversight liability of governments. As pension reform becomes more crucial to the fiscal solvency of the states, more litigation is inevitable.

A Method to Estimate the Pension Contribution and Pension Liability for Your City or County

July 24, 2013

Summary: With last week’s announcement that Detroit has declared bankruptcy, many wonder how their city, county, school district, or other government organization is doing. Citizens want their elected officials to behave responsibly so that what happened to Detroit won’t happen to them. But elected officials are not always cooperative when it comes to transparency. Politicians have been hiding from the consequences of their bad decisions on public employee pensions for years. By yielding to union pressure, they gave out pensions that were too generous in good times, covered budget shortfalls by failing to fund pensions in bad times, and now misrepresent how much taxpayers owe (called “unfunded liabilities”) to cover these mistakes by pretending that money already invested in their pension plan will earn more money than anyone can realistically expect.

To help keep elected officials accountable, the CPPC has developed a simple spreadsheet to calculate the unfunded liabilities and the required annual payments of the pension plans, using assumptions that make sense from the perspective of good government. We begin with a realistic rate of return on invested pension funds, which we borrowed from Moody’s: 5.7%. The average rate of return used by pension plans in this State is 7.2%. Second, once we adopt a more realistic rate of return, we can calculate a realistic unfunded liability and learn how much a pension plan really needs in new contributions each year. Responsible policy requires a responsible repayment plan of 20 years or less. Any plan that stretches longer will just cost taxpayers additional millions, or even billions, in interest.

The following tutorial and downloadable spreadsheet will empower the user to perform “what-if” analysis on the financial statements of public employee pension funds. To provide an example, the downloadable spreadsheet uses data that attempts to replicate the consolidated financial status of all of California’s public employee pension plans. The example uses the 5.7% Moody’s rate of return and a moderately accelerated payment plan, eliminating the unfunded liability over a 20 year period. Wherever possible, using assumptions and logic from Moody’s recent pronouncements on pensions – the spreadsheet calculates new estimates for California’s total estimated unfunded liability, normal required pension contribution, and “catch-up” contribution to reduce the unfunded liability.

When entering these values, using the sources and assumptions as described, the following changes to the financial condition of California’s public employee pensions would be indicated as of 6-30-2011:

All California Public Sector Pensions – Revalued Unfunded Liability:
– Officially reported unfunded liability = $158 billion.
– Revalued unfunded liability at 5.7% annual rate of return (discount rate) = $315 billion.

All California Public Sector Pensions – Revalued Annual Required Contribution:
– Officially reported total pension contributions (normal and catch-up) = $27.6 billion.
– Revalued total pension contributions (normal and catch-up) = $43.3 billion (based on an estimated normal contribution of $16.6 billion and a catch-up contribution of $26.7 billion).

This model can be used by anyone with basic financial knowledge and spreadsheet skills, in order to analyze and critique the official financial statements of any public employee pension fund.

*   *   *

INTRODUCTION

The financial challenges facing public sector pensions now receive regular press coverage. These press reports quote various financial statistics relating to pensions, citing as their sources the official pronouncements and financial statements from the pension funds, or citing independent studies. Almost always missing from this dialogue, however, are attempts to provide quantitative tools to journalists, policymakers, activists and researchers to allow them to personally analyze pension data.

The purpose of this study is provide a downloadable spreadsheet that will accept various assumptions in order to estimate three things, (1) the amount of the unfunded liability (or surplus), (2) the amount of the annual so-called “normal contribution” that pays for future pension benefits that are earned in any given year, (3) the amount of the annual “catch-up” contribution due to the pension fund in order to restore full funding.

With this spreadsheet, the user may evaluate the official data provided by the pension funds for any participant group – including an entire state, or any given city or county – and come up with a variety of estimates based on changing key assumptions. The user can then compare these estimates to the officially reported amounts for any pension fund’s unfunded liability as well as for its required annual catch-up and normal contribution.

This model is not designed nor meant to replace a thorough financial analysis by a certified actuary or certified public accountant and is intended for educational purposes only.

The remainder of this study is a tutorial that attempts to (1) explain the concepts of pension unfunded liabilities, normal pension contributions, and catch-up pension contributions, and (2) explain how to use the downloadable spreadsheet to allow the user to make independent estimates of these amounts using various assumptions. This study assumes the reader has some background in accounting or finance, as well as basic spreadsheet skills. As footnoted wherever applicable, most assumptions used in the examples presented are drawn from Moody’s “Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013.  [1].

*   *   *

PENSIONS:  KEY REPORTING VARIABLES

Unfunded Liability = The Value of Invested Pension Fund Assets minus the present value of all future liabilities to pay pensions. If the result is less than zero, the pension plan is said to be underfunded.

Unfunded Contribution = The annual catch-up payment to the pension fund necessary to restore the plan to full funding.

Normal Contribution = The annual payment to the pension fund necessary to match the present value of future pension benefits earned in the current year to invested assets.

*   *   *

If you would like to perform what-if analysis, using the financial statements provided by any public pension fund, before reading this tutorial, please download the spreadsheet: 

Impact-of-Returns-and-Amortization-Assumptions-on-Pension-Contributions.xlsx

HOW TO ESTIMATE THE UNFUNDED PENSION LIABILITY USING VARIOUS ASSUMPTIONS

For this analysis, please refer to the spreadsheet’s “unfunded liability and payment” tab.

Table 1 below is a screen shot of the “unfunded liability and payment” tab from the spreadsheet. The first two rows of data immediately under the title “OFFICIALLY REPORTED NUMBERS” show the two key variables that determine the amount of an unfunded pension liability; (1) the present value of the total future pension liability less (2) the total assets currently held by the fund. The cells in yellow are input cells where assumptions are entered.

The data being used in all of the examples to follow is taken from the California State Controller’s “Public Retirement Systems Annual Report for the fiscal year ended June 30, 2011,” which was released on May 22, 2013 and is the most recent data available on the consolidated performance of all of California’s public employee pension funds combined [2].

As can be seen in the yellow input cells, the present value of all future pension payment obligations to all participants in California’s public employee pension funds was officially estimated as of 6-30-2011 to be $763 billion. Since the officially reported combined assets of all of California’s public employee pension funds was $604 billion, the officially recognized total unfunded pension liability was $158 billion.

The second half of the spreadsheet shown in Table 1, titled “REVALUATION OF UNFUNDED PENSION LIABILITY,” allows the user to revise the estimate of the unfunded pension liability using methods described by Moody’s in their “Revised New Approach to Adjusting Reported State and Local Government Pension Data.” While the logic used by the spreadsheet is a shortcut that cannot replace a comprehensive actuarial update, it utilizes the same logic employed by Moody’s credit analysts and can be quite useful. Here’s how it works:

The variable that is the hardest to estimate is not the assets in a pension fund, which have a current market value that is fairly objective, but the present value of the future liabilities. Rather than perform an actuarial analyses that encompasses every estimated annual payment for every year of every participating employee’s current or eventual retirement, and applying a discount rate to each of these literally millions of data points in order to come up with a new present value for these future liabilities, Moody’s assumes that the “future value” of these payments over time has a midpoint of 13 years. A somewhat simplified way to explain the choice of 13 years would be because the average duration of retirements already earned within the participant population is estimated at 26 years, as a result 13 years is the midpoint. Here is how Moody’s explains their methodology to revalue an unfunded pension liability, including the rationale for their choice of 13 years [3]:

“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL [what Moody’s refers to as the “Accrued Actuarial Liability” is the total pension liability, i.e., the present value of future pension payments], of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate.”

TABLE 1  –  RECALCULATING THE UNFUNDED PENSION LIABILITY

pension-July2013-table1r3

As Table 1 hopefully illustrates, in order to estimate the impact of a lower discount rate on a pension plan’s unfunded liability, you enter the officially reported total pension liability and total pension assets into the first two yellow input cells. The spreadsheet automatically calculates the official unfunded liability. To then revalue the total pension liability, using the yellow input cells, first enter, in years, the assumed midpoint of the future payment streams (“years to project forward”), then enter the official rate of annual investment return projected by the pension fund (“forward projection interest rate”). In the case of California’s consolidated pension funds, the average official annual return is 7.2% [4]. The spreadsheet then calculates the future value of these payment obligations. To get a revised present value using a lower rate of return, just enter the revised interest rate projection. Moody’s has recommended the “Citibank Pension Liability Index (Index) posted as of the date of the pension financial statements being analyzed, which for 6-30-2011 was 5.7% [5].

As shown in the green results cell on Table 1, using this tool, if California’s pension funds, in aggregate, were using a 5.7% annual rate of return projection, instead of a 7.2% return projection, their official unfunded pension liability would swell from $158 billion to $315 billion. This spreadsheet can be used to estimate the unfunded pension liability based on a more conservative rate of return for any public sector pension fund.

*   *   *

HOW TO ESTIMATE THE ANNUAL “CATCH-UP” CONTRIBUTION

For this analysis, please refer to lower section of the spreadsheet’s “unfunded liability and payment” tab.

Explaining the various methodologies currently employed to estimate the annual catch-up contribution goes beyond the scope of this study. What will be striking however is the disparity between the catch-up payments necessary according to the spreadsheet – which again emulates the new Moody’s evaluation criteria – and the actual catch-up payments being collected from participating employers by most public sector pension plans.

The first step towards estimating the catch-up payment is to determine the amount of the unfunded pension liability, since that is the balance that will need to be reduced to zero over a reasonable period of time. But even if you calculate the catch-up payment using the officially recognized amount for the unfunded pension liability, you may find the required payment is still much higher than is being paid into the plan you are analyzing. This is because many of pension funds are estimating the required payments using terms that are longer than the 20 years recommended by Moody’s [6], and they are also – quite often – using a graduated payment plan that has very low payments in the early years of the term. In many cases the officially agreed catch-up payments are so low that they cause negative amortization. Moody’s recommends a 20 year, level payment plan based on an interest rate of 5.7% [7].

Table 2, below, shows how the spreadsheet calculates the annual catch-up contribution. Refer to the rows immediately under the title “ESTIMATED ANNUAL ‘CATCH-UP’ PAYMENTS.” The revalued total unfunded pension liability for all of California’s pension funds, $315 billion, is entered in the first yellow input cell “revalued total unfunded pension liability.” The term, 20 years, and the interest rate, 5.7%, are entered in the next two yellow input cells. The spreadsheet calculates even payments on a 20 year fixed rate, fixed payment amortization of the principle.

As can be seen in the green results cell, based on these assumptions, the annual catch-up payments required to restore California’s public employee pensions to 100% funding status is $26.7 billion per year.

TABLE 2  –  ESTIMATING THE ANNUAL PAYMENTS ON THE UNFUNDED LIABILITY

*   *   *

HOW TO ESTIMATE THE NORMAL CONTRIBUTION

To properly use the spreadsheet to estimate the normal contribution, it is important to understand the concept. The “normal contribution,” simply stated, needs to be an amount equal to the present value of future pension payment obligations earned in the current year. This is distinct from the unfunded liability, is calculated by comparing the present value of previously earned pension benefits (prior to the current year’s pension benefit earnings) to the assets on hand (prior to the normal contribution).

Revaluing the Normal Contribution if the Official Normal Contribution is Disclosed:

For this analysis, please refer to the spreadsheet’s “normal contribution (known)” tab.

If the financial statements for the pension fund under analysis disclose how much they collected in normal contributions during the fiscal year, then revaluing the required normal contribution using differing assumptions is relatively easy. Since the normal contribution must be exactly the same amount as the present value of the future liabilities created during the most recent fiscal year – by employee participants accruing one more year of pension benefits – if you know the amount of the contribution, by definition you also know the estimated new future liability.

Table 3, below, shows this calculation on the spreadsheet. Using the exact same logic as the 2nd half of the spreadsheet segment depicted on Table 1, the first step is to enter in the first yellow input cell the amount of the “officially reported normal contribution.” In the example below, $1,000 is used to normalize the results – it is not possible to use numbers representative of all of California’s pension plans because the State Controller’s report did not provide that breakout.

The next step is to enter the “years to project forward,” with 17 entered in the example because this is the number Moody’s determined was the most likely average “active employee duration.” Here is how Moody’s describes this [8]:

“The 17-year duration assumption reflects our estimate of the average remaining service life of employees based on a sample of public pension plans. We acknowledge that this is a simplifying assumption that may be too long or too short for different plans.”

In order to complete the recalculation, enter the official interest rate used by the pension fund, which in this case is the average rate used by all of California’s pension funds, 7.2% [9], then enter the “revised interest rate projection” as recommended by Moody’s [10].

The spreadsheet result in the green cell shows that using lower interest rate assumptions, the required normal contributions have to be increased by 27.7%.

TABLE 3  –  NORMAL PENSION CONTRIBUTIONS  (OFFICIAL AMOUNT DISCLOSED)

pension-July2013-table3

Revaluing the Normal Contribution if the Official Normal Contribution is NOT Disclosed:

For this analysis, please refer to the spreadsheet’s “normal contribution (imputed)” tab.

Table 4, below, offers a method to estimate the required normal contribution in cases where the pension fund’s financial statements only provide one number for their “annual contributions,” instead of breaking that number into two: “Normal contributions,” and “Catch-up contributions.” The California State Controller, for example, in their “Public Retirement Systems Annual Report for the fiscal year ended June 30, 2011,” discloses total pension fund contributions for the year of $27.6 billion [11], but do not disclose how much was for the normal contribution and how much was “catch-up” payments on the unfunded liability.

In order to estimate the required normal contribution, the spreadsheet gathers information for one hypothetical employee whose earnings and other actuarial data are representative of the average employee in the participating population, then multiplies the results by the number of participants. While this is a gross simplification, and, unlike the other calculations described so far, does not emulate a methodology recommended by Moody’s, it yields surprisingly accurate results.

In the example on Table 4, most of the assumptions entered in the yellow input cells are documented, others are selected based on reasonable estimates of what averages probably are for the overall population of actively employed public pension plan participants in California.

For example, according to the U.S. Census Bureau, the average salary in 2011 for a full-time state or local worker in California in FYE 6-30-2011 was $71,155, and in that same year there were 1,158,327 full-time state and local government workers in California [12]. The average years till retirement, 17 years, is based on estimates from Moody’s as previously discussed [13], as is the projected discount rate of 5.67% [14].

For the remaining variables, we have tried to use conservative assumptions that will understate the resulting estimate. The % COLA growth per year, along with the % merit growth per year, totaling 3%, represents the before-inflation average increase in pension eligible pay during the working years of a typical participant (probably low when the so-called “step increases” are taken into account); the “pension COLA” of 2.0% represents the average cost-of-living increases to the pension benefit during a typical participant’s retirement. The “average years retired,” 20, is almost certainly lower than the true number, as is the “pension formula/yr” of 2.25%.

By examining the three calculations on Table 4 – the three rows of numbers and descriptions situated below the yellow input cells and above the final green results cell, one may gain insight into how pension benefits accrue each year.

First, the spreadsheet calculates the amount that the participant will collect per year during retirement, based on their work in the current year. It does this by calculating how much their average salary ($71,155 in this example) will increase between the current year and retirement in 20 years (71,155 x 1.03)^20 = $117,608.

Second, the “projected average final salary” is multiplied by the “pension formula/yr” of 2.25%. The product, $2,646, appears next, described as “base year earned pension in first year of retirement.”

It is important to reiterate that the “normal” required annual pension contribution is only to fund the amount of future pension earned by one year of working, which is why the amounts appearing in this representative sample are so small. In this example, in one year working, the average state or local government employee in California earns a lifetime income of $2,646 per year. Over the next 20 years that amount escalates via the 2.0% COLA to become $3,885 in the final year of retirement.

To understand the 3rd calculation, “present value of all projected retirement payments earned in base year,” it is necessary to review the two columns of results on the far right of the lower section of the spreadsheet, titled “earned pension w COLA” and “base year PV of benefit.” The earned pension with COLA is denominated in future dollars. As described already, it starts at $2,646 per year and grows via the COLA’s to $3,855 per year. The column immediately to the right then converts those future dollars into current (today’s) dollars using the projected discount rate of 5.67%. For each cell in this column, a simple present value formula is applied as follows: PV = FV/(1+.0567)^Y, where “Y” equals the years from 2011 to the year in question.

The 3rd calculation, therefore, is the sum of all the numbers in the far right column, “base year PV of benefit.” This amount, $14,311, is the present value of the future pension benefits earned by one participant in a single year.

This all leads to the amount in the green results cell, “projected normal annual pension contribution for the entire workforce.” When the present value of one representative participant’s annual benefit accrual, $14,311, is multiplied by the number of participants in the pension plan, the result is how much money must be contributed to the pension fund in that year; the “normal contribution.”

In this example, using known data and this logic, the required normal contribution into California’s consolidated public employee pension funds in the year ended 6-30-2011 would have been 16.6 billion.

TABLE 4  –  NORMAL PENSION CONTRIBUTIONS  (OFFICIAL AMOUNT NOT DISCLOSED)

pension-July2013-table4r4

*   *   *

CONCLUSION

While the complete financial mechanics of this model are not necessarily immediately obvious, anyone with access to the data who has basic spreadsheet knowledge can use this model. By inputting the variables into the yellow cells in the model, one may evaluate any pension plan’s financial statements and perform “what-if” analysis using differing assumptions.

Except for the “normal contribution (known)” tab, the baseline model available for downloading has default values – which can be changed by the user – entered in the yellow cells that attempt to replicate the the consolidated financial status of all of California’s public employee pension plans. It is interesting to observe that when entering these values, using the sources and assumptions as described, the following changes to the financial condition of California’s public employee pensions would be indicated as of 6-30-2011:

All California Public Sector Pensions – Revalued Unfunded Liability:
Officially reported unfunded liability = $158 billion.
Revalued unfunded liability at 5.7% annual rate of return (discount rate) = $315 billion.

All California Public Sector Pensions – Revalued Annual Required Contribution:
Officially reported total pension contributions (normal and catch-up) = $27.6 billion.
Revalued total pension contributions (normal and catch-up) = $43.3 billion (based on a estimated normal contribution of $16.6 billion and a catch-up contribution of $26.7 billion.

*   *   *

Footnotes:

(1)  Moody’s “Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013.

(2)  Public Retirement Systems Annual Report for the fiscal year ended June 30, 2011, page xv, Figure 2.

(3)  Moody’s Request for Comment, July 2, 2012, Adjustments to US State and Local Government Reported Pension Data, page 6.

(4)  Public Retirement Systems Annual Report for the fiscal year ended June 30, 2011, ref. “Interest Rate Assumptions,” page xiii.

(5)  Citibank Pension Liability Index, as posted on the date of the valuation.

(6)  Moody’s “Revised New Approach to Adjusting Reported State and Local Government Pension Data,” ref. “The Adjustments,” #3, “Amortized adjusted net pension liability.”

(7)  Citibank Pension Liability Index, as posted on the date of the valuation. The recommended rate will change depending on what the closing date is for the financial statements being analyzed.

(8)  Moody’s Request for Comment, July 2, 2012, Adjustments to US State and Local Government Reported Pension Data, ref. “New Discount Rate Applied to Normal Cost,” page 8.

(9)  Public Retirement Systems Annual Report for the fiscal year ended June 30, 2011, ref. “Interest Rate Assumptions,” page xiii.

(10)  Citibank Pension Liability Index, as posted on the date of the valuation.

(11)  Public Retirement Systems Annual Report for the fiscal year ended June 30, 2011, ref. Figure 12 “Public Employee Retirement System Revenues, Reporting Year 2010-11,” page xii.

(12)  California 2011 Public Employment and Payroll Data, state government, and California 2011 Public Employment and Payroll Data, local government.

(13)  Moody’s Request for Comment, July 2, 2012, Adjustments to US State and Local Government Reported Pension Data, ref. “New Discount Rate Applied to Normal Cost,” page 8.

(14)  Citibank Pension Liability Index, as posted on the date of the valuation.

*   *   *

About the Author:  

Ed Ring is the research director for the California Policy Center and the editor of UnionWatch.org. Before joining the CPPC, he worked in finance and media, primarily for start-up companies in the Silicon Valley. As a consultant and full-time employee for private companies, Ring has done financial modeling and financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

How Big Are California’s State and Local Governments Combined?

June 21, 2013

By Bill Fletcher and Ed Ring

SUMMARY:  California’s local governments and agencies spent far more in FYE 6-30-2011, $316 billion, when compared to spending for direct state government operations, $49 billion. Similarly, using realistic assumptions regarding the value of unfunded retirement pension and healthcare obligations, the amount of long-term debt carried by California’s local governments and agencies, $611 billion, is far greater than that carried by the state directly, $237 billion. The current financial reporting practices of California’s state and local governments do not provide adequate, accurate, or timely consolidated data. At a minimum, California’s state and local governments need to require all financial statements to be audited, incorporating proactively the latest GASB standards, with faster deadlines for completion, submittal, and consolidation. With accurate consolidated data on total state and local spending and debt, California’s State Controller or Dept. of Finance should prepare annual “what-if” scenarios for policymakers that display the financial impact of, for example, lower rates of investment returns on the unfunded liability for pension funds, as well as the impact of higher borrowing costs as today’s very low interest rates return to normal.

The conclusion of this study, based not only on extensive review of publicly available data but also on many interviews with financial professionals within state and local government agencies, is that (1) California’s total state and local government debt and annual spending is higher than is generally understood, (2) current financial reporting practices of state and local governments are fragmented, unaudited, use obsolete standards, and are not timely, and (3) policymakers do not currently have the information they need to anticipate and prevent financial problems, especially those facing California’s cities and counties.

*   *   *

INTRODUCTION

This study attempts to estimate total state and local government spending in California from all sources and show the financial relationships between the various government organizations; state, county, city, school districts, special districts and redevelopment agencies. In discussing California’s finances, it is misleading to focus on the state’s budget that is only about 36 percent of total state and local spending. Most budget discussions are even more narrowly focused on the General Fund that is about 70 percent of the state’s budget and only 25 percent of total spending.

Total state and local spending in the state, $365.1 billion, is about 19 percent of gross state product, a very substantial sum. About 23 percent is paid for by the federal government and the rest is paid for by state and local taxes and fees.

Note that this study uses data for the 2010-11 fiscal year. This is the latest year for which spending by the counties, cities, special districts, and redevelopment agencies are available. Redevelopment agencies were eliminated in 2012 and will be replaced by successor agencies in future reports.

Why do we need to include local spending?

(1)  Local spending is greater that spending by the state, especially if local assistance funds are included.

(2)  There is very little visibility of developing financial problems at the local level. No one is consolidating spending and deficits at the local level to highlight developing problems.

(3)  The state can transfer financial problems to the local level by transferring responsibilities to local government without providing all funding required. The county and city governments have limited opportunities to increase revenues to close any resulting funding gaps.

(4)  CalPERS and other pension funds can require the counties and cities to increase pension contributions to cover any pension shortfalls without consideration of their ability to pay. New pension reporting guidelines to be implemented in FY 2013-14 will require more accurate reporting of pension obligations.

(5)  Retiree health care expenses are not pre-funded for most public employees during the years they are working. Counties and cities are liable for these expenses but have not accrued for them, much less set aside funds to pay for them.

(6)  Refinancing bond debt could be difficult to support in the future if present low interest rates return to normal.

As a result, California’s financial problems are more likely to show up at the local level without much warning as expenses and obligations increase faster than revenues. Potential problems would be aggravated by any financial mismanagement at the local level which would be difficult to spot before becoming serious problems.

Table 1, below, uses data from the California Policy Center’s earlier study, Calculating California’s Total State and Local Government Debt. It shows that nearly three-quarters of the state’s debt and unfunded obligations are at the local level and have limited visibility. Over-indebtedness as well as budget deficits are problems at the local level. A serious problem is the use of borrowed funds to cover current expenses including catch-up payments towards underfunded retirement pension obligations. Equally serious is that, in many cases, retirement health care obligations are unfunded. Pension and retiree health care benefits should be fully funded while an employee is working; these costs should not be passed on to future taxpayers after an employee has retired.

Total-CA-Budgets_Table-1r4

CALIFORNIA’S TOTAL STATE AND LOCAL GOVERNMENT SPENDING

Most spending in the state is at the local level. Table 2, below, shows the total spending at both the state and local level in California for the fiscal year ended June 30, 2011, which is the most recent fiscal year for which data is available. Of the state budget of $131 billion (column 1 total, “State”), about 30 percent is spent directly by the state, state operations, and the remainder is distributed to local government entities as local assistance. Federal funds provide about 23 percent of state and local spending.

Total-CA-Budgets_Table-2r5

The following tables summarize in more detail spending by:

(1)  State operations, direct spending by the state, including funds received from the Federal Government (Table 3).

(2)  Local assistance, funds allocated to the school districts, counties and cities from the state and federal government (Tables 4 and 5).

(3)  Local spending supported by local taxes and fees (Table 6).

There were cases where data showing intergovernmental funding appeared to be inconsistent – that is, the amount of outgoing funding from one government entity was different from the amount reported by the receiving entity. In other cases, such as with K-12 school districts, consolidated financial information was simply not available. We have tried to make careful note of the gaps and inconsistencies we uncovered, as well as what assumptions we were compelled to make as a result.

STATE OPERATIONS

The state budget for the fiscal year ended June 30, 2011 was $131 billion, but most of that money was passed through by the state to local agencies as local assistance. To determine what portion of the gross budget was actually used for direct state expenditures, detailed information can be found in the Appendix to the California Dept. of Finance’s current state budget summary on Schedule 9, “Comparative Statement of Expenditures.” This link will take you to the Governor’s Budget Summary for 2011-12 which includes actual expenditures for 2010-11.

As shown earlier on Table 2, $39.2 billion (30%) of the gross state budget of $131 billion is retained to fund direct state operations. When federal funding is added, primarily to help fund higher education, total direct state spending rises to $48.7 billion. Table 3, below, categorizes direct state government spending by agency. The columns break this spending out by source of funds. The top three categories of direct state spending are higher education at $14.6 billion, prisons at $9.5 billion, and infrastructure at $7.6 billion.

Total-CA-Budgets_Table-3r4

STATE AND FEDERAL ASSISTANCE TO LOCAL GOVERNMENTS

As shown earlier on Table 2, 68% of state revenues, $88.5 billion, are used to fund local governments and agencies, and 86% of federal funds allocated to the state, $73.2 billion, are distributed to local governments. These funds are allocated for Health and Human Services ($80.8 billion), K-12 education including Community Colleges ($47.9 billion), and Labor and Workforce Development ($20.4 billion) for unemployment benefit payments. A relatively small remainder, $12.5 billion, is allocated to all other local government activities.

As shown on Table 4, below, the total sum of state and federal funds, administered by the state, that flows through to local governments as local assistance ($161.7 billion), is highlighted in yellow. The reason for this is to compare this amount, reported by the state, to the amount on Table 6, also highlighted, that was reported as received from state and federal sources by the local governments and agencies. That amount, $32.7 billion, is the portion of that $161.7 billion that was retained by the counties and cities to fund the costs of administering the programs; the rest, $129 billion, was passed through to fund K-12 education and the Community Colleges, and for entitlements, primarily in the form of Medicaid, welfare, and unemployment compensation.

Total-CA-Budgets_Table-4r4

Table 5 below, shows a complete summary of what appears on the California Dept. of Finance’s “Comparative Statement of Expenditures,” Schedule 9 (ref. FN 1), which is the most comprehensive source we have found that shows how state government funds, along with federal funds administered by the state government, are allocated in California. The first two rows of data contain the totals from Table 3, Direct State Government Funding of $48.8 billion, and Table 4, Local Government Funding of $161.7 billion. Not appearing on the previous tables, because it is unclear whether or not the funds were used at the state or local level, are an additional $3.9 billion in miscellaneous “Capital Outlays” and unclassified spending of $1.3 billion. Altogether the total state and federal funds spent in California during the fiscal year ended June 30, 2011 was $215.7 billion.

Total-CA-Budgets_Table-5r4


LOCAL GOVERNMENT OPERATIONS

The information on Table 6, below, is fairly straightforward, being drawn directly from the Consolidated Annual Financial Reports (“CAFRs”) for California’s 57 counties, 481 cities, 4,772 special districts, and 427 redevelopment agencies. These reports, as referenced in footnotes 2, 3, 4, and 5, are prepared by the California State Controller every year. Because these compilations cannot begin until after the various local entities have themselves completed their annual reports, the most recent data is through the fiscal year ended June 30, 2011. The next set of consolidated annual financial reports is expected from the California state controller in the late summer or early fall of 2013, for the fiscal year ended June 30, 2012. The California State Controller has not issued a consolidated annual financial statement for K-12 and Community College education since 2000. Our assumption is that the $47.9 billion noted on Table 2 under state and federal funds allocated to local agencies for Education captures that amount.

The Governor’s Budget Summary for 2012-13 Figure K12-02 shows actual K-12 spending for 2010-11 of $66.8 billion with $38.1 billion from the state, $9.3 billion from the federal funds, and $19.4 billion from local taxes (Footnote 6).  Note that these estimates for state and federal funds for K-12 education don’t match the figures used in the tables that come from Schedule 9 in the same Budget Summary.  We were not able to reconcile this and several other apparent reporting inconsistencies.

As noted, the state and federal funds – highlighted in yellow – are not included in the calculation of total state and local government spending in order to avoid double-counting.

The total local taxes, fees, sales of bonds and notes, enterprise activities and other revenues in FYE 6-30-2011 for California was $149.4 billion.

Total-CA-Budgets_Table-6r5

CALIFORNIA’S TOTAL STATE AND LOCAL GOVERNMENT SPENDING  –  WHERE THE MONEY COMES FROM AND WHERE IT GOES:

The flow of funds through state and local government entities is complex. Table 7, below, constitutes a flow-chart, using the reported amounts as represented on the previous tables according to “sources of funds” (revenue) and “spending agencies” (expenses). The boxes on the left represent the funding agencies, with the total of all of them equal (apart from rounding errors) to the $365.1 billion as shown on Table 2. The largest single source of revenue is state taxes, fees, and bond financings at $131.0 billion, followed by federal contributions to state and local agencies at $84.8 billion. The box in the center at the top, “State Budget,” shows that along with the $131.0 billion in state government revenue, the state administers $9.5 billion of federal funds that go directly to the state government. Of that $140.5 billion, $48.7 billion is used to fund direct state operations including the University of California and the Cal State University systems, and the rest goes to cities and counties as shown on Tables 5 and 6.

The four lower boxes on the left, in the revenue column on Table 7, correspond to the amount of local government revenue sourced locally. This corresponds to the second subtotal in Table 6, “Sources of Funds – Local Revenue.” Note that the box “County Taxes & Fees” includes the sum of $29.8 billion in local county revenues used to fund county operations, plus $19.4 billion that the county retains from property taxes and other local sources to fund K-12 and community college districts. In sum, local agency revenue totaled $149.4 billion in FYE 6-30-2011.

As Table 7 makes clear, California’s local government agencies spend far more than the state does directly. Just K-12 school districts and community colleges (as noted in Table 4, “Education,” plus Table 6 “K-12 & Colleges”) spent nearly 40% more in FYE 6-30-2011, $67.4 billion, than the entire state government including higher education. The total spending (including state and federal funding) for the remaining four categories of local governments (Cities, Counties, Special Districts, and Redevelopment Agencies) totaled another $162.7 billion as shown in the four lower boxes on the right, and also in the row “Total – All Sources” for the first four columns of data on Table 6.

When the amounts showing as expenses in the boxes representing spending agencies on the right on Table 6 are added up, the total, $278.8 billion, does not equal the amount showing as revenue, $365.1 billion (notwithstanding rounding errors which put the total on the flow-chart at $365.3 billion). This is because, as noted in the right margin, an additional $86.3 billion in direct payments to Medicaid, welfare, and unemployment insurance beneficiaries is administered by California’s counties, but does not appear on the State Controller’s consolidated annual financial reports for counties (Footnote 2). When we attempted to tie the $86.3 billion to the amounts showing on Table 1 for “Health and Human Services” (Medicaid and Welfare), $80.8 billion, and “Labor and Workforce Development” (Unemployment Insurance), $20.4 billion, they totaled $101.2 billion, exceeding the $86.3 billion by $14.9 billion. Our discussions with experts on county budgets confirmed that the $14.9 billion was retained by the counties for their costs to administer these programs.

Total California Budgets FYE 6-30-2011, Table 7 ($=B)
State and Local Government Sources and Uses of Funds Flow ChartTotal-CA-Budgets_Table-7r5

OBSERVATIONS AND RECOMMENDATIONS

Note that there isn’t any year-end financial statement for the state summarizing actual spending for the recently completed fiscal year. Schedule 9 (Footnote 1) is as close as we can get. There is no available reporting of totals for school districts. Reporting for counties, cities, and special districts have a reporting lag of about 15-18 months. The supporting documents for counties, cities, and special districts, their CAFRs, are not all audited as required and some are not completed on time. And they don’t include the basic financial information need to identify developing budget problems at the local level or estimate their ability to support their current and future debt levels and unfunded obligations for retiree pensions and health care.

In preparing this compilation of total California state and local government spending, it became evident that there are few readily available sources of consolidated data. The state and federal sources and uses of funds could only be found in some detail in a lengthy appendix to the California budget (ref. Footnote 1). The only source of consolidated financial information on local agency activities are the state controller’s “CAFR” (Consolidated Annual Financial Report) documents which we used to gather data on counties, cities, special districts and community redevelopment agencies, and these reports lag the fiscal year ends by over two years. For K-12 school districts, the state controller hasn’t produced a CAFR since 2000.

Not only was good data hard to find, but there are inadequate standards in place to reconcile funds distributed, which, for example, appear in the state budget as state and federal aid to counties and cities, with funds received as reported by the receiving agencies. The constraints introduced by the lack of accessible data or standardized reporting formats should caution anyone reviewing any analysis of California’s state and local finances.

While the paucity of available data renders detailed analysis problematic, there are nonetheless useful observations to be made from a global perspective:

  • The state and local government spending, $365.1 billion in FYE 6-30-2011 includes the cost of servicing outstanding debt of $382.9 billion – not including unfunded pension and retirement health care liabilities (ref. Footnote 7). As interest rates return to normal, servicing this debt will require an increasing share of government spending.
  • If only the officially recognized debt for unfunded retirement pensions and healthcare is added to the outstanding bond debt, the total borrowing of California’s state and local governments is $648.0 billion. If pension funds continue to struggle to achieve average long-term rates of return of 7.0% or more, annual contributions to pension funds will have to be increased and take a larger share of government spending.
  • Most state and local government employee retirement heath care obligations are not pre-funded. As more government employees retire with generous retiree healthcare benefits, this will represent an additional claim – not currently accrued – on government revenue. Because these obligations are for services, not relatively predictable monetary amounts, the eventual costs are even harder to forecast than pensions.
  • The total state and local government spending of $365.1 billion represents 19.2% of California’s Gross Domestic Product in 2011 (ref. Footnote 8).
  • State spending on direct state operations, which includes the University of California and CalState University, $48.8 billion, is exceeded by a factor of more than six-to-one by local agency spending of $298.7 billion.
  • While state and local government spending on pensions (not including employee contributions) was only $18.6 billion in FYE 6-30-2011 (ref. Footnote 9), CalPERS has announced a 50% increase to the required contribution (ref. Footnote 10), and it is not clear how much of this – because it is to reduce the unfunded liability and thus not subject to the “50/50” terms of SB 340 (Pension Reform), it could increase those payments by another $13.8 billion, bringing the employer’s pension payments share of the total state and local budgets from the current 5.3% to 9.3%. And it isn’t clear that the state’s pension systems can survive with only a 50% increase in contributions.

Based on these findings, we recommend the following:

  • The California Controller should resume preparation of a Consolidated Annual Financial Report for California’s K-12 school districts and community college districts.
  • All local government financial statements should be audited and submitted to the state controller under deadlines that permit consolidated data to be available to the public in less than one year after a fiscal year end.
  • California’s state and local governments should proactively adopt new GASB standards that require recognition of unfunded pension and health care obligations as long-term debt.
  • Either the California Controller’s office or the California Dept. of Finance should compile reports similar to those we have attempted to develop in these studies: Reports that consolidate and clearly communicate the total state and local government spending, deficits, and outstanding debt and make some attempt to identify those counties and cities that are having or are likely to have serious financial problems.  Are problems such as those being experienced by Stockton and San Bernardino rare events or an indication of more widespread problems at the local level?
  • The state legislature should mandate all state and local government organizations begin pre-funding all retirement commitments, including retirement health care. To better ensure that budgets aren’t unexpectedly consumed by dramatic and unexpected increases to these annual funding obligations, the state legislature should require more conservative investment return assumptions to be adopted, especially by the pension funds.
  • Either the California Controller’s office or the California Dept. of Finance should compile “what-if” analyses showing the impact of lower rates of investment returns on the unfunded liability and annual required contributions to state and local pension funds and retirement health care funds.

Footnotes:

1 – California Budget FAQs, Program Expenditures by Fund 1976-77 to 2013-14  –  California Dept. of Finance, Schedule 9 – Comparative Statement of Expenditures.  The total expenditures as noted on Table 3 can be found on page 37 of the Appendix. The subtotals are sprinkled throughout the details by expenditure category, beginning on page 19.

2 – Counties Annual Report, FYE June 30, 2011, Figure 3 – California State Controller

3 – Cities Annual Report, FYE June 30, 2011, Figure 1-  California State Controller

4 – Special Districts Annual Report, FYE 6-30-2011, Figure 3 – California State Controller

5 – Community Redevelopment Agencies Annual Report, FYE 6-30-2011  –  California State Controller

6 – Governor’s Proposed Budget Summary 2012-13 signed January 5, 2012. The chart is on page 133 Figure K12-02 Sources of Revenue for California’s K-12 Schools.

7 – Calculating California’s Total State and Local Government Debt, Table 7 – California Policy Center

8 – California GDP and Personal Income 2011 – U.S. Dept. of Commerce, Bureau of Economic Analysis

9 – Public Retirement Systems Annual Report for the fiscal year ended June 30, 2011, Figure 12, page xxii – California State Controller

10 – CalPERS rate hike: 50 percent over six years, CalPensions.com, March 25, 2013

Other Notes:

On Table 1, the total unfunded pension and retiree healthcare liabilities were allocated between state and local government entities by prorating the full-time headcounts per state and local government in California, referencing the U.S. Census Bureau’s 2011 data for California’s state and local government. Official reports typically reference CalPERS and CalSTRS pension liabilities as state liabilities, when many cities, counties and local agencies participate in CalPERS, and school districts participating in CalSTRS are also local entities.

About the Authors:

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.

Ed Ring is the research director for the California Policy Center and the editor of UnionWatch.org. Before joining the CPPC, he worked in finance and media, primarily for start-up companies in the Silicon Valley. As a consultant and full-time employee for private companies, Ring has done financial modeling and financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

Moody’s Final Adopted Adjustments of Government Pension Data

June 2, 2013

By John G. Dickerson

About the Author: John Dickerson is a financial professional living in Mendocino County who is involved in public sector pension analysis and reform. Dickerson focuses on the impact of unfunded pension debt on the 21 California counties that operate their own independent Pension Funds. He is a financial and organizational planner and analyst with 30 years of experience. He earned his MBA in Strategic Planning from the University of Texas at Austin. This paper is copyrighted by John G Dickerson, and quotes from this paper should be attributed to: John G Dickerson, YourPublicMoney.com. It may be copied and distributed at will if it is provided to readers and other users for free. However, it must not be changed nor can any type of fee be charged in relation to this material without the author’s express written permission.

ABSTRACT

At the end of June 2012 the Governmental Accounting Standards Board imposed new pension financial reporting requirements on state and local governments that will kick in over the next couple of years. One week later Moody’s Investors Services announced their intention to modify pension financial data reported by state and local governments in Moody’s credit rating analysis. They published their final adopted adjustments on April 17, 2013. They believe current and even the new government financial reports understate the risk of unfunded pensions to buyers of government bonds and do not provide for adequate transparency and comparability. Moody’s will only use these adjustments in their internal credit rating analysis for state and local governments. The adjustments are not a “guide, standard or requirement.” Moody’s projects their adjustments would have increased total state and local government unfunded pension debt from about $782 Billion in 2011 to about $1.9 Trillion – over $1 Trillion more. State and local Pension Funds reported they had 74% of the assets they needed to be “fully funded.” Moody’s adjustments would have reduced that to 53%.

The purpose of this paper is mostly to focus on Moody’s adopted adjustments, compare them to the earlier proposals, and demonstrate how these adjustments and GASB’s new rules will change government pension data.

I applied Moody’s adjustments and GASB’s new pension financial reporting rules on the 2011 statements of 7 California counties’ with County Pension Funds (Alameda, Contra Costa, Marin, Mendocino, Orange, San Mateo, and Sonoma). They reported $1.7 Billion of Pension Obligation Bond (POB) Debt. GASB’s old rules don’t require them to report unfunded pension debt as liabilities – the new rules will. These counties would have reported at least $7.6 Billion of additional liabilities using the new rules. Including the Pension Obligation Bonds, they would have reported nearly $10.0 Billion in unfunded pension debt. Moody’s adjustments increased unfunded pension debt (POB + Net Pension Liability) to about $18.45 Billion. Dickenson_MoodyFinal_intro The impact on Net Assets (Net Worth) is dramatic. The counties reported they had over $10.2 Billion more assets than debts – but they didn’t report the impact of unfunded pension debt as GASB will require next year. Under GASB’s new rules, they would have reported Net Assets were not quite $1.0 Billion – an “overnight” drop of over $9.0 Billion of Net Worth. Moody’s adjustments are even more astonishing – they would have shown the combined Net Worth of these seven counties was a negative $7.4 Billion. Only Marin is left with positive Net Assets.

Moody’s final adopted adjustments are:

1. Multiple-employer cost-sharing plan liabilities will be allocated to specific government employers based on proportionate shares of total plan contributions. (Same as proposed)

2. Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation. (Slight change)

3. Asset smoothing will be replaced with reported market or fair value as of the actuarial reporting date. (But not for local governments – significant change)

4. The resulting adjusted net pension liability (i.e. adjusted liabilities less assets) will be amortized over 20 years using a level-dollar amortization. (significant change)

Compared to the Proposed Adjustments of last summer the biggest change is that Normal Yearly Pension Contribution by states will not be adjusted. Consistent with their original proposals, Moody’s will adjust State Net Pension Liability amortization payments and will not adjust local government payments. Other significant changes are that Moody’s will use the “Actuarial (Smoothed) Value of Assets” for local governments (while still converting to Market Value for states) and will assume unfunded pensions should be eliminated in 20 years rather than the proposed 17 years.

*   *   *

Table of Contents

I. INTRODUCTION 3
II. THE ADJUSTMENTS 2
A. PROPOSED – JULY 13, 2012 2
B. ADOPTED – APRIL 17, 2013 2
C. CHANGES 3
1. Summary 3
2. What Didn’t Change 3
3. What Changed a Little 4
4. Pension Asset Value – States No Change – Local Governments Change 5
5. Significant Changes – Government Payments to Pension Funds 5
III. MOODY’S PROJECTIONS OF THE IMPACT OF THEIR ADJUSTMENTS 7
A. SIGNIFICANT IMPACT ON PENSION FINANCIAL VALUES 7
B. MOODY’S PROJECTS MODEST IMPACT ON CREDIT RATINGS 8
C. MOODY’S CREDIT RATINGS RESULT FROM MANY FACTORS 8
IV. MOODY’S ADJUSTMENTS APPLIED TO SEVEN CALIFORNIA COUNTIES 10
A. FIRST MAJOR IMPACT – UNFUNDED PENSION DEBT 10
1. Doubles Unfunded Pension Debt 10
2. From $10 Billion of Positive Net Worth to $7.5 Billion “In the Hole” 11
B. SECOND MAJOR IMPACT – STATE PAYMENTS TO PENSION FUNDS 19
C. SUMMARY OF IMPACTS 21
V. ATTACHMENTS 22
A. ANALYSIS OF PROPOSED MOODY’S ADJUSTMENTS – 1/21/13 – ONE PAGE SUMMARY 22
B. UNMASKING STAGGERING PENSION DEBT & HIDDEN EXPENSE – 3/13/13 – ONE PAGE SUMMARY 23
C. MOODY’S CREDIT RATING FACTORS FOR LOCAL GOVERNMENT GENERAL OBLIGATION BONDS 24
D. DATA SOURCES 25

Table of Figures

FIGURE 1 – CITIBANK PENSION LIABILITY INDEX DISCOUNT RATE 4
FIGURE 2 – INDEPENDENT COUNTY PENSION FUNDS 10
FIGURE 3 – NET PENSION LIABILITY PER $100 UAAL 10
FIGURE 4 FATAL FLAW: UNFUNDED PENSIONS 13
FIGURE 5 FATAL FLAW: AMORTIZATION PAYMENTS 13
FIGURE 6 FATAL FLAW: HOW UNFUNDED PENSIONS DEVELOPED 13
FIGURE 7 FATAL FLAW: TODAY’S STATEMENTS TELL US THE PAYMENT OF DEBT “CREATES” DEBT – ABSURD 14
FIGURE 8 FATAL FLAW: THE REAL EXPENSE CREATES THE UNFUNDED PENSION DEBT THAT MUST BE PAID 14
FIGURE 9 MENDOCINO – UAAL, COUNTY PENSION FUND CONTRIBUTIONS, PENSION OBLIGATION BONDS 14
FIGURE 10 – IMPACT OF GASB 68 AND MOODY’S ADJUSTMENTS: 7 COUNTIES – 2011 BALANCE SHEETS (TOTAL ASSETS = 100%) 17
FIGURE 11 – GOV. PAYMENTS TO PENSION FUND PER $100 OF PAYMENTS DEFINED IN VALUATIONS 20

Table of Tables

TABLE 1 – MOODY’S SUMMARY OF CHANGES BETWEEN PROPOSED AND ADOPTED ADJUSTMENTS 3
TABLE 2 – MOODY’S PROJECTED IMPACT ON GOVERNMENT FINANCIAL STATEMENTS FISCAL YEAR 2011 – $BILLIONS 7
TABLE 3 – NET PENSION LIABILITY 10
TABLE 4 – NET PENSION LIABILITY ($MILLIONS) 11
TABLE 5 – BALANCE SHEETS REPORTED BY COUNTIES – FY2011 ($ MILLIONS) 11
TABLE 6 – IMPACT OF GASB 68 AND MOODY’S ADJUSTMENTS: 7 COUNTIES – 2011 BALANCE SHEETS ($MILLIONS) 16
TABLE 7 – ADJUSTED PAYMENTS TO PENSION FUND 20
TABLE 8 – PAYMENTS TO PENSION FUNDS ($MILLION) 20
TABLE 9 – SUMMARY IMPACT OF MOODY’S ADJUSTMENTS – 7 COUNTIES 21

*   *   *

I  –  INTRODUCTION

At the end of June 2012 the Governmental Accounting Standards Board (GASB) imposed major changes in pension financial reporting requirements on state and local governments that will kick in over the next couple of years. One week later Moody’s Investors Services (one of the two most powerful credit rating agencies in the US – the other is Standard and Poors) published a report titled “Adjustments to US State and Local Government Reported Pension Data.” They described proposed significant adjustments they would make in their credit rating analysis to pension financial data reported by state and local governments. On April 17, 2013 they released a document with the same title – a description of the adjustments they finally adopted. [1]

I published a paper analyzing Moody’s proposed changes on 1/11/13 that showed what the impact of those changes would have been on six California counties. I produced another paper on 3/13/13 combining that paper with analysis of GASB’s new pension financial reporting rules known as GASB 68. I showed the impact of both on seven California counties. [2]

The purpose of this paper is to:

    • Describe Moody’s adopted adjustments 
    • Compare them to those that were proposed (what changed, what didn’t) • 
    • Demonstrate the impact of both the proposed and final Moody’s adjustments and GASB’s new rules on government financial statements.

Moody’s describes its purposes in making these adjustments:

Moody’s focus is the evaluation of credit risk of rated debt obligations. Because pensions represent material financial commitments that affect a government’s financial risk profile, we have always incorporated pensions into our credit analysis where we have been aware of significant unfunded liabilities. As pension stress began to be a driving factor in a number of government rating downgrades over the past few years, we recognized a need to bring greater transparency and comparability to the pension measures used in our analysis. [3]

Current government financial reporting standards don’t require unfunded pension obligations to be reported as “bona fide” liabilities. Governments and their Pension Funds adopt widely varying actuarial assumptions (expected rate of investment return, number of years and method to eliminate unfunded obligations, etc.) that produce significantly different values even if when there are no fundamental differences in the financial condition of pension funds. Further, current standards don’t require multiple-employer government Pension Funds to allocate unfunded obligations to participating governments.

Moody’s adjustments are designed to approximate unfunded pension obligations for all public pension plans as if they had all used the same target rates of return, policies about eliminating unfunded pension obligations, etc. That makes the adjusted values more “comparable”. By specifically including adjusted unfunded pension values as debts and assigning values to governments in multiple-employer pension plans Moody’s adjustments make these obligations more “transparent.”

Moody’s wants everyone to be very clear about one thing – these adjustments will only be used in their internal credit rating analysis. “Our adjustments are not intended as a guide, standard or requirement for state or local governments to report or fund their obligations.” No government has to change its reporting of its pension finances or increase pension funding. But as a practical matter I think it’s fair to say that Moody’s adjustments regarding payments to eliminate unfunded pensions are in effect “benchmarks.” Governments don’t have to pay that much, but if they don’t they are putting their credit ratings at risk.

*   *   *

II  –  ADJUSTMENTS

A. Proposed – July 13, 2012

These were Moody’s four proposed adjustments in their July Moody’s Proposed Adjustments (page 1):

1. Multiple-employer cost-sharing plan liabilities will be allocated to specific government employers based on proportionate shares of total plan contributions.

2. Accrued actuarial liabilities will be adjusted based on a high-grade long-term corporate bond index discount rate (5.5% for 2010 and 2011).

3. Asset smoothing will be replaced with reported market or fair value as of the actuarial reporting date.

4. Annual pension contributions will be adjusted to reflect the foregoing changes as well as a common (adjusted net pension liability) amortization period.

They also proposed to combine adjusted pension debt with other debts to measure long-term liabilities.

Further, Moody’s example of a government’s net pension liability amortization payments used “beginning of year amortization” rather than “end of year”. That is, the amortization payments were based on the assumption that payments were made at the beginning of each year. That meant there was no interest expense included in the first year’s payment – therefore amortization payments were lower than they would have been had the more common “end of year payment” amortization method been used. (In an email the research manager in charge of developing the adjustments on behalf of Moody’s confirmed that was the method they would use.)

B. Adopted – April 17, 2013

These are the adjustments announced by Moody’s in their April Moody’s Final Adjustments (page 3):

1. Multiple-employer cost-sharing plan liabilities will be allocated to specific government employers based on proportionate shares of total plan contributions. (Same as proposed)

2. Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation. (Slight change – see below)

3. Asset smoothing will be replaced with reported market or fair value as of the actuarial reporting date. (Changed – see below)

4. The resulting adjusted net pension liability (i.e. adjusted liabilities less assets) will be amortized over 20 years using a level-dollar amortization. (Significant change – see below)

Moody’s won’t combine their adjusted unfunded pension debt value with other debt. Moody’s also changed to the “end of year” amortization payment method. However, they didn’t note that change in their text.

C. Changes

1. Summary

Moody’s provided this exhibit summarizing the changes [5]: Dickenson_MoodyFinal_t1 2. What Didn’t Change

a) Allocation of Multi-Government Pension Funds

The financial data for “Cost Sharing Multiple Government Employer Pension Funds (“CSP”) as a whole will be allocated to participating governments in proportion to each government’s total contribution to the Fund as a percent of contributions from all governments. However, if the Pension Fund’s valuation provides an adequate allocation of total Pension Fund values to individual governments Moody’s would use those values.

b) Common Period to Adjust Total Pension Liability

To determine the value of Total Pension Liability Actuaries first project the amount of pension payments that have already been earned that will be made each year in the future, then they “discount” each future year’s projected payments by the Pension Fund’s assumed rate of investment return to obtain the amount of money that should be in the Pension Fund today. This amount is the “Actuarially Accrued (Pension) Liability” (“AAL”).

Moody’s will use a different – and today a significantly lower discount rate than Pension Funds’ assumed investment rate of return. (For more about the “discount rate” see “Change in “Index” Used” below.) However, Moody’s can’t simply replicate the calculation made by Actuaries using a different discount rate because they don’t have the projected payments in each future year of pensions that have already been earned. Therefore Moody’s devised an “estimating” calculation that approximates the value of Total Pension Liability had the Actuary used the lower discount rate.

The value of the Actuarially Accrued Pension Liability will be projected 13 years into the future using the Pension Fund’s assumed rate of return, and then “discounted” back to the present using the lower return described below. This will produce a higher Total Pension Liability value than the AAL.

There was no change in this 13 year “liability adjustment period”.

3. What Changed a Little

a) Combined Debt and Pension Metrics

We will measure and evaluate debt and pensions separately to reflect a number of factors that differentiate pension liabilities from bonded debt. Most municipal market debt service payments are predictable, set contractually, and subject to default. Pension liabilities are estimates (including an element of future salary growth for current employees) and in many cases can be changed through policy action. Governmental pension contributions are generally not subject to default. [6]

I assume this isn’t a big change – but if the separate values are subject to different mathematical or qualitative analysis this could be more impactful. (I didn’t see anything about this in Moody’s documents.)

b) Discount Rate

(1) Change in “Index” Used

The amount Moody’s will consider to be “pension debt” for a government will be the difference between its shares of the value of a Pension Fund’s assets and it’s Total Pension Liability. The discount rate is used in calculating the Total Pension Liability.

Government Pension Funds use their assumed rate of investment return as a “discount rate” to determine the net present value of future pension payments that have already been earned. That’s the amount of money the Pension Fund is supposed to have today – the “Actuarially Accrued Liability” or “Total Pension Liability”. Assumed rates today are typically in the 7.25% to 7.9% range.

The rules for reporting pension liabilities in the private sector require their Pension Funds to use a much lower discount rate which results in significantly higher Total Pension Liability values. Moody’s will adjust government-reported Actuarially Accrued Liability to approximate what it would have been had the much lower rate used in the private sector been used.

Moody’s initially proposed to use a “high-grade long-term corporate bond index discount rate”. However, the rate defined in their Final Adjustments is “Citibank’s Pension Liability Index”.

The (Citibank Pension Liability Index is composed of high credit quality (Aa rated or higher) taxable bonds and is duration-weighted by Citibank for purposes of creating a discount rate for a typical pension plan in the private sector. [7]

There appears to be very little practical difference between a high quality corporate bond index and Citibank’s Pension Liability Index. However, the Citibank index is commonly used in the private sector to calculate the Total Liability. Therefore the rationale for its use is already established.

Figure 1 shows the value of the Citibank Index over the past several years: [8] Dickenson_MoodyFinal_f1 (2) Change in Date of Index Value

Moody’s originally proposed to set a discount rate that would be used throughout each year, but their final adopted adjustments will apply the Citibank Index discount rate as of the date of a Pension Fund’s Actuarial Valuation. Therefore the discount rate will vary somewhat through each year.

c) End of Year Amortization

In their proposed adjustments Moody’s constructed net pension liability payment schedules based on the assumption that governments would make one payment per year at the beginning of each year rather than at the end of the year. In my paper presenting my analysis of Moody’s proposed adjustments I wrote:

In an email exchange the author of Moody’s paper indicated Moody’s believes the “correct” method of calculating interest expense is “beginning of period” rather than “end of period”. Also they are simplifying the amortization schedules by assuming annual payments. I and several other financial professionals don’t understand the idea that “one payment per year” wouldn’t incur interest expense in the first year. It would have to be made on the first day of the first year in order to have no interest expense – it would all go to reduce debt principal. Payments are generally made to Pension Funds when governments make payrolls or shortly thereafter. Government paydays are sometimes once a month, or twice a month, and sometimes every two weeks or 26 times a year. In any of these “real world” systems there would be at most only one payment for anywhere from a two-week to one-month period that doesn’t accrue interest expense and then only if that payday occurs on the first day of the first fiscal year. However – since this is Moody’s assumption the analysis in this paper uses that assumption – even though we don’t think it’s realistic. [9]

Well … in their paper describing their final adopted adjustments Moody’s changed its amortization payments to the “end of year” payment method thereby incurring a full year’s interest expense in the first year. They didn’t point that change out in their text. This change makes “more sense” – but as indicated above governments typically make payments to their Pension Funds every payday rather than once a year. The one-payment at end-of-year method used in Moody’s Financial Adjustments overstates the expected interest expense. However, the difference between beginning of year and end of year payments is only about 4% or so – not terribly significant.

4. Pension Asset Value – States No Change – Local Governments Change

Moody’s original proposal was to use the Market (or “Fair”) Value of Pension Fund Assets in calculating the Net Pension Liability instead of a “smoothed” Actuarial Value of Assets (“AVA”). Moody’s Final Adjustments maintain that change for States but reverts to using the AVA for local governments. Moody’s says that Market Value is not readily available for many local governments. We’ll see the impact of this change for local governments below.

5. Significant Changes – Government Payments to Pension Funds

Governments make two major types of payments to their Pension Funds:

    • “Normal” Yearly Contributions – calculated by Actuaries to be the amount of money that needs to be contributed in a year so that the part of future pension payments that are being earned that year will be able to be paid assuming all the other assumptions in the Pension Funding plan come true (return on investment, life spans, etc.) This amount typically is split between governments and each year’s employees in varying proportions.
    • Unfunded Pension Obligation Amortization Payments – if in the future the Pension Fund’s Actuary calculates that the Pension Fund in fact has significantly less money than it needs to be able to pay the part of future pensions that were earned in the past (not in the current year – but in past years) then the government must pay additional money to the Pension Fund to eliminate that deficit.

Moody’s final adopted adjustments regarding these payments are significantly different from what they originally proposed.

a) No Adjustment to “Normal” Yearly Contribution

Moody’s originally proposed to adjust the amount of the Normal Yearly Contribution governments should be paying to Pension Funds in a manner similar to how they will adjust the Total Pension Liability. However in their final adopted adjustments they announced they will not change the value of the Normal Yearly Contribution. Moody’s explains:

As initially proposed, our adjusted annual cost measure required computation of normal cost for each issuer. In many cases, actual normal costs are not reported and must be estimated from percentages set in actuarial valuations from previous years. This process was arduous, introduced errors into our data, and was impractical to apply to the local government sector, which consists of about 8,000 rated entities. [10]

This has a significant impact on adjusted government payments to Pension Funds as we will see below. It is the biggest financial difference between the impact of the proposed and the final adopted adjustments.

b) Unfunded Pension Amortization Payments

Governments are required to pay additional money to their Pension Funds if unfunded pension obligations develop.

(1) What Stayed the Same

(a) Only State Payments Will Be Adjusted

Moody’s originally proposed to adjust the amount of these payments for States but not recalculate the value of these payments for local governments. That remains the same in Moody’s Final Adjustments. Moody’s explains that the data needed for these recalculations for local governments is often not easily available. I encouraged them to make these adjustments for local governments for which the data is readily available – but Moody’s decided not to follow my advice (as difficult as I’m sure that decision was for them).

(b) Interest Rate (Basically the Same)

Moody’s will calculate a new “amortization schedule” for each State. Two aspects of the new payment schedule remain essentially the same as originally proposed. Firs,t Moody’s will use the lower interest rate they will use to adjust the value of Total Pension Liabilities. (As discussed in ”Change in “Index” Used” above they will use a slightly different source for the rate they will use but it most likely won’t make a big mathematical difference.

(c) Level Dollar Amortization – Not Level Percent of Payroll

Second, Moody’s will use the “Level Dollar Amortization” method instead of the “Level Percent of Payroll” method used by most Pension Funds and governments.

The “Level Dollar” method is basically the same as the traditional 30 year fixed interest rate & payment home mortgage except the number of years can be shorter. You borrow money to buy a house and pay it back by making equal payments every month for 30 years. Most of the early payments are interest but the last payments mostly reduce debt.

Under the “Level Percent of Payroll” method the Actuary first estimates how much the government’s total payroll will be in each year of the amortization period assuming it will grow the same percent each year – usually projected at about four percent. Then the Actuary calculates a fixed percentage of each year’s payroll the government needs to pay to eliminate the unfunded pension debt by the end of the amortization period. That fixed – or “level” percent of each future year’s projected payroll is projected to be each future year’s payment.

The Level Percent of Payroll method produces payments that are significantly lower than the Level Dollar method in the early years and significantly higher in later years. If the “amortization period” (the number of years payments are made) extends beyond 18 years or so the payments in the early years will be less than the yearly interest expense on the debt and therefore the debt will grow for a number of years. This is called “negative amortization” because the debt grows rather than shrinks.

(2) What Changed – 20 Year Amortization, Not 17 Year

Moody’s originally proposed to use a 17 year amortization period. Their Final Adjustment is to use a 20 year period. They explain:

[We] will amortize adjusted net pension liabilities on a level dollar basis over a period of 20 years rather than the proposed 17 year period. The change to 20 years makes the amortization similar to a bond payment structure, as opposed to the average employee remaining service life concept on which the 17-year proposal was based. The resulting metric is a pro-forma measure of the potential annual cost of addressing prior service liabilities over a time period similar to that of bonded debt. [11]

Those extra 3 years lower the annual payment amount.

*   *   *

III  –  MOODY’S PROJECTIONS OF THE IMPACT OF THEIR ADJUSTMENTS

A. Significant Impact on Pension Financial Values

Moody’s Final Adjustment report presented these changes in Net Pension Liability as a result of their adjustments as applied to fiscal year 2011 financial statements. [12] Dickenson_MoodyFinal_t2 The Market Value of Pension Fund Assets for states was $71 Billion less than the reported Actuarial Value – 7% less. However, Moody’s Adjusted Total Pension Liability was $485 Billion more than the reported Actuarial Liability – 34% more, Moody’s adjustments added $556 Billion to the states’ Net Pension Liability that Moody’s would have used in its credit rating analysis had the adjustments been made for 2011. The resulting $964 Billion of Net Pension Liability was 2.4 times greater than the reported Actuarial Value.

Moody’s has decided not to adjust the value of Local Government Pension Fund Assets. But their adjustments added $537 Billion to Total Pension Liabilities which therefore increased the Net Pension Liabilities by the same amount. This was also 2.4 times larger than the reported Actuarial Value.

The combined Moody’s Adjustment Net Pension Liability grew from $782 Billion to $1,875 Billion.

The “Funding Ratio” (Pension Fund Assets/Total Pension Liabilities) for states declined about 1/3 and that of local government Pension Funds went down about a quarter.

B. Moody’s Projects Modest Impact on Credit Ratings

At first glance Moody’s adjustments produce such striking changes in pension funding values that it seems “intuitive” they would lead to a significant number of government credit rating downgrades. But Moody’s indicates the portion of downgrades would be very minor at most – at least in the immediate future.

The application of the adjusted pension data in our ratings of state governments is discussed in “US States Rating Methodology” released simultaneously with this report. The incorporation of the pension adjustments into our updated methodology will have no immediate impact on state ratings.

Application of the adjusted pension data in our ratings of local governments will be made within the context of our methodology, “General Obligation Bonds Issued by US Local Governments”. We expect that less than 2% of the total population of local general obligation (GO) and equivalent and related ratings will be placed under review for possible downgrade as a result of adopting the adjustments. The affected ratings will be for those local governments whose adjusted pension obligations relative to their resources place them as significant outliers in their ratings categories. [13]

How can Moody’s adjustments result in Net Pension Liabilities nearly two and a half times larger on average than is reported today by state and local governments and have such a negligible impact on credit ratings? Frankly – I don’t know – doesn’t make sense to me. However, the answer may lie at least in part in the methodology Moody’s uses to determine credit ratings as defined in the two documents cited above.

C. Moody’s Credit Ratings Result from Many Factors

As cited above Moody’s released two other updated documents with its Final Adjustments on April 17:

    • US States Rating Methodology
    • General Obligation Bonds Issued by US Local Governments [14]

These documents generally describe how Moody’s evaluates state and local government credit worthiness. The adjustments to pension financial data will impact Moody’s credit ratings in the context of these methodologies. Moody’s describes its general approach in analyzing Local Governments this way:

Moody’s employs a weighted average approach to analyzing these factors (described below) to arrive at a rating range. The precise rating is based on a comparison with peers, interactions of the individual factors, and additional considerations that may not adequately be captured within the factors. While this framework is comprehensive, it still may not adequately capture the complex web of economic, financial and political issues that affect a local government’s relative creditworthiness. Therefore, some of our general obligation ratings may lie outside the rating range implied by the weighted average approach. [15]

The factors Moody’s uses in evaluating credit rating and the “weight” given to each are:

    • Economic Strength
    • Financial Strength 30%
    • Management and Governance 20%
    • Debt Profile 10%

See Moody’s Credit Rating Factors for Local Government General Obligation Bonds on page 22 for a list of the four major factors and 16 sub-factors used in Moody’s analysis.)

At first glance it might appear that Moody’s adjusted values for unfunded pension debt might only be relevant to the last factor – Debt Profile – that has only a 10% impact on credit ratings. Perhaps that’s why Moody’s projects a very modest portion of rating downgrades – such seemingly large changes in Net Pension Liabilities might only be a part of the Debt Profile that all together drives only 10% of a credit rating.

Economic Strength is a factor largely separate from the internal financial reality of a government, although it plays a major role in determining that internal financial reality. Basically – how strong are the local economies that provide the revenue base for governments, are they growing or shrinking and how risky are projections of those local economies?

A local government could be in good financial condition, have good management and governance, and a debt profile that is not disturbing, but it could be mired in a dying local economy and therefore its financial prospects could be not good in spite of how well the government has managed its finances. Conversely a local government that has not been well managed in the past, has squandered financial strength, and has a difficult debt profile could be located in a securely booming economy. In that circumstance, the strong economy can somewhat offset the government’s weakness.

However, adjustments of unfunded pension debt could play a role in measurements of Financial Strength and of Management and Governance as well. As seen in Attachment V.A the major factor of Financial Strength has sub-factors titled “Balance Sheet/Liquidity” and “Budgetary Performance”. Management and Governance has sub-factors titled “Financial Planning and Budgeting” and “Debt Management and Capital Planning”. Why wouldn’t Moody’s greatly increased adjusted Net Pension Liability lead to concerns about these issues?

The main points of all this regarding the impact of Moody’s adjustments are:

    • Many other factors other than Net Pension Liability go into determining Moody’s ultimate credit ratings.
    • Moody’s suggests their adjustments will lead only to a very modest portion of credit downgrades.
    • At least this analyst doesn’t understand how such huge increases in adjusted debt that will have to be paid (even given the uncertainties) could only lead to a very modest portion of downgrades.

*   *   *

IV  –  MOODY’S ADJUSTMENTS AND NEW GOVERNMENT PENSION REPORTING RULES APPLIED TO SEVEN CALIFORNIA COUNTIES

Twenty one California counties (highlighted in map) don’t participate in CalPERS; they have their own independent County Pension Funds. Twenty of these County Pension Funds are organized under the state’s County Employees Retirement Law (CERL). I applied Moody’s proposed adjustments from July 2012 and their final announced adjustments in April 2013 to seven of these (red on this map) – 6 in the Bay Area (Mendocino, Sonoma, Marin, Contra Costa, Alameda, San Mateo) and one in Southern California (Orange). I used fiscal year 2011 financial statements and Pension Fund Actuarial Valuations for these counties. Dickenson_MoodyFinal_f2 A. First Major Impact – Unfunded Pension Debt

1.  Doubles Unfunded Pension Debt

Table 3 and Figure 3 answer these questions:

    • For every $100 of reported “Unfunded Actuarially Accrued (Pension) Liability” (UAAL) for these 7 counties, how much would Moody’s proposed and final adopted adjusted Net Pension Liability be? 
    • What is the percentage difference between reported UAAL and the adjusted Net Pension Liability Moody’s will use in their credit rating analysis? 
    • What’s the difference between the proposed adjustments and the final adopted adjustments?

Dickenson_MoodyFinal_t3 Dickenson_MoodyFinal_f3 On average – for every $100 of UAAL reported for these County Pension Funds on average Moody’s proposed adjusted Net Pension Liability would have been $231 and the final adopted adjusted Net Liability would have been $220. On average Moody’s final adopted adjustments are 5% less than what the proposed adjustments would have produced – not a huge difference. And – bottom line – on average the value of Net Pension Liability Moody’s would have used in its credit rating analysis would have been well more than double.

There’s some variation between counties, but not huge. The final adjustments for Sonoma and Contra Costa produced somewhat lower Net Pension Liability values than those produced by the proposed adjustments whereas Alameda’s final adjusted Net Pension Liability was a bit more. This results from Moody’s decision to use the Actuarial Value of Pension Fund Assets (AVA) instead of the Market (Fair) Value for local governments.

In calculating the value of Pension Fund assets Actuaries apply a technique called “smoothing” that slows down year to year changes in value. This prevents sudden chaotic surges in government payments to Pension Funds that would result from the unavoidable precipitous declines in the stock market that happen from time to time.

Moody’s had proposed to use the Market Value rather than the smoothed Actuarial Value (AVA). But in their final adopted adjustments they decided to use the AVA for local governments because they felt it would be difficult and costly to obtain the market value for all local governments. They will use Market Value for states.

Table 4 shows the dollar amounts of UAAL and adjusted Net Pension Liability and the differences among them. Dickenson_MoodyFinal_t4 These counties reported a total of $7.6 billion of Unfunded Pension Obligations. Moody’s proposed adjustment was about $10 billion higher – $17.5 billion. Their adopted adjustment produces a Net Liability of $16 2/3 billion – $880 million less than the proposed adjustment but over $9 billion more than the reported UAAL.

Under today’s government accounting rules unfunded pension obligations are not listed as a “bona fide” liability. New rules will be imposed within 2 years for force governments to report a Net Pension Liability on their financial statements. If those rules had been in effect in 2011and the UAAL was an “accurate” estimation of that liability, then these 7 counties would be forced to “write off” $7.6 billion of their “net worth”. But if Moody’s adjustment was “accurate”, then they’d have to write off $16⅔ billion – just 7 out of 3000 counties in the US.

Moody’s adjustments very significantly increased the Net Pension Liability that Moody’s would have used in their internal credit rating analysis for all 7 counties [16] – ranging from double to three and a half times greater for the proposed adjustments and from double to triple for the final adopted adjustments.

2. From $10 Billion of Positive Net Worth to $7.5 Billion “In the Hole”

a) County Reported Statement of Net Assets (Balance Sheet)

Table 5 shows the Balance Sheets (Statement of Net Assets) reported by these counties as of June 30, 2011. Dickenson_MoodyFinal_t5

They all reported their assets were worth more than their liabilities – and therefore they had positive “Net Worth” – or “Net Assets”. Both GASB’s new rules and Moody’s adjustments change this picture drastically.

b) GASB 68 Elimination of Most “Net Pension Assets”

Note that in Table 5 four of these counties reported a total of almost $1 Billion of “Net Pension Assets”. Curious – those four counties reported on their Balance Sheets that their Pension Obligation Bond debt was a total of $1.7 Billion. All four counties owed more on their Pension Bonds than the Net Pension Asset – and that doesn’t count their unfunded pension obligations.

The Governmental Accounting Standards Board (GASB) sets the basic rules for government financial reporting in the United States. Last June GASB announced major reforms in how governments must report the finances of their pension benefits and obligations. [17] GASB Statement 67 establishes new rules for government Pension Funds (GASB 67), and Statement 68 establishes rules for governments themselves (GASB 68). Government Pension Funds must conform to GASB 67 no later than for fiscal years beginning after 6/15/13. Governments must use GASB 68 for financial statements beginning no later than for fiscal years starting after 6/15/14.

One aspect of GASB 68 is important to understand when considering the impact of Moody’s adjustment of Net Pension Liabilities on government Balance Sheets. But first – we need to understand the “theory” of how governments are supposed to eliminate unfunded pension obligations.

(1) How Governments Are Supposed to Eliminate Unfunded Pension Obligations

If a significant unfunded pension gap develops usually ONLY the government must pay more money into the Pension Fund to eliminate this deficit. Employees rarely have that obligation and retirees in California never have to do so. Governments have two ways to eliminate unfunded pensions.

(a) Amortization

The first is unfunded amortization payments. Unfunded pensions are almost always decades in the future. The Actuary has to plan that at some point between now and then the deficit will be eliminated. The actuary draws up an “amortization schedule” – kind of like a home mortgage. The County will make payments up to 30 years – but often less – to eliminate this gap. The county will pay an interest expense equal to the Pension Fund’s target rate of return. There’s a second way governments eliminate unfunded pensions.

(b) Pension Obligation Bonds

Municipal bond interest rates are a lot lower than Pension Fund target rates of return. Lots of governments borrowed money by selling “Pension Obligation Bonds” (“POB’s”) hoping to get a lower interest rate. They gave the proceeds to their Pension Fund to eliminate the unfunded pensions. Six of the 7 counties in this analysis have sold POBs.

All that happened is that these counties “restructured” their unfunded pension debts. They changed the form of the debt – but the source of the debt is the same – unfunded pensions. The Pension Fund got the money – but the County – which really means – We the People kept the debt.

You must include Pension Bonds when considering the financial impact of unfunded pensions. More to the point in this paper the Net Pension Assets reported by these four counties was set up when they sold Pension Bonds.

A quick aside about Pension Bonds – Right after Mendocino County sold its 2nd pension bonds in 2002 the County CEO was interviewed on a local news show. The lady said “Hey – wow – the County’s debt really shot up last year. What’s up with that?” The CEO said – “Listen – our County Board of Supervisors deserves huge praise from the people of Mendocino County. They cut our interest expense in half. They saved the people tens of millions of dollars over the next 20 years – money we’ll have for vital public services”. Now – of course it’s better to only pay 4% interest than 8%. That’s not the question. The question is “why are we in debt – why are we paying any interest at all? You said you were properly funding pensions all along – what happened? How are you going to stop putting us deeper in debt?” Unfortunately these county officials weren’t confronted by those questions when these Bonds were sold. (I’ve also written extensively on Pension Obligation Bonds – available at www.YourPublicMoney.com). 

(2) The Fatal Flaw in Current Government Financial Reporting of Pension Finances

To explain this aspect of GASB 68 and how it influences the impact of Moody’s Adjusted Net Pension Liability we have to look at the “fatal flaw” in GASB’s old rules about pension financial reporting. Among other huge problems it created, it led to the creation of these Net Pension Assets – that aren’t real assets at all.

The most important concept in the old rules is the “Annual Required Contribution” – or “ARC” – simply what the Actuary says the government must pay the Pension Fund each year. Each year’s ARC is reported as each year’s pension expense. That’s a simplification – it’s more complicated – but that’s the core concept.

I’ll illustrate the “fatal flaw” using Mendocino County.

Mendocino had a $125 million unfunded pension obligation going into 2012 (Figure 4). The County was obligated to eliminate it. Dickenson_MoodyFinal_f4 The Actuary set up this unfunded pension payment schedule over 30 years (Figure 5). If everything went exactly according to plan – at that point the unfunded pensions would be eliminated. Dickenson_MoodyFinal_f5 Figure 6 shows how the unfunded pension obligation developed. Mendocino sold $90 million in Pension Bonds in December 02. They didn’t reduce unfunded pensions to zero – but we’ll assume they did for this explanation. The columns are each year’s change in the UAAL. The pink area is the balance of the UAAL up to the $125 million.

There were a couple of good years when the UAAL went down – but 6 of these 8 years saw the UAAL increase. Dickenson_MoodyFinal_f6 The Trillion Dollar question is –

When does the pension expense that created this $125 million debt happen?

Today’s massive unfunded pension debt in our country happened because for more than 2 decades GASB gave us the wrong answer.

Under today’s rules the Annual Required Contribution is what the County will report as its pension expense each year –the sum of the government’s Normal Cost Contribution – AND UAAL AMORTIZATION PAYMENTS. These payments (Figure 7) over the next three decades would be added to the Normal Contributions in those years to produce the reported pension expense in each of those years. The pension expense related to the $125 million UAAL will be reported over 30 years in the future.

That’s saying the payments of a debt create the debt. That’s absurd. The payments of a debt eliminate a debt –they don’t create it. Dickenson_MoodyFinal_f7 The real economic pension expense that created this debt happened here (Figure 8) – it’s what built up the $125 million debt.

GASB 68’s most profound change is that instead of deferring reporting the true economic pension expense that created today’s unfunded pension debt decades into the future while the debt is paid governments will be forced to report them pretty much when they happen. (As usual when dealing with pension finance it’s more complicated than that – but if you boil it down that’s what GASB 68’s most important change is.) Dickenson_MoodyFinal_f8

(3) GASB’s “Fatal Flaw” and Reported Net Pension Assets

Mendocino County again – 93 through 03 (Figure 9). The red stalactites hanging down are the Unfunded Pension Liability reported by the County’s Pension Fund (but not reported as a debt on the County’s Balance Sheet as it will be when GASB 68 kicks in). The little green columns are the Annual Required Contribution.

The red columns are the proceeds of Pension Bonds. The County sold its first Pension Bonds in 97. They sold their second in 03.

What’s the impact of these Bonds on financial statements?

The borrowing is simple. They have a $112 million liability – Pension Bonds. They got $106 million in cash and the “Bond Boys” kept $6 million as their cut – part of the county’s cost of issuing the Bonds. Where it gets weird is what they did with the $106 million. They gave the money to the Pension Fund – but what did the County report they got for it? Dickenson_MoodyFinal_f9 Imagine this – you gave your kid a credit card. The kid tells you he’s only spending a few hundred dollars a month on the credit card. What’s really happening is he’s only paying the minimum payment – but charging thousands a month. 

A $10,000 balance builds up. The minimum payment is $1000. Your kid borrows $10,000 from Aunt Betsy – a generous soul. He pays it to the credit card. You ask your kid what the heck is going on – and he says: “Hey Dad – Mom – you don’t understand. Sure I owe Aunt Betsy $10,000 – BUT I’VE GOT A PREPAID CREDIT CARD BALANCE OF $9000 – SO – I REALLY only owe $1000.” He says he’s got a $9000 prepaid balance – an asset – because that’s how much he paid above the minimum payment, even though he owed $10,000 when he made that payment. Does that make sense? 

That’s what governments that sold Pension Bonds did. The amount they paid to the Pension Fund over the minimum payment (which is what the Annual Required Contribution is, by the way) was reported as a Net Pension Asset – prepaid pensions. But it isn’t a “real” asset – it provides absolutely no value to the County’s operations in the future. Its only value is that the officials who sold the Bonds don’t have to take the political heat that would occur if they had to report the financial truth – that pension expenses were much more than were reported in the past, that the government was almost certainly really operating with a significant deficit, and they wouldn’t have been able to say they had a Net Pension Asset that was almost as much as the Pension Bond debt. They wouldn’t have been able to say – like your kid – “you don’t understand – sure we owe the Bonds but we have an asset that offsets most of that debt because we ‘prepaid’ millions of our future payments to the Pension Fund and saved a ton of money”.

When GASB 68 goes into effect the Net Pension Assets reported by these four counties will go “poof” – they will be wiped off their Balance Sheets. If GASB 68 had been in effect in 2011 when the summary Statements of Net Assets (the Balance Sheet) shown in Table 5 on page 11 those $1 Billion of Net Assets wouldn’t have been reported. One Billion dollars of these counties’ “Net Worth” (Net Assets) would have disappeared.

I’m including this impact of GASB 68 in analyzing the impact of Moody’s adjustment of Net Pension Liability on the Balance Sheet. When GASB 68 goes into effect next year those false assets will no longer be reported.

c) Impact of Moody’s Adjusted Net Pension Debt and GASB 68

This paper doesn’t delve into the other extensive changes about to be imposed by GASB’s new rules for reporting government employee pension finance. [18] However, I’m showing what the impact of both GASB 68 and Moody’s adjustments would have been on the Statements of Net Assets (Balance Sheet) for these 7 counties in their 2011 financial statements (Table 6 below). You can compare these two sets of changes. Also – Moody’s adjustments will not be reflected in government financial statements – GASB’s new rules will.

The first section of Table 6 repeats Table 5 –Balance Sheets reported by the counties. These are for the “general government” parts of these counties. They don’t include enterprises (water, waste water, etc.).

The second section – “GASB 58 IMPACT” – shows the change GASB 68 would have imposed on the reported Balance Sheets. The third – “MOODY’S IMPACT” – shows the change Moody’s adjustments would have made to the reported statements. The changes relate to the reported Balance Sheets – not to GASB’s changes. Dickenson_MoodyFinal_t6 Figure 10 shows the proportion Liabilities and Net Assets are of Total Assets as reported by the counties in 2011, what they would have been had GASB 68 been in effect, and what they would have been using Moody’s final adopted adjustments. Net Pension Liabilities and Pension Bonds (in a box) are both red because they are two forms of the same debt – unfunded pension-created debt. Dickenson_MoodyFinal_f10 These 7 counties reported they together had Net Assets of over $10 Billion. GASB 68 will have two big impacts on Balance Sheets. The biggest is Net Pension Liability will be reported for the first time. Less impactful will be the disappearance of most “Net Pension Assets”. These changes would have cut these counties’ combined Net Assets by 90% down to less than $1 Billion. A reduction of $9.3 Billion in just these 7 counties – what will be the total “write off” for the more than 3000 counties in the US, tens of thousands of cities, school districts, special districts, and all the 50 states! Two of these counties – Contra Costa and Mendocino – would have reported more Net Pension Liability than the value of their Total Assets. Orange County’s Net Assets would have essentially been wiped out.

Moody’s adjustments are worse. Instead of total Net Assets of $10.2 Billion for the 7 counties combined, Moody’s adjustments would produce negative Net Assets of ($7.4 Billion) – a “write down” of over $17½ Billion! These 7 counties would be deemed by Moody’s to owe $7½ Billion more than the value of their Assets. Only one county would be left “above water” – Marin, which happens to have the highest per capita income of all counties in the United States!

(1) Reported

The first section of Table 6 shows the values that were actually reported by those counties in 2011. The first graph in Figure 10 shows the percentage that Pension Obligation Bonds, all other reported liabilities and “Net Assets” (or Net Worth) were of Total Assets. All 7 counties reported they have more assets than debt. Marin’s debt was reported to be only about 22% of the value of its Total Assets, whereas Mendocino and Contra Costa reported total debt equal to ⅔ of the value of their Total Assets. The average for all 7 counties was Total Liabilities equaling about 45% of Total Assets.

Mendocino’s Pension Obligation Bond debt represented the largest claim against these 7 counties’ Total Assets – nearly 40%. Contra Costa’s POB’s were 24% of Total Assets and Sonoma’s were 22%. Only San Mateo had never sold POBs, and Orange County had only a 1% claim by POB’s against their Total Assets.

(2) GASB 68

GASB 68 will have two big impacts on government Balance Sheets:

    • Net Pension Asset: As discussed in “GASB 68 Elimination of Most “Net Pension Assets” beginning on page 12 GASB 68 will eliminate most reported Net Pension Assets – and would have eliminated all of the $1 Billion of Net Pension Assets reported by these counties in 2011.
    • Net Pension Liability: The big change is that unfunded pension obligations will be listed on government Balance Sheets as a bona fide liability for the first time. The process of calculating the Total Pension Liability is complicated as I’ll explain below.

The second section in Table 6 shows the changes GASB 68 would have made to the reported Balance Sheets. Almost $1 Billion of what was reported as Net Pension Assets in total for these counties would have been removed from the Assets, and about $8.3 Billion of Net Pension Liabilities would have been added to Liabilities. The second graph in Figure 10 shows what the relative impact of GASB 68 would have been. Two counties would have been significantly “upside down” – Contra Costa and Mendocino would have reported they had more than $160 of debt for every $100 of assets. These counties’ would have been forced to report their Unfunded Pension Debt (Net Pension Liability + Pension Bonds) was more than the value of their Total Assets. Orange County’s Total Liabilities would have been reported as just slightly more than Total Assets.

The Net Pension Liability is the result of subtracting the Total Pension Liability from the value of Pension Fund assets. It’s possible the value of Pension Fund Assets would be more in which case a Net Pension Asset would exist – which would be a “real” asset unlike the “false” Net Pension Assets of today. But we aren’t going to see many of those in the US when GASB 68 is implemented.

GASB 68 will require the actual market value of Pension Fund assets be used instead of the “smoothed” Actuarial Value of Assets. [19] That’s fairly simple to determine.

However, the value of the Total Pension Liability will result from a very complex cash flow projection for the Pension Fund that will extend many decades into the future. It’s not within the scope of this paper to describe that cash flow projection. Very briefly – if a government has a history of paying the total “Annual Required Contribution” (ARC) then the Total Pension Liability will calculated based on the Pension Fund’s target rate of return. However, if it has a history of not paying its ARC, then a lower assumed rate of return will be used that will vary depending on the results of the cash flow projection. The result of using a lower rate will increase the reported Total Pension Liability which in turn will increase the Net Pension Liability reported on Balance Sheets.

Only Actuaries have the data necessary to make these projections, and so I use the Total Pension Liability as calculated by Pension Fund Actuaries based on the target rate of return. This produces the lowest possible Net Pension Liability. I’ve seen studies that suggest the Net Liability of half the nation’s local and state governments would be higher because the cash flow projection would “trigger” the use of a lower assumed rate of return. That means the values for Net Pension Liability in the GASB portion of Table 6 are the “best case” from the counties’ point of view. It’s quite likely some of these counties will wind up reporting higher Net Pension Liabilities because they will be forced by GASB 68 to use lower assumed rates of return. In that case the reduction in Net Assets would be even greater.

(3) Moody’s Adjustments

Remember – the only “real world” use of Moody’s adjustments will be in their internal credit rating analysis of state and local governments. Governments will not use Moody’s adjustments for financial reporting – indeed they can’t. Moody’s doesn’t set Generally Accepted Accounting Principles (GAAP) – GASB does. And Moody’s really – really wants everyone to know their adjustments aren’t recommendations or a “public standard”.

BUT – Moody’s settled on these adjustments because they believe they help them more accurately analyze the risk that unfunded pension obligations pose to purchasers of government bonds. I think it’s completely fair for us to use the result of these adjustments in evaluating the financial risks posed by unfunded pension obligations to our governments’ ability to do one of their core duties – provide high quality governmental services and infrastructure at a fair cost to the public consistently through the decades to come.

Moody’s adjustments result in an apparent “loss” of $17.5 Billion of these counties’ Net Assets – their Net Worth. Together, instead of being “worth” $10 Billion as they reported in 2011, Moody’s adjustments would have indicated they collectively were $7.5 Billion “in the hole”. Only one county – Marin – retained positive Net Worth. The other six were “underwater”.

As discussed in “Moody’s Projections of The Impact of Their Adjustments” on page 7 even though Moody’s own projections of the impact of their adjustments on the financial statements of state and local governments across the US are very significant, they also state they expect only minor portions of credit downgrades. And – as I said in that section – I don’t really know how such astonishing “liquidations” of Net Assets for most of these 7 counties wouldn’t drive significant credit downgrades for the counties Moody’s analyzes. We’ll have to wait a year to see what really happens.

B. Second Major Impact – State Payments to Pension Funds

As was stated in their proposed adjustments and confirmed in their adopted adjustments, Moody’s will only adjust the value of state payments to Pension Funds; they won’t adjust payments by local governments. However, I applied their payment adjustment to these 7 counties to show the relative impact the adjustments would have and the scale of adjustments to state payments that will likely result. Further – although Moody’s very emphatically states these adjustments should not be interpreted as recommendations I do think it’s fair to infer they consider the results in effect a “benchmark” of “prudent funding”. It’s useful for concerned citizens and government officials to consider whether or not this “benchmark” is indeed a measure of prudent payment.

Table 7 below answers these questions:

    • For every $100 of county payments to their Pension Funds projected in the Funds’ Actuarial Valuations what would Moody’s proposed and final adopted adjusted payments be? 
    • What is the percentage difference between payments projected in Actuarial Valuations UAAL and the payments produced by Moody’s adjustments?
    • What’s the difference between the proposed adjusted and the final adopted adjusted payments?

Dickenson_MoodyFinal_t7 Dickenson_MoodyFinal_f11 For every $100 of payments projected in these County Pension Funds’ Valuations on average Moody’s proposed adjusted payments would have been $219 and the final adopted adjusted payments would have been $176. On average the value of County payments to their Pension Funds Moody’s would have used in its credit rating analysis would have been ¾ more than the payments projected in the Valuations. (Remember – Moody’s won’t adjust payments for local governments. They will only do so for states. This is only to illustrate the math.)

The final adjusted payments for all counties were significantly less than Moody’s proposed adjustment payments and were 20% less than the proposed payments on average. In contrast the final adjusted Net Pension Liability was only 5% less than the proposed adjusted Net Liability and those for 3 counties were actually higher.

Moody’s made a much more impactful change in its final adjustments of payments than for Net Liability. Governments make two kinds of major payments to Pension Funds – “Normal Yearly Contributions” and “Unfunded Pension Amortization Payments.” Moody’s initially proposed to adjust both kinds of payments. But they decided not to adjust Normal Contributions in their final adopted adjustments. This accounts for most of the difference between the proposed and final adjustments. Moody’s also a) extended the amortization period for Unfunded Pension Payments from 17 to 20 years which reduced adjusted payments, and b) used “end of year” amortization instead of the “beginning of year” method used in its Proposed Adjustments which had the effect of increasing payments because of the inclusion of an additional year of interest expense.

Table 4 shows the dollar amounts of payments to these Pension Funds – those that were projected in the County Pension Fund’s Actuarial Valuations, Moody’s proposed adjusted payments, and their final approved adjusted payments. Dickenson_MoodyFinal_t8 The Actuarial Valuations for these seven county Pension Funds projected a total of nearly $1.1 billion of County payments to their Pension Funds. If Moody’s proposed adjustments to payments had been applied to these counties total payments would have been about $1.3 billion higher – $2.4 billion. Their final adopted adjustments would have produced total County payments of $1.93 billion- about $835 million more than what they were paying but almost $470 million less than the proposed adjustment.

Both the proposed and final adopted adjustments significantly increased the payments Moody’s would have used in their internal credit rating analysis for all 7 counties if they applied their payment adjustments to local governments.

C. Summary of Impacts

Table 9 shows the total impact of Moody’s proposed and final adopted adjustments on these 7 counties relative to their financial statements in 2011. Since Moody’s won’t adjust payments to Pension Funds by local governments the “Payments” are only to illustrate what the impact of the adjustments are likely to be on states, and to show what I believe Moody’s inherent “benchmark” for prudent pension funding would be for these counties. Dickenson_MoodyFinal_t9 On average Moody’s final adopted adjustment of Net Pension Liability would have been about 220% greater than the Unfunded Actuarially Accrued Liability that was reported by the Pension Funds and provided in footnotes to the counties’ financial statements. Payments to Pension Funds would have been about 76% higher than the payments specified in the Pension Fund Actuarial Valuations.

Moody’s final adopted adjustments produce values for Net Pension Liabilities and government payments to Pension Funds that are less than those produced by their earlier proposed adjustments. The difference in Net Pension Liability is rather small (-5%). In contrast the decrease in payments is somewhat large (-20%).

*   *   *

V. ATTACHMENTS

A. Analysis of Proposed Moody’s Adjustments – 1/21/13 – One Page Summary

On July 2, 2012 Moody’s Investors Services published a “Request for Comment” titled Adjustments to US State and Local Government Reported Pension Data. Moody’s is one of the nation’s major “credit-rating agencies” for state and local governments. They have concluded that published government employee pension financial data greatly understates the credit risks created by unfunded pensions. They propose to make adjustments to that data to use in their credit analysis. Moody’s doesn’t have authority to make governments change their financial statements or fund pensions differently. These proposed adjustments should not be seen as “suggestions” or “requirements” from Moody’s. Governments don’t have to conform to the “benchmarks” implied by these adjustments – but if they don’t their credit rating is at risk.

I developed a financial model to project how Moody’s adjustments would restate published government pension data. I applied the model to 6 Bay Area – North Coast California counties that do not participate in CalPERS; they have independent County Pension Funds. The “logic” of these restatements is Moody’s – my part was only whether I correctly applied the math of Moody’s proposed adjustments.

Moody’s would make four adjustments – two are very significant. First, pension debt would be adjusted using a high-grade long term corporate bond rate (5.5% for 2010-2011) instead of a Pension Fund’s target rate of return (7.75% more or less). Second, government payments to Pension Funds would be adjusted to reflect the lower discount rate, the need to fully fund pensions by the time employees retire, and a 17 year level-dollar amortization of unfunded pensions.

Moody’s adjustments would have two major impacts on government pension financial data. Moody’s states these adjustments would triple the amount of unfunded government pension debt across the US they would use to set credit rates. Moody’s analysis will indicate most governments are paying far less to their Pension Funds than they should.

The main importance of Moody’s proposals to concerned citizens is they strongly support the view that unfunded pensions put state and local government finances at great risk, much more than is reported to the people. They help explain how unfunded pensions produce much greater risk and by implication what to do about it.

These County Pension Funds reported County unfunded pension obligations were a little over $4 billion. Moody’s adjustments would add about $6 billion which would reduce average reported pension funding ratios from 77% to 58%.

Under today’s accounting rules governments don’t report unfunded pensions as debt directly in their financial statements. (New government accounting rules will make them to do so in two years.) Moody’s would include the restated $9.9 billion unfunded pension debt in its credit rating process. In addition these six counties reported Pension Obligation Bond (POB) debt as of June, 2011 of $1.7 billion. They borrowed that money to pay down earlier large unfunded pension deficits. Therefore total unfunded pension-created debt using Moody’s adjustments would be close to $12 billion. All other reported debt (not including unfunded retiree healthcare and other post-employment benefits) was $4.1 billion. Thus Moody’s adjustments would increase the total debt for these counties used in their credit rating analysis from the reported $5.8 billion to $15.8 billion – about triple.

These counties pay about $640 million to their Pension Funds. These adjustments would increase this to $1.4 billion – from 29% of payroll to 63%. Payments to Pension Funds and Pension Bonds today consume about half these counties’ property tax income. The adjusted payments would consume all county property tax income on average.

Moody’s stated they would recalculate total debt for both state and local governments but would calculate what “prudent” government payments to pension funds should be only for states. I strongly urged Moody’s to apply their “prudent payment” adjustments to local governments as well. Moody’s has not yet announced their final decision.

B. Unmasking Staggering Pension Debt & Hidden Expense – 3/13/13 – One Page Summary

Only pension accounting fraud allows governments to pretend their budgets are balanced. – Bill Gates

My County – Mendocino – incurred hundreds of millions of past pension expenses they never reported to the people. Across the nation the hundreds of billions of past government pension expenses that created today’s huge unfunded pension debt have been hidden by a “Fatal Flaw” in how governments report pension finances.

That’s about to change. Big Time.

At the end of June, 2012 the Governmental Accounting Standards Board (“GASB”) imposed major reforms in how state and local governments report pension finances that will kick in over 2 years. Then Moody’s announced their intention to make big adjustments to government reported pension finances in their credit-rating analysis. This report is the content of a presentation about these changes I’ve given to reform groups in counties analyzed in this report.

My specific goal is to show how GASB’s current rules have a “Fatal Flaw” – how that Fatal Flaw allowed hundreds of billions of unfunded government pension debt to develop – and why the new rules are absolutely necessary. My general goal is to describe to concerned citizens what the impact of GASB’s new rules and Moody’s adjustments will be.

The Fatal Flaw is that pension expenses that create unfunded pension debt are reported in the future as that debt is paid. That’s absurd – the payments of a debt eliminate the debt, they don’t create it. Unfunded pension debt is created by pension expenses in the past – most of which have never been reported to the people. GASB is changing that.

GASB’s changes are only about how governments must report pension finances. Moody’s changes are only about how they will analyze government pension financial data in their internal credit rating analysis. Neither will “tell” governments how much they should pay to Pension Funds and Moody’s won’t change government financial statements.

This report shows the impact these changes would have had on 7 California counties that have their own County Pension Funds (Alameda, Contra Costa, Marin, Mendocino, Orange, San Mateo, and Sonoma).To the extent I modeled GASB’s changes and Moody’s adjustments correctly and obtained the correct data – if you don’t “like” the results your argument is with GASB and Moody’s – not me. I’m the messenger.

This paper presents a simple model of how pension funding “works” which is what financial statements must report. GASB’s main impacts on statements will be to list Net Pension Liability as real debt for the first time, remove Net Pension Assets related to Pension Obligation Bonds, and make profound changes in how pension expense is reported. Moody’s will also adjust the value of unfunded pension debt, but they won’t recalculate the value of government assets or pension expenses. However, Moody’s will calculate a “benchmark” for payments to Pension Funds – GASB won’t. Dickenson_MoodyFinal_summary GASB’s new rules would have quadrupled Mendocino County’s pension expenses for 2004 through 2011. Instead of a $63 million surplus they would have reported a $115 million deficit. Most governments will report this type of shift. 

This shows the impact GASB’s new rules would have had on the 7 counties’ 2011 Balance Sheets. Over $9 billion of “net assets” would have been written off the Balance Sheets of just these 7 counties. There are over 3000 counties in the US, tens of thousands of cities, school districts, & special districts.

In addition, the year GASB’s new rules are implemented these counties will be forced to report somewhere around $9 billion of past pension expenses in one year.

Moody’s adjustments would produce a Net Pension Liability of $17.5 billion instead of GASB’s $8.3 billion. If that had been reported as the Net Pension Liability these counties collectively would have had negative Net Assets of ($8.3 Billion). Moody’s adjusted annual payments to Pension Funds would have gone from $1.1 billion to $2.4 billion.

C. Moody’s Credit Rating Factors for Local Government General Obligation Bonds

This is quoted from pages 3 & 4 of Moody’s Final Adjustment paper.

The G.O. (General Obligation Bond) rating generally conveys the highest and best security that a state or local government can offer, typically based upon a pledge of its full faith and credit. While local government GO bonds are secured by a pledge to levy property taxes sufficient to pay debt service, the analysis of GO credit quality is not limited to the narrow coverage of debt service by dedicated property taxes. The unconditional nature of this pledge ensures that in most cases all revenue producing powers of the municipality are legally committed to debt repayment. Accordingly, the GO analysis assesses overall financial flexibility and distance to distress, based on a broad evaluation of four rating factors.

Methodological Approach – Rating Factors

Moody’s rating approach for local government GO bonds includes an analysis of four key rating factors and 16 sub-factors: 1.  ECONOMIC STRENGTH

    • Size and growth trend
    • Type of economy
    • Socioeconomic and demographic profile
    • Workforce profile

2.  FINANCIAL STRENGTH

    • Balance sheet/liquidity
    • Operating flexibility
    • Budgetary performance

3.  MANAGEMENT AND GOVERNANCE

    • Financial planning and budgeting
    • Debt management and capital planning
    • Management of economy / tax base
    • Governing structure
    • Disclosure

4.  DEBT PROFILE

    • Debt burden
    • Debt structure and composition
    • Debt management and financial impact/flexibility
    • Other long-term commitments and liabilities

D. Data Sources

Audited financial statements as of 6/30/2011 for these six counties were downloaded and analyzed.

In addition the most recent available Actuarial Valuations were downloaded in early fall, 2012. They are for these counties “County Employees Retirement Associations” – as in “Alameda County Employees Retirement Association”. Dickenson_MoodyFinal_sources There are three kinds of Pension Funds that offer “guaranteed pension benefits” to state and local government employees”

Single Employer Funds – The Pension Fund is for only one government employer. Therefore all the financial balances and activity in the Pension Fund impact that one government.

Then there are two types of “Multi-Employer” Pension Funds in which the Pension Fund provides pension benefits to retirees of more than one governments.

Agent Funds – the Pension Fund maintains its books so that the obligations and balances of each employer government can be specifically identified. Therefore one government may have a lower relative level of unfunded pension obligation than another.

Cost-Sharing Funds – Balances are not maintained for individual governments. As a result unfunded pension obligations are shared among all participating governments even though some governments may have paid a higher portion of its obligations than others. Balances are allocated to individual governments based on the portion of that government’s payments to the Pension Fund relative to all other governments’ payments.

*   *   *

FOOTNOTES

1 – The four Moody’s documents discussed in this paper are available at www.YourPublicMoney.com in the Data/Reports/Video section of the site. The July 2012 document is referred to in this paper and its footnotes as “Moody’s Proposed Adjustments” and the April 2013 document is referred to as “Moody’s Final Adjustments”.

2 – Moody’s Investor Services Proposed Changes in Analyzing Government Pension Finances and Unmasking Staggering Pension Debt & Hidden Expense, both available at www.YourPublicMoney.com. At this point I don’t intend to update those two reports to reflect Moody’s final adopted adjustments. These reports delve into pension funding math and larger issues regarding government unfunded pension debt far more than this current report. One-page summaries are provided in Attachment V.A on page 14 and Attachment V.B on page 15.

3 – Moody’s Final Adjustments, Page 2

4 – Moody’s Final Adjustments, page 2

5 – Moody’s Final Adjustments, page 3

6 – Moody’s Final Adjustments, page 5

7 – Moody’s Final Adjustments, page 8

8 – Data for 2007 through Nov. 2009 from Citibank Pension Liability Index, Harper Daneshhttp://www.harperdanesh.com/system/resources/0000/0049/Citigroup_Index_Rates_with_revised_methodology_Final.pdf. Data from Dec. 2009 through Mar. 2013 from Citigroup Pension Discount Curve and Liability Index (a downloadable excel file), Society of Actuarieshttp://www.soa.org/professional-interests/pension/resources/pen-resources-pension.aspx

9 – The Impact of Moody’s Proposed Changes in Analyzing Government Pension Finances, John G Dickerson, 1/21/13, page 9

10 – Moody’s Final Adjustments, page 5

11 – Page 5, Moody’s Final Adjustments

12 – Moody’s Final Adjustments, pages 10 & 11

13 – Moody’s Final Adjustments, page 2

14 – Both documents are in the “Data/Reports/Video” section of www.YourPublicMoney.com

15 – General Obligation Bonds Issued by US Local Governments, Moody’s Investors Services, 10/29 updated 4/13, page 1

16 – Moody’s produces credit ratings for most but not all these counties.

17 – Interestingly these new rules were published (after a very extensive 5 year development process) a week before Moody’s published their proposed adjustments last July. I’ve produced papers analyzing GASB’s new requirements and comparing GASB’s requirements with Moody’s proposed adjustments. They are available at my website www.YourPublicMoney.com.

18 – See www.YourPublicMoney.com for reports on GASB 68.

19 – As explained in Pension Asset Value – States No Change – Local Governments Change on page 5 Moody’s initial proposal was also to use Market Value of Pension Fund assets for both state and local governments. However, they elected to not use Market Value for local governments; they will use the “smoothed” Value. They stated the data to calculate Market Value wasn’t available for too many local governments. However, when GASB 68 is implemented that value will be calculated for all local governments as well. I assume Moody’s will also shift to Market Value for local governments at that time.

AUTHOR’S NOTES Moody’s Investors Services was not involved in the creation of this paper beyond the publication of its “Request for Comment” described below. Moody’s has not reviewed the results of my model – this paper is solely my responsibility.

This is complex modeling of even more complex data. The Actuarial Valuations of the Pension Funds used for this report are complex – especially that for Contra Costa County (very – very complex!). I’ve tried to be careful – but if you see an error of fact or of analytical technique please let me know. I’ll correct it and apologize if warranted.

I published two earlier papers on Moody’s proposed adjustments.

    • The Impact of Moody’s Proposed Changes in Analyzing Government Pension Finances: Example – Six Independent County Pension Funds and Counties in California (1/21/13)
    • Unmasking Staggering Pension Debt & Hidden Expense: Seven Counties in California (3/13/13)

Both papers included analysis of Moody’s proposed changes and demonstrations of their impact on the financial statements of those counties. The “Unmasking” paper was also based on analysis of new government pension financial reporting requirements approved by the Governmental Accounting Standards Board last summer (“GASB 68”). This current report focuses specifically on the mathematics of Moody’s final adopted adjustments and on comparing them to their earlier proposed adjustments. These two previous reports were much broader in scope, especially the “Unmasking” paper. In addition to analyzing the math I discussed the much broader nature of Pension Fund finances and the very dangerous unfunded pension debt that has developed across the county. I also dove much deeper into the impacts of Moody’s adjustments – both the math and financial implications for these counties. The “Unmasking” paper was more focused on GASB 68’s new pension reporting requirements and the “fatal flaw” in current reporting requirements that allowed today’s huge unfunded pension to develop almost “sight unseen”.

I have not updated those two previous papers to reflect the final adopted Moody’s adjustments – and it’s likely I won’t. Time marches on and other issues demand attention. The “Unmasking” paper is the “more important” of the two, and its analysis of the new GASB reporting requirements remains valid.

Particular thanks go to Mike Sabin of Sunnyvale Pension Reform

(http://www.sunnyvalepensionreform.com/) and Bob Bunnell of Marin County’s Citizens for Sustainable Pension Plans (http://marincountypensions.com/) for their detailed review of my Moody’s Predictor Model.

This paper is copyrighted by John G Dickerson. It may be copied and distributed at will. However, it must not be changed without the express written permission of Dickerson. Quotes from this paper should be attributed to: John G. Dickerson, YourPublicMoney.com.

Calculating California’s Total State and Local Government Debt

SUMMARY:  The total outstanding government debt confronting California’s taxpayers is bigger than is generally known. Earlier this year, when Governor Brown referred to the $27.8 billion in state budgetary borrowings as a “Wall of Debt,” his intention was probably to warn Californians that balancing the state budget was only a first step towards achieving financial sustainability.

This study compiles information on California’s state and local government debt, relying primarily on official reports prepared by the State Controller and State Treasurer. When, along with the $27.8 billion “Wall of Debt,” long-term debt incurred by California’s state, county, and city governments, along with school districts, redevelopment agencies and special districts are totaled, the outstanding balance is $383.0 billion. The officially recognized unfunded liability for California’s public employee retirement benefits – pensions and retirement health care – adds another $265.1 billion. Applying a potentially more realistic 5.5% discount rate to calculate the unfunded pension liability adds an additional $200.3 billion. All of these outstanding debts combined total $848.4 billion. The study also shows that by extrapolating from available data that is either outdated or incomplete, and using a 4.5% discount rate to calculate the unfunded pension liability, the estimated total debt soars to over $1.1 trillion.

The conclusion of this study is (1) the outstanding debt owed by California’s state and local governments, using responsible actuarial assumptions, is almost certainly in excess of $1.0 trillion, and (2) it is surprising that none of our government institutions in California can themselves provide an authoritative estimate of total state and local government debt, updated annually and available to the public.

This study is part of an ongoing CPPC project to provide a more transparent view of California’s state and local government finances. An earlier CPPC study “The California Budget Crisis – Causes and Recommendations, published in December 2012, focused on budget issues and comparisons to other states.

*  *  *

Trillion-dollar-debt-problem

*   *   *

INTRODUCTION

While in theory there is a single number that represents the correct total for all of California’s state and local government debt currently outstanding, in practice it is impossible to calculate this number. Most outstanding government debt in California is incurred locally, in literally thousands of school districts, special districts, redevelopment districts, cities, and counties. The reports from the State Controller that compile the individual annual financial reports from these thousands of entities  are issued fifteen months after their fiscal year ends. Since 2003, the State Controller was no longer responsible for reporting school district debt. We were not able to find any other source for this information.

Starting in 2014, the Government Accounting Standards Board will enforce a new ruling requiring unfunded liabilities for future retirement benefits to be included on government balance sheets as long-term debt. Even without this ruling, these unfunded obligations belong in any complete compilation of government debt. But the actuarial assumptions necessary to determine how much of a future financial obligation should have been already funded today have a huge impact on the calculation. For this reason, in this study we present three sets of assumptions for unfunded pensions, based on the official rate of return currently used by pension funds, 7.5%, along with more conservative rates of return, 5.5% and 4.5%. With respect to government obligations to fund retirement health care benefits, estimating how much should have already been funded today is complicated even further because the obligation is for a defined service, not a defined payment as is the case with pensions. We have provided two estimates to take into account available data, but as will be explained, believe both estimates to be short of what is likely to be an accurate total.

While unfunded retirement obligations are considered government debt and were included in this study, not included are the hundreds of billions in deferred maintenance and upgrades to California’s infrastructure. Nonetheless, to the extent California’s government has not maintained investment in infrastructure maintenance and upgrades to keep up with normal wear and to keep pace with an expanding population, it has passed this cost on to future generations.

What should be apparent as the many categories of government debt are evaluated in this study is that much of it might be characterized as “bad debt.” There are several broad categories of debt as follows:

1. Debt that is an investment in an asset that generates a future income by way of taxes or fees sufficient to pay off the interest and principle on the debt. A toll road or water treatment plant would be an example.

2. Debt that is an investment in an asset such as a new highway or government building that would be used by future taxpayers who are responsible for paying the interest and principle on the debt by way of taxes or fees.

3. Debt and unfunded obligations that is used to cover current expenses but paid for by future taxpayers. This form of debt is essentially deferred taxation and passes a current expense to future taxpayers. Examples of this form of debt are lease obligation bonds, pension obligation bonds, unfunded retirement health care obligations, and unfunded pension benefits.

With some exceptions, we consider the first two of these categories as good debt. The third is bad debt from a taxpayers’ point of view. Borrowing to pay the current portions of payments due to fund future retirement obligations means compounding the payments due going forward.

There are additional questions that remain to be addressed. We have not looked at trends. How much faster has state and local debt grown compared to the state’s economy that has to support the debt? We have not made any attempt to determine if the level of debt is beyond what the state can afford to service or what the impact of future interest rate increases may have on the ability of state and local government entities to service this level of debt in the future.

The remainder of this report will compile outstanding debt by issuer, starting with the state government, followed by K-12 public schools, cities, counties, special districts, and redevelopment agencies. It will then examine, using various assumptions as noted, the unfunded liabilities for retiree health care and pensions.

STATE GOVERNMENT BORROWING

Short and long-term debts incurred directly by the state government total $132.6 billion as depicted on Table 1. In addition to the “Wall of Debt” incurred through budgetary borrowings, there is a $10.9 billion loan balance in California’s unemployment insurance trust fund account, along with $93.9 billion in various types of outstanding state issued bonds. As noted in the footnotes (as numbered in the “ref.” column beside each figure on every table in this report), these figures came from the Governor’s Budget Summary, the U.S. Dept. of Labor, and the State of California Debt Affordability Report of Oct. 2012. For all debt figures reported in this study, the reader may click on the footnote links. For verification, in the Footnotes section, not only are the direct links provided to the source documents, but a description of the exact page and table where every debt figure is located.

Total_CA_Debt_2012_T-1


K-12 PUBLIC SCHOOL BORROWING

The currently outstanding long-term debt incurred by K-12 public school districts in California is not easily compiled. Every year, for California’s cities, counties, redevelopment agencies, and special districts (as summarized on Tables 3, 4, and 5), the State Controller publishes an annual financial report. In each of these financial reports the consolidated outstanding long-term debt for all of these entities is disclosed. But as confirmed by the State Controller’s office, they have not produced an annual report for K-12 public school districts since 2003, for the fiscal year ended 12-31-2000 (School Districts Annual Report, FYE 6-30-2000).

Because the available consolidated data for K-12 public school district debt comes from a State Controller’s annual report that is twelve years old, we are reporting on Table 2 outstanding debt through 12-31-2000 of $13.4 billion, but we had to turn to other sources to develop a current estimate. The California Debt and Investment Advisory Commission (CDIAC) compiles data on bond issues by state and local government entities, but their reports do not differentiate between new issues of bonds and refinancing of existing bonds outstanding. CDIAC did provide us a spreadsheet (download CDIAC bond data and analysis – 6.9MB) showing all bonds issued between January 1, 2000 and December 31, 2012.

A review of the CDIAC data shows that during the thirteen years through the end of 2012, the state and local government entities in California issued 22,738 bonds, totaling $897.1 billion. Our analysis of this data indicates that of that gross total, $641.8 billion was classified as “New Money/New Debt,” and of that total, $442.1 billion had a cancellation date after December 31, 2012. While this could suggest that this entire sum is outstanding, it is possible that many of these bonds were refinanced prior to their maturity dates. As shown on the CDIAC spreadsheet, the total K-12 School District bonds issued between 2000 and the end of 2012, with a post-2012 maturity date, totaled $58.5 billion. To estimate how much of the pre-2000 $13.4 billion and post-2000 $58.5 billion is still outstanding, we took into account the ratio between the total reported debt outstanding as of 12-31-2012, $305.4B, and the total new bond financing since 2000 that had post-2012 maturity dates, $442 billion. It is reasonable to assume this ratio, 69.1%, represents the amount of of new bond issues since 2000, with post-2012 maturity dates, that have not been refinanced. By applying the ratio of 69.1% to the sum of the original $13.4 billion in bonds and the 58.5 of bonds issued since 2000 (69.1% x $71.9 billion), we estimate $49.7 billion as the total bond debt currently outstanding for K-12 Public School Districts.

Total_CA_Debt_2012_T-2(est)
CITY GOVERNMENT BORROWING

Long-term debt outstanding for California’s city governments totaled $68.1 billion according to the State Controller’s “Cities Annual Report” released in September of 2012. It is important to note that even though, unlike for K-12 School Districts, the California State Controller is releasing annual reports for cities, counties, special districts and redevelopment districts every year, this doesn’t mean the data is up-to-date. The release dates of these annual financial compilations lag the fiscal year ends by 15 months, meaning these September 2012 annual reports refer to fiscal years ending 6-30-2011. For all practical purposes, all of the information on long-term debt seen here is about two years old. One only need consider what the collective deficits – and resultant debt issues – have been in California during the past two years to understand the implications of using data from June 2011 in these estimates. Everything we’re presenting is undoubtedly understated.

Another relevant observation with respect to city and county data is that a significant portion of their long-term indebtedness is for lease obligations; for cities this total is $25.5 billion, and for counties it is $10.1 billion. To the extent these totals reflect the increasingly prevalent practice of selling government assets to meet current obligations and leasing them back in order to raise cash to cover current operating deficits, it shows just how much debt can result from this short-term fix. Ongoing payments on these leases increases the level of nondiscretionary, fixed expenses that will challenge city and county budgets for years to come.

Total_CA_Debt_2012_T-3
COUNTY GOVERNMENT BORROWING

Long-term debt outstanding for California’s county governments totaled $22.1 billion according to the State Controller’s most recent annual report (Counties Annual Report), which, as noted, provides balances as of the fiscal year ended 6-30-2011. One noteworthy feature of county government debt is the significant portion of debt represented by pension obligation bonds, $6.3 billion. A pension obligation bond is issued when a city or county doesn’t have sufficient cash on hand to make their annual pension fund contribution. In some respects, these pension obligation bonds should be considered as part of California’s overall unfunded pension liability, since they represent additional debt incurred to lower the unfunded balance.

Total_CA_Debt_2012_T-4
REDEVELOPMENT AGENCIES AND SPECIAL DISTRICTS BORROWING

Just as any examination of California’s government debt cannot be complete unless the local government debt incurred by cities and counties and school districts are included, there are also significant state/local government assessments, expenditures and borrowing done by redevelopment agencies and “special districts.” Table 5, using data that also relies on the State Controller’s most recent annual reports (Community Redevelopment Agencies Annual Report, and Special Districts Annual Report, FYE 6-30-2011), show just how much money is owed by these entities. As of 6-30-2011, $29.8 billion was owed by California’s redevelopment agencies, and California’s many special districts owed another $80.6 billion.

As of the date this report is published, it’s not certain where the redevelopment debts will show up in the future. Redevelopment agencies have been dissolved and their outstanding debts are in the process of being transferred to other government agencies. In February 2012 425 Redevelopment Agencies were abolished and will be replaced by about 400 successor agencies responsible for paying off remaining debts.

It should be noted that the interest and principal repayments for revenue bonds are funded by the revenue from whatever specific project the proceeds were used to finance. Similarly, a “certificate of participation” is defined as “a type of financing where an investor purchases a share of the lease revenues [to fund current expenses] of a program rather than the bond being secured by those revenues.” California’s special districts as of 6-30-2013 owe $51.4 billion in revenue bonds outstanding, and $16.3 billion in certificates of participation. The question to ask is whether or not revenues from new or upgraded municipal assets are being assigned to these financing instruments in cases where in the past these assets were constructed and financed without pledging their earnings to the investors. To the extent a nontraditional levy on revenue is attached to a civic asset, the government loses revenues from that asset in the future that used to be part of their income stream. The growing practice of attaching revenues from municipal assets to investor claims, like that of selling civic assets and leasing them back, are short term solutions that in the long run take revenue that will be needed to pay for future government services.  These claims on future government income will have to be made up through higher taxes and fees or cuts in services.

Total_CA_Debt_2012_T-5(s)


UNFUNDED STATE AND LOCAL GOVERNMENT RETIREMENT OBLIGATIONS

If this analysis ended here, the total long-term debt owed by California’s state and local government entities would total $383.0 billion (including $27.8 billion in state budgetary borrowings which is arguably short-term debt). But unfunded retirement obligations are considered long-term debt by any reasonable accounting standard. In fact, as explored in a March 2013 study published by the CPPC entitled “How New Rules from Moody’s and GASB Affect the Financial Reporting of Pensions in Seven California Counties,” for fiscal years beginning 7-01-2013 and beyond, government entities will be required to report the underfunding of their pensions and retirement health care obligations as long-term debt on their balance sheets. The principle behind this is clear: retirement benefits are earned during the years an employee works. To the extent the pension fund assets do not equal the present value of this future liability, a debt is created.

Even without the recent GASB ruling, whether or not an unfunded pension liability constitutes long-term debt is no longer a topic of serious debate. Controversy rages, however, over just how much this unfunded liability should be worth. Calculating the level of underfunding is greatly affected by how much the pension fund projects it will earn each year on its investments. Most pension funds in California currently use a rate of return between 7.0% and 7.9%. If these rate-of-return projections are lowered, the assets in the fund will not appreciate at the same rate, and in turn either the annual contributions must be increased or the estimated amount of underfunding will be increased.

Taking all this into account, the California State Controller issues a “Public Retirement Systems Annual Report” every March. The most recent available is from March 2012, reporting on actuarial data submitted by the more than eighty state and local government employee pension funds for the fiscal year ended 6-30-2010 (their actuarial data lags their financial reporting by one year because of the time required to perform the analyses). The figures in the top portion of Table 6 for pensions, “Officially Recognized Underfunding,” are produced by the State Controller and may be considered the minimum estimates. They are based on a discount rate, or projected rate of return for these funds, which in 2010 averaged about 7.5%. According to the State Controller’s most recent annual report, the officially recognized amount of pension plan underfunding is $128.3 billion.

The middle section of Table 6 presents the additional amount that would be added to the unfunded pension liability for California’s state and local government workers if the rate of return projected for the fund were to drop from 7.5% to 5.5%. The rate of 5.5% is not selected at random, it is based on a July 2012 announcement by Moody’s Investor Services, the largest bond credit rating agency, that they intend to begin discounting future pension fund liabilities to present value at a rate of 5.5% when doing their credit evaluations for government entities. Moody’s based the 5.5% figure on the yields from high-grade corporate bonds, which are considered of moderate risk. When a stream of future payments is discounted to today’s present value at a rate of 5.5% instead of 7.5%, they necessarily become much larger numbers. Again, since the calculation of an unfunded liability is based on the value of the current fund assets, less the present value of the fund’s future liabilities, the larger the present value estimate is for that liability, the greater amount by which the value of that liability will be likely to exceed the value of the assets in the fund.

Using the 5.5% discount rate more than doubles the projected unfunded pension liability, adding another $200.3 billion to the estimate. This increase illustrates just how sensitive pension funding is to the assumptions made regarding the long term rate of return. How this amount is derived is explored in depth in the March 2013 CPPC study entitled “How Lower Earnings Will Impact California’s Total Unfunded Pension Liability.” Without discussing the mechanics of that calculation here, since the reader may refer to the March 2013 study where it is thoroughly documented, the methods used were precisely those specified by Moody’s in their July 2012 Request for Comment, and the variables used were those reported by the State Controller in the most recent Annual Report of State Retirement Systems.

The lower section of Table 6 references what is, to-date, the most nebulous of all long-term liabilities confronting California’s state and local governments, their obligations to provide health insurance benefits to their employees when they retire. Calculating the level of underfunding for retirement health care obligations uses very similar financial methods as pension obligations, with one additional complicating variable. As noted, a retirement pension is considered underfunded to the extent the present value of the future liability exceeds the current value of the fund’s invested assets. But with pensions, the future liability is based on actuarial considerations such as life expectancy and expected retirement dates, along with work history and expected final salaries (or final few years of salary, averaged) upon which to apply the pension formula. Pension liability calculations also take into account economic assumptions such as expected rates of inflation which impact the amount of future cost-of-living adjustments. These pension liability estimates are aggregated for the entire pool of participants and are refined into an actual dollar amount. With retirement health care obligations, however, it isn’t a defined financial benefit that must be quantified for all participants, but rather a defined service benefit. Nobody knows how much health care premiums are going to cost in ten, twenty, thirty years. Making an assumption for this additional necessary variable complicates projections. It should be noted that current California state employees can qualify for 50% of the maximum retirement health benefits after 10 years of employment, and 100% after 20 years. At the city and county level, in many cases, these retirement health benefits are 100% vested after even shorter periods of employment.

A few more observations are necessary to explain the estimated state and local government debt for underfunded future health care obligations to their employees. First, perhaps because of the additional complexity of these calculations, the discount rate used is typically not as aggressive as that used by the pension funds. This increases the amount of the officially estimated liability, and lowers the probability that it is understated. Second, unlike pension funds, which are actively managed with (just in California) about $600 billion in invested assets according to the State Controller’s data from 6-30-2010, almost no money has been set aside so far to fund future healthcare obligations to retirees. Third, acquiring the data to estimate the aggregate state and local retiree healthcare underfunding is not easy. The most authoritative source we found was a report by the State Budget Crisis Task Force, issued in 2012, that estimated California’s total underfunding to be $136.9 billion. Because the analysts claimed they were not able to acquire data from all of the state and local government entities who have made these commitments, this is undoubtedly a minimum estimate.

Total_CA_Debt_2012_T-6(s)
CALIFORNIA’S TOTAL STATE AND LOCAL GOVERNMENT DEBT

As should be evident, it is impossible to precisely calculate California’s total state and local government debt. Table 7 shows a summary of the data, but every one of those numbers should be questioned. Our approach was to use totals that were, if anything, underestimating the actual obligations. Here are factors that should be considered for each of these estimates:

All of the data from the State Controller’s Annual Reports – our primary source for K-12, City, County, Redevelopment Agency, and Special District borrowing – is nearly two years old. The reader may consider which scenario is most likely: That in the period since 6-30-2011 these entities have operated with significant budget surpluses and have reduced this debt, or during that period these entities have logged another two years of fiscal year deficits and have increased the amount of their outstanding debt?

When producing data for direct state government debt, we included short-term borrowing. This data was not readily accessible for the other entities, which in aggregate report long-term debt of $250.3 billion compared to direct state long-term debt of $104.8 billion. Simply pro-rating the $27.8 billion of state short-term borrowing according to the 2.4x greater local long-term debt compared to state long-term debt yields an estimated additional 66.4 billion in short-term debt outstanding for California’s K-12 school districts, cities, counties, redevelopment agencies and special districts.

On Table 6 we show an estimated $328.6 billion in unfunded retirement obligations for pensions, broken out as follows: $95.6 billion for state employees, $21.1 billion for county employees, $10.1 billion for city employees, $1.1 billion for special district employees, along with an additional $200.3 billion in underfunded pensions based on applying a 5.5% discount rate.

But what if the 5.5% pension fund rate of return prediction is actually too high?

A major issue is what will the pension fund rate of return be over the next 20 or 30 years, 7.5% per year, 5.5% per year or something else? The authors’ opinion favors a lower return estimate. The economic landscape that generated an historic 7.5% average rate of return for these funds has been seismically altered. Interest rates are at historically low levels because of actions by the U.S. Federal Reserve and other central banks. This reduces pension fund interest income near-term and could lead to losses on bond portfolios when interest rates eventually return to normal. The world economies are likely to grow more slowly due to aging populations, growing government debt, and higher taxes. As the population ages, there will be fewer workers to support each retiree so that taxes are likely to increase which should lower the growth of all the major world economies. With the aging populations, retirees and pension funds will become net sellers of financial assets which may reduce equity returns which would also be depressed if the world’s economies grow more slowly than in the past.

This raises an important issue. Future taxpayers, not the retirees, bear all the risk of a shortfall in pension fund returns. As currently structured, any pension underfunding has to be made up be increased pension fund contributions by state and local government organizations, not the employees. This gives the employees and their unions a big incentive to use optimistic assumptions since they have nothing to loose if actual returns are less.

Can public employee pension funds in the U.S., which now have over $3.0 trillion of invested assets, possibly avoid skewing the market when suddenly they become net sellers instead of net buyers? More generous pension formulas were only introduced in the last 10-15 years, meaning that as these people enter the retirement pool, these massive pension funds will have to start paying out as much or more in pension benefits to retirees as they are taking in pension contributions from active workers.

What about the fact that America’s citizens over 65 years old will double, from 11% of the population in 1980 to 22% of the population by 2030? Won’t this mean that twice as many people – as a percent of the U.S. population – will be selling their assets to finance their retirement, instead of buying assets in order to save for retirement? Won’t this also put downwards pressure on investment assets? What about the debt binge that has seen total market debt (public and private) as a percent of GDP nearly triple in the last 40 years, to over 350% of GDP?

Can future rates of economic growth, which fuels the rate of price appreciation for invested assets, maintain the pace it logged in the past when net borrowing was increasing – pushing cash into the economy – now that net borrowing has reached its limit and is now declinging as companies, banks and individuals take actions to reduce their debt burdens?

As referenced in our February 2013 CPPC study on the connection between rates of return and the level of unfunded returns for pensions in California, if the sustainable rate of return for these funds lowered to 4.5% per year, which is not all that unlikely, the total unfunded pension debt would increase as follows: $128 billion at 7.5% (official), $329 billion at 5.5% (Moody’s), and $450 billion at 4.5%. These findings are consistent, if not somewhat lower, than the numbers reported in a definitive study from December 2011, Pension Math: How California’s Retirement Spending is Squeezing The State Budget, conducted by a Stanford University team led by economist and former Democratic state assemblyman Joe Nation. In that study, they estimated that even a 4.5% rate of return was only about 80.9% likely to be achieved by the pension funds (compared to a dismal 50.7% probability of achieving a 7.1% rate of return), and that at a 4.5% rate of return, these funds in aggregate would be less than 50% funded. A 4.5% rate of return assumption for pension funds adds $121 billion to the unfunded liability.

Finally, what about the unfunded liabilities for retirement health care for California’s nearly 1.5 million state and local government workers? On Table 7, $136.9 billion of the officially recognized total of $265.1 billion for future retirement obligations is for health care. And as noted, this is using incomplete data. Instead of setting aside and investing assets when the employees are working, assets that can eventually be used to pay these healthcare premiums, most of California’s state and local government agencies are engaging in a pay-as-you go funding. And as the costs for healthcare have escalated at rates far exceeding the rate of inflation for decades, this liability has grown proportionally. How much might really be owed? Estimating the true value of the unfunded healthcare liability is well beyond the scope of this analysis, but it would be conservative to assume the official number could be increased by 50%, or by another $68.5 billion.

Total_CA_Debt_2012_T-7(total-s)
CONCLUSION

To our knowledge, there is no source of previously compiled data that attempts to estimate California’s total outstanding state and local government debt. The amount we calculated as summarized on Table 7 we consider to be an absolute best case, $848.4 billion. Here are what we consider reasonable estimates of how much more may actually be owed as of the end of this fiscal year – June 30, 2013:

Adjusting for deficits incurred since 6-30-2011: The fact that the State Controller’s data for K-12 schools, cities, counties, special districts and redevelopment agencies is two years old suggests the reported $250.3 billion would have increased. In our December 2012 CPPC study “The California Budget Crisis – Causes and Recommendations,” we estimated the combined budget for these entities to be $218.9 billion per year (Chart 2). If we assume these entities have all incurred 5% budget deficits over the past two years which have translated themselves into long-term instruments such as pension obligation bonds, capital appreciation bonds, revenue bonds, special assessment bonds, etc., add $21.9 billion.

Accounting for local government short-term loans: Short-term borrowing is typically rolled over from year to year, representing outstanding payables that are not necessarily converted into long-term debt. As noted already, if one merely applies the ratio of short-term to long-term debt that applies at the state level to the local entities, this would yield an estimated additional $66.4 billion in debt.

Making realistic assumptions with respect to funding retirement benefits: If pension funds only earn 4.5% instead of 5.5% – not unlikely in our debt saturated economy and aging society – add another $121 billion to the unfunded liability. And it is probably an underestimate to merely increase our projected unfunded retirement health coverage liability by 50%. Adding another $68.5 billion is conservative.

Based on our investigation, the reported $848.4 billion in total state and local government debt in California is a low estimate. Adding $21.9 billion in new long-term debt incurred by K-12 schools, cities, counties, special districts and redevelopment agencies over the past two years, $66.4 billion in rolling short-term debt accruing to these same entities, $121 billion in additional unfunded pension liabilities based on a 4.5% discount rate, and $68.5 billion in additional liabilities for future retirement healthcare, and that $848.4 billion swells to a whopping $1.13 trillion. That’s about $30,000 each for every resident of the Golden State; over $80,000 per household.

Total_CA_Debt_2012_T-8(addl)

It is important to reiterate that compiling these numbers with absolute accuracy is nearly impossible with currently available data. It should be of concern to any citizen in California that not one entity in state government is officially tasked with consolidating the data on California’s total state and local government debt. Experts on this topic are invited to present their own data, or explain why any reasonable analysis of what we have uncovered here would contradict the following statement: California’s state and local government entities, combined, now owe over $1.0 trillion in outstanding debt.

*   *   *

Footnotes (ref.):

1  –  Governor’s Budget Summary-2013-14, January 2013, Introduction, Page 7, Figure INT-03

2  –  National Conference of State Legislatures (NCSL), January 2013, Unemployment Insurance: State Trust Fund Loans

3  –  California Treasurer’s Debt Affordability Report, October 2012, page 7, Figure 9

4  –  School Districts Annual Report, FYE 6-30-2000, page vii, Figure 6

5  –  CPPC Analysis of CA Debt & Advisory Commission Data, April 2013, Table 2 (6.9 MB)

6  –  Cities Annual Report, FYE 6-30-2011, page xxix, Figure 24

7  –  Cities Annual Report, FYE 6-30-2011, page xxix, “Long-Term Indebtedness – Other Special Debt”

8  –  Cities Annual Report, FYE 6-30-2011, page xxx, Figure 25

9  –  Cities Annual Report, FYE 6-30-2011, page xxxi, Figure 26

10  –  Counties Annual Report, FYE 6-30-2011, page 249, Table 6

11  –  Community Redevelopment Agencies Annual Report, May 2012, Introduction, page i

12  –  Special Districts Annual Report, FYE 6-30-2011, page ix, Figure 6

13  –  State Controller Public Retirement Systems Annual Report, FYE 6-30-2010 (rel. 3-30-2012), page xv, Figure 2

14  –  Governor’s Budget Summary-2013-14 dated January 2013, Introduction, page 7, Figure INT-04

15  –  CPPC Study “How Lower Earnings Will Impact CA’s Total Unfunded Pension Liability,” Feb. 2013, 2nd Chart

16  –  Report of the State Budget Crisis Task Force, July 2012, page 44, Table 13

About the Authors:

William Fletcher is an experienced 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.

Ed Ring is the research director for the California Policy Center and the editor of UnionWatch.org. Before joining the CPPC, he worked in finance and media, primarily for start-up companies in the Silicon Valley. As a consultant and full-time employee for private companies, Ring has done financial modeling and financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

Irvine, California – City Employee Compensation Analysis

April 8, 2013

INTRODUCTION

When the issue of public sector compensation is discussed, it is vital for participants to fully understand the concept of total compensation. Because the “wages” paid directly to a worker are only part of what they earn. Any costs for any direct benefits enjoyed by an employee that are paid for by the employer are part of that worker’s total compensation, and this amount is the only truly meaningful measurement that can be used when comparing rates of pay in the public sector to rates of pay in the private sector.

To make this completely clear, consider the difference between “wages” and total compensation for someone who works as an independent contractor. There is no difference. If a self-employed person earns $50,000 per year from their clients, then their “wages,” and their total compensation are both the same amount, $50,000. From these earnings they must themselves pay both the 6.25% due Social Security as an employee, as well as the 6.25% due Social Security as an employer – since they are “self-employed.” From these earnings, similarly, they must pay both the employer and employee’s required contributions to medicare. They must purchase their own health insurance, disability insurance, life insurance, etc., and of course, they must make contributions to any private retirement savings account they may have. All of this comes out of their $50,000 of total compensation.

To underscore this distinction, and to raise public awareness as to just how much local government employees are really earning per year, the California Policy Center has already published in-depth total compensation studies for three California cities, San Jose, Anaheim, and Costa Mesa. These studies use data provided directly to the CPPC by the payroll departments of those cities. They are offered in clarification to the data available on the California State Controller’s “Government Compensation in California” website, which summarizes compensation data submitted by cities and counties based not only on just wages (instead of total compensation), but also averaged to include in the denominator all part-time employees. This creates the impression that California’s state and local government workers earn dramatically less than they actually are paid, and unfortunately, these misleading statistics find their way into press releases and news reports.

METHODS

The following study will analyse the total compensation paid to full-time employees of Irvine, using detailed payroll data provided by the city. Before beginning, here is a screen shot of what California’s State Controller presents as the “average wages” for a worker employed by the city of Irvine:

Irvine_State-Controller_avg-wage

The methods employed in this study mirror those used in the three prior studies. The format in which we analyze and report the data also closely follows that of the earlier studies. The source data was a spreadsheet showing compensation by category for every employee in Irvine. The original spreadsheet, along with tabs that have been added to perform the necessary analysis, can be downloaded and reviewed by clicking on this link: Irvine_Total_Employee_Cost_2012.xlsx

To facilitate verification that we have not altered the data in any way, the original spreadsheet provided is retained on the tabs designated “(original KEY)” and “(original) DATA.”

The goal of this study is to report average and median annual income for Irvine’s full time city employees by department. Here is a summary of the key assumptions:

  • In order to develop representative averages, employees who retired or were terminated during the calendar year were not considered in the calculation.
  • Similarly, employees who were classified as part-time were not included in the calculation. This included city council members and their assistants, recreation staff, and other interns and part-time employees. The first three columns added on the “analysis” and “median” tabs of the spreadsheet clearly indicate which employees were excluded from the calculations based on these criteria.

As an examination of the original data will reveal, the city of Irvine provided unambiguous data that made the status of every employer very clear – part-time vs. full-time, employed the entire year vs. hired or retired/terminated during the year – so virtually no interpretation of the data was necessary to remove these records from the calculations of average and median total compensation for full time, full year employees.

RESULTS

Table #1 provides a summary by department of both the number of employees in each department and their average pay. As can be readily ascertained, the average base pay is highest, at $83,013 per year, for the 394 full time general (apart from Public Safety, Irvine’s “rest-of-workforce” employees fall into six departments; Administrative Services, Community Development, City Manager, Community Services, Orange County Great Park, and Public Works) employees, closely followed, at $82,970 per year, by the 265 full time police officers. but base pay doesn’t tell the whole story, because Irvine pays a significant percentage of its compensation before benefits in the form of other direct pay, which not only includes overtime, but also “credential” pay “special assignment” pay, “management” pay, and “select benefit” pay.

It is clear from reviewing Table #1 that “Base Pay” would be a highly misleading number to report as representative, even for current year earnings. Because as can be seen, the current pay earned in 2012, when base pay and “other pay” are combined, averaged $95,088 for Irvine’s police officers, and $87,409 for the 394 full time employees comprising the rest of their workforce. When you include overtime to calculate the average for all three categories of direct pay, Irvine’s full time police officers earned an average of $106,779 in 2012, and the rest of the workforce earned an average of $88,335. But no analysis of an employee’s true earnings is complete without taking into account the employer paid costs for their current health benefits, as well as the employer paid current year costs to fund their retirement benefits.

When the cost of benefits are included, as can be seen, the average total compensation in 2012 for Irvine’s police officers was $168,336, and for the rest of the workforce it was $127,115. When the payroll records for employees of all departments are consolidated, the average total compensation for an employee of the city of Irvine in 2012 was $143,691.

Irvine#1

Table #2 compares average to median total compensation for employees of the city of Irvine. This comparison is important because an average, which merely divides the payroll for an entire department by the number of employees working in that department, can potentially be skewed upwards due to the presence of a small and unrepresentative handful of highly compensated managers. To determine whether or not this is the case in Irvine, we calculated the median total compensation for the police department employees, as well as for all other employees. Because a properly calculated median compensation amount must have an equal number of individuals making more than the median as those making less than the median, when the median is significantly less than the average, you may infer that the average is unrepresentative of the typical employee.

As it turns out, however, in Irvine the average total compensation for police is actually less than the median by 2%, and for the rest of the workforce, the average total compensation only exceeds the median total compensation by 6%. Clearly the average total compensation figures developed in this analysis are not being skewed by the presence of highly compensated members of city management.

Irvine#2

Table #3 examines Irvine’s base pay averages compared to U.S. Census figures reporting average base pay for employees of local governments in California in 2011 (the most recent year of data available, ref. CA Local Government Payroll 2011). As can be seen, Irvine’s employees enjoy rates of base pay that significantly exceed the reported averages for local government employees in California.

There are several possible reasons for this, but primary among them is the probability that “other pay” and other categories of direct compensation are not reported to the U.S. Census Bureau as base pay. Irvine’s police, for example, during 2012 on average received “credential pay” of $,7428, “special assignment pay” of $1,466, and other categories of direct pay of $3,224. In addition, the average overtime pay for Irvine’s police during 2012 was $11,690. Another reason for the significant difference for the disparity in average individual pay for the entire workforce is because U.S. Census data shows a much lower percentage of police working for local governments in California in general compared to Irvine in particular. This is mostly because local data includes county governments which have a far higher percentage of social service employees and healthcare workers, as well as large cities which often include very large percentages of utility workers. Since, in general, police receive greater average compensation than all other employees, this also pulls Irvine’s averages up.

What appears unlikely as an explanation for this disparity, however, is that Irvine actually has unusually high rates of pay for their city employees compared to other cities in California, as indicated by our recently published analyses of Costa Mesa, San Jose and Anaheim’s payroll and our examination of payroll for several other California cities and counties.

Irvine#3
Table #4 shows how total compensation breaks down between base pay and direct overhead, which must be included in any calculation of how much an employee actually makes. Direct overhead refers to all benefits enjoyed by the employee that are paid for by the employer, including insurance premiums, payments to fund future retirement pensions and retirement health benefits, and any other employer paid benefits, such as accrued vacation reimbursement, accrued sick leave reimbursement, tuition reimbursement, housing allowance, uniform allowance, car allowance, etc.

The idea that total compensation, including benefits, must be what one uses when comparing public sector rates of pay to private sector rates of pay should be beyond serious debate. To reiterate; as any self-employed individual understands all too well, the difference in their case between total compensation and base pay is zero. Any benefits they enjoy, they pay for themselves.

To better understand the relationship between base pay and total compensation, Table #4 calculates payroll overhead as a percent of base pay, by treating the total employer paid benefits as the numerator, and base pay as the denominator. As can be seen, the overhead, i.e., the employer paid benefits as a percent of base pay, for employees of the city of Irvine, varies between 44% and 58%. As the next table will demonstrate, this significantly exceeds the rate of payroll overhead paid under even the most generous plans available in the private sector.

Irvine#4
Table #5 calculates what the total compensation would be for the average private sector worker in Irvine, using two exceedingly generous assumptions: (1) Base pay is assumed to be the average household income for Costa Mesa (ref. City-Data.com, Irvine), and, (2) payroll overhead is assumed to comprise the best set of employer provided benefits available anywhere. Since more than one wage earner occupies the typical household, and since only about 20% of all employers (if that), offer benefits this rich, we are clearly overstating how much the private sector worker in Irvine actually makes. And yet, even using these absurdly generous assumptions, the total compensation for the average employee working for the city of Irvine exceeds that of a private sector household in Irvine by 40%, nearly half-again as much.

Irvine#5

No discussion of public sector employee total compensation is complete without a mention of pension benefits, which must be pre-funded during the years an employee works. Currently the city of Irvine pays 17.5% of their total compensation budget into pension funds. Put another way, as a percent of direct pay, Irvine contributes 26.3% into pension funds, and as a percent of direct pay not including overtime, Irvine contributes 27.8% into pension funds. But this level of funding may not be nearly enough. As we prove in our study “A Pension Analysis Tool for Everyone,” which includes a downloadable Pension Analysis Model, for every 1.0% that a pension fund’s long-term rate of return goes down, the annual contribution to the pension fund must go up by 10% of base pay. Because the pensions are currently underfunded, and because pension benefits are being accrued or paid out to employees who are about to retire or have already retired, this rough estimate of how much more payments will rise per each 1.0% drop in returns is definitely on the low side.

To refrain a passage from our recent studies of other city payrolls, to properly assess how much Irvine’s city employees really make in total compensation, one needs to rebuke the preposterous notion that pension funds will reliably earn 7.5% per year for the next several decades, and instead assume they will only earn somewhere between 3.0% and 5.0% per year. CalPERS themselves discount pension liabilities at a rate of 3.8% for any participant who wants to opt out of their program, a telling indication of what they consider the “risk free” rate of return. At a 3.8% rate of return, you would have to increase the average total compensation for the typical employee of the city of Irvine from the current $143,691 per year to around $175,000 per year.

It is important to emphasize that the employment packages Irvine has awarded their unionized city workforce are not unique. In much larger cities, San Jose and Anaheim, analysis of original and comprehensive payroll data has yielded very similar results:

San Jose: Average total compensation, all workers = $149,907
Anaheim: Average total compensation, all workers = $146,551
Costa Mesa: Average total compensation, all workers = $146,863

CONCLUSION

Workers employed by local governments in California are earning total compensation that averages about $150,000 per year. And this is without taking into account the looming impact of lower earnings forecasts from the pension funds, nor does it take into account the huge unfunded liability these local governments carry for future retirement healthcare obligations they have granted their employees.

Journalists who dutifully report “base pay” rates for city workers that sound somewhat high, but not ridiculously unreasonable, are ignoring glaring facts about compensation: (1) “Other pay” now adds more than 50% to the current earnings of many city workers, and (2) The only honest measure of how much someone earns is their total compensation, i.e., everything the employer pays each year in direct pay and benefits for an employee. That is the number that should be compared to what taxpayers themselves earn.

It is impossible to overstate the importance for journalists to examine total compensation rather than just “wages” when reporting on how much government workers are actually costing taxpayers, and whether or not their rates of pay can be justified when compared to what private sector workers. Another compelling example of how misleading the statistics being promulgated by California’s state controller, and parroted by journalists as fact, relates to the “amount spent on total wages per resident,” as it appears on the state controller’s summary information regarding Irvine. The amount, $337 per resident, appears indeed modest. But the true amount is many times that amount. Here’s why:

If you include all compensation, and not just wages, the $111.2 million divided by 219,156 residents equates to $507 per resident. Since Irvine uses county services for their firefighters, and since firefighter payroll consumes about 20% of a typical municipal payroll (19.8% in San Jose, 18.6% in Anaheim, and 25.4% in Costa Mesa), a more accurate estimated per capita cost for city services must be elevated to $634 to include firefighters. And since, according to CityData.com, there are 2.6 persons on average per household, this number must increase to $1,649 per household. Every household in Irvine, on average, pays $1,649 to pay total compensation for city employees. And unless either (1) the Dow Jones average goes up to 30,000 within the next ten years – and keeps going, or (2) rates of retirement benefits for existing workers and retirees are renegotiated downwards, add 20% or more to that amount to ensure that pensions and retirement health benefits remain solvent for Irvine’s city employees.

It is left to each individual taxpayer to decide if city employees in Irvine should earn total compensation that averages $143,691 per year (median total compensation of $133,782), or whether or not those levels of total compensation should be increased by 20% or more if pension funds and retirement health care obligations continue to encounter financial challenges. Similarly, it is left to each individual taxpayer to decide if a financial burden of $1,649 per household, or more as noted, is an appropriate level of taxation to pay for the total compensation currently enjoyed by Irvine’s city employees, particularly when one must add to this their per household share of the costs for similarly compensated Orange County employees, California state employees, and Federal employees. What is less debatable, however, is the obligation of journalists and politicians to overcome their innumeracy and report to their readers and constituents, frequently, complete and accurate total compensation statistics for California’s full-time state and local government employees. They are relevant, if not central, to any report or discussion of public sector finance.

*   *   *

About the Author: Ed Ring is the research director for the California Policy Center. Before joining the CPPC, he worked in finance and media, primarily for start-up companies in the Silicon Valley. As a consultant and full-time employee for private companies, Ring has done financial modeling and financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

The California Policy Center produces studies designed to provide quantitative, top-down financial information and analysis of California’s state and local government finances, including reports on total state and local government revenue and expenses, as well as total state and local government debt. Related areas of focus include reports on the solvency of public sector pension plans and public employee total compensation. The CPPC also produces studies designed to explore the challenges and opportunities – both financial and operational – facing public education, public safety, government services, and public infrastructure projects. Other areas of focus include campaign finance and the impact of influential participants including corporate interests and public sector unions. CPPC studies are calibrated to offer more depth than a typical investigative report in a newspaper, while remaining as concise as possible in order to provide a useful, accessible reference for readers who may not be specialists in these areas.

How Lower Earnings Will Impact California's Total Unfunded Pension Liability

By Ed Ring, February 18, 2013

SUMMARY:  This study describes how actuaries calculate two key variables that govern pension solvency; the plan’s “accrued actuarial liability,” defined as the present value of all future obligations to pay pensions, and the plan’s “actuarial value of assets,” defined as the current value – adjusted upwards or downwards to account for market volatility – of the plan’s invested funds. The amount of the unfunded liability is the amount by which any pension plan’s liabilities exceed their assets. This study then calculates the impact of new credit evaluation standards, proposed by Moody’s Investor Services to take effect in 2014, on the calculation of a pension plan’s liability. Using the most recent data that consolidates all state and local pension plans in California, provided by the California State Controller’s Office, this study revalues the accrued actuarial liability according to Moody’s new criteria. The calculations reveal that the unfunded pension liability for all of California’s state and local government pension plans combined increases from the official estimate of $128.3 billion, to $328.6 billion using Moody’s new criteria. Included with this study are downloadable spreadsheets that allow the reader to conduct their own analysis using their own assumptions.

*   *   *

When assessing just how much debt California’s taxpayers owe their government, it is misleading to suggest that all future obligations represent current debt. After all, future tax revenues will be available to pay future obligations. But to the extent money should be set aside today to fund future obligations, and has not been, by any reasonable accounting standard, this funding shortfall is considered debt.

This principle is particularly applicable to retirement pensions, which must be funded with money set aside during each year a beneficiary is working. A retirement pension fund accumulates money that is set aside during the entire term of a beneficiary’s career, the money is invested and the returns are added to the fund. If all goes according to plan, by the time the beneficiary retires, sufficient funds (which continue to earn interest) are on hand to pay the expected pension for the duration of the beneficiary’s expected lifespan. To view a relatively simple financial model that illustrates these pension dynamics, download the CPPC produced spreadsheet “Flexible Pension Analysis.” A much more detailed explanation of how the model works can be found in the CPPC study “A Pension Analysis Tool for Everyone.”

When considering not an individual pension, but a pension fund, the principles just described all apply, but the contributions for all of the participating individuals are pooled into a single set of investments. This pooling results in considerably lower risk to participants for two reasons – financial and actuarial. The financial risk is lowered since a fund that pools the contributions of thousands (or millions) of participants can be diversified, professionally managed, and operated essentially in perpetuity (which mitigates the impact when the market has a few bad years). The actuarial risk is lowered because it is much easier to predict how long the participants will live on average, and fund their retirement accounts accordingly.

Despite the virtues of aggregated pension funds vs. individual retirement accounts, maintaining the solvency of a pension fund is a complex and potentially risky undertaking. Problems can arise if there is an unusually prolonged period of lower than expected investment performance. Problems can also arise if, during an unusually prolonged period of higher than expected investment performance, pension benefits are enhanced beyond what is actually sustainable.

This is exactly what happened with California’s state and local public employee pension funds. During the internet fueled stock bubble of the late 1990’s, followed by the real estate bubble during the early 2000’s, pension benefits were enhanced. Not only were these future obligations increased, but the new, more generous pension formulas were enhanced retroactively, so participants who were close to retirement saw their per year pension benefit accruals enhanced for their entire career. But what goes up, must come down.

The remainder of this report will not focus on whether or not it is practical to project long term investment returns at 7.5% per year, which is what pension funds currently use for their projections. Rather, this report will perform sensitivity analysis, using the latest consolidated data available for all of California’s state and local public employee pension funds, and determine what the unfunded liability would be based on lower long term rates of return. The assumptions we will use are taken from Moody’s Investment Services “Adjustments to US State and Local Government Reported Pension Data,” a proposal that was released for comments in July 2012. The methods we will employ mirror those used by John Dickerson, editor of YourPublicMoney.com, in a study he contributed to the California Policy Center in January 2013 entitled “The Impact of Moody’s Proposed Changes in Analyzing Government Pension Data.” But whereas Dickerson performed this analysis for the independent pension funds serving six Northern California counties, we will use data from the California State Controller’s office that consolidates the financial statements of every state and local public employee pension fund in California. This data is found in a document released on March 20, 2012 entitled “Public Retirement Systems Annual Report for the fiscal year ended June 30, 2010.”

It is unfortunate that the only data available that consolidates over 80 independent state and local public employee pension funds in California is nearly three years old. Much of the reason for this is unavoidable since the actuarial analysis itself takes several months. As a result, even if it were practical to attempt to duplicate the state controller’s efforts and consolidate these many pension fund financial statements independently, there still would be a considerable time lag. For example, in the annual reports for CalPERS and CalSTRS, the section that presents their solvency analysis, which depends on updated actuarial studies, lags a full year behind their financials. In reality, the state controller’s office works pretty fast to consolidate this data. The financial statements for the pension funds are released six months after their fiscal year ends; i.e., in December 2012, most pension funds released their annual reports for the fiscal year ended on June 30th, 2012. Those reports, in turn, contained solvency analysis for the year ended June 30th, 2011, since the actuaries can’t even begin their work until the financial statements are completed. Therefore, by March 2013, the state controller will have again consolidated all of this data in an updated annual report, allowing us access to consolidated pension fund solvency analysis for the fiscal year ended June 30, 2011. But for now, we will have to go with data for the fiscal year ended June 30, 2010.

Here then is the official unfunded pension liability for the fiscal year ended June 30, 2010. The source for this is page 15 (XV) of the introduction to the above referenced state controller’s report, and is based on a long term rate of return projection that, in general, is about 7.5% per year for the more than 80 funds consolidated here.

CA-pension-underfunding-official

In order to explain how to revalue the estimated amount of underfunding using a lower projected rate of return, it is helpful to define the two variables that govern whether or not a pension fund is overfunded or underfunded.

The actuarial accrued liability represents the present value of all future retirement payments due all participants in the pension funds. This value must be continuously adjusted based on changes to the participant population. As new employees enter the funds with distinct benefit formulas, as current employees retire, and as retirees eventually die, the amount of this liability must be painstakingly recalculated.

The actuarial value of the assets represents how much money the pension funds have on hand to invest and to fund existing payouts to retirees. The value increases each year by the amount the funds earn through investment returns, as well as by the amount that is contributed to the funds. Their value decreases by the amount paid out by the funds to retirees, as well as by the amount it costs to administer the funds. Many funds don’t perform an actuarial revaluation of their assets because they use the market value of their funds when calculating solvency. CalPERS, for example, recently began using the market value of their assets instead of the actuarial value for their solvency analysis. But the state controller uses the actuarial value, as does CalSTRS and many other funds. The only difference between the actuarial value and the market value is that the actuarial value is based on an adjustment to market value that takes into account historical trends. This means, for example, if the market value of the funds have dropped faster than average over the past few years, the actuarial value of the funds will be higher than the market value, on the assumption the markets will recover. Conversely, if the market value of the funds have appreciated faster than average over the past few years, the actuarial value of the funds will be lower than the market value.

While there is room for debate as to whether or not the actuarial value of assets is accurate, or, for that matter, whether or not many of the invested assets have sufficiently transparent data regarding their value or are sufficiently liquid to have any reliable market value, it is the actuarial value of the liability to pay future pensions that generates the most controversy. This is because once the future value of these future financial obligations is calculated, in future dollars, the rate at which they are discounted to reduce them to a present value has an extreme impact on just how much these liabilities are worth. As of June 30, 2010, California’s consolidated state and local public employee pension funds had liabilities valued at $724 billion, and 82% of those liabilities were matched by assets, which were valued at $596 billion.

This discussion is more than academic, despite the fact that it is impossible to have a meaningful dialogue with anyone about pension solvency if they don’t have a clear understanding of the difference between present value and future value. Because if the present value of the future pension liabilities is not equal to the present value of the pension fund assets, the plan is underfunded. And to the extent it is underfunded, it will not generate sufficient investment income to maintain whatever level of funding it does enjoy. That is, when a pension fund is underfunded, unless contributions from participants are increased to cover the shortfall in investment returns, the fund will become even more underfunded in an accelerating cascade that can eventually result in a bankrupt fund. Put another way, if a fund is 50% funded instead of 100% funded, it cannot survive by hitting its return on investment target of 7.5%, because it is earning that 7.5% on half as much money as it needs. It has to earn 15.0%, just to stay at 50% funded. From this perspective, it is misleading to suggest that California’s pension funds are within adequate bounds if they were, as the data from FYE 6-30-2010 indicates, 82% funded.

What Moody’s has suggested is to calculate the present value of pension fund obligations at the high-grade long-term corporate bond rate of 5.5%, which they deem to be less risky than 7.5%. Since the rate at which pension funds project their annual earnings is the same rate at which they discount their future liabilities, the adjustment calculations are relatively easy. Along with assuming a 5.5% discount rate, Moody’s has to make an assumption regarding what point in the future the liability must be discounted from. In reality, the actuaries calculate the future obligations for every year in the future, starting with next year, and projecting out to the point at which they estimate the participants who were hired this year (or their survivors if they receive survivor benefits) will have all died. They calculate the total amount that they estimate participant population will collect in every year between now and, say, 2072, taking into account mortality statistics, projected earnings growth (which affects the final pension calculation), cost-of-living adjustments, and any other variables that would affect the estimates. They then discount each year’s estimated obligation back to the present, and add them all together. In order to revalue these liabilities without having access to every actuarial calculation from every fund, what Moody’s proposes is to simply estimate the midpoint of the future payments stream. They select 13 years into the future, which seems a bit conservative. Here is their rationale:

Moody’s Adjustments to US State and Local Government Reported Pension Data, request for comment, July 2nd, 2012, page 6:

“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate. For example, a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.

We recognize this duration estimate may be higher than warranted for some plans and lower than warranted for others. Each pension plan has a unique benefit structure and demographic profile that affects the time-weighted profile (duration) of future benefit payment liabilities. However, plan durations are not reported, and calculating duration individually for each plan is not feasible. Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.”

Here is the formula that governs this readjustment:

Adj PV  =  [ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years

Here is the formula with the actual variables provided by the California state controller (in billions):

Adj PV  =  [ 724.4 x ( 1 + 7.5% ) ^ 13 ]  /  ( 1 + 5.5% ) ^ 13

Here then is the adjusted unfunded pension liability for the fiscal year ended June 30, 2010, using a discount rate of 5.5% instead of 7.5%:

CA-pension-underfunding-low-risk

As can be seen, if the discount rate is lowered to 5.5%, and the actuarial accrued liability is revalued according to Moody’s proposed criteria scheduled for adoption in 2014, it results in the estimated funding status of California’s consolidated state and local government pension plans lowering from 82% funded to 64% funded.

The next table is also available as a downloadable spreadsheet entitled “Impact of Discount Rate on Pension Liability.” The reader is invited to download this spreadsheet and conduct their own analysis. In the table presented below, seven scenarios are considered, each using distinct, but credible assumptions regarding the discount rate and the duration in years between the present value and the future value of the pension liability. Scenarios 1 and 3 (columns 1 and 3) have already been covered; the first is the official amount of California’s combined unfunded pension liability for all state and local government pensions according to the California state controller, the third is the restated liability and consequent amount of underfunding using Moody’s proposed new credit evaluation criteria.

The second scenario (column 2) uses a discount rate of 6.2%, which is referred to as the average long-term investment returns of a “Blended 20th Century Fund.” Here is how Stanford University professor Joe Nation describes that rate of return in his December 2011 paper entitled “Pension Math: How California’s Retirement Spending is Squeezing The State Budget:”

“This 6.0 to 6.5 percent figure is based on the performance of a hypothetical fund containing 80 percent equity and 20 percent income instruments between 1900 and 1999. It assumes an equity rate based on the 20th-century Dow Jones industrial annual average of 5.3 percent, plus 2 percent in dividends, less 0.5 percent in fees. Combined with income instruments with a net rate of return of 4.5 percent, this hypothetical fund would have earned an average annual rate of 6.2 percent.”

As can be seen, if the discount rate is only lowered to 6.2%, it still results in the estimated funding status of California’s pensions lowering from 82% funded to 70% funded.

The fourth scenario (column 4) uses what is called the “Low Risk or Treasury Rate” of 4.5%. As noted in Nation’s study, even this rate is not considered 100% risk free, and is by no means a worst case. Using a 4.5% projected rate of return means that the unfunded pension liability for California’s state and local public employees is not $128 billion, but $329 billion. And this still may be optimistic.

The next three scenarios, columns 5, 6, and 7, show what happens if the “mid-point” of the future obligations is not 13 years in the future, but 17 years in the future. And why wouldn’t it be? As Moody’s themselves state, “Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.” One must take into account the fact that the center of gravity of pension plan obligations, or the “time weighted profile of future benefit payments” is not merely a function of the age distribution, but also of the generosity of the benefits bestowed. From this perspective, the older participants in California’s public sector pension plans, those who retired prior to the benefit enhancements of the late 1990’s and early 2000’s, are impacting the plan less than their numbers, because their benefits are significantly lower, per capita, than the benefits of the people who have just retired or are about to retire. This means the 13 year duration may be too short.

If you increase the duration of the pension plan discounting to what is probably a more representative 17 years, then, as the chart indicates, the unfunded pension liability at 6.2% is $295 billion (67% funded), at 5.5% it rises to $401 billion (60% funded), and at 4.5% it rises to $576 billion (51% funded). Scenario 7, which assumes a 17 year horizon for discounting and a discount rate of 4.7%, is not at all unrealistic.

CA-pension-underfunding-scenarios

The data used in this analysis, while the most current available, is nonetheless quite dated. It shall be interesting to see what the June 30, 2011 data will indicate. That data should be released by the State Controller’s office in a month or two. To try to get an idea, however, we looked at the June 30th 2010 solvency tests for CalPERS and CalSTRS as disclosed on their most recent annual reports (CalPERS, page 128, CalSTRS, page 113). Because the tables show solvency test results for multiple years, we were able to see the June 30, 2010 data, as well as the June 30, 2011 data, on their annual reports for the fiscal year ended June 30, 2012.

As it turns out, as of June 30, 2010, the actuarial value of the assets managed by CalPERS and CalSTRS combined accounted for 67% of the total assets disclosed by the state controller for all of California’s pension funds, and they accounted for 70% of the total liabilities disclosed for all of California’s pension funds. With this in mind, the performance of these two very large funds over the past few years could provide some indication as to whether or not the official calculation of the consolidated pension plans underfunding will have improved or worsened over the past two  years. In the two years ended June 30, 2012, CalPERS earned 21.7% and 0.01%, respectively. CalSTRS earned 23.0% and 1.84% for the same two years. This suggests that the official level of underfunding for California’s state and local government employee pension funds has improved marginally. But these returns also evince the unsettling volatility of investment returns, even with very large, professionally managed funds. And as we have demonstrated here, what average rate of return is ultimately delivered over the next 10-20 years by these funds has an extreme impact on whether or not these funds can remain solvent.

This report was prepared by CPPC Research Director Ed Ring, with assistance from John Dickerson, Marcia Fritz, and Joe Nation.