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.

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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.

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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.

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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.

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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:

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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).

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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.

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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.

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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.

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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

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

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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.

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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.

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(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.

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(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.

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(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.

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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.

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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.

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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.

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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.

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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.

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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.
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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.
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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%.

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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.

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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.

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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.

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

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)

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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?

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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.

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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.

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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

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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

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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

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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

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

Gina Raimondo’s Shining Example – Pension Reform in Rhode Island

January 28, 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. Since 2008 Dickerson has been the publisher of the influential website and newsletter www.YourPublicMoney.com. He 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. The original version of this study was published on October 5, 2012 by Dickerson and can be downloaded from his website. This version, incorporating updates provided by the author on January 24, 2013, is presented here in html or as a PDF document to download and print by the California Policy Center.

ABSTRACT

Gina Raimondo was running a Rhode Island venture capital firm when the mother of two read that a growing fiscal crisis might force cutbacks in libraries and busses. The threat drove her to seek public office for the first time. “I literally put the paper down and said ‘I have to do this. I have to run.’” (Bloomberg – see below) Raimondo was elected Treasurer of Rhode Island in November 2010 in a landslide. One year later because of her incredible leadership Rhode Island adopted the nation’s most extensive public pension reform ever. The heavily Democratic union-supporting Legislature passed the bill 57 to 15 in the House, 35 to 2 in the Senate.

California has much to learn. Both are Democratic and unionized. But there are big differences. Rhode Island’s area and population is the size of Contra Costa county. “Retail” politics works in Rhode Island. California – not so much.

Rhode Island’s pension funds have been in serious trouble for some time. The Legislature passed four rounds of “reforms” beginning in 2005 claiming they’d “solved the problem”. But local and state government finances continued to deteriorate.

Raimondo’s first accomplishment was to lower the assumed rate of investment return in April 2011 from 8.25% to 7.5%. That immediately increased the calculated unfunded pension debt and significantly increased government pension fund payments. Then the City of Central Falls went into receivership, slashed public services and cut pensions in half. These made the crisis very real.

Raimondo published a 14 page report to the people titled Truth in Numbers in June 2011. The purpose was to tell the people what the unfunded pension debt was, diagnose the key drivers of structural pension deficits, lay out the implications of inaction, and provide a framework for solutions. “Ensuring a common understanding of the current pension situation is critical to fostering a lively and informed debate among all stakeholders … Past pension efforts have not been comprehensive enough to address the root causes of the problem. (We must) avoid the temptation to rush reforms that may be ill-designed or incomplete. Hard working state employees and teachers have done nothing wrong … the problem does not lie with them.” This report played a key role in making it possible for reform proposals to gain broad support and be adopted. She identified these key requirements of reform: accurate and transparent assumptions, equitable and reasonable changes in pensions, intergenerational fairness, comprehensive and self-correcting processes, and a realization that unfunded liability for past service must be reduced because it’s the lion’s share of the problem. Raimondo attended 100 community meetings in 8 months delivering this message.

Key reforms are that retiree cost of living adjustments are limited to once every 5 years until pension funds are at least 80% funded and they earn close to their target rate of return on average over 5 years, a “hybrid” system was imposed combining a much smaller guaranteed pension with a defined contribution benefit, and retirement ages were raised.

The existing system created perverse incentives because employees kept more money if actual results were significantly below target. Contributions deducted from paychecks were lower but they still received guaranteed pensions in retirement. By making pensions dependent on positive pension fund results public employee and retiree interests were realigned to support actions to make pension funds stronger. Actuarial estimates are that unfunded pension debt and government pension payments declined 40% as a result of the reforms. Today Raimondo is focusing in independent local government pension reform.

Raimondo is a Democrat and a financial realist who demands governments do their job. She’s among the best known national Democratic leaders rebelling not against labor but rather against myopic self-centered public union leadership that is driving governments bankrupt, throwing the next generation of public employees under the bus, and putting public retirements at risk. “Cutting benefits isn’t what you think about when you think about a progressive Democrat. But you have to do it because if you don’t, then you can’t invest in the future.” Raimondo created political space that allowed public employees to support reform.

Just as in Rhode Island things will probably have to get much worse in California before they can get better – before enough public employees, retirees, and the public get worried enough to accept big changes and sacrifices. Although Raimondo’s leadership was amazing, she believes the very real crisis in Rhode Island was necessary to make her accomplishments possible. The public had to get very worried about specific consequences in their lives if the pension mess wasn’t fixed.

Gina Raimondo made her rebellion with heart, with mind, with soul – calm, determined, and triumphant.

*   *   *

Gina Raimundo
State General Treasurer, Rhode Island

Dickerson_Raimundo_Study_GR-portrait

Gina Raimondo was running a Rhode Island venture-capital firm when the mother of two read that a growing fiscal crisis might force cutbacks in libraries and buses.

The threat drove her to seek public office for the first time. “I literally put the paper down and said, “I have to do this, I have to run.” Raimondo grew up in an Italian-American family riding public buses to public schools attending summer recreation programs in public parks. Her immigrant grandfather learned English at evening classes at the public library. Her father went to college on the GI Bill. She values public services and appreciates those who provide them. “We’re in the fight of our lives for the future of this state,” Ms. Raimondo said. And if the fight is lost? “Either the pension fund runs out of money or cities go bankrupt.”

On 9/8/11 Raimondo attended one of dozens of public meetings with union members. “You’re going after the retirees! In this economic time, how could you possibly take a pension away?” yelled a union official. Another said her efforts were immoral. Rhode Island, she said, had a choice: it could pay for schoolbooks, roadwork, care for the elderly and so on, or it could keep every promise to its retirees. “I would ask you, is it morally right to do nothing, and not provide services to the state’s most vulnerable citizens?” she asked the crowd. “Yes, sir, I think this (pension reform) is moral.”

Pension reforms that only affect future employees don’t save much money for decades. Californians should think about what Raimondo says when thinking about California’s recent “reforms.” A lot of “people say we’ve done pension reform when all they’ve done is tweaked something,” Ms. Raimondo points out. “This problem will not go away, and I don’t know what people are thinking. By the nature of the problem, it gets bigger and harder the longer you wait.”

OUTLINE

  1. Rhode Island Compared to California
    1. Major Differences
    2. Strong Public Unions & Democratic
  2. First Year in Office – Development and Passage of Pension Reform
    1. Lowering of Target Rate of Return and Central Falls Insolvency
    2. Truth in Numbers – Report to the People on Pension Crisis
      1. Introduction
      2. Estimating the Price Tag for Past Service
      3. Diagnosing the Key Drivers of the Structural Pension Deficit
      4. Understanding the Implications of Further Inaction
      5. Providing a Framework for Solutions
      6. The Time To Act is Now
    3. Development and Passage of Pension Reform
    4. Raimondo’s Public Outreach – 100 Community Meetings
  3. Changes to Rhode Island’s Pensions
    1. Retirees
    2. Current and Future Employees
      1. Current Employees – Past Service
      2. Future Service including New Employees
      3. Retirement Age
  4. Realignment of Employee-Retiree Focus on Pension Fund Performance
  5. Financial Impact of Rhode Island’s Pension Reform
  6. Rhode Island’s Current Pension Debt Crisis – Local Pension Funds
  7. Raimondo, Democrats and the Unions
  8. What Californians Can Learn from Gina Raimondo and Rhode Island

*   *   *

I.  RHODE ISLAND COMPARED TO CALIFORNIA

According to numerous analysts pension reform in the tiny State of Rhode Island is the most extensive in American history. Democratic State Treasurer Gina Raimondo made it happen. The contrast of her leadership with California’s is stark.

A.  Major Differences

There are huge differences between California and Rhode Island. Some are obvious. Rhode Island with 2 US Senators has almost exactly the same population and land area as Contra Costa County (1 million people in 800 square miles). If it were a California County Rhode Island would have the 9th largest population.

One newspaper covers the entire state. Radio and TV stations reach the entire population. It takes an hour to drive from one corner of the state to the other. Compared to California there are far fewer “degrees of separation” between people in Rhode Island, they are far more likely to get their news and opinions from the same local media, they are much closer to each other.

California’s economy is far larger and much more diverse. Rhode Island politics are “retail” – California’s “wholesale”.

Other differences aren’t so obvious. Retirement benefits for most government employees in Rhode Island are established by the state legislature – not by collective bargaining as in California. The governing bodies of some local governments in Rhode Island establish retirement benefits for their employees – but again they are not set in labor contracts. Acts of the legislature or local governing bodies can unilaterally change government retirement benefits. As is true in 75% of the states in the US Rhode Island does not subscribe to the “California Rule” that holds that public employees have a right to the best “pension deal” in effect at any point of their employment. They know they have the legal right to reduce retirement benefits for employees and even retirees.

B.  Strong Public Unions & Democratic

However – both Rhode Island and California are heavily Democratic States with very strong public labor unions. About 18% of employees in both states are unionized. Public unions exert very strong influence in both States. In this context – in a strong unionized and Democratic State – the legislature in early 2012 passed Raimondo’s Rhode Island Retirement Security Act 57 to 15 in the House and 35 to 2 in the Senate. A strong majority of Democrats in both houses voted for the bill. It’s now the law.

*   *   *

II.  FIRST YEAR IN OFFICE – DEVELOPMENT AND PASSAGE OF PENSION REFORM

Raimondo earned her Bachelor’s degree in Economics at Harvard – Magna Cum Laude, a D. Phil. in Sociology as a Rhodes Scholar at Oxford, and a law degree at Yale. She helped establish a venture capital firm then was founder of Rhode Island’s largest venture firm – Point Judith Capital – specializing in health care. Clearly an “over-achiever” – she understands financial math.

Rhode Island’s Pension Funds had been in trouble a long time. The Legislature passed four rounds of “pension reform” since 2005 each time claiming they’d addressed the problem. But they did what California’s Public Employee Pension Reform Act signed into law by Jerry Brown in September 2012 did – reduced pension benefits for future employees, but pretty much left current employees and retirees alone. But the Pension Fund’s situation kept deteriorating.

Raimondo was elected State General Treasurer in November 2010 with 62% of the vote. During her campaign she pointedly refused to promise that state jobs and pension benefits would be protected no matter what. Instead, she promised she would tackle the state’s increasingly dire pension debt crisis. She won by a landslide at a time when the state’s Pension Fund reported it was 48% funded.

A.  Lowering of Target Rate of Return and Central Falls Insolvency

Her first major action came in April – just 3 months into office. She persuaded the state’s Pension Board to cut the Fund’s assumed rate of investment profits to 7.5 percent from 8.25 percent. The Pension Fund’s actuary had reported less than a 30 percent chance the Fund would earn 8.25 percent over the next 2 decades. The actual return over the past 10 years had been 2.28%!

By lowering the assumed rate of return the state’s calculated unfunded pension obligation immediately increased. And that meant the Legislature had to come up with an additional $300 million in the next year – either higher taxes, deeper service cuts, increased worker contributions or benefit cuts. That set the stage for comprehensive pension reform because Legislators realized they couldn’t raise that much money in the next year.

And then a month later the City Council of Central Falls declared the City insolvent and filed to be placed in State receivership. The city’s pension fund  was completely out of money. The city obtained a court’s permission to cut pensions of retired police officers and firefighters in half. The pension debt crisis was no longer abstract. A sense of crisis rapidly spread through the state.

B.  Truth in Numbers – Report to the People on Pension Crisis

Raimondo published a 14-page report to the people of Rhode Island titled “Truth in Numbers, The Security and Sustainability of Rhode Island’s Retirement System” in June. Her purpose was “to lay out the main reasons for the state’s pension challenges, explain the implications for all Rhode Islanders, and offer a framework for devising solutions”. [1] Below are quotes …

Dickerson_Raimundo_Study_truth-in-numbers
1.  Introduction

A robust state retirement system plays a critical role in recruiting and retaining talented employees on whom we depend for quality public services … Such a system is also designed to provide a level of secure income to these employees, once they retire. To be viable, a state retirement system must be affordable for both the employees and the taxpayers who support it.

Today Rhode Island’s pension plans provide neither retirement security nor financial sustainability and are in dire need of re-design…. Each year that the state delays action to address its fundamental structural pension issues, the more risk the system faces and the harder it becomes to fix.

This report is organized around four key objectives:

  • Estimating the price tag for past service
  • Diagnosing the key drivers of the structural pension deficit
  • Understanding the implications of further inaction
  • Providing a framework for solutions

Ensuring a common understanding of the current pension situation is critical to fostering a lively and informed debate among all stakeholders, including: public sector employees; taxpayers; and state and local elected and appointed officials, on how to fix it.

Only by developing a workable solution to the pension crisis can a financially secure future for all Rhode Islanders be created. While it is necessary to address this problem as quickly as possible, it is more important to make sure that solutions are thoughtfully considered and lasting. … Past pension reform efforts … have not been comprehensive enough to address the root causes of the problem. The result of this piecemeal approach is that state employees and teachers have endured several rounds of changes to their benefits, which have produced anxiety and insecurity, while the system remains woefully underfunded. The task ahead is to move swiftly to outline solutions, and to avoid the temptation to rush reforms that may be ill-designed or incomplete.

Above all, it is important to remember that real people and families are connected to every number and every actuarial assumption in this report. Any proposed reform has immediate and direct consequences for hardworking state employees and teachers, who have done nothing wrong and contributed what was asked of them to the pension system. The problem does not lie with them; rather the problem is a poorly designed system that has been faltering for decades. Another vital consideration is the hardworking Rhode Islanders outside the pension system, who are struggling to save for their own retirements, and are being asked to pay higher taxes, in good part, to fund the pension system. Of course, we all suffer if the state has to make severe cuts to vital public services to maintain the current pension system.

Ultimately, honest dialogue and real sacrifices will be required to re-design a system that:

  • Attracts quality employees
  • Provides a level of security for its retirees
  • Preserves funding for public services
  • Protects taxpayers

Comprehensive, one-time pension reform is required for a financially secure RI.

2.  Estimating the Price Tag for Past Service:

After considering both private and public accounting rules, RI’s current unfunded liability is $6.8 to $9 billion.

3.  Diagnosing the Key Drivers of the Structural Pension Deficit

  • Failing to utilize sound actuarial practices.
  • Generous benefit improvements without corresponding taxpayer or employee contributions.
  • Current pension plan design – the true normal cost for nearly all employees and retirees has never been fully contributed to the system.
  • Retirees living longer – as people live longer, the impact of the COLA (Cost of Living Adjustment) on the cost of providing pensions is especially large.
  • Lower than assumed investment returns.

4. Understanding the Implications of Further Inaction

  • Unsustainable annual costs for taxpayers – it is unrealistic to believe that taxpayers can continue to support these ever-increasing required contributions and unfair to let current state employees and retirees believe that this is likely.
  • Burden on active state employees – compared to current retirees, active state employees and teachers are contributing more toward their retirement, but will receive lower levels of retirement benefits. If changes are not made, they face the risk that retirement fund assets might not be there at all…. Each generation of taxpayers should pay the full costs (including the pension costs) for the public services it receives. … The vast majority (of annual contributions to the Pension Fund – about 75%) was required to underwrite the unfunded liabilities for past service.
  • Threats to vital public services.
  • Pension Fund could run out of money.
  • Impact of increasing pension expenses on borrowing costs – the state relies on the ability to access the bond market on favorable terms to support critical long term projects, such as roads, bridges, and the infrastructure at higher education facilities. The state’s underfunded pension system will automatically have a negative impact on the state’s (credit) rating if funding levels fall further.

5.  Providing a Framework for Solutions

The path to comprehensive pension reform should begin with agreement on a definition of retirement security. Reform impacting only new employees will not affect the … unfunded liability. A comprehensive & long-term solution must achieve the dual goals of retirement security & taxpayer affordability.

Any comprehensive legislative solution should be informed by the following principles:

a) Accurate and Transparent Assumptions

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 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.

b) Equitable and Reasonable Changes

Any reform impacting only new employees will not affect the existing $7 billion to $9 billion unfunded liability for past service. This problem is decades 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:

  • Increase retirement age including for current employees.
  • Reduce the “pension accrual rate” – the benefit.
  • COLA – any comprehensive solution requires analysis of Cost of Living Allowances.
  • Hybrid plans and portability-combine defined benefits and defined contributions.
  • Others such as anti-spiking, coordination with Social Security, etc.

c) Intergenerational Fairness

Newer employees bear a greater burden than their predecessors, are forced to help contribute to their elders’ retirements, and have a greater risk that pensions won’t be there for them. Budget cuts today force lower wages, unpaid furlough days and service cuts. Any solution needs to ensure fairness between newer and more veteran employees and retirees.

d) Comprehensive and Self-Correcting Processes

It is critical the state adopt measures that provide automatic self-corrections such as establishing funding targets, adjusting benefit and contribution levels automatically and temporarily if funding targets aren’t achieved, linking employer and employee contributions to more evenly share the risk between taxpayers and employees, integrate state and local systems to prohibit “double dipping” and help local systems solve their deep debt problems.

e) Unfunded Liability is the Lion’s Share of the Problem

The pension system 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 both an infusion of assets and a change to benefits.

6.  The Time To Act is Now

The pension system cannot be allowed to fail, nor can the state afford to fund the current system at least without massive tax increases or extremely painful budget cuts. It is unfair to ask taxpayers to pay for the growing level of required contributions and it is dishonest to let state employees, teachers and retirees believe that full benefits will be there for their retirement. We have the opportunity to lead the way forward in confronting and solving this problem and, in so doing, serve as a model for other states to follow.

C.  Development and Passage of Pension Reform

Immediately after publishing Truth in Numbers Raimondo convened a 12 person commission, included four union representatives as well as other state officials, accountants and consultants. The group met from late June through September and developed pension-reform legislation. Raimondo and Gov. Lincoln Chafee introduced the legislation in October.

Seven joint public hearings of the House and Senate Finance Committees received public testimony. The Legislature met in Special Session solely to debate the pension reform bill. Only pension reform was on the agenda to prevent “horse-trading” for votes in which legislators would require support for unrelated bills.

The legislature – dominated by labor-backed Democrats – passed Raimondo’s reforms on November 17, 2011 less than one year after she took office! The House passed the bill 57 to 15 and the Senate 35 to 2.

Dickerson_Raimundo_Study_three-central-goals

D.  Raimondo’s Public Outreach – 100 Community Meetings

In her first 8 months in office Raimondo attended about 100 community meetings across the state. She was fearless, repeatedly putting herself before hostile crowds of government retirees and employees.

She wasn’t afraid to “walk into the belly of the beast” and tell the unions point-blank that “you were lied to [by former politicians] and the system is broken. Today we’re arguing about whether you get a COLA [cost-ofliving adjustment], tomorrow we’ll be arguing about whether you get a pension.” Exhibit A was Central Falls, where many retired police officers and firefighters have had their pensions cut in half. [2]

*   *   *

III.  CHANGES TO RHODE ISLAND’S PENSIONS

The “Rhode Island Retirement Security Act” is rather complex. Different classes of employees have different pension benefits and funding systems. This discussion is only for some of the major main changes for the larger groups of employees who participate in the State’s pension system.

A.  Retirees

Cost of Living Adjustments (COLA) for all groups of retirees are suspended until the Pension Fund is at least 80% funded. The funding status of all of the State’s different pension systems will be aggregated to determine if the 80% requirement has been achieved. Previously COLAs were based on changes in the Consumer Price Index – in the future they will be based on Pension Fund earnings. They will be calculated based on the Pension Fund’s five-year average investment rate of return minus 5.5% and will range from zero to four percent. For example, if the 5-year average return is the target rate of 7.5% then the COLA that year will be 2%.

Under previous policy the COLA was only on the first $35K of pensions, now they are only on the first $25K. However, since it’s expected that it might take 15 to 20 years for the Pension Fund to achieve 80% funding the Legislature required a COLA at least once every five years so there will be some increase for current retirees.

This change has a very major impact on reducing the State’s unfunded pension obligation. It’s a “self-regulating” system. COLA’s can’t create large unfunded pension obligations as they did in the past.

B.  Current and Future Employees

1.  Current Employees – Past Service

There is no change in the accrued pension benefit for past service for those who are eligible to retire by 6/30/12. For those that won’t be eligible to retire by that date it is “frozen” – the amount of this part of the pension will not be increased as a result of future work. The amortization period for the unfunded pension obligation is extended from 19 years to 25 years – which reduces the State’s yearly UAAL amortization payment.

2.  Future Service including New Employees

The traditional defined benefit pension plan is replaced by a “hybrid”. There will be a much smaller defined benefit pension benefit. Most employees will receive one percent of the average of their highest 5 years of compensation multiplied by the number of years worked. Correctional Officers and State Police will receive two percent. General employees will contribute 3.75% of their compensation. Correctional officers and state police will contribute 8.75% – it appears they will retain a defined-benefit only pension plan.

A defined contribution plan has been added. General employees will contribute 5% with a 1% match from the employer (usually the state). An additional 2% will be added to both contributions for general employees who are not in Social Security 3% for many safety employees. State correctional officers, state police and judges will not be part of this plan.

3.  Retirement Age

Employees will be able to retire at their Social Security normal retirement age – but the eligibility will not be higher than 67 years of age. Employees with 5 or more years of service will be able to retire somewhat earlier depending on how many years of service they have – the more they have the younger they may retire. However, the minimum retirement age is 59. Those with 10 or more years of service may elect to retire at the pre-reform specified age, but their pensions may be adjusted downward.

Retirement ages for all safety employees except State police were raised. State Police may retire when they have accrued a pension equal to 50% of their whole salary, and must retire when they have accrued 65%. Correctional officers may retire at 55 if they have 25 years of service. If they retire before 25 years of service they will begin receiving pensions when they reach normal Social Security retirement age.

*   *   *

IV.  REALIGNMENT OF EMPLOYEE-RETIREE FOCUS ON PENSION FUND PERFORMANCE

I think this is the most powerful “mega-change” in Rhode Island’s pension benefit.

A core financial truth that must be understood is that in almost every case the development of unfunded pension debt means not enough money was contributed to the pension fund in the past.

The pension benefit was “guaranteed”. Pension Fund investment performance seemingly had no impact on pensions because the State guaranteed pensions. They didn’t seem to be affected by how well overall actual results matched Actuarial projections such as life-span, actual v. projected future pension payments, disability-related retirements, etc.

In the future the bulk of the benefit will be determined by how well Pension Fund investments “work” and how well Actuarial projections match actual future results. Retirees will get COLAs if the Pension Fund’s investment perform well – if not they don’t. If too many of the other Actuarial assumptions turn out to be too “rosy” and the Pension Fund develops significant deficits, they won’t get COLAs. If the Pension Fund’s investments achieve their targets then employees will receive roughly the same retirement benefit as they would have under the old completely-guaranteed pensions. If they do better than target they will receive more. But if performance is worse, they get less.

The bizarre truth is that under the old system employees got a “better deal” from the development of huge unfunded pension debts because less money was deducted from their paychecks for their share of pension contributions while they were working but they still got their guaranteed pensions. Politicians had more money to spend on things other than pensions – in the short-run – because they weren’t paying the true cost of the promises they were making about retirement to employees. They earned political credit from unions for the promise – and didn’t have to pay for a large part of it. These perverse incentives for government work forces and politicians are a major reason thousands of local and state governments across the country are so deeply mired in unfunded pension debt today.

I think Rhode Island’s move from guaranteed pensions to making retirement benefits more a function of economic growth and good Pension Fund management will have a very powerful and even transformative effect on the attitudes of government employees and retirees.

*   *   *

V.  FINANCIAL IMPACT OF RHODE ISLAND’S PENSION REFORM

Gabriel Roeder Smith & Company produced an Actuarial Analysis of the Rhode Island Retirement Security Act of 2011. [3] They calculated that the Unfunded Actuarially Accrued Pension Liability as of 6/30/10 was $7.3 billion. The State’s pension reform reduced that by $3 billion down to $4.3 billion – a reduction of over 40%. They calculated Rhode Island and local governments that participated in the State’s Pension Funds would have paid $690 million to the Pension Fund in fiscal year 2013. As a result of pension reform payments were reduced by $275 million from $690 million to $415 million – a reduction of 40%. These are astonishing reductions in one year!

There’s a mountain of complexity in these projections. One of the most important is they assume everything works out as planned –which never happens exactly. One of the most important impacts of Rhode Island’s changes is that if things turn out worse than planned the State’s unfunded pension liability will be far less than it would have been.

*   *   *

VI.  RHODE ISLAND’S CURRENT PENSION DEBT CRISIS – LOCAL PENSION FUNDS

Raimondo’s reforms (with the Governor and key Legislative leaders) focused on the State – not on dozens of local government pension systems. But many if not most of these local systems are in as bad if not worse shape as was the State when Raimondo was elected. The Treasurer is today focusing on the local systems. Although her authority over local plans is extremely limited compared to her significant power regarding state plans, she is attempting to bring the same types of reforms to them as she and her allies brought to the State. For more information visit this page on the Treasurer’s website:

*   *   *

VII.  RAIMONDO, DEMOCRATS AND THE UNIONS

Raimondo is a Democrat and a financial realist who demands government s do their job. She is a progressive supporter of strong social services – one of the best known national Democratic Party leaders making pension reform happen. Hers is the face of rebellion within the Democratic Party –not against labor, but against a myopic and self-absorbed public union leadership that stubbornly refuses to face financial reality, continues to drive governments into bankruptcy, throws the next generation of public employees under the bus, and puts their members’ retirement at risk.

“A government that doesn’t work is in no one’s interest,” she (Raimondo) says. “Budgets that don’t balance, public programs that aren’t funded, pension funds that are running out of money, schools that aren’t funded—How does that help anyone? I don’t really care if you’re a Republican or Democrat or you want to fight about the size of government. How about a government that just works?” [4]

“There is a generation of Democrats who are becoming truth tellers to their own party about very difficult things,” said Matt Bennett, co-founder of Third Way in Washington, a nonprofit group that advocates for moderate public policies. “That’s going to happen at the national level when it comes to entitlement reform and it’s happening at the state level when it comes to pension reform.” [5]

Gina Raimondo challenged the leadership of public employee unions and forced the rank and file to face hard truths. Democratic office-holders are increasingly doing so across the nation such as San Jose Democratic Mayor Chuck Reed and San Francisco Public Defender Jeff Adachi in California and most recently in Chicago by Democratic Mayor Rahm Emanuel. They are making decisions based on the long-run interests of the people and not continuing the subservience of too many Democratic Party officeholders to public union patrons.

“I went toe-to-toe with the public unions looking out for the kids of Rhode Island because if we didn’t fix those pensions, there would be no good public schools,” Raimondo said … “That is what motivated me, every single day.” [6]

Cutting benefits for public employees “isn’t what you think about when you think about a progressive Democrat,” Raimondo said in the interview last month. “But you have to do it because if you don’t, then you can’t invest in the future.” [7]

Ms. Raimondo downplays the opposition from her former union allies. As she tells it, the reforms passed because she conducted “a huge, long, relentless public-education campaign,” and there was no “rushing to a solution.” Plus, the unions were at the table the entire time, she says. “Yes, there was a big protest. They weren’t entirely supportive, but we had a reasonably productive dialogue the entire time—which we still have.” [8]

“I’m generally upset and saddened by all the antigovernment rhetoric that is in our country today,” Ms. Raimondo says. “I respect public employees and school teachers. They deserve a secure retirement.” [9]

“That was my mantra the whole time: Progressives care about public services,” Raimondo told me. “A coalition of supporters developed, and it wasn’t just the chamber of commerce. It was younger teachers, police, heads of social service agencies. Advocates for the disabled really came out.” [10]

What Raimondo has proven is that real public pension reform is not “just” a conservative issue. And although many union leaders want to present their members as unified in opposition to reform – they aren’t.

In some ways, the central question is not only what the government owes to pensioners but what citizens owe to one another. … Cindy Gould, a fourth-grade teacher, said that under the current system, she had 11 years to go until retirement. Under Ms. Raimondo’s plan, she might have to work longer. But, Ms. Gould, 54, said she was willing to do so if that meant the elderly would get the medical care they need. [11]

At the 2012 Democratic national convention in Charlotte, a delegate from Rhode Island walked up to Gina Raimondo and said, “You cost me $300,000.”

Raimondo, the state treasurer who had quarterbacked a major pension reform, steeled herself for abuse. Instead, the delegate, a retired schoolteacher and wife of another retired schoolteacher, thanked Raimondo and gave her a big hug.

“This system was going to blow up,” she said. “Thank God you fixed it.” [12]

Raimondo created the political space for public employees to move into support of pension reform.

*   *   *

VIII.  WHAT CALIFORNIANS CAN LEARN FROM GINA RAIMONDO AND RHODE ISLAND

In the six years before Raimondo decided to run for state treasurer the Rhode Island Legislature adopted a series of incomplete half-baked tepid “reforms” at the state level. They claimed they “solved the problem”. But state and local finances continued their significant deterioration and an intolerable financial situation arose.

Raimondo’s first big accomplishment was to lower the assumed rate of investment returns for the State Pension Funds from 8.25% to 7.5%, .This increased the unfunded pension debt (UAAL) very significantly which in turn would have forced state and participating local governments to pay significantly higher UAAL amortization payments the next year. Then the City of Central Falls entered receivership, slashed public services, and cut pensions in half. These two events made crisis become very real.

Many analysts have concluded that without a combination of strong leadership from elected officials and a palpable threatening immediate government financial crisis it’s extremely hard to motivate most folks to be concerned about pension reform more than on a casual conversational basis. Raimondo appears to agree.

“Social Security has an unfunded liability of $8.9 trillion over the next 75 years, according to its trustees. The recipe for putting it on sound footing isn’t complicated. Yet Washington politicians, divided between Democrats who resist any reform and Republicans who periodically champion privatization, do nothing, preferring to use the issue as a club to beat each other with and making the problem harder to solve …”

The Rhode Island approach — face the facts; get everyone to the table; look to solve the problem, not demonize — would seem to offer some obvious lessons. But when I tried to draw an analogy, Raimondo wasn’t entirely encouraging.

“Rhode Island’s pension system was in crisis today — you would have seen other cities going bankrupt, devastating cuts to social services,” she said. “I do think that that enabled what we did here.”

The all-too-real effects of crisis generated support for reform. “People don’t really want to hear about the $3 trillion,” Raimondo said. “They want to hear, your property taxes are going up, the bus you take to work is going to be cut, your kid’s school is going to be underfunded. That got people calling the State House.” [13]

We’re likely to go through the same steps in California – five or more years of continuing financial deterioration, inadequate attempts at “reform”, and a growing sense of dread. Things will have to get a lot worse before they can get better. At that point pray that California’s Gina Raimondo shows up. But those are the crises that call forth such leaders.

Gina Raimondo’s leadership made a real difference. She was relentless – driven. She stuck to her message. Although she didn’t hesitate to lay blame on past officials she didn’t dwell on it. Her focus was on fixing the future.

Consider what Raimondo accomplished with Truth in Numbers and in the hundred community meetings and countless interviews before she began to put specific reform proposals on paper:

  • She produced an honest analysis that identified the major causes of the unfunded pension debt crippling the state and dozens of local governments.
  • She produced capable projections of the range of probable financial futures of these obligations and their impact on the ability of governments to provide their core public services.
  • She identified financial objectives to restore governmental financial stability to provide the services the public needs.
  • She named a set of fair basic principles on which pension reform had to be constructed. Then – based on these she led the production of a set of coordinated actions that formed a comprehensive long-term solution and that spread the burden of restoring the State’s financial health across all major stakeholder groups. And she worked – every day – at communicating what she was doing to the people. She was tireless in her pursuit of reform.

“The larger lesson here is that government can work,”… “Government can solve problems when leaders lead, and citizens engage, and when we focus on the problem and on the solution, and not on the politics.” [14]

“Government worked tonight”, she said after her surprising victory. “On one of the toughest, most financially complicated, politically charged issues we face, we did something right.” [15]

Gina Raimondo made her rebellion with heart, with mind, with soul – calm, determined, and triumphant.

*   *   *

Download Print Version

FOOTNOTES

[1] Truth in Numbers, Gina M. Raimondo, Office of Rhode Island General Treasurer, June 2011, page 2

[2] The Democrat Who Took On the Unions, Allysia Finley, Wall Street Journal, 3/25/12, available as of 9/18/12 at http://online.wsj.com/article/SB10001424052970204136404577207433215374066.html

[3] Available at

[4] The Democrat Who Took On the Unions, Allysia Finley, Wall Street Journal, 3/25/12, available as of 9/18/12 at http://online.wsj.com/article/SB10001424052970204136404577207433215374066.html

[5] Gina Raimondo Math Convinces Rhode Island of America’s Prospects With Debt, Michael McDonald, Bloomberg.com, 1/9/12, http://www.bloomberg.com/news/2012-01-10/gina-raimondo-math-convinces-rhode-island-of-america-s-prospects-with-debt.html

[6] The Democrat Who Took On the Unions, Allysia Finley, Wall Street Journal, 3/25/12, available as of 9/18/12 at http://online.wsj.com/article/SB10001424052970204136404577207433215374066.html

[7] Gina Raimondo Math Convinces Rhode Island of America’s Prospects With Debt, Michael McDonald, Bloomberg.com, 1/9/12, http://www.bloomberg.com/news/2012-01-10/gina-raimondo-math-convinces-rhode-island-of-america-s-prospects-with-debt.html

[8] The Democrat Who Took On the Unions, Allysia Finley, Wall Street Journal, 3/25/12, available as of 9/18/12 at http://online.wsj.com/article/SB10001424052970204136404577207433215374066.html

[9] The Democrat Who Took On the Unions, Allysia Finley, Wall Street Journal, 3/25/12, available as of 9/18/12 at http://online.wsj.com/article/SB10001424052970204136404577207433215374066.html

[10] Rhode Island’s Gina Raimondo Navigates Pension Reform, Fred Hiatt, Washington Post, 9/9/12, available as of 9/15/12 at http://www.washingtonpost.com/opinions/fred-hiatt-rhode-islands-gina-raimondo-navigates-pension-reform/2012/09/09/0a06ce00-f92b-11e1-8b93-c4f4ab1c8d13_story.html

[11] The Little State with a Big Mess, Mary Williams Walsh, New York Times, 10/22/11, available as of 9/18/12 at http://www.nytimes.com/2011/10/23/business/for-rhode-island-the-pension-crisis-is-now.html?pagewanted=all

[12] Rhode Island’s Gina Raimondo Navigates Pension Reform, Fred Hiatt, Washington Post, 9/9/12, available as of 9/15/12 at http://www.washingtonpost.com/opinions/fred-hiatt-rhode-islands-gina-raimondo-navigates-pension-reform/2012/09/09/0a06ce00-f92b-11e1-8b93-c4f4ab1c8d13_story.html

[13] Rhode Island’s Gina Raimondo Navigates Pension Reform, Fred Hiatt, Washington Post, 9/9/12, available as of 9/15/12 at http://www.washingtonpost.com/opinions/fred-hiatt-rhode-islands-gina-raimondo-navigates-pension-reform/2012/09/09/0a06ce00-f92b-11e1-8b93-c4f4ab1c8d13_story.html

[14] Yale Law School Website – URL as of 9/18/12:

[15] The Little State That Could, Time Magazine, David Von Drehle,  December 5, 2011, page 32

The Impact of Moody's Proposed Changes in Analyzing Government Pension Data

January 8, 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. Since 2008 Dickerson has been the publisher of the influential website and newsletter www.YourPublicMoney.com. He 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. The original version of this study was published on January 3, 2012 by Dickerson and can be downloaded from his website. This version, incorporating minor changes to the original, is presented here in html or as a PDF document to download and print by the California Policy Center.

ABSTRACT

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. As such, while Moody’s doesn’t have authority to make governments change their financial statements or fund pensions differently, they do control how they analyze and report government credit-worthiness. Moody’s has concluded that published government employee pension financial data greatly understates the credit risks created by unfunded pensions. Moody’s proposed adjustments are likely to lead to reductions in credit ratings for many governments which could cause them to pay more interest expense and/or reduce access to credit and loans.

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.

Moody’s adjustments would have two major impacts on most governments. First, Moody’s states these adjustments would triple the amount of unfunded government pension debt across the US they would use to set credit rates. Second, Moody’s analysis will conclude that most governments are paying far less to their Pension Funds than they should.

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.

I developed a financial model to project how Moody’s adjustments would restate published government pension data. I applied the model to the 6 Bay Area – North Coast California counties that do not participate in CalPERS; they have independent County Pension Funds (Alameda, Contra Costa, Marin, Mendocino, San Mateo, and Sonoma). The model uses data from recent Actuarial Valuations. It produces four core restated values – total pension debt, unfunded pension debt, government normal yearly contributions, and government unfunded pension amortization payments.

These County Pension Funds reported total unfunded pension obligations were a little over $4 billion. Moody’s adjustments would increase these unfunded pension obligations by about another $6 billion which would reduce average reported pension funding ratios from 78% 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 $10.2 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, including Pension Obligation Bonds, the 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 $2.8 billion. Thus Moody’s adjustments would increase the total debt for these counties used in their credit rating analysis from the reported $4.5 billion to $14.6 billion – slightly more than triple what is currently reported.

These counties pay about $640 million each year to their Pension Funds. These adjustments would increase this annual payment to $1.4 billion – from 29% of payroll to 63%. To put this in perspective, payments to Pension Funds and Pension Bonds today consume about half of these counties independent property tax income. These adjustments show they should consume all county property tax income.

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.

OUTLINE

    1. Introduction
    1. Moody’s Four Adjustments of Government Credit Analysis.
    1. First Major Impact – Unfunded Pension Debt.
        1. Pension Fund Asset Value.
            1. How Actuaries Calculate Pension Fund Asset Value.
            1. Moody’s Proposed Adjustment of Pension Fund Asset Values.
        1. Total Pension Liability.
            1. First – Estimate Future Pension Payments That Have Already Been Earned.
            1. Calculate Net Present Value of Future Payments Already Earned.
        1. Net Pension Liability – or Asset.
        1. Two Further Considerations.
            1. The Myth that “80% Funding is OK”.
            1. Pension Obligation Bonds Must Be Included in Total Unfunded Pension Debt.
    1. Second Major Impact – Government Payments to Pension Funds.
        1. Two Main Types of Government Payments to Pension Funds.
            1. Normal Yearly Contributions.
            1. Unfunded Pension Amortization Payments.
            1. Other Payments.
        1. Why Moody’s Should Restate Payments by Local Governments – Not Just State Payments.
            1. Many Local Governments are Larger than Many States.
            1. Availability of Data.
            1. The Threat to Owners of California Local Government Pension Obligation Bonds.
        1. Actuarially Calculated Payments to Pension Funds.
        1. Moody’s Adjustments to Government Payments.
            1. Calculate Normal Annual Cost Contribution Payments at 5.5% Rate of Return
            1. Increase Pension Liability Amortization Payments to be “Fully Funded Over a Reasonable Time Horizon”.
            1. Use “Level Dollar” method to Calculate Unfunded Pension Liability Amortization Payment
            1. How Much Will Moody’s Adjustments Increase Catch-Up Payments to Restore Pensions to 100% Funding?
            1. Summary: Impact of Moody Adjustments on Normal and Catch-Up Pension Fund Payments:
    1. Conclusion – What this Should Mean to Concerned Citizens.
    1. Attachment – Data Sources and Footnotes

*   *   *

I.  INTRODUCTION

Moody’s Investors Services and Standard and Poor’s are the most powerful credit rating agencies in the US. They, along with Fitch, are considered the “Big Three Credit Rating Agencies”. [1] On July 2, 2012 Moody’s published a “Request for Comment” titled Adjustments to US State and Local Government Reported Pension Data (referred to herein as “Moody’s Paper”). [2] Moody’s believes government reports about the finances of state and local government pension finances often significantly understate the financial risk of unfunded pension debt. They intend to modify government-reported pension financial data in analyzing credit-worthiness and setting credit ratings for state and local governments in the US.

Moody’s doesn’t expect significant changes in state credit ratings but the weakest state pension funding positions would be identified. Although they expect to reduce credit ratings for local governments whose adjusted debt is deemed excessive Moody’s was still evaluating the extent of likely downgrades. [3] I applied these proposed adjustments to the six counties in the San Francisco Bay Area – California North Coast region that have their own independent County Pension Funds. The results are reported in this paper. The results of applying these adjustments to these six counties suggests that if Moody’s takes its methods seriously there would be a significant number of local government downgrades that would reduce access to debt financing and/or increase the cost of borrowing.

Concerned citizens should understand Moody’s reasoning in making these changes and take the dire warning inherent in what they propose seriously. Many state and local governments are putting their finances at great risk through deeply flawed financial management of their pensions, and their financial reports don’t convey that essential fact.

*   *   *

II.  MOODY’S FOUR ADJUSTMENTS OF GOVERNMENT CREDIT ANALYSIS

These are Moody’s four proposed adjustments [4]:

1. Multiple-employer cost-sharing plan liabilities will be allocated to specific government employers based on proportionate shares of total plan contributions (Note – we don’t examine this aspect in this paper; it’s pretty simple.)

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 amortization period

A significant aspect of Moody’s proposals is to attempt to make government pension financial data far more comparable. Governments and their Pension Funds are free to use assumptions that vary significantly from each other. Moody’s believes these hugely divergent pension funding assumptions creates an analytical “Tower of Babel” that seriously compromises the ability to compare the financial impact of pensions on government finances. Moody’s will eliminate un-standardized adjustments made by actuaries to the value of Pension Fund assets, attempt to standardize assumed investment rates of return, establish a common period in which pensions must be fully funded for current employees, and a common amortization period for unfunded pension debt.

The two major financial impacts of Moody’s proposed adjustments would be [5]:

    • Increased Unfunded Pension Debt:
      Moody’s projects these adjustments would nearly triple reported unfunded actuarial accrued liability (“UAAL”) for the 50 states and local governments in their database to $2.2 trillion from $766 billion divided almost equally between state and local governments.
    • Recalculated “Reasonable” Employer Pension Fund Contributions:
      Moody’s adjustments increase 2010 state pension contributions to $128.8 billion, compared to the $36.6 billion states actually contributed. Moody’s doesn’t intend to restate local government payments.

*   *   *

III.  FIRST MAJOR IMPACT – INCREASED UNFUNDED PENSION DEBT

The calculation of unfunded pension debt is a three-step process described below:
A    Pension Fund Asset Value, less
B     Total Pension Liability, equals
C     Overfunded or Unfunded Pension Liability

A.  Pension Fund Asset Value

Actuaries produce financial analyses of Pension Funds in reports called “Actuarial Valuations” [6] . Moody’s will not use the Pension Fund asset values used by Actuaries.

1.  How Actuaries Calculate Pension Fund Asset Value:

Actuaries almost always make one simple adjustment to the value of a Pension Fund’s assets and often make a second adjustment as well. Actuaries start with the Market Value of Pension Fund Assets.

    • Smoothing: Actuaries use a “smoothed” value of assets. “Smoothing” is a type of “moving average” that “slows down” changes in asset values to prevent chaotic one-year surges in government payments to Pension Funds caused by rapid decline in stock markets. The “smoothed” value of Pension Fund assets is called the “Actuarial Value of Assets”, or “AVA”. Smoothing is usually constrained by a “Corridor Limit” that prevents the smoothed value of assets from being more than a set percentage different from the actual market value. However, the difference rarely is greater than the corridor limit so it is not often used. There is considerable variation in how actuaries apply smoothing and the corridor limit.
    • “Actuarial Value of Assets” (AVA) v. “Valuation Value of Assets” (VVA): Most Valuations use the AVA, but some make a second adjustment. Pension Funds set aside “reserves” for various purposes some of which are not available to pay pensions. These are always only a very small part of the Pension Fund’s assets. Some Actuaries deduct these “non-pension” reserves from the smoothed value of Pension Fund assets – the “AVA” – to produce the “Valuation Value of Assets”, or “VVA”. There isn’t much difference between them.

2.  Moody’s Proposed Adjustment of Pension Fund Asset Values:

It’s simple – Moody’s will use the Market Value of Pension Fund Assets, not the Actuarial or Valuation Value. This will result in greater volatility in Pension Fund asset values. It will also eliminate the considerable “artificial” variation in asset values that results from the wide range of allowable smoothing, corridor limit, and reserve options used by actuaries. The table below shows the change in values for the six county Pension Funds. Pension Fund assets increased for three of these counties and decreased for three. The difference is driven by smoothing methods and timing of Actuarial Valuations. The average pension asset value declined by a little less than one percent.

Dickenson-Moody-table-1

B.  Total Pension Liability

There are two steps. The first wouldn’t be changed by Moody’s – the second would be profoundly changed.

1. Estimate Future Pension Payments That Have Already Been Earned:

The Pension Fund’s Actuary estimates the part of each future year’s pension payments that have already been earned by employees in the past. This is by far the most complicated process performed by Actuaries in Valuations. Thankfully – the result of this step is not the direct focus of Moody’s proposed adjustments. These estimates don’t include the part of future pension payments employees will earn in the future. A government’s total pension liability is entirely created by work performed by its employees in the past. It is part of the cost of providing services in the past – not in the future. [7]

2. Calculate Net Present Value of Future Payments Already Earned:

How much needs to be in the Pension Fund today so that future pension payments that have already been earned can be paid if all assumptions come true? In financial terms this is the total “Net Present Value” of each of those estimated payments in future years.  The most important assumption is the expected annual rate of investment profits the Pension Fund will earn until those future payments are made. Actuaries assume one rate – Moody’s will assume a lower rate.

a) Current Actuarial Calculation – Target Rate of Return is Discount Rate:

Actuaries assume the Pension Fund will earn a “target investment rate of return” (often called an “interest rate”). This shows the assumed rate of investment return (profits) for the six counties in the San Francisco Bay Area – California North Coast that have their own County Pension Funds. These are fairly typical for government Pension Funds.

Dickenson-Moody-table-2

Actuaries use the assumed rate of return to estimate how much should be in the Pension Fund as of their Valuation. This is the “Actuarially Accrued Liability”, or “AAL”. It’s their version of the Total Pension Liability. Moody’s disagrees.

b) Moody’s Adjustment – Target Rate of Return is High-Grade Corporate Bond Rate [8]:

Moody’s proposes to replace the Pension Fund’s target rate of return with a “high-grade corporate bond index” which would have been 5.5% for 2010. They explain their reasoning:

Pension liabilities are widely acknowledged to be understated, and critics are particularly focused on the discount rate as the primary reason for the understatement.(See, for example, Alicia Munnell et al, “Valuing Liabilities in State and Local Plans,” Center for Retirement Research at Boston College, June 2010; Joe Nation, “Pension Math: How California’s Retirement Spending is Squeezing the State Budget,” Stanford Institute for Economic Policy Research, December, 2011; and Robert Novy-Marx and Joshua Rauh, “Policy Options for State Pension Systems and Their Impact on Plan Liabilities,” National Bureau of Economic Research, October 2010.)

In public pension plans, the assumed rate of return on invested pension plan assets is identical to the discount rate that measures the present value of benefits accrued by current employees and retirees. Because plans (often guided by state legislation) develop their own investment rate-of-return assumptions, the discount rate accordingly varies across plans and often among plans within a state. Most public plans currently use discount rates—and assumed rates of return—in the range of 7.5% to 8.25%, which reflects some reductions made in recent years.

We propose replacing the differing discount rates with a common rate based on a high-grade bond index because:

    • Investment return assumptions in use by public plans today are inconsistent with actual return experience over the past decade (when total returns on the S&P 500 index grew at about 4.1% annually) and today’s low fixed income yield environment. According to Wilshire Associates, public plans in the aggregate allocate roughly one-third of assets to fixed income …
    • A high-grade bond index is a reasonable proxy for government’s cost of financing portions of its pension liability with additional bonded debt …

For adjustments to 2010 and 2011 pension data, the proposed discount rate is 5.5%, which is based on Citibank’s Pension Discount Curve. Based on high-quality (Aa or better) corporate bonds, this curve is duration-weighted by Citibank for purposes of creating a discount rate for a typical pension plan in the private sector. The 5.5% rate is a rounded average of the rates published for May, June, and July of 2010 and 2011. This proposed approach to the discount rate is similar to that used in the private sector, where Financial Accounting Standards Board (FASB) regulations require pension systems to discount assets at a rate consistent with the yield on high-quality corporate bonds. We propose to revisit the discount rate annually.

Moody’s doesn’t have the complex projections made by Actuaries for each Pension Fund – they only have the final value reported as the “(Total) Actuarially Accrued Liability”. Moody’s therefore can’t perform a recalculation based on the specific data – so they must come up with a “simplifying calculation” to estimate what the recalculated Net Present Value of the Total Pension Liability would be. They will take the reported “Actuarially Accrued Liability,” project them forward for 13 years using the Pension Fund’s target rate of return, then “discount” the resulting value back 13 years using the high-quality corporate bond rate which was 5.5% for 2010. Moody’s states “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.”

This table shows the effect of this adjustment on the six Bay Area – North Coast counties:

Dickenson-Moody-table-3C.  Net Pension Liability – or Asset

The third step to determine unfunded pension debt is very simple. Total Pension Liability is subtracted from the value of Pension Fund Assets. This graph shows the proportional change in Net Pension Liability for these six counties.

Dickenson-Moody-figure-1

The table below shows the actuarial calculation and Moody’s proposed adjustment. Moody’s calculates the total value of State and Local Government Pension Liabilities in the nation will roughly triple as a result of this adjustment. The results for these six counties are somewhat less than triple [9].

Dickenson-Moody-table-4

D.  Two Further Considerations

These are two other issues citizens need to consider related to those specifically discussed in the Moody’s paper.

1. The Myth that “80% Funding is OK”:

It’s often said that so-called “experts” say a Pension Funding ratio of 80% is OK. That is a financially absurd assertion [10]. The long-term goal of Pension Funds should be to be 100% funded on average. Pension Funds will never be precisely 100% funded. At the top of stock market cycles the Fund should be around 125% funded. At the bottom – and only at the bottom – the Fund would be about 80% funded. If the long-term average is 80% then a very significant portion of pension expenses incurred by governments to provide services to the people in the past (increased by interest expense) is transferred to future generations. There is no other possible conclusion.

The table below shows the impact of Moody’s adjustments on the “Funding Ratio” of the six Bay Area – North Coast County Pension Funds (Assets/Total Liabilities).

Dickenson-Moody-table-5

 2. Pension Obligation Bonds Must Be Included in Total Unfunded Pension Debt:

Net Pension Liabilities (or UAAL’s) are not the only kind of unfunded pension-created debt. Many governments borrowed money to eliminate Pension deficits by selling “Pension Obligation Bonds” (POB). The Pension Fund got the money – the people through their government kept the debt. Pension Bonds are simply unfunded pensions restructured in the hopes of incurring a lower interest expense. But their source is exactly the same – unfunded pensions.

All too often government and retirement officials only report the Pension Fund’s ratio as reported in Actuarial Valuations. Not only does that ignore the reasons given by Moody’s as to why reported pension funding ratios significantly overstate the real funding position of most government Pension Funds, but it ignores unfunded pension debt in the form of Pension Bonds. It is one of the most obvious examples of how all too many government and retirement officials do not tell the important financial truths about unfunded pension debt to the people.

The outstanding balance of Pension Bonds must be added to Net Pension Liabilities to quantify the total debt created by unfunded pensions. And payments for Pension Bonds are part of total debt payments created by unfunded pensions.

This shows the balance owed on Pension Bonds for the six counties added to Moody’s adjusted Net Pension Debt. The Total percentages are averages of the six percentages for the counties – not based on total dollars. Dickenson-Moody-table-6

The impact of adding the balance of Pension Bonds to Moody’s adjusted Net Pension Liability is profound. Sonoma County’s Actuary reported the pension funding ratio was 84%. Moody’s adjustments reduce that ratio to 59%. But the addition of Pension Bonds drops the ratio falls to 40%. The people of Sonoma County still owe 60% of what should be in the Pension Fund assuming Moody’s is correct. Even if we use the actuarially calculated Pension Funding ratio and deduct the outstanding balance of Pension Bonds Sonoma County still owes more than 1/3 of what should be in the Fund.

It’s extremely important to understand that Actuarial Valuations are in fact government pension funding plans (see “Normal Yearly Contributions”). Simply put – there should never be significant unfunded pension obligations (or at least never more than 20% of total obligations and then only at the bottom of stock market cycles) or Pension Bond debt. The existence of significant balances in either form of unfunded pension-created debt is on its face proof of the failure to achieve their self-proclaimed pension funding goals. On average, given Moody’s adjustments, these six counties and their Pension Funds achieved only half their self-proclaimed pension funding goals.

*   *   *

IV.  SECOND MAJOR IMPACT – GOVERNMENT PAYMENTS TO PENSION FUNDS

Debt wouldn’t be so bad if it weren’t for the annoying habit of creditors to expect to be paid. The creditors in this case are retirees who expect to get their pensions. But governments don’t pay pensions directly to retirees. They make payments to independent Pension Funds. The Pension Funds are “fiduciaries” responsible to make sure that retirees get their pensions. Therefore the immediate creditor is the Pension Fund. Moody’s proposes to make very significant adjustments to restate what governments should be paying to their Pension Funds. The more unfunded pension debt that develops the more a government’s payments to eliminate that debt will rise. That in turn reduces government services, which erodes governments’ core duty – to be government of the people, by the people, and for the people.

A. Two Main Types of Government Payments to Pension Funds

In general there are two types of payments governments make to their Pension Funds.

1. Normal Yearly Contributions:

In general governments and their employees pay what’s called the “Normal Annual Cost Contribution” to their Pension Fund each year. This is the amount the Pension Fund Actuary calculates is necessary so that if all their assumptions and projections for the next 60 years or so come true there will be enough money in the Pension Fund in the future to pay the part of future pension payments that will be earned that year. It’s extremely important to realize that Pension Fund Actuarial Valuations are in fact pension funding plans based on the fundamental assumption that the only money that should ever have to be paid to a Pension Fund is the annual Normal Contribution.

2. Unfunded Pension Amortization Payments:

If a significant Pension Fund deficit develops usually only the government must make additional payments to eliminate that deficit. Further, if such a significant deficit develops it is proof on its face that the government’s basic pension funding plan has failed.

3. Other Payments:

a) Pension Obligation Bonds are Unfunded Pension Debt Payments:

Payments on Pension Bonds must be added to a government’s payments to Pension Funds to understand the total impact on current and projected government spending of their pension benefits.

b) Other Types of Payments:

Governments can make several other types of payments to Pension Funds such as reimbursement of administrative expenses and payments towards other types of benefits. But we won’t consider those payments in this paper.

B. Why Moody’s Should Restate Payments by Local Governments – Not Just State Payments

Moody’s states “current disclosures allow us to propose making the adjustment only for states at this time.” Moody’s will do what it wants to do – but I disagree for 3 main reasons.

1. Many Local Governments are Larger than Many States:

Los Angeles County’s Total Pension Liability is $50 billion – larger than 30 states in the US. Many US local governments have larger pension liabilities than many states.

2. Availability of Data:

The data Moody’s needs are readily available for many local governments. Users of Moody’s ratings will be better served by receiving more complete creditworthiness information about these entities than to have it not provided because the necessary data is unavailable for some other local governments.

3. The Threat to Owners of California Local Government Pension Obligation Bonds:

The purchasers and insurers of California local government Pension Obligation Bonds are facing an extreme threat. The cities of San Bernardino and Stockton have filed for federal bankruptcy and propose to not pay most of the remaining balance of their Pension Bonds. If they sustain this threat other local governments are very likely to follow.

The municipal finance industry led investors in these bonds into an extremely dangerous political situation. The people of California have repeatedly voted to require their approval before governments enter into the levels of debt represented by Pension Bonds. But the municipal finance industry developed methods of issuing Pension Bonds to avoid the people’s expressed demand to require a vote [11]. In this situation “moral hazard” properly refers to the industry’s purposeful design of methods to avoid what they knew was the express will of the people to control their governments’ debt. The industry placed the purchasers of these Bonds at far greater political risk than was disclosed. Even many conservatives, when they find out about how the industry purposefully side-stepped their repeated demand to submit debt of this kind to a vote, feel less morally obligated to pay these bonds.

Moody’s did not reflect this significant political risk in its credit ratings when these bonds were originally issued. They should do so now and in the future. Moody’s modifications of what government payments to their Pension Funds should be provide important additional information to properly evaluate investors’ credit risks.

C.  How Actuaries Calculate Payments to Pension Funds

This is a general description of how Actuaries calculate the two main payments governments make to Pension Funds.

a)  Payment #1, Calculating the Normal Yearly Contribution

Actuaries calculate the “Normal Yearly Contribution” (aka “Normal Cost”) to Pension Funds exactly as they do “Total Pension Liability” as described above with only one difference.

In calculating Total Pension Liability – called “Actuarially Accrued (Pension) Liability” – they first project the part of future pension payments employees and retirees have already earned in the past. Second, they “discount” that by the Pension Fund’s assumed target rate of return to come up with the amount that should be in the Pension Fund today.

When calculating the Normal Yearly Contribution instead of projecting the part of future pension payments that have already been earned the Actuary projects the amount that will be earned by employees in the upcoming year. That is “discounted” by the assumed rate of return to project how much money must be contributed to the Pension Fund next year so that pensions being earned next year can be paid. This is expressed as a percentage of each payroll for each class of employee rather than as a dollar amount, although a dollar estimation is included in Valuations. Then the Actuary allocates part of the Normal Cost to the government’s employees and the rest is allocated to the government. Many governments pay a portion of the “Employee Share” – but that is rarely reported. It should be – but it isn’t. This shows the allocation of the Normal Contribution between governments and their employees for the six Bay Area – North Coast counties with their own County Pension Funds as of the most recently available Actuarial Valuations.

Dickenson-Moody-table-7

Except for Contra Costa the portion of employee contributions actually paid by these counties is not shown in the Actuarial Valuations for these County Pension Funds.

b)  Payment #2, Calculating the Unfunded Pension (UAAL) Amortization Payments

The number of years a government plans to take to eliminate an Unfunded Actuarially Accrued (Pension) Liability (UAAL) is called the “amortization period”. California county governments may take as long as 30 years to pay off a UAAL. The interest expense incurred is the same as the Pension Fund’s target rate of return. There are two common methods used to calculate the amount of these UAAL Amortization Payments:

    • Level Dollar – the same dollar amount is paid each pay period.
    • Level Percent of Payroll – the same percent of each payroll is paid each pay period.

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. Four percent yearly growth
is often assumed. 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.

Let’s compare the results of these two methods. Assume:

    • UAAL = $100 million
    • Amortization period = 30 years
    • Interest rate = average target rate of return for the 6 Bay Area – North Coast County Pension Funds (7.73%)
    • One payment made at the beginning of each year [12]
    • Every assumption and projection over the next 30 years works out perfectly

(1) Level Dollar Amortization:

Payments are $8,882,743 a year for 30 years. This method is simple to calculate and understand.

(2) Level Percent of Payroll Amortization:

Assume Payroll is $75 million and will grow 4% a year in each of the next 30 years. If the government pays exactly 7.62146% of each of these payrolls through the next 30 years the UAAL will be eliminated. Payments start at $5.7 million and grow to $17.8 million 30 years from now. Both payroll and payments grow at a rate of 4% a year.

(3) Comparing Amortization of Unfunded Pensions Using “Level Dollar” vs. “Level Percent of Payroll”:

Those who advocate the “Level Percent of Payroll” method provide two arguments for why this is a good idea. First, although annual payments will grow as total payroll grows, at the same time the government will supposedly be earning more income because of increased taxes, fees and grants. So – this method is thought to even out the financial burden over time. Second, the regular yearly pension contributions are figured as a percentage of regular payroll each pay period. Since this “Level Percent” method is used for regular yearly payments, it’s easy to tack on a set percentage for unfunded pensions. But the Level Percent approach has problems.

a) Percent of Payroll – Much Lower Payments Early – Much Higher Later

Payments that are much less for the first third (or so) of the amortization period using the Level Percent method than it would under the Level Dollar method. As shown in Figure 2, for the first several years, the payments using the Level Percent of Payroll method are much lower than the payments required under the Level Dollar Method. The government officials who make the decision are in office now. It is quite likely they decide to use the Level Percent of Payroll method to make things a whole lot easier for themselves. The way they make it easier on themselves is to shove much larger payments off into the future when they won’t be in office. Someone else will have to deal with the problem.

Dickenson-Moody-figure-2

(b) Percent of Payroll – Negative Amortization Increases Debt

The next  graph, Figure 3, shows the annual payments under the Level Percent of Payroll method and the annual interest expense. For the first 12 years the payments are less than the annual interest expense. This is called “negative amortization” – the unpaid interest actually increases the debt. The pink area is unpaid annual interest – the debt is actually increasing.

Dickenson-Moody-figure-3

The bottom graph in Figure 3 shows the balance of unfunded pensions over the entire 30 year amortization period. The payments for the first 12 years are less than the annual interest expense and so the balance of unfunded pension debt increases for the first 12 years. At that point if we assume payroll really did grow 4% a year and therefore payments also increased 4% a year, finally the payments “catch up” with interest expense. But over those 12 years unfunded pensions actually increased nearly $16.5 million making total debt $116.5 million in year 12 instead of the beginning debt of $100 million. It then takes another 8 years for the increasing payments to pay the accumulated unpaid interest balance over the first 12 years. Therefore the balance of unfunded pensions doesn’t get back to its original $100 million until 20 years in the future.

The entire original balance of $100 million of unfunded pensions will be paid from 21 to 30 years from now. In this realistic example
today’s government officials shoved today’s unfunded pensions off to an entirely new generation of citizens and officials.

Both methods pay off the debt over 30 years. But the Level Percent of Payroll causes nearly $65 million more in interest expense – about 40% more (again – assuming all other assumptions and projections come true).

D.  How Moody’s Adjustments Will Affect Required Government Pension Fund Payments

These are county payments to Pension Funds projected in their Actuarial Valuations. We’ll see how Moody’s
adjustments would change these payments. (These don’t reflect County payments of part of employee contributions.)

Dickenson-Moody-table-8

Moody’s delves into their proposed adjustments to these two government payments to Pension Funds [13].

Ideally, participating government employers make annual contributions to their pension plans that result in those plans becoming fully funded over a reasonable time horizon. We propose to adjust annual contributions to reflect the adjustments we have made to pension liabilities. We believe this adjustment would function as a more accurate indicator of fiscal burden. We would not intend it to be a prescriptive funding strategy…

…We will adjust the ENC (Employer Normal Cost) to reflect our common discount rate, and the amortization payment to reflect our adjusted unfunded liability, a common amortization period, and a level-dollar funding approach.”

Moody’s Adjustment #1. Normal Annual Cost Contribution Payments Calculated at Much Lower Projected Rate of Return

In adjusting the normal yearly government contribution Moody’s would project the normal cost forward for 17 years at the plan’s reported discount rate, and then discount it back at 5.5%, after which employee contributions are deducted to determine the adjusted government yearly contribution. Using this approach, a reported normal cost payment of $100 million based on an 8% discount rate would grow to $149 million based on a 5.5% discount rate. This adjustment is quite simple mathematically. This is only an approximation of what the normal contribution would be if Moody’s were to use the Actuary’s projections of the part of future pension payments estimated to be earned in the upcoming year. That data isn’t available to Moody’s and even if it were it would be a lot of work to process. This shows the effect of this proposed Moody’s adjustment on the six Bay Area – North Coast counties:

Dickenson-Moody-table-9This adjustment increases the amount of the normal annual contribution Moody’s believes these counties should be paying from 66% to about 90% – not quite double. This is a very significant increase – but not nearly as significant for many governments as the next payment adjustment.

Moody’s Adjustment #2. Return Pensions to “Fully Funded Over a Reasonable Time Horizon”

a) Furthers the Goal of Intergenerational (or Inter-period) Equity

Who should pay for government employee pensions – people who receive their services, or the next generation? Employees earn their pensions while they are still working for government – it’s part of their compensation. Retirees never earn their pensions when they receive them. The payment of pensions in the future is the payment of a debt. Assuming they meet all the requirements to receive a pension, the day someone leaves a government’s employment they have 100% earned all those future pension payments.

But there’s a huge problem. We don’t know how much a retiree’s total pension payments will be when they retire. We can’t be sure how much the true economic expense of that employee’s pension was when he or she earned those future pension payments, nor do we know how much should be in the Pension Fund when they retire.

The Governmental Accounting Standards Board (GASB) establishes “Generally Accepted Accounting Principles” (GAAP) for state and federal governments. GASB describes “Inter-generational Equity” this way – “the current generation of citizens should not be able to shift the burden of paying for current-year services to future-year taxpayers. … financial reporting should help users assess whether current-year revenues are sufficient to pay for the services provided that year and whether future taxpayers will be required to assume burdens for services previously provided” [14]. Moody’s proposed adjustments are necessary in large part because current GASB accounting standards have not fulfilled this principle. GASB has allowed governments to report the pension expenses that created today’s massive unfunded pension debt decades after employees earned those pensions. The public didn’t see that “future taxpayers will be required to assume burdens for services previously provided” [15].

b) Moody’s To Use 17 Years as “Reasonable Time Horizon”

Moody’s believes a “reasonable time frame for government payments to Pension Funds” is the remaining number of years current employees will continue to work for a government. Moody’s will assume a standard 17 year remain service life for all governments. At that point the Pension Fund should be fully funded. The failure of governments to achieve this goal of “prudent” financial management imposed hundreds of billions of unfunded pension debt on future generations. They won’t receive one minute of public services or one dime of public infrastructure for those massive payments. If government officials had been required to fully fund pensions by the time employees retired this unfair unfunded pension debt would not have been shoved onto future generations.

Moody’s Adjustment #3. Unfunded Pension Liability Amortization Payments to Use Level Dollar Method

Moody’s proposes to require the Level Dollar method to calculate the catch-up payments necessary to restore pension funds to 100% funding within 17 years, not Level Percent of Payroll method. This adjustment clearly exposes the deeply flawed financial management of many if not most public pension systems.

The Level Percent of Payroll method actually increases a government’s unfunded pension debt 15% to 25% over the first 1/3 of the amortization period. As discussed earlier, it is likely the main reason government officials choose to use this method is to make it easier on themselves while they are in office at the cost of shoving even greater debt onto the next generation. It’s beyond the scope of this analysis to determine the prevalence of this method nationally. However, the Actuarial Valuations of the six counties in the San Francisco Bay Area and California North Coast region clearly indicate all six use this method. This table shows each county’s assume yearly increase in payroll and therefore UAAL amortization payments and the number of years taken to amortize the UAAL.

Dickenson-Moody-table-10
Unfunded pension debt is actually increasing for five of these six counties as a result of this method. It’s decreasing for one – San Mateo – because that county chose to eliminate unfunded pensions over an unusually short number of years – even less than Moody’s standard 17-year amortization period. They appear to be beyond the point at which payments begin to be larger than interest expense. Therefore they are beyond the period of “negative amortization” inherent in Level Percent of Payroll amortization.

This sample of six counties is far too small to generalize about the broad behavior of state and local governments. But I think it’s safe to say that the temptations of the Level Percent of Payroll amortization method are so great that many and probably most governments use that method – thereby actually choosing to increase their unfunded pension debt. Very few citizens realize their elected officials responsible to manage their local government finances have actually chosen methods to amortize unfunded pension debt that in fact significantly increases that debt. My experience is that when citizens realize this fact – regardless of their political ideology – they find it appalling.

4.  How Much Will Moody’s Adjustments Increase Catch-Up Payments to Restore Pensions to 100% Funding?

a) Recalculate the Amount of Underfunding Using the 5.5% Rate of Return:

As shown already on Table 4, by lowering the discount rate, or annual rate of return, on the future pension obligations already earned, to Moody’s much more conservative 5.5%,  the unfunded pension liability for the six counties increases from $4.1 billion to $10.2 billion. This change is summarized per county in Table 11 below:

Dickenson-Moody-table-11

Moody’s adjusted Net Pension Liability averages about 2.5 times larger than the UAAL reported by these six counties. By itself this will significantly increase the amount Moody’s considers a “prudent” unfunded pensions payment.

b) Calculate Catch-Up Payments Using New 17 Year Amortization Schedule and Apply Level Dollar Payment Method:

Table 12 shows the astonishing impact of Moody’s adjustments on the payment calculations. If Moody’s is correct these six counties – on average – should be paying nearly three times as much as they are to eliminate their Net Unfunded Pension Liability. (Again – the total percentage increase is the average increase for the counties – not based on total dollars.)

Dickenson-Moody-table-125. Summary: Impact of Moody Adjustments on Normal and Catch-Up Pension Fund Payments:

a) Government Payments to Pension Funds:

The graph below shows the proportional change in County payments to Pension Funds. The first stack for each county is the amount projected in the Actuarial Valuations. They equal 1.0 (or 100%). The second is the Moody’s adjusted payment. Green is the Normal Cost and pink-red is Unfunded Pension payments.

Other than San Mateo payments more than double using Moody’s adjustments. Sonoma is pushing 3 times greater and Mendocino is 2.5 times greater.

Dickenson-Moody-figure-4

The table below shows the actuarial calculation and Moody’s proposed adjustment. This table summarizes the changes in these six counties’ payments to their Pension Funds described above. It shows payments projected in Actuarial Valuations compared to those produced by Moody’s adjustments. Again – the total percent change is the average percentage for the 6 counties – it isn’t “dollar-weighted” (not based on the total dollars).

Dickenson-Moody-table-13

All together these six counties were projected to pay about $312 million to their County Pension Funds as their Normal Contribution and a little more than that – about $328 million – as UAAL Amortization Payments (catch-up payments to restore 100% funding). Total payments were projected to be about $640 million.

Moody’s adjustments more than doubled those combined payments for all six counties to over $1.4 billion – 125% more than currently defined by the Actuaries hired by these counties. The adjustments increased total annual Normal Contributions 78%, but increased payments to eliminate the Net Pension Liability 172%. San Mateo had the lowest increase. Even so Moody’s adjustments suggest it should be paying nearly double (an 87% increase overall). San Mateo’s comparatively short UAAL Amortization Period of 15 years for each year’s UAAL produced much higher Actuarially-defined UAAL payments than the methods used by the other counties. Moody’s adjustments nearly tripled Sonoma County’s payments – an increase of 182%.

b) Government Payments to Eliminate Additional Unfunded Pension POB Debt:

Pension Obligation Bonds (POB) are simply unfunded pension debt restructured into bonded debt in the hopes of obtaining a lower interest rate. Pension Bond payments must be added to Net Pension Liability amortization payments to see the total yearly “cost” to eliminate unfunded pensions. Once again Moody’s adjustments double these payments.

Dickenson-Moody-table-14

c) Overall Impact on County Budgets:

Most of the money spent by local governments comes from the State and Federal governments. Local governments must “match” a portion of Federal and State funds out of their independent local revenue base which includes property and sales taxes. The more they divert their independent tax base to pay Pension Funds and Pension Bonds the less they have to match and the less they have to spend on locally-funded projects. The more these payments consume their local tax base the more local governments lose control of their budgets.

These are, first, the 6 counties’ property tax income [16] compared to current payments to Pension Funds and Pension Bonds, and second, to the modified payments restated by Moody’s. Total Percentages are averages of the percentages for each county – they aren’t dollar weighted based on Total Dollars.

Dickenson-Moody-table-15

These six counties retained nearly $1.6 billion of the property taxes paid in those counties as their own revenue. Their total actuarially defined payments to their County Pension Funds were nearly $640 million or 37% of this County property tax revenue. Payments on Pension Bonds were about $177 million which was 12% of total property tax income. Therefore total payments projected by Actuaries to County Pension Funds and Pension Bond payments were projected to be slightly less than $820 million, half of their property tax income.

Moody’s adjustments make a huge difference. Total adjusted payments to Pension Funds jumped from 37% of County property tax income to 86% – well more than double. Then when Pension Bond payments are added in all these payments combined they consume almost all these counties’ property tax income.

If Moody’s is correct – that these are the payments necessary to prevent imposing significant unfair debt on the next generation and to prevent further deterioration of these counties’ finances – then these counties should have already lost control over practically all their property tax income. The only reason they still retain control over some of their property tax income is they are not managing their pension benefit finances prudently – they are in effect choosing to force the next generation to pay huge unfunded pension debts.

*   *   *

V.  CONCLUSION – WHAT THIS SHOULD MEAN TO CONCERNED CITIZENS

Moody’s believes current government financial reporting badly understates the financial risk created by government unfunded pension debt. Further – they believe today’s financial reporting by governments and their Pension Funds allow such a wide range of assumptions and accounting treatments that it’s practically impossible to compare governments meaningfully in terms of the finances of their pension benefits.

Although the focus on this paper is on Moody’s proposed adjustments, Moody’s conclusions are highly consistent with those reached by the Governmental Accounting Standards Board when they issued radically new pension financial reporting requirements this past summer (June 2012). Both will greatly increase reported unfunded pension debt. And the conclusion that most governments should be paying considerably more to their Pension Funds will be inescapable.

Moody’s believes the rate of investment profits assumed by practically all local and state government Pension Funds is significantly too optimistic. They believe return assumptions should be more consistent with those used for private sector Pension Funds. Moody’s believes the “true economic” state and local government unfunded pension debt is more like three times greater than the values those governments report today.

The six California counties analyzed for this report would report Net Pension Liabilities nearly three times more than their Pension Fund Valuations report today.

Given Moody’s adjustments and including the balances of Pension Bonds just these six counties together owe a total of over $1.6 billion in unfunded pension-created debt. They’ve only achieved about half their self-proclaimed pension funding requirements. By extension the debt for all local governments in California is massive.

Moody’s adjustments indicate they believe that if the finances of these six counties’ pension benefits were being prudently managed they would be paying over $1.4 billion each year to their Pension Funds instead of the less than half that amount they are in fact paying. When payments of Pension Obligation Bonds are included – even given the lower payments defined by actuaries today these counties are paying half their property tax income to their Pension Funds and to holders of their Pension Bonds. But if Moody’s adjustments are correct they should be paying all their property tax income. Again, if Moody’s is correct, the only reason these counties are retaining any of their property tax income for other purposes is they are pushing hundreds of billions of unfair debt onto the backs of the next generation.

Today’s financial management of government pension benefits is deeply flawed and in terrible need of major reform.

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Download Print Version

VI.  DATA SOURCES

Audited financial statements as of 6/30/2011 for these six counties were downloaded and analyzed. They have been aggregated and are all available for downloading on the www.yourpublicmoney.com website. Here are the direct links:

Alameda County’s 6-30-2011 Audited Financial Statements

Contra Costa County’s 6-30-2011 Audited Financial Statements

Marin County’s 6-30-2011 Audited Financial Statements

Mendocino County’s 6-30-2011 Audited Financial Statements

San Mateo County’s 6-30-2011 Audited Financial Statements

Sonoma County’s 6-30-2011 Audited Financial Statements

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-Moody-data-sources

Here are the direct links to download these actuarial valuations for all six counties:

Alameda County Actuarial Valuation

Contra Costa County Actuarial Valuation

Marin County Actuarial Valuation

Mendocino County Actuarial Valuation

San Mateo County Actuarial Valuation

Sonoma County Actuarial Valuation

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] Big Three (Credit Rating Agencies), Wikipedia, http://en.wikipedia.org/wiki/Big_Three_(credit_rating_agencies), (downloaded 12/2/12)

[2] Moody’s paper and other information about Moody’s proposed adjustments are available at my website www.YourPublicMoney.com in the Data/Reports/Video section of the site.

[3] Adjustments to US State and Local Government Reported Pension Data – Request for Comment, Moody’s Investors Service, July 2, 2012, page 2

[4] Moody’s, ibid, page 1

[5] Moody’s, ibid, page 2

[6] For a “plain-language” description of pension math that explains many of the terms in this paper (such as “smoothing”, “corridor limit”, “UAAL”, “Pension Obligation Bonds”, etc.) see How Pension Funds Work (click to access) in the “Data/Reports/Video” section of my website.

[7] This is the most important concept people concerned about unfunded pension debt need to understand to know how the huge unfunded pension debt that grips state and local governments was created and what needs to change – regardless of what changes you wind up wanting to see. See How Pension Funds Work.

[8] Moody’s, ibid, pages 5 – 6

[9] There’s an interesting “twist” to the math of Moody’s adjustments. The percentage change in asset values shown in Table 1 – Moody’s Adjustment of Pension Fund Asset Value – Six CA Counties ($Millions) at first glance seems to be less than the percentage change in Table 3 – Moody’s Adjustment of Total Pension Liability – Six CA Counties ($Millions). But the range of the percent change in asset values is much greater than that for Total Pension Liability. It’s this greater range of change in asset values that drives the even greater spread in the percentage change in Net Pension Liability.

[10] For an outstanding explanation of the absurdity of this “myth” see Pension Puffery: Here are 12 half-truths that deserve to be debunked in 2012, Governing Magazine online, Girard Miller, 1/5/12

[11] See Appendix B – “California” in An Introduction to Pension Obligation Bonds and Other Post-Employment Benefits – Third Edition (click to access), Roger L. Davis, Orrick Herrington & Sutcliffe, LLP, 2006. Also see “Pension Obligations Bonds” on page 21 of How Pension Funds Work.

[12] 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.

[13] Moody’s, ibid, page 8

[14] Concepts Statement No. 1: Objectives of Financial Reporting, Governmental Account Standards Board, No. 037, May 1987, page i

[15] GASB released new pension financial reporting standards in June 2012 that must be implemented by governments no later than their financial statements for fiscal years that begin after 6/15/14. These new standards will generally correct this glaring error in their current standards. I prepared several papers analyzing these new GASB standards. They are available at www.YourPublicMoney.com in the “Data/Reports/Videos” section.

[16] California counties collect all the property taxes paid within a county and then disburse significant amounts of the proceeds to other property tax supported agencies such as cities, school districts, and so on. The counties retain a set portion of the property taxes for themselves. The property tax values shown in this table are the amounts retained by the counties as their own revenue – not the total paid by property owners in the county.

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The California Budget Crisis – Causes and Recommendations

December 31, 2012

Download Printable Version

By William D. Fletcher

INTRODUCTION

California needs the equivalent of a readable annual report that lets everyone who is interested see how well the state is doing and where it’s headed. Hopefully, this report is a step in that direction. The closest overview available is the State Controller’s Office annual report and reports published by the LAO (Legislative Analyst’s Office).

This report is not trying to make a political statement or promote a specific agenda. The objective is to present the facts and any logical conclusions supported by the facts. The author is a social moderate and a fiscal conservative who is in favor of a social safety net, progressive taxation, and good pay and benefits for public employees. However, we should only promise what we can deliver longer-term. And, we should pay our way now and not burden future generations with excessive debts and unfunded obligations.

California is the “golden state” and should be the leading state in the nation. The state has the largest population and GDP by far. If California were an independent country, it would be the ninth largest economy in the world, slightly smaller that Italy but significantly larger than countries such as Spain, Russia, and India. California is the gateway to the Pacific, the fastest growing region in the world. The state has rich agriculture and other natural resources and is a leader in attracting high-tech investments. The state has an excellent university system, a terrific climate, is the entertainment capital of the world, and is a major tourist destination.

However, our finances are not in order. When analyzing California’s finances, there is a lot of data, but not much information. What is missing – or at least not easily accessible includes:

• Trend analysis, where are we headed?
• A long-term forecast
• Productivity, performance, or competitiveness measurements
• Comparisons to other states
• Total debt, underfunded liabilities, and other obligations

While there are several think tanks analyzing California’s finances, they are largely focused on the micro view, single topics or issues, or complex, in-depth analysis.

Slide01
WHERE ARE WE HEADED?

Where you might think the state is heading depends upon whether you are an optimist or somewhat pessimistic. This diagram is a simple model of the dynamics driving California’s economy. Will higher taxes and a poor business climate retard the state’s growth, keep unemployment high, and increase entitlement spending? Will our debts and underfunded liabilities lead to a financial crisis?

The economist Herb Stein stated “if something can’t go on forever, it will stop.” We just don’t know when or how. Hopefully, this report will give some insights as to how it could end and what needs to be done.

Slide02

This is an attempt to get an overview of the state’s public finances. The state budget only captures about 40 percent of the public spending in the state. In addition to the state government, there are:

• 984 school districts
• 4,772 special districts such as for power generation, flood control, and water conservation
• 57 counties
• 481 incorporated cities

Each of these entities has the ability to raise and spend money from taxes, fees, and other sources and incur debts that must be paid by taxpayers. The state’s finances are complicated and hard to understand. These other government entities are even less visible. Because the numbers on this chart come from several sources, it’s not possible to balance revenues and expenses. However, the numbers do give an idea of the relative size of these organizations. Federal payments are only payments that go to state and local government organizations. The largest single federal grant is for Medicaid. Federal spending that goes directly to citizens and organizations such as Medicare and Social Security payments, student loans, pay and benefits for military personnel and federal government employees in the state are not included.

Slide03

This is another overview of the state’s finances. Most discussion is over the General Fund. The General Fund is that portion of the budget over which the Governor and the legislature have the most control. However, the General Fund is only about 64 percent of the state’s spending and about 27 percent of the total. Proposition 98 directs that about 40 percent of General Fund spending has to go to K through 12 education. Recently, in a process referred to as “realignment” about $6 billion of annual spending has been shifted from the General Fund to Special Funds. This is cost shifting and not a reduction in spending.

Slide04

How are we doing? The state has run deficits since the 2000-01 fiscal year. When times were good and tax revenues were increasing, we spent it all and more. When times were tough and tax revenues were down, we ran bigger deficits.

During good times, pay and benefits were increased and budgets grew making it harder to control or reduce spending during slowdowns and recessions. The state should have a rainy day fund to set aside some money during boom times to cover deficits during lean times. There is legislation to this effect but it has not been effective in setting aside any funds.

Note that in 1999, Governor Gray Davis signed SB400 giving state workers significantly enhanced pensions and granting some retroactive pension increases to retirees. The assumption was that the high investment returns earned by the state’s pension funds would pay for this generosity, $600 million/year at the time, and no additional pension contributions would be required. Unfortunately, this was about a year before the Tech Bubble burst and investment returns fell to earth.

These generous retiree pension and healthcare benefits are taking a larger share of the state’s budget and causing big problems for many cities and counties.

Slide05

In about 1990, the state’s revenues depended on personal income taxes, corporate income taxes, and sales taxes for more or less equal shares of revenue. Since then, the state has increasingly become dependent upon the very volatile income tax for most state revenue. High-income taxpayers (top 10 percent) pay about 80 percent of these income taxes. A significant portion of their income is dependent upon capital gains and other investment income that is very dependent upon changes in the economy. The wealthiest citizens should pay a high share of income taxes. However, this volatility needs to be taken into account when preparing the state’s budgets. Don’t spend it all during good times because it won’t be there in bad times.

Slide06

This volatility has had a big impact on the state’s spending on education and Health & Human Services since the Real Estate Bubble burst in the 2007-08 fiscal year. Spending has been flat to down since the Housing Bubble collapsed.  However, this was after substantial spending increases over the previous ten years.

Slide07

Since the Housing Bubble burst in 2008, General Fund spending was reduced but more than made up for by federal stimulus funds so that total spending has been essentially flat. There hasn’t been any significant reduction in state employment during this period. Locally, about 30,000 teachers lost their jobs, or about ten percent of the state’s teachers. There have also been cuts in public safety and other employees at the county and city level.

Slide08

Due to the passage of Propositions 30 and 39, the state will have additional revenue starting this fiscal year. In addition, the Governor and the legislature have agreed on a number of budget cuts. The state’s economy is improving slowly, but steadily. All are good signs. According to the state’s Legislative Analyst’s Office, there is a good chance that the state will balance its budget this fiscal year, 2012-13, and over the next five years. This will depend upon the Governor and the legislature where the Democrats have a super majority in both houses, having the discipline to control spending. Five months into the current fiscal year, the state has a $2.7 billion deficit according to the Controller’s Office. It will be necessary to wait a few months to see if Propositions 30 and 39 and the improving economy close this gap.

We should probably dismiss the possible effects of going over the “fiscal cliff.” Even if congress and the President let the country go over the edge, they will eventually take actions to soften or eliminate its effects. A potentially bigger concern is implementation of the Affordable Care Act, a.k.a. Obamacare. California has committed to fully implement this program. The ACA is scheduled to be fully implemented in 2014, about a year from now. The ACA’s cost is hard to estimate. For example:

• How many new enrollees will sign up?
• What will be the cost per enrollee?
• Will more employers drop company-provided health insurance in favor of the public option?
• How much of the cost will be covered by the federal government?
• Will cost control measures yield intended results?

Medicaid is already one of the largest expense items in California’s state budget, second only to K-12 education.

Today, California has about 11.0 million enrolled in Medi-Cal, the state’s Medicaid program. There are an estimated 7.1 million uninsured in the state, and it is estimated that about 5.0 million of these uninsured will become eligible for benefits under the ACA.

Slide09

Where’s the balance sheet? What are the state’s total liabilities, including underfunded benefits and entitlements? There isn’t an accurate overview of the state’s total liabilities. Most debt is at the local level and does not show up in the state’s financial statements. The Controller’s Office does attempt to summarize the finances of the counties, cities, school districts, and special districts in annual reports. These reports list revenue, spending and debts but do not comment on any potential problems or required actions.

There are problems at the county and city level with the bankruptcies of Vallejo, San Bernadino, Mammoth Lakes and Stockton. Are these exceptional situations or an indication of a much wider developing problem?

Slide10

The next two charts summarize 2012-13 revenue and spending from the General and Special Funds as reported in the Governor’s Budget Summary for the enacted budget.

General Fund and Special Funds forecast revenues are $11.9 billion more than was raised in 2011-12, a 9.8 percent increase over last year. This includes the additional revenue anticipated by the approval of Propositions 30 and 39.

Slide11

General Fund and Special Funds spending for this fiscal year, 2012-13, is forecast to be about $7.1 billion greater than last year. Bond Fund spending is forecast to be about $1.0 billion less than last year. We can see that K-12 education and Health and Human Services make up the two largest spending categories by far.

Bond fund spending is from bonds issued by the state, not from current income. The interest and principle payments on these bonds is an expense under the General and Special Funds.

Slide12

Demographic trends are not favorable. Retirees, people over 65 years old, are the fastest growing segment of the state’s population by far. As people enter retirement, their earnings and taxes paid go down, and their demands on the state’s services go up, especially for healthcare. For a very long time, California had about five wage earners for every person of retirement age. This ratio is expected to decline to 3.6 wage earners per retiree in 2020, about eight years from now, and to less than 3.0 wage earners per retiree in 2030.

This demographic trend will put a lot of pressure on the state’s finances as retirees pay fewer taxes but require more state services.

California is also losing population through net migration to other states as reported in a recent study by the Manhattan Institute. Since 1990, California has lost about 3.4 million residents to other states. California’s population growth is due to internal growth (births minus deaths) and foreign immigration. Domestically, California has more residents leaving for other states, than those who are choosing to move to California.

The states that are receiving the most former California residents are Texas, Arizona, Nevada, Oregon, and Washington, in that order.

Who cares? Isn’t it a good idea to have lower growth? There will be less demand on the environment, infrastructure, school systems, etc. Unfortunately, there will be fewer taxpayers to pay for the state’s aging population, infrastructure improvements, public employee retirement benefits, and other essential state expenditures. It’s much easier to balance the budget and fund the future if the state has a growing population and economy.

In 1960, New York was the largest state with a population of 16.8 million. California was a close second. Since 1960, over 50 years, New York’s population has only increased about 17 percent to 19.6 million while California’s population has grown 240 percent and Texas’ population has grown 270 percent. Will California’s growth rate stagnate like New York’s going forward? If so, it will be harder to balance the budget and pay for essential services.

Slide13

Another ominous trend is the growing share of the state’s budget being consumed by retiree pensions and healthcare for state employees. There will be increasing crowding out of other essential spending. Controlling pension and retiree healthcare obligations is essential for the future of California’s finances.

STATE-BY-STATE COMPARISONS

How does California compare to other states?

Intitally, the plan was to compare California to Texas, the next largest state. New York and Florida were added to give comparisons of the four largest states and states that have some similarities and important differences in how they are managed. Findings are grouped under several headings: governance, the economy, taxation, finances, K-12 education, higher education, social policies, and the prison system.

Tables for each of these headings summarize the comparisons of these four states. This report will highlight what’s most significant in each table.

What is Texas doing right?

One statistic that is overwhelming is Texas’ job growth. For over 20 years, Texas has led the nation in the creation of new jobs.

Slide14

Two of the other largest states, California and New York, are laggards. Florida was doing well until the Housing Bubble collapsed. Some people dismiss Texas’ job growth as jobs for “hamburger flippers.” This isn’t true. Texas has growing high-tech, energy, and service industries and there is no reason to believe that jobs created in Texas are lower quality than those created in other states. Fast growing Austin, Houston, Dallas, and San Antonio all have abundant high-tech, and high paying service and professional jobs.

Slide15

A recent study of job growth by major city showed Texas having four cities in the top 10. Austin and Houston are the top two cities in the nation for job growth. California had one city, San Jose, barely make the top ten and three cities in the bottom ten: Oakland, Sacramento, and Riverside.

Slide16

California is by far the largest state by population and GDP with almost 38 million residents. California is almost fifty percent larger than Texas, and is twice the size of New York and Florida. Two states are heavily Democratic, California and New York, and two are largely Republican, Texas and Florida. California and New York have high sales and personal and corporate income taxes while Texas and Florida don’t have any personal income tax. California and Texas are both border states with identical percentages of their populations made up of Hispanics.

Slide17

In comparing the governments in each state, it’s interesting to note that Texas and Florida have part-time legislatures. The Texas legislature meets every other year for 90 days and the Florida legislature meets every year for 60 days. The governors of these states can call special sessions of the legislature if needed to deal with a specific issue.

In Texas’ part-time legislature about seventy five percent of the legislators are employed in businesses, farming, or medicine and nineteen percent work as attorneys in private practice. They have day jobs. In California, the legislature is essentially in continuous session and only about eighteen percent of the legislators worked in business or medicine before being elected to the legislature. Most were in government, worked as attorneys, or were community organizers.

Does the Texas legislature’s composition and part-time nature have any relationship to the state’s lower taxes, balanced budgets, or job growth?

Slide18

California has the largest economy by far as measured by GDP. As stated earlier, California’s economy would be slightly smaller than Italy’s if California were a separate country, and larger than the economies of Spain, Russia, or India.

In looking at job growth for approximately the last ten years, California had a net loss of almost 500,000 jobs at a time when Texas added about 1.3 million jobs. If we adjust for California’s larger population, Texas jobs growth equals about 1.9 million equivalent jobs in California. Think about how much better off the people of California would be today if California had approached Texas’ rate of job creation. There would have been more tax revenue, lower unemployment, and lower spending on entitlements.

A big part of the problem is California’s business climate that includes high taxes as well as burdensome regulations and other deterrents to business formation and job growth. Recent surveys show that California ranks very low as a place to do business, dead last in a recent CNBC survey. On the other hand, Texas ranked first in two leading surveys.

It’s not the policy of the governor or legislature to be anti-business. However, it is perhaps the unintended consequence of other actions that raise the cost and complexity of doing business in California. Improving the state’s business climate and promoting job growth has to be the cornerstone of the state’s economic policies.

Slide19

California’s tax burden is significantly higher than Texas or Florida, but lower than New York’s. These statistics are from earlier in the year and do not reflect the higher taxes associated with Propositions 30 and 39.

California’s maximum personal income tax rate is 13.3 percent following voter approval of Proposition 30. California now has the highest income tax rate of all the states. It remains to be seen if this tax increase raises as much revenue as anticipated. It also remains to be seen if this rate increase leads to more high income taxpayers changing their residences and making other changes to reduce their California income tax bill. California’s corporate income tax rate is also the highest of the other three states in the comparison, and is among the highest in the U.S.

It’s interesting to note that California collects more property tax revenue per resident and per home when compared to Texas or Florida even though these states don’t have state personal income taxes as a source of income. The higher cost of housing in California offsets the lower property tax rate dictated by Proposition 13. New York’s property taxes are the highest of these states.

Slide20

This chart shows how each state’s revenues are allocated. Florida and Texas don’t have personal income taxes and rely more heavily on property taxes and sales taxes. Texas doesn’t have a corporate income tax but does have a gross receipts tax that’s applied to businesses in the state.

Slide21

As stated earlier, California has run deficits for over ten years. Texas has been able to take actions to close its deficits and has about $7.0 billion in a rainy day fund. California is expected to balance its budget this fiscal year, 2012-13, but has a year-to-date deficit of $2.7 billion as of the end of November. All four states have high debt burdens and large unfunded obligations for public employee pensions and retiree healthcare. This is a national problem at the state level.

Another concern is that California has the lowest or next to lowest bond rating in the U.S. and has to pay an interest rate premium estimated to be 0.66 percent on its debt. If the state’s budget is balanced this year, and spending is controlled, this low bond rating should improve.

Slide22

California’s per pupil spending for K though 12th grade education has been declining due to budget pressures. On a per pupil basis, California still spends more than Texas and Florida but only about half of what New York spends. California does have the highest paid teachers in the U.S.  Results as measured by 8th grade math and reading tests, a common national metric, show that California is one of the poorest performing states. New York doesn’t do much better even though they spend twice as much per pupil as California, Texas, or Florida. Studies have shown that per pupil spending does not correlate closely with improved educational outcomes. California needs school reform as well as increased spending on K-12 education.

Slide23

It’s widely known that state funding for higher education in California has been reduced, costs are up, and tuition and fees have increased to close the gap. One striking fact is that there are now as many administrative personnel as there are faculty in both the University of California and California State University systems. For example, the California State University system has 12,019 faculty positions, whereas there are 12,183 administrative positions, and the University of California system has 8,669 faculty positions, and 8,822 administrative positions. Is this a sign of a growing bureaucracy and unnecessary cost increases? Could we deliver quality education for less if we really tried?

Slide24

An often-quoted statistic is that California has about twelve percent of the U.S. population but about thirty three percent of those on public assistance. This is due to California’s more relaxed eligibility requirements for TANF, Temporary Assistance for Needy Families. California didn’t adopt the national guidelines established under President Clinton’s welfare reform legislation. If California followed national guidelines, the state would have about 870,000 fewer people receiving benefits.

California also has the highest percentage of its population on Medicaid of any state, about 30 percent. This is partly due to the fact that more children are enrolled. However, California’s Medicaid reimbursement rate is the lowest in the U.S. California’s reimbursement rate is about half the Medicare rate, compared to a national average of about seventy percent. If you are a California resident dependent upon Medicaid, can you find a doctor who will accept you as a patient?

Slide25

California’s prison system is very expensive both relative to other states and relative to other state expenditures. California spends almost as much on its prison system, $8.9 billion, as on its university system, $10 billion. California’s cost per inmate is twice that of Texas and Florida.

Slide26

HOW DOES IT END?

Has California passed a tipping point? Is it still possible to make reasonable changes to stimulate growth of the economy, control spending, reform entitlements, and improve California’s debt ratings? Or, have we reached a point where external forces will dictate solutions to the states’s problems such as a bankruptcy court, reluctant lenders, or voters through the initiative process?

Slide27

There isn’t enough information to make a specific forecast. Instead, two future scenarios have been defined, one rosy or optimistic, and one that’s not so rosy. These scenarios are to illustrate the possible outcomes facing the state. The reader can choose one of these scenarios or something in between.

We should be cautiously optimistic but recognize that there is the potential for a bad outcome. It would probably show up as continuing deficits at the state level, and more bankruptcies at the county and city level.  Growth of the economy, job creation, and business formation could also stagnate, along with the number of high income taxpayers.  There is also the potential for a pension and retiree health care crisis if underfunded pension funds continue to earn less than the assumed 7.50 percent per year and retiree benefits absorb an increasing share of tax revenues. If we increased K-12 funding, how much would actually make it to the classroom?

RECOMMENDATIONS

What needs to be done? Specific actions are for the Governor and legislature to work out. This report will focus on the three big issues that need to be addressed:

1. Improve the state’s business climate and get the economy growing faster.
2. Control spending and balance the budget.
3. Reform state employee retirement programs to reduce costs and avoid a crisis.

Grow the economy:

As James Carville famously said “it’s the economy, stupid.” California must improve its business climate to grow the economy faster because:

Growing the economy is the best way by far to increase the state’s tax revenues.

Growing the economy is the only way to reduce unemployment and create the new jobs needed for the state’s high school and college graduates.

Growing the economy also reduces entitlement spending and the number of people who depend upon government programs.

Balance the budget:

California must also balance its budget and start paying down debt to improve its bond rating. Propositions 30 and 39 plus steady but slow growth of California’s economy will increase tax revenues, at least short-term. However, spending increases can easily overwhelm any increase in revenue. Today, the Democratic Party controls the state’s government. All state-wide political offices are held by Democrats. In addition to a Democratic governor, Democrats have a super majority in both houses of the state legislature. They have complete control of the state’s finances. It will be a big test of the Governor and the legislature to show the self-discipline needed to keep the budget in balance, and deal with other financial problems such as the state’s bond rating and needed entitlement reforms.

The voter-approved tax increases in Propositions 30 and 39 should increase revenue. However, it remains to be seen if this revenue equals what is anticipated from these tax increases. It also remains to be seen if California’s even higher taxes will, over time, further discourage new business formation and cause high income taxpayers to move their residences to other states and take other actions to decrease their taxable income.

Reform retirement programs:

The state needs to reform state employee pension and retiree healthcare benefits. Pension and healthcare benefits are already crowding out other state spending and forcing some cities into bankruptcy. These benefits shouldn’t be blamed totally for these bankruptcies but they are a major contributor. Pension plans at the state and local level still assume that their investment returns will be the 7.50 percent/year needed to adequately fund future benefits. Actual results for the past 10 years are much lower and pension plans are underfunded. If there isn’t a dramatic and permanent increase in investment returns, then the state is digging a big hole in the form of underfunded pension plans. Retiree healthcare benefits are less expensive than pensions but are significant. Also, most healthcare benefits are not funded and are paid out of current income.

If the state has to eventually admit that pension funds’ investment returns are less than current assumptions, then there will be a very big hole to fill. There is also the issue of fairness. Who should pay for any shortfall? Should current taxpayers be responsible for underfunding that occurred over the past ten or twenty years? Would these generous pension and health care benefits have been awarded in the first place if there was an honest accounting of the cost?  Also, how long will voters be willing to support public employee pay and benefits that are more generous than those available in the private sector?

One final thought is that we the voters are responsible for the government we have and are ultimately responsible for California’s success or failure.

*   *   *

About the author:
William (Bill) Fletcher retired as Senior Vice President at Rockwell International. During most of his time there he was responsible for 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 oganizations dealing with national security and international relations. The author retains all rights to the text and charts in this report.  He can be reached at cafinances@cox.net.

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Sources:
The following is a list of the main sources used in preparing this report.

Governor’s Enacted Budget 2012-2013
California State Controller’s Office
California Legislative Analyst’s Office
U.S. Census Bureau
Bureau of Labor Statistics
Bureau of Economic Analysis
State Budget Crisis Task Force
Manhattan Institute
U.S. Energy Information Administration
State Budget Solutions
PEW Center on the States
Tax Foundation
California Tax Reform Association
California Budget Project
Reason Foundation
Stanford Institute for Economic Policy
California Policy Center
California Progress Report
California Common Sense
League of California Cities
National Right to Work Foundation
CalWatchDog
CNBC’s America’s Top States for Business 2012
New York Times
Forbes
Wall Street Journal
Orange County Register
Los Angeles Times
USA Today
The Business Journals
The Taxpayers Network
Wikipedia.com
Google.com
About.com

Costa Mesa, California – City Employee Compensation Analysis

October 3, 2012

If San Jose and San Diego are ground zero for the grassroots battle to reform public sector pensions – in California at least – then Costa Mesa may be ground zero for an even broader public sector reform agenda. Because the city council in Costa Mesa has a majority of members who have been involved in a protracted and bitter fight with the public sector unions representing their employees, trying to restore financial sustainability not only to their pension benefits, but the entire package of employment compensation and work rules.

After already reporting on the total compensation packages enjoyed by the employees of San Jose (ref. “San Jose 2011 Compensation Analysis,” August 10, 2012), and Anaheim (ref. “Anaheim 2011 Compensation Analysis,” August 29, 2011), it is fitting to perform a similar analysis for the city of Costa Mesa.

The methods employed in this study mirror those used in the two 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 Costa Mesa. 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: Costa_Mesa_Total_Employee_Cost_2011.xlsx. The original spreadsheet is on the tab designated “original.” The only alteration that we have made to the original spreadsheet provided by the city of Costa Mesa’s payroll department was to delete the names of the employees in order to respect their privacy. Their job titles and departments have been retained, along with all available details regarding their compensation.

The goal of this study is to report average and median annual income for Costa Mesa’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.

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 $100,469 per year, for the 133 full time police officers, closely followed, at $98,372 per year, by the 76 full time firefighters. But base pay doesn’t tell the whole story, because Costa Mesa pays an unusually high percentage of its compensation before benefits in the form of “other pay,” which not only includes overtime, but also “certification” pay and “specialty” pay, along with other less significant sources of income. For example, the average payout of $56,395 in annual “Other Pay” on Table #1 for Costa Mesa’s firefighters included, on average, $44,810 of overtime pay in 2011.

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 2011, when base pay and “other pay” are combined, averaged $128,650 for Costa Mesa’s police officers, $154,767 for their firefighters, and $80,327 for the 216 full time employees comprising the rest of their workforce. 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 2011 for Costa Mesa’s police officers was $181,709, for their firefighters it was $208,401, and for the rest of the workforce it was $103,755. When the payroll records for employees of all departments are consolidated, the average total compensation for an employee of the city of Costa Mesa in 2011 was $146,863.

Table #2 compares average to median total compensation for employees of the city of Costa Mesa. 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 Costa Mesa, we calculated the median total compensation for the police department employees, the fire department employees, and 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 Costa Mesa the average total compensation for police only exceeds the median by 3%, for firefighters by 2%, and for the rest of the workforce, by 9%. Interestingly, because about 50% of the employees are police or firefighting personnel, who are compensated at a significantly higher rate of pay than the rest of the workforce, the total workforce comparison between average and median total compensation comes to within a half of one percent – virtually identical. Clearly the average total compensation figures developed in this analysis are not being skewed by the presence of highly compensated members of city management.

Table #3 examines Costa Mesa’s base pay averages compared to U.S. Census figures reporting average base pay for employees of local governments in California in 2010 (the most recent year of data available, ref. CA Local Government Payroll 2010). As can be seen, Costa Mesa’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. Costa Mesa’s firefighters, for example, on average received “other pay” of $56,395 each in 2011; the police on average received “other pay” of $28,181 each in 2011. 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 and firefighters working for local governments in California in general compared to Costa Mesa in particular. Since, in general, police and firefighters receive far greater average compensation than all other employees, this pulls Costa Mesa’s averages way up.

What appears unlikely as an explanation for this disparity, however, is that Costa Mesa 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 San Jose and Anaheim’s payroll and our examination of payroll for several other California cities and counties.


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. 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 Costa Mesa, varies between 29% and 41%. 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.


Table #5 calculates what the total compensation would be for the average private sector worker in Costa Mesa, using two exceedingly generous assumptions: (1) Base pay is assumed to be the average household income for Costa Mesa (ref. City-Data.com, Costa Mesa), 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 Costa Mesa actually makes. And yet, even using these absurdly generous assumptions, the total compensation for the average employee working for the city of Costa Mesa exceeds that of a private sector resident of Costa Mesa by 82%, nearly twice as much.

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 Costa Mesa pays 20.3% of their total compensation budget into pension funds. Put another way, as a percent of base pay, Costa Mesa contributes 34.4% into pension funds. Costa Mesa’s employees contribute via payroll withholding an additional 3.8 percent of their total compensation (6.4% of their base pay) to their pensions. But 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 San Jose and Anaheim’s city payroll, to properly assess how much Costa Mesa’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 Costa Mesa from the current $146,863 per year to around $175,000 per year. The typical firefighter’s pay would have to increase from the current $208,401 average per year to around $250,000 per year.

It is important to emphasize that the employment packages Costa Mesa 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

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. It is in this context that the ongoing debate between Costa Mesa’s union representatives and Costa Mesa’s elected officials must be viewed. By any objective analysis, Costa Mesa’s city employees earn more than twice as much as the local residents they serve.

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 what they earn. That is what they cost taxpayers. That is the number that should be compared to what taxpayers themselves earn. In Costa Mesa, the average employee’s total compensation of $146,863 adds 69% on top of their base pay. This is real money, and journalists who continue to ignore total compensation statistics in favor reporting only base pay are doing their public a disservice.

Conversely, the elected officials in Costa Mesa who are making these statistics transparent, and are attempting to bring their city’s employee compensation packages into parity with private sector norms, are blazing a trail that other elected officials must follow if California’s cities and counties are to avoid bankruptcy.

Anaheim, California – City Employee Compensation Analysis

August 29, 2012

Earlier this year the California Policy Center obtained from the city of Anaheim a comprehensive record of all payroll-related disbursements for 2011. This information was provided in the form of a spreadsheet that provided compensation details for every full and part-time employee of the city of Anaheim during 2011.

We performed subsequent analysis in order to develop total compensation averages per department. The spreadsheet provided by Anaheim’s payroll department, unaltered, can be found on the “original” tab of the larger downloadable spreadsheet, available for review, at this link: Anaheim_Total_Employee_Cost_2011.xlsx. The only data that has been deleted are the names of the individuals working for the city, in the interests of protecting their privacy. Their job titles, departments, and all other details of their compensation have been preserved.

The methodology we employed to properly develop average and median total compensation figures per department is relatively simple, and is modeled after an earlier CPPC study, published on August 10, 2012, that analyzes 2011 compensation by department for employees of the city of San Jose. In that study, entitled “San Jose, California – City Employee Total Compensation Analysis,” the reader will find a very thorough explanation of all assumptions made, assumptions that were precisely replicated in this analysis. Here is a summary of the key assumptions:

    • In order to develop representative averages, records for employees who were designated as “part-time” in their job descriptions were not included in the calculation.
    • Similarly, employees whose annual base pay was lower than the minimum annual base pay for their job description, as documented in the “City of Anaheim Pay Rates” available on the city website, were assumed to have not worked a full year, either because they were hired after January 1st, 2011, or because they retired or otherwise left service with the city before December 31st, 2011. These employee records were also not included in the calculation of average rates of compensation.

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 $118,373 per year, for the 24 full time employees of the City Attorney department. They are followed, at $102,029 per year, by the 17 employees of the City Administration. When the cost of benefits are included however, the 257 employees of Anaheim’s fire department have the highest average total compensation, at $193,516 per year. In terms of total compensation, the fire department is followed the 24 employees of the City Attorney’s office at $180,042, then the 523 employees of the police department at $170,866. As a whole, Anaheim’s full time workforce’s average annual base pay is $84,158, and their average total compensation is $146,551.

Table #2 compares average to median total compensation for employees of the city of Anaheim. 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 Anaheim, we calculated the median total compensation for the police department employees, the fire department employees, and all other employees. Because a properly calculated median compensation amount must have an equal number of individuals making more than the media 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 can be seen, however, the median income for police employees is actually higher than the average, meaning that if anything, the average total compensation is unrepresentative of the typical officer because it is too low. In the case of Anaheim’s firefighters, the median and the average are almost exactly the same, strongly suggesting that the average total compensation is entirely representative of a typical firefighter’s pay. And even for the rest of the workforce, the average only exceeds the median by 11%. Clearly the average total compensation figures developed in this analysis are not being skewed by the presence of highly compensated members of city management.

Table #3 examines Anaheim’s base pay averages compared to U.S. Census figures reporting average base pay for employees of local governments in California in 2010 (the most recent year of data available, ref. CA Local Government Payroll 2010). As can be seen, Anaheim’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 likelyhood that “other pay” and other categories of direct compensation are not reported to the U.S. Census Bureau as base pay. Anaheim’s firefighters, for example, on average received “other pay” of $29,776 each in 2011; the police on average received “other pay” of $17,827 each in 2011. Another reason for the significant difference is because U.S. Census data shows a much lower percentage of police and firefighters working for local governments in California than Anaheim. Since, in general, police and firefighters receive far greater average compensation than all other employees, this pulls Anaheim’s averages way up. What appears unlikely as an explanation for this disparity, however, is that Anaheim actually has unusually high rates of pay for their city employees compared to other cities in California, as indicated by published analysis of San Jose’s payroll and our examination of payroll for several other California cities and counties.

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. 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 Anaheim, varies between 48% and 56%. As the next table will demonstrate, this is more than twice the rate of payroll overhead paid under even the most generous plans available in the private sector.

Table #5 calculates what the total compensation would be for the average private sector worker in Anaheim, using two exceedingly generous assumptions: (1) Base pay is assumed to be the average household income for Anaheim (ref. City-Data.com, Anaheim), and 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 Anaheim actually makes. And yet, even using these absurdly generous assumptions, the total compensation for the average employee working for the city of Anaheim is more than twice that of a private sector resident of Anaheim.

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 Anaheim pays 17.3% of their total compensation budget into pension funds. Presumably some additional percentage is paid by the employees via payroll withholding. But 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 properly assess how much Anaheim’s city employees really make in total compensation, therefore, 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 Anaheim from the current $146,551 per year to at least around $190,000 per year. The typical firefighter’s pay would have to increase from the current $193,516 average per year to at least around $235,000 per year.

It is the obligation of journalists reporting on government budget deficits, as well as policymakers who face these challenges, to produce analyses of this nature for the cities and counties where they report or where they serve. Municipal payroll data is publicly available and the techniques necessary to perform this analysis are not beyond the abilities of anyone with an intermediate command of Excel. It is unconscionable to report on negotiations over furlough days, foregone cost-of-living adjustments, deferred benefit enhancements, or any other details relating to the eternal bargaining between public sector unions and politicians attempting to manage municipal budgets, without providing the overall context. How much do public employees really make in total compensation? How much will they make if their retirement benefits are prefunded at realistic rates of investment return? Anaheim and San Jose are but two examples, and they are likely typical of nearly every other city and county in California.

San Jose, California – City Employee Total Compensation Analysis

August 10, 2012

On June 5, 2012 the City of San Jose thrust itself into the forefront of the national debate over public sector pensions with its passage of Measure B, a landmark measure that dramatically restructured the pension and retirement benefits of the city’s current employees. Though the internal pressure that led to this measure had been building for some time, the passage of this measure was still quite noteworthy in itself. For one, this measure forced city employees to either now contribute much more towards their pension plan or be placed in a pension scheme that offered far fewer benefits than is typically enjoyed by public sector employees in California.

More remarkable, though, was the fact that this measure was passed in one of California’s largest cities and in its most liberal region. For the state’s public sector unions, this was home turf. Yet, Measure B was supported by an overwhelming 69.6% of San Jose voters, by San Jose’s Democrat Mayor, Chuck Reed, who lobbied hard on its behalf, and by a significant portion of the city council. So strong was the public support for this measure that the city’s public sector unions didn’t even seriously attempt to challenge it during the election, and instead looked to the courts as where they would have it overturned.

As to be expected, San Jose’s Measure B has generated a significant amount of discussion and commentary within the nation’s political and legal circles, all of who have taken a keen interest in the outcome of San Jose’s efforts to avoid financial ruin. In an attempt to add to this discussion, we have prepared a detailed analysis of the total compensation packages for all of San Jose’s city employees from payroll data provided directly to us from the City of San Jose. Though it is true that a multitude of causes has contributed to San Jose’s financial predicament, including the real estate downturn and recession of 2008, we will show that the most primary cause of San Jose’s problems is the pension and healthcare benefits they have committed themselves to with their employees. In the paragraphs to follow, we will make this point more evident by detailing the figures we derived from San Jose’s actual payroll report for the 12 month period through 12-31-2011 and the publicly available pension data the city provides on its website.

Method:

Since the primary focus of this analysis is how the city’s employment costs have affected its financial stability, we first requested and obtained a copy of the city’s payroll report that listed all of actual expenditures for each employee for the entire year 2011, separated by department. During this period, the City of San Jose employed 7,752 workers. In order to get as precise of a reading as possible for our analysis, we made sure to have the city separate and identify all of the expenditures for each employee (e.g., salary, overtime, cash benefits, sick pay). This allowed us to get a better idea of what types of benefits the employees were able to obtain and what the average employee was getting for each of these types of benefits. The payroll report we obtained also showed each type of deduction taken from each employee’s paycheck, such as health insurance, pension contributions, etc. Of course, all of these figures varied from department to department, so we were careful to separately analyze all of the workers by department.

In the interests of both making our research as transparent as possible, and also to provide a detailed example for anyone wishing to perform this analysis for their community, we have uploaded the Excel file used for this analysis. Anyone who would like to look at the data is encouraged to download this file onto a computer equipped with Excel 2010. The reader will note that the spreadsheet has two primary tabs, the “original” which is what we received from the City of San Jose’s payroll department, and the “analysis,” which retains everything in the original, but has a few additional columns added that allowed us to screen out part-time and partial year workers. The only data we have omitted are the actual names of the individuals themselves, out of respect for their privacy. If you download this spreadsheet, San_Jose_Total_Employee_Cost_2011.xlsx, please be aware that it is over 3.0 megabytes.

To avoid skewing our averages, we had the city identify all the employees who retired during 2011. We also worked with the city to identify all employees who worked on either a part-time basis or for less than a year so we could exclude them from our primary computations. The assumption we made to screen out part-time employees was simply to sort the payroll records by job title and flag any record where the job title included the words “temporary,” “intern,” or “part-time (ref. column B of analysis).” The assumption we made to screen out partial-year employees was to sort the payroll record by job title, then by base salary, and flag all records where salaries that fell below the minimum base salary for that job title (ref. column C of analysis).

This process, while time consuming, is an accurate way of making certain that employees who only worked a partial year didn’t have their necessarily lower salaries included in the average. Since the city also provided data on who retired during 2011 (ref. column P of analysis), we were able to correlate our analysis based on base salary comparisons with that data and found it was a nearly perfect match. Those employees who did not retire, yet had lower base salaries than the minimum for their job title were assumed to be employees newly hired or newly promoted to that job classification. Because we used the minimum salary for our criteria, this exercise still understates the impact of partial year employees on the average. Our reference for this information, “City of San Jose Pay Plan,” is posted on the city’s website.

The importance of this step became apparent when we compared the averages for all categories of compensation before and after excluding part-time and partial year employees. The only average that didn’t rise considerably once part-time and partial year employees were excluded was the sick and vacation payoffs, which will be discussed in the findings section of this analysis.

Lastly, we carefully verified all of our assumptions about this data by reviewing the labor agreements (MOUs) and other payroll documents that San Jose provides through their website. We also had several discussions with members of San Jose’s Human Resources and Payroll Departments. In all of our requests and questions, we found these employees to be very gracious and accommodating, and their assistance proved to be wholly invaluable to our efforts.

Findings:

The first thing to note was the degree to which base pay is not an accurate indicator of total compensation. When comparing rates of compensation it is necessary to include all payments made by an employer that directly benefit the employee, including salary and overtime, but also any “other compensation,” “deferred compensation,” the cost for medical benefits, and the cost to contribute annually to the employee’s future retirement benefits, both health insurance and pensions. Table #1 shows the average total compensation for San Jose’s full time employees in 2011, sorted by department:

In Table #1, above, one can readily see that virtually all full time employees working for San Jose enjoy a total compensation of over $100,000 per year. Only the 65 employees who report to City Council members, barely one percent of the workforce, make less than that; their average in 2011 was $94,662 per year. Whenever comparing public sector employee compensation, it is necessary to review the averages for public safety employees separately from the rest of the workforce, because their average compensation is dramatically higher than the rest of the employees. As can be seen, the average policeman in San Jose in 2011 earned total compensation of $178,821, the average firefighter earned $203,098, and the average for all other employees was $120,092.

A frequent criticism of “averages” when discussing California’s state and local employee compensation is that the average includes highly compensated public administrators and therefore skews the data. For this reason, we also have included an analysis of median data, wherein half of all employees make more than the median employee, and half of them make less. For the median calculation, we used the total earnings including city paid benefits, i.e., the total reported compensation of San Jose’s city employees. We excluded, of course, employees who worked part-time or retired during 2011, since that information will also prevent an accurate assessment of what a truly representative median, or average, might be.

As shown on Table #2, for all San Jose city employees, the median total compensation in 2011 was $139,634. For police officers, including the leadership, but also including the data technicians, i.e., all police personnel, the median total compensation in 2011 was $189,411 in 2011. For firefighters, again, including all members of the department, the median total compensation was $205,557 in 2011. And for all full-time employees in San Jose not including police or firefighters, the median total compensation in 2011 was $114,923.

The significance of this fact, that the median total compensation for San Jose’s city workers is nearly identical to their average total compensation, is easily understated. One certainly might say it  proves a commendable level of pay equity exists between the highest and lowest paid positions. And it entirely puts to rest the contention that studies that cite average pay are presenting distorted data because a handful of grossly overpaid executive positions pull the average up to an unrepresentative level. As a matter of fact, for San Jose’s public safety personnel, the median total compensation actually exceeds the average, implying – using this same logic – that the lower echelon positions are actually overpaying.

The impact of “other pay” adds a great deal to total direct compensation on top of base pay. In our subtotals, “Other Pay” includes overtime, sick and vacation payouts, and “other cash compensation,” which is defined by the San Jose’s payroll dept. as “Premium Pays,” “Certification Pays,” “Higher Class Pays,” “Retroactive Pays,” ” Taxable Reimbursements,” “Benefits ‘in-Lieu’ payments,” and “Supplemental Pays.” The fact that this other pay is awarded sporadically, and therefore may not be reported by census respondents as part of their income, could help account for the fact that San Jose’s average payroll is considerably higher than what is reported per department by the U.S. Census Bureau for California’s local government workers.
Table #3 illustrates the degree of this disparity – as can be seen, the full time workplace averages for San Jose’s city workers are fully 39% higher than the averages reported by the U.S. Census Bureau for 2010 for local government workers in California. This point requires emphasis, because when critics who are concerned about potential cases of overcompensation point to U.S. Census data as their proof, they are often accused of exaggerating their figures. In reality, certainly in the case of San Jose, the U.S. Census data significantly understates the average direct compensation.
Not reported by the U.S. Census, but evident in precise amounts from the City of San Jose’s payroll records, are the other elements of total compensation – the employer paid benefits including Medicare, health insurance, retirement pension contributions, and other miscellaneous benefits such as life insurance and disability insurance. A valid way to compare total compensation between San Jose’s city workers and the taxpayers who support them begins by calculating the employer paid benefits, and dividing that amount by the total direct pay. This yields a payroll overhead rate that can be compared to overhead rates that typically apply in the private sector.
In Table #4, all other pay is included in the denominator, making total direct pay the sum of base pay, overtime, and “other pay.” In the case of San Jose’s firefighters, this “other pay” classification (defined earlier) comprises a major portion of total compensation, averaging nearly $15,000 per year.
As can be seen, the major element of employer paid benefits is the retirement pension contribution, averaging over $50,000 per year per police officer and over $60,000 per year per firefighter. Even for the rest of the workforce, over $26,000 per year is being contributed towards their pension every year by the city. And the amount being contributed per year towards health insurance by the city – nearly $12,000 per year for the firefighters, and over $10,000 per year for the police and the rest of the workforce – significantly exceeds private sector norms.
In all, the average total compensation for a worker in the city of San Jose is just under $150,000 per year. Firefighters average over $200,000 per year in total compensation. And their payroll overhead averages 55% per year, 60% for police, 62% for firefighters, and 48% for the rest of the workforce. This payroll overhead represents hard dollar expenditures by the employer, and must be included in any comparison of how much San Jose’s city workers make, on average, compared to how much the taxpayers who pay this are themselves earning.
Table #5 provides an absolute best case average for the compensation earned by the private sector residents of San Jose. For total direct pay, the figure of $76,495 is taken from the San Jose Profile on the website City-Data.com. This figure is the estimated household income for San Jose residents – household income – and is undoubtedly higher than the per worker average since a significant percentage of households have more than one income earner.

Using this obviously best-case amount as the denominator, the table then goes on to apply best-case averages for employer paid benefits, including Medicare at 1.45% per year, Social Security at 6.2% per year, health insurance at $6,000 per year – a very good package for most companies which almost universally require significant employee co-pays via payroll withholding – and a top-of-class 401K retirement plan contribution of 6.0%. As can be seen, even under the best assumptions possible, the payroll overhead for a premium private sector position is only 21% of total direct pay. This is a staggering disparity.

If one simply assumes that only 50% of the households in San Jose have two income earners, the average direct pay reduces from $92,937 per year to $61,958 per year. And even if you apply a 21% payroll overhead rate, which represents a premium, clearly unrepresentative and overstated estimate, you arrive at an average total compensation for San Jose’s private sector taxpayers of $74,969 per year, only half as much as the average for city workers. This private sector average is still probably on the high side. Taxpayers and policymakers must ask themselves, does the premium deserved by city workers for the risks they take and for their greater average educational attainment justify paying them twice as much as the taxpayers they serve?

No discussion of how much city workers make is complete without further discussion of retirement benefits. Immediately upon retirement, for example, San Jose’s city employees typically “cash-out” their sick and vacation time, which is permitted to accrue without limit. This practice is virtually unheard of in the private sector. But in San Jose in 2011, there were 410 employees who retired, and their average sick and vacation time payouts (these figures did NOT figure into the averages reported anywhere else in the preceding analysis) were as follows:

  • 100 police retirees with an average sick/vacation payout of $56,273
  • 72 firefighter retirees with an average sick/vacation payout of $63,306
  • 238 other retirees with an average sick/vacation payout of $28,547

Returning to the issue that impelled the pension reform vote in San Jose is necessary to fully appreciate just how much San Jose’s city workers make. Because the average total compensation of $149,829 earned by these employees is based on their pension fund contributions earning an annual rate of return of 7.5% from now on. This remains the official rate used for projections by San Jose’s pension fund. This is the same rate of return still used for projections by CalPERS and CalSTRS. The pension contribution hikes of recent years have been necessary to make up for sub-7.5% returns in past years, but these increases have not added enough money to the funds to allow sub-7.5% returns from now on. The implications of lower than 7.5% returns are sobering, and should be obvious to anyone who truly appreciates the concept of compound interest.

The California Policy Center has prepared a spreadsheet that anyone wishing to analyze the sensitivity of pension fund contributions to projected rates of return. This information can be found by referring to the study “A Pension Analysis Tool for Everyone.” A quick summary of that study would be this: For every 1.0% the pension fund’s projected rate of return drops, the required pension contribution must go up by 10% of payroll. Put another way, if the direct pay of the average worker in San Jose – not including overtime – is $90,000 per year, and it is, then if San Jose’s pension fund can only return 6.5% per year from now on, the annual pension fund contribution per employee must go up by $9,000. If that fund can only return 5.5% per year, the annual pension fund contribution per employee must go up by $18,000, and so on. In reality, because pension funds are supporting people who are already retired, and employees whose benefits were retroactively increased over the past 10 years – leaving them already underfunded – each 1.0% drop in the projected rate of return has an even greater impact than 10% of payroll. And the irrefutable conclusion that follows is that unless the pension benefits are lowered and the required employee contributions to their pensions are increased, then if long-term rates of return for San Jose’s pension funds drop by at least 2.0%, the total compensation of employees in San Jose is not roughly $150,000 per year, but at least $170,000 per year.

The other pressing obligation that has constrained the city’s long-term financial health is its obligations to cover its retiree’s healthcare benefits. To the extent the City of San Jose is contractually bound to pay a portion of their retired employee’s health insurance premiums, the pre-funding of those costs during the years these employees work is something that, like pension contributions, must be considered part of payroll overhead and must be considered an integral part of their total annual compensation. In our analysis of the payroll data and the MOUs that govern the employee benefits, we were able to confirm that the city and employees each contribute equally towards (1:1) the health care benefit fund for retiree healthcare, and at a rate of 3:1 for retiree dental benefits. Further, any portion of these funds that do not achieve total funding is borne equally by the city and employee alike. This is little comfort for the City’s managers, however, since as of 2011 these funds were only 10% funded.  Although the city has also implemented a plan to achieve full funding for these plans over the course of 30 years through a series of increased contributions which began, at a minute scale, during the 2nd half of 2011, this huge outlay is still a serious impediment affecting the financial stability of San Jose for many years to come. If this obligation were fully funded, proper ongoing pre-funding would add at least a few thousand dollars per year to the average total compensation of every employee working for the City of San Jose. Because, however, San Jose is only beginning to contribute to an adequate reserve for funding retirement health insurance commitments to its retirees, a credible estimate of what it would truly take to move their retirement health insurance fund into a position of 100% solvency is probably many times that amount.

As we have shown in our analysis, the average total compensation for a full time employee with the City of San Jose averages nearly $150,000 per year. If one assumes only a modest drop in pension fund future returns, from 7.5% per year to 5.5% per year, this average total compensation jumps to at least $170,000 per year. If pension fund returns drop more than 2.0% off the current projection, average total compensation will have to go up even more. And retirement health care obligations, while amounting to less in absolute dollars than pension obligations, are significantly underfunded. Bringing them up to solvency will require additional significant increases to the average total compensation. With only modest reductions in pension fund returns, it is clear that the payroll overhead for San Jose’s city workers easily reaches 100%, whereas in the private sector, such overhead rarely exceeds 20%. And our analysis has shown, even absent these reductions in rates of return for the pension funds, and absent any increases to retirement health care pre-funding, the average worker for the City of San Jose makes more than twice as much as the average private sector worker – in an area that boasts some of the highest average rates of private sector compensation in the United States.

It is left to the reader to determine whether or not this is an appropriate level of compensation for the government workers who serve the taxpayers, or whether or not any voter approved contract modification that might reduce such a disparity between private sector and public sector compensation should pass intact through court proceedings.

Understanding the Financial Disclosure Requirements of Public Sector Unions

June 12, 2012

As political scholars and pundits across the nation continue with their post-mortem analysis of the disastrous recall effort against Wisconsin Governor Scott Walker, one charge that has gained a significant amount of traction has been that the recall campaign against the governor was overwhelmed by the amount of “secret and corporate money” that propelled the Walker campaign to victory. [1]

At its core, this claim echoes many of the criticisms that have been directed against the Supreme Court’s decision in Citizens United v. Federal Election Commission in which the Court held that corporations and unions enjoy the same rights of free speech  as those of natural human beings. [2] Whether or not this decision and its laissez-faire attitude towards political speech and campaign finance regulation compromised certain desirable qualities of the electoral process is certainly worthy of a serious and candid discussion. Nevertheless, there is also a great deal of irony in invoking this line of criticism within the context of the Wisconsin recall insofar as the very entities that led the attack against Governor Walker – i.e. the public sector unions of Wisconsin and the larger Midwest- themselves enjoy a level of privacy with regards to their financial affairs that is disproportionately greater than most other private and corporate entities in the United States.

In an attempt to make this point more clear (and the consequences that stem from it more palpable), this article will briefly describe the basic financial reporting requirements that govern public sector unions. Following from this discussion, this article will then detail a few sources of information on the public sector unions and the benefits that are conferred upon their members. To illustrate these methods, the financial positions of several major public sector unions in California will be also be given. In conclusion, this article will consider the nature of this problem in relation to the size and power of these unions and the need for an update to the laws that govern their financial reporting requirements.

Financial Reporting Requirements of Public Sector Unions

In general, public sector unions have very few reporting requirements when it comes to disclosing their financial positions to their members and to the public. This dearth of oversight is a significant contrast from the financial reporting laws that govern private sector unions, most of which impose a much greater level of openness and transparency than is found with public sector unions.

Under federal law, most of the labor unions that represent private sector employees are bound by reporting requirements of the Labor Management Reporting and Disclosure Act (LMRDA), which among other things, requires that they file an annual financial report with the Department of Labor. [3] This law was specifically designed to make the internal workings of the labor unions fully transparent to both their members as well as the public in the hopes that such openness would hinder corruption on the part of union management. [4] This law also applies to unions where an individual chapter or affiliate represents both public and private sector employees. [5] Certain chapters of the IBEW, for instance, fall under the reporting requirements of this law insofar as they have members who are employed by both municipal and private entities. [6]

In most circumstances, a union that is bound by the reporting requirements of this law will have an outside accounting firm conduct an audit of their financial records, and they will then prepare and file either an LM-2, LM-3, or LM-4 form that details their findings. The LM-2 forms are filed by unions who have over $250,000 in annual receipts; the LM-3 form is for unions that have less than $250,000 but more than $10,000 in annual receipts; and the LM-4 forms are for those unions with less than $10,000 in annual receipts. [7] These reports reflect the standard financial metrics typical of any financial statement, such as the union’s assets and liabilities, expenditures, the salaries of the union’s board members and employees, any monetary disbursements made by the union, etc. [8] Although these reports are fairly comprehensive in the data they report on, they only represent a snapshot view of a union’s financial position at the end of the fiscal year, so their application is generally limited in the absence of more extensive information.

The LMRDA also requires that these reports must be made available to all members of the union every year. [9] And in the event that a grievance suit is initiated by a union member concerning the union’s finances or its use of membership dues, the raw data from which the figures in the report are derived (e.g., accounting statements, receipts, etc.,) must also be provided to the complaining party for review upon a showing of just cause. [10]

For unions that are comprised solely of public sector employees, however, federal law does not impose any reporting requirements under the LMRDA or any law similar to it. Instead, they are only required to file a 990 tax form with the IRS, which is the same tax form that is used by most non-profit entities that fall within 501(c) of the tax code and do not claim any income. [11] This form is fairly similar in content to the LM-2/3/4 forms, and all private and public-sector unions alike must file one. But as with the LM-2/3/4 forms, the 990 provides little more than a cursory glance of a union’s financial position at the end of the fiscal year, so their usefulness is fairly narrow.

Under state law, the financial reporting requirements of the public sector unions are more scant than under federal law. In fact, they are almost non-existent. An overwhelming majority of states impose no financial reporting requirements at all upon the public sector unions that operate within their state, and only a very small few actively collect any financial data at all. [12] California, for example, only requires that a yearly financial statement be “made available” to the board of each union and to the individual union members themselves. [13] These reports that are provided to the members of the union are sometimes referred to as Hudson Reports, and like the other various filings that have been discussed, these forms only provide a very basic overview of the union’s financial position at the end of the fiscal year.

In our own discussions with the California Public Employment Relations Board, we were able to confirm that this agency does not actively monitor the financial expenditures of California’s public sector unions. [14] We were even informed that this agency will only collect a union’s financial report upon the filing of grievance complaint. Additionally, it also appears that no other state agency reviews this information either. So for all intents and purposes then, it appears that public sector unions such as the CTA or SEIU 1000, both of whom command tens of millions of dollars in revenue, are free from any significant threat of an audit or internal review of their operations.

Collecting the Data

As we have shown, there are very few available sources of information on the financial data of the public sector unions. However, there are still a number of sources from which fairly solid data on these organizations can be obtained.

From our own experiences, we believe that the most consistent and direct way to gather data on these organizations is to first obtain their 990 forms that they must file each year with the Internal Revenue Service. This can be accomplished by using the databases provided on websites such as guidestar.org or foundationcenter.org. [15] (It does not appear that the Internal Revenue Service provides any sort of database for searching the 990 forms of 501(c) entities). These two sites gather a wide variety of data on non-profit organizations, including their 990s, and they allow their users to search by region, city, net worth, etc. Although these sites generally do not charge anything to run a basic search, they may require an email registration to use their services.

For unions that fall under the reporting requirements of the LMRDA, you can obtain their financial statements (LM-2, et seq.) and other required disclosures through the portal maintained by the Department of Labor at http://kcerds.dol-esa.gov/query/getOrgQry.do. This site is a very useful option as well, and the information it provides often compliments the other sites quiet nicely. The only real limitation with this site, however, is that  financial documents it provides do not offer a very penetrating account of the financial position of the unions it reports on. It is also worth pointing out though that this site also has certain other documents available through this site such as private and public sector collective bargaining agreements. But these documents are not always current, so they are sometimes of little help. [16]

Incidentally, it is also worth noting that it is sometimes possible to obtain financial information and other relevant data on a public sector union from their own website. The website for the Southern California division of the SEIU 721, for instance, provides links to its bylaws, constitution, and current and past financial statements. [17] Although this is atypical of most other unions, it would not be a waste of time to explore this option in the chance that such information is being made available. These sites are can also be extremely useful when reviewing the search results from other sites such as guidestar.org or even Google because they can help delineate each chapter and affiliate. One city may contain several chapters or affiliate unions with similar name, so these sites can provide an invaluable reference point for keeping each entity clearly identified.

Another important and closely related source of information on the public sector unions is the collective bargaining agreements and memorandums of understanding that they enter into with the cities and counties they contract with. In California, all state and local government websites will provide links through their human resources websites to the MOUs and salary/benefit schedules that they have stipulated to under the collective bargaining agreement. These are very helpful to review because they detail the nature and duration of the collective bargaining agreement currently in force between the unions and the municipalities that their members are employed by. These documents are indispensable when conducting a more extended analysis of a city’s finances because they provide a necessary foundation for analyzing how their budget is shaped. The only downside to these documents is that they usually do not provide any specific numbers or actual expenditures. Without more facts to work with, these items can only provide a general idea of the financial obligations that a municipality or other state entity has committed themselves to.

Summary of 990 Data on Major California Public Sector Unions

To better illustrate some of the methods that have been discussed here about gathering public sector union data, we have created a table below that details the financial holdings of several major California public sector unions. These findings are based on the 990 and LM-2 data that we obtained from the websites we listed, and we have also included links to the pdf copies of all of these documents as well for further verification.

Links to all of the Federal 990 forms used for the information presented on the above table are listed as reference links immediately below this article. It is important to emphasize that the 16 entities represented here represent only a small fraction of the public sector labor organizations active in California. For example, there are 20 (public sector) SEIU local affiliates, 42 AFSME local affiliates, 45 AFT local affiliates, over 1,300 CTA local affiliates, several hundred CSEA (School Employees) local affiliates, and hundreds of CPF (Firefighter) local affiliates. With the possible exception of the CCPOA, most of the statewide unions noted here, such as the CTA, the CSEA, the CFT, and the CPF, collect revenue from members through their local affiliates, which themselves retain most of the money for local collective bargaining and political expenditures. As can be seen, many of these local affiliates are quite powerful financially – just the local police unions in the City of Los Angeles plus Los Angeles County spent nearly $20 million in 2010 (the data presented for local union chapters referenced in this article and on the above table is net of the funds transferred to state headquarters to avoid double counting). Then there are federations of various unions, such as the California State Employees Association and the Peace Officers Research Association of California, which also collect revenue from members through local affiliates.

To amalgamate the financial information provided by literally thousands of local public sector union affiliates across every department and agency throughout California’s 478 incorporated cities and 57 counties would be a herculean task, but it is reasonable to assume that the total annual dues revenue and expenditures of California’s public sector unions is at least twice what the total derived from totaling these 16 major organization’s 990 data. Put another way, at the end of 2010, following a lively election season, California’s public sector unions, collectively, were probably still sitting on well over $200 million in cash, and had just spent nearly $1.0 billion dollars on collective bargaining and political activity. It is left to the reader to ascertain why any spending to pursue the agenda of organized government workers is not intrinsically political, but dissecting actual political spending from the sparse data provided in 990 forms is an exercise in futility. And it is sobering to think that after 2011 (typically the unions file for an extension, meaning we won’t see their 2011 financials until sometime in September at the earliest), during which little election activity occurred, California’s public sector unions will probably have amassed additional hundreds of millions in cash.

As we have shown, there are only a few effective ways in which to gather data on the public sector unions and their finances. Insofar as these same entities exert an enormous amount of influence with state and national politics, it should be clear that their financial reporting requirements need to be brought up to the same standards as those for all other corporations and private sector unions. As noted above, the headquarters for the California Teacher’s Association reported a net worth of $186 million dollars for the 2009 fiscal year, an amount that does not include the net worth of the individual chapters of the California Teacher’s Association. As anyone who has ever spent anytime studying California politics well knows, this organization wields a massive amount of political power in state and local government. Yet, most citizens would probably find it shocking to know that the CTA is burdened with such little oversight. Given the well recognized legal problems associated with campaign finance on both sides of the political spectrum and the almost universal desire to keep the political process free from “secret money”, it should hardly be an extreme position to argue that these laws need to be updated.

REFERENCES

[1] Brendan O’Brian, “Democratic Leader Consoles Party After the Recall,” Reuters, June 9, 2012, http://in.reuters.com/article/2012/06/09/us-usa-wisconsin-recall-idINBRE8580BQ20120609.  See also E.J. Dionne, Jr., “Secret Money Fuels the 2012 Elections,” Washington Post, June 13, 2012.  http://www.washingtonpost.com/secret-money-fuels-the-2012-elections/2012/06/13/gJQAsZ4FaV_story.html?tid=pm_opinions_pop.

[2] Citizens United v. Federal Election Commission, 558 U.S. 50 (2010)

[3] Labor Management Reporting and Disclosure Act, 29 U.S.C.A. §§ 401, 431(b) (1959). For more information see also: http://www.dol.gov/olms/regs/compliance/rrlo/lmrda.htm.

[4] See McNamara v. Johnston, 360 F. Supp. 517, 522  (D.C. Ill. 1973).

[5] 29. U.S.C.A. §402(j)

[6] IBEW Local 47  is one example of such a union. This union represents workers for a number of private and municipal employers throughout Southern California. See http://www.ibew47.org/ for further details.

[7]  http://webapps.dol.gov/libraryforms/FormsByNum.asp

[8]  29. U.S.C.A § 431(b)

[9] Id. § 431 (c)

[10] Id.

[11] http://www.guidestar.org/rxa/news/articles/2001-older/understanding-the-irs-form-990.aspx

[12] Benjamin DeGrow, Public-Sector Union Transparency, (2009) http://www.bestthinking.com/articles/politics_government/legislation/public-sector-union-transparency

[13] Cal. Gov. Code §§ 3546.5, 3587; Cal. Pub. Util. Code § 99566.3 (West, 2010).

[14] http://www.perb.ca.gov/

[15] http://www.guidestar.org/http://www.foundationcenter.org/.

[16] http://www.dol.gov/olms/regs/compliance/cba/index.htm.

[17] http://www.seiu721.org/about/financial-statements.php

LINKS TO FEDERAL 990 FORMS FOR MAJOR CALIFORNIA PUBLIC SECTOR UNIONS

California Teachers Association (2009 data)

United Teachers Los Angeles (CTA Chapter)

California School Employees Association

California Federation of Teachers

California Professional Firefighters

California Correctional Peace Officers Association

Association for Los Angeles County Deputy Sheriffs

Los Angeles Police Protective League

California Peace Officers Association

AFSCME Sacramento

AFSCME Oakland

AFSCME San Diego

SEIU Local 1000

California State Employees Association

Why Lower Rates of Return Will Destroy Pension Funds

May 18, 2012

As reported today in Capitol Weekly, in a post entitled “CalPERS ignores Brown, delays pension payment” by Ed Mendel, the amount taxpayers will have to fork over to CalPERS next year will rise by $213 million, to a total of $3.7 billion. Governor Brown, quite rightly, believes the full amount of the necessary increase should have been assessed, another $149 million, instead of being “smoothed” over the next twenty years.

But CalPERS – the largest of over 30 major government worker pension funds in California, only manages about a third of the the state and local public sector pensions. And CalPERS is basing their increase on a lowering of their projected rate of return for their invested funds by one quarter of one percent, from 7.75% down to 7.5%.

People may debate endlessly over whether or not government worker pension funds in America, now managing over $4.0 trillion in assets, can actually earn 7.5% per year, every year, for decades on end. We have argued repeatedly that this rate of return is impossible to achieve any longer, because (1) high returns in the past depended on debt accumulation, which poured cash into the economy, which stimulated consumer spending, investing, and asset appreciation – enabling more borrowing – all of which caused investment returns to grow at levels that cannot continue now that borrowing has reached its practical limit, (2) our aging population means more people will be selling their investments to finance their retirements – including the pension funds whose participants themselves are aging and are retiring with higher benefits than previous retirees – and this puts more sellers in the market, lowering asset values and returns on invested assets, and (3) pension funds are much larger as a percent of GDP than they were in previous decades, and they are now too big to consistently beat the market.

This debate will not go away. But it is at least worth examining just how much it will cost Californians if the rates of return on state and local government worker pension funds drops by 1.0%, 2.0%, or 3.0%. The fact is, they might drop by even more than that. Go to a commercial bank and try to buy a U.S. Treasury bill or certificate of deposit that pays 4.75%. Or examine the returns on the major stock exchanges over the past 10+ years. Yields are well under 4.75%, yet CalPERS has lowered their rate of return by only one-quarter of one percent to 7.5?

What are they scared of? Why not pick a risk-free, much lower rate of return?

The table below shows how much the annual pension contribution as a percent of payroll increases when the rate of return drops. Column one shows the contributions required under the original 7.75% long-term rate of return projection, which has just been lowered to 7.5%. Columns two, three and four show the contributions required under lower rates of return, 6.75%, 5.75%, and 4.75%. The rows show just how much these contributions need to be under various pension formulas. These formulas govern most government worker pensions – the percentage noted, “1.25% per year,” for example, means that if a government worker retires after 30 years, their pension will be calculated as follows: 1.25% x 30 x final salary, or in this case, 37.5% of final salary. The amounts selected for these rows are representative of the following pension formulas:

    • 1.25% per year  –  for typical non-safety employees up until around 2000.
    • 1.6% per year  –  the average of non-safety and safety employees up until around 2000.
    • 2.0% per year  –  for typical safety employees up until around 2000; for typical non-safety employees since then.
    • 2.5% per year  –  the average of non-safety and safety employees since around 2000.
    • 3.0% per year  –  for typical safety employees since around 2000.

On the table below, row four of the pension formulas, outlined, shows how lowered rates of return will impact the contributions necessary to fund a 2.5% per year formula. Since 2.5% per year is the blended average that would represent all current state and local government employees in California, the results in this row should be of great interest to taxpayers and public employees alike. As can be seen in this case, the annual pension contribution as a percent of payroll must increase from 16.3% at the rosy rate of return of 7.75% to 21.4% (at 6.75% return), to 28% (at 5.75% return), to 36.6% (at a still impressive 4.75% rate of return).

The table above concludes by taking these pension contributions and applying them to the total payroll of California’s state and local governments, which is (using conservative estimates) 1,500,000 employees times an average annual salary of $70,000 per year (ref. U.S. Census, 2010 CA State Gov. Payroll, and 2010 CA Local Gov. Payroll). As can be seen, if the rate of return for California’s state and local government employee pension funds drops from 7.75% to 6.75%, this will cost taxpayers another $5.4 billion per year. If the return projection drops to 5.75%, it will cost taxpayers another $12.3 billion per year. And if the return projection drops to 4.75% per year, it will cost taxpayers an additional $21.3 billion per year. But wait, because the above analysis still understates the problem.

There’s one more big gotcha.

The first table is entitled “Impact of Lowered Return Projections if we could Retroactively Increase Contributions.” But we can’t do that. Contributions that are in the funds currently were made under the assumption that the 7.75% rate of return would last forever. If we lower that assumption, we still have to fund our pension obligations by investing the money we’ve already got, plus whatever additional monies we can collect from now on. This severely compounds the problem.

The next table, below, calculates how much lowered return projections will cause pension contributions to increase, if half of the contributions are already made. This assumes that in aggregate, the participants in California’s government worker pensions are at mid-career. This is an extremely conservative assumption, because there are millions of government workers who are already retired, whose pension payments are equally dependent on investment returns from the pension funds. This next table therefore understates the impact of lower investment returns on the required contributions to the fund from existing workers.

As can be seen in this more realistic, but still very much a best case scenario, if the rate of return for California’s state and local government employee pension funds drops from 7.75% to 6.75%, this will cost taxpayers another $11.3 billion per year. If the return projection drops to 5.75%, it will cost taxpayers another $24.9 billion per year. And if the return projection drops to a still quite aggressive 4.75% per year, it will cost taxpayers an additional $40.8 billion per year.


This is what the pension funds are up against. These are the scenarios the pension bankers exchange in closed meetings, where the press and even their own PR people don’t attend. Imagine if CalPERS admitted, as they should, that their funds cannot reliably expect to earn more than 4.75% per year. It would mean that – assuming all 10 million of California’s households pay taxes, which obviously is not the case – that every household in the state would have to fork over another $4,000 per year in increased taxes.

These calculations were done using a tool prepared by the California Policy Center that can be downloaded by clicking on “pension_analysis_model.” An explanation of how to use this model can be found in our April 2nd post “A Pension Analysis Tool for Everyone.” It is now in use by pension analysts and activists in several California cities and counties.

Critics of pensions and critics of pension reform alike are invited to verify for themselves the calculations made here, either using the model we provide, or their own tools for financial analysis. To imply, as CalPERS has, that about another $1.0 billion per year, spread among the 30 California government worker pension funds and “smoothed” over the next 20 years, is all it will take to shore up their solvency, is irresponsible. The additional amount necessary to save California’s government worker pensions is probably closer to $40 billion per year, from now until these pension formulas are reduced, across the board, and retroactively, of course.

A Pension Analysis Tool for Everyone

April 2, 2012

A concern often voiced by pension reform activists and politicians interested in better understanding pension finance is that they have to depend solely on the information delivered by actuaries. This information, in turn, is typically delivered in a report so voluminous and so technical that the activists and politicians have to hire their own experts to explain it all to them. The mass of data and assumptions are usually so intimidating that ultimately many people who need to understand pension finance give up. Additionally, it is difficult to eradicate bias from expert analyses of pension solvency. The result is that many people, including paid professional spokespersons and other opinion makers, offer assertions that do not necessarily reflect the reality of pension finance, while voters and policymakers alike remain uncertain regarding the the nature and severity of the problem.

This post is to provide anyone who wishes to understand some of the fundamentals of pension finance a tool that allows them to do their own “what-ifs” on pensions. Because this model has distilled the mechanics of a pension fund to a single page of data and calculations, it offers a glimpse of how pensions operate that is relatively understandable and extremely transparent. This model is not intended in any way to replace the far more complex models used by actuaries, but it can be quite useful to illustrate, for example, how very sensitive the required annual contribution to a pension is to any change in other assumptions – especially the rate of return.

To download this Excel model, simply click on “pension_analysis_model” and you will have a spreadsheet to save and experiment with. Start with the first tab “constant inputs,” the 2nd tab will be explained later. The graphic images below show the upper section of this spreadsheet; all of the cells that accept inputs are at the top of the spreadsheet and are highlighted in yellow. While this model is only designed to show the pension fund performance by year for one person, it is important to understand that pension funds that aggregate pension contributions and allocate pension benefits for thousands of people follow the same rules.

To use this model, simply enter the assumptions you would like to use into the yellow cells. Don’t enter anything in a cell that is not highlighted in yellow or you will overwrite a formula. The result that matters is displayed in the one cell highlighted in green. If this number is positive, it indicates a pension would be adequately funded under the assumptions input by the user. If this number is negative, it shows by how much a pension would be underfunded. The goal is to enter a combination of assumptions in the yellow cells that yields the smallest amount in the green cell possible without being a negative number. That is a financially sustainable pension.

The three examples provided here are chosen because they clearly illustrate some of the key financial issues that challenge the solvency of pensions today. In all three examples, the pensioner is assumed to work 30 years and enjoy 25 years of retirement. They are assumed to earn a 1.0% increase in their salary each of those 30 years for merit (promotions and raises), and a 3.0% increase in their salary each year for cost of living adjustments (COLAs). Once retired, they are assumed to get a 2.0% COLA increase in their pension each year. These assumptions can all be changed, since they are all driven by inputs in the yellow highlighted cells, but to show the impact of two key variables – the pension benefit formula, and the rate of return – they are held constant on all three examples to follow.

The first example, on the table immediately below this paragraph, shows what public safety pensions were historically – up until somewhere between 5 and 15 years ago, when virtually every city and county in California adopted more generous pension formulas. In the “pension formula/yr” cell, 2.0% is entered, which means that for every year worked, the pensioner will receive 2.0% of their final salary in retirement. This means a person who works 30 years, as in this example, will receive 60% of their final salary per year as a retirement pension. In the “fund return %” cell, the typical long-term rate of return for the pension funds is entered, 7.75% per year. Once you enter all these numbers, go to the “% of salary to pension” cell and enter various amounts until you arrive at one that provides the smallest positive number possible in the green cell. Doing this indicates that under these assumptions, an employee would require an amount equivalent to 13.1% of their salary to be set aside each year to fund a pension benefit equal to 60% of their final salary.

In the next example, shown below, one can view the impact of a change in the benefit formula from 2.0% to 3.0%. That is, the only change that has been made to the assumptions is the change in the “pension formula/yr” cell from 2.0% to 3.0%. This is to model the current typical pension formula for safety employees, 3.0% times years worked, times final salary. As shown, in order to still have a positive fund ending balance in the green cell, the amount to be contributed each year into the pension fund, “% of salary to pension,” now has to increase from 13.1% to 19.6%.

It is important to digress here to point out that because the change in the pension benefit formula from 2.0% to 3.0% (or from 1.25% to 2.0% for non-safety employees) was done retroactively, pension funds would have been required to increase their rate of contributions far beyond 19.6% going forward. This is because, for example, a mid-career employee, suddenly receiving this retroactive benefit enhancement, would have only been putting 13.1% into their pension fund for the entire first half of their career, a critical period since money invested that early has more time for earnings to compound. The impact of making the benefit enhancement retroactive will be explored at the end of this post.

The third and final example, below, shows the impact of a lowering of the fund’s rate of return. In this case, not only is the benefit formula enhanced from 2.0% per year to 3.0% per year, but the rate of return for the fund is lowered from 7.75% per year to 6.00% per year. At this rate of return, pension solvency would not require an annual contribution equivalent to 13.1% of payroll, or 19.6% of payroll, but 31.4% of payroll. This is a huge adjustment. In the concluding section of this post, a more in-depth analysis is presented explaining why even this may not be enough.

The model presented thus far is not designed to allow the user to input differing values in each year under analysis, but in the same Excel file “pension_analysis_model,” there is a 2nd tab, “flexible inputs,” that does provide this ability to the user. To delve into the details of how to use this model would go beyond the scope of this post. In short, any cell highlighted in yellow is an input cell, including entire columns where each row corresponds to a different year. The user will still iterate to achieve a near-zero result in the lone green cell which represents the final ending balance of the fund. The model on the 2nd tab uses exactly the same formulas and logic as the model illustrated above, except the user can assume and input differing values per year on this version. Here is a summary of the default case that is already entered on the downloadable spreadsheet, tab two, entitled “variable inputs:”

This analysis assumes that the change to the benefit formula from 2.0% per year to 3.0% per year was done in late 2000, in mid-career for the employee (year 15 of a 30 year career). This means that through the year 2000, holding all other assumptions constant, the annual pension contribution was only 13.1% of salary (because at through that point, that was all it needed to be – see example #1 above). What also happened starting around the year 2001 was the rate of return earned by pension funds fell – they have actually fallen to around 4.0% during the past decade, but in this analysis, the rate is lowered to 6.0% per year and held there through the rest of the timeline. Prior to 2001, from 1985 through 2000, the rate of return is assumed to be 7.75% per year.

Based on these assumptions, which reflect a fairly realistic assessment of history to-date, starting in 2001 it is necessary for an employee with these rate-of-return and benefit changes to make an annual contribution to their pension fund equaling 54.5% of their salary. And for every year they have not done this, that percentage must rise. Nowhere in this analysis, moreover, is the all-too-frequent practice of “spiking” accounted for, which raises necessary annual contributions still further.

By using in this final example a person for whom the pension fund adjustment was made in mid-career, it is reasonably accurate to say that whatever unfunded liability may exist in reality in this individual case, could be used as a basis for calculating the total unfunded liability of the fund in aggregate. To get a global estimate, of course, one must input a blended benefit rate that takes into account the lower formulas that apply to non-safety employees, or run them as separate studies.

Again, this model is not meant to replace actuarial models that take into account specific fund demographics and deliver results precisely aggregated for all participants in the fund. But actuarial models, for all their precision and complexity, must nonetheless rely on the same set of assumptions this model does, and how those assumptions are made delivers vastly differing outcomes. For anyone who uses it, this model may serve as a useful tool to better understand and communicate the dynamics of pensions, and to sanity check whatever does come out of the black boxes reserved for qualified actuaries.