Analyzing the Cost and Performance of LAUSD Traditional High Schools and LAUSD Alliance Charter High Schools

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Summary:  This study examines cost-per-pupil for high school students in the Los Angeles Unified School District (LAUSD), comparing its traditional public schools to those attending its largest charter school network, the Alliance College Ready Public Schools. It also examines the educational achievement outcomes for traditional and charter high school students, focusing on nine LAUSD traditional schools and nine LAUSD Alliance charter schools. The schools were chosen because of their close proximity to each other and similar demographic makeup, limiting extraneous variables from corrupting the study, and making for as close to an “apples-to-apples” comparison as is possible. 

Charter schools have a lower cost per pupil than traditional schools:  Based on an analysis of relevant school costs and the number of enrolled high school students, the data shows the per pupil per pupil costs for Alliance charter high school students to be $10,649 per year, compared to $15,372 per year for students at traditional public high schools within LAUSD, that is, we find a per pupil cost differential of 44% in favor of Alliance charter schools.

Charter schools have higher API scores and graduation rates than traditional schools:  Academically, comparing LAUSD Alliance charter high schools to LAUSD traditional high schools located in the same neighborhoods, we found the Alliance schools have decisively higher API scores, 762 vs. 701, and higher graduation rates, 91.5% vs. 84.1%.

Charter schools have higher normalized SAT scores than traditional schools:  With respect to SAT scores, when we normalized the comparison between the LAUSD Alliance charter and LAUSD traditional schools under consideration to equalize the rate of test participation, we found that the Alliance charter students outperformed the LAUSD traditional students with average scores of 1417 vs. 1299 – a significant difference. Among college bound students, an SAT score of 1299 puts the student in the bottom 27% nationally. A score of 1417, by contrast, places the student at 41% nationally.

We have reached these conclusions by collecting district and school level data, and making common-sense adjustments where appropriate, and as noted in the text. Throughout this report, and especially in the footnotes, we have explained and documented our sources and calculations. We invite other researchers to conduct similar analysis and believe they will come to similar conclusions.

The academic comparisons we have made involve 18 high schools, nine LAUSD Alliance charter high schools, and nine LAUSD traditional high schools. Our financial comparisons are somewhat broader in scope – involving the cost per high school pupil attending one of the largest public school districts in the nation and those attending a large charter school system.

We can conclude from this data that an effective charter school operator can better learning outcomes at lower cost than traditional public schools serving a similar population. Ultimately, this finding supports the educational choice concept: by replacing a “one size fits all” solution with an array of educational choices, we can provide better results for California’s children and taxpayers.

INTRODUCTION

The purpose of this study is to help assess to what extent charter schools have the potential to provide a higher quality, more cost-effective educational solution for California K-12 students over traditional schools, particularly those in low income communities. Our study is not meant to provide a comprehensive assessment of the comparative quality of all traditional public schools vs. all public charter schools, but rather to focus on high school education in one of the most challenging parts of California for delivering quality educational outcomes, the low income communities of Los Angeles.

The students in these communities fall within the Los Angeles Unified School District (LAUSD). The charter schools we selected for analysis are part of the Alliance College Ready Public Schools (Alliance), a nonprofit company that operates 26 charter middle schools and high schools, all of them part of LAUSD, and most of them located in south-central Los Angeles. The first section of this study will analyze the per pupil costs for LAUSD traditional schools vs. LAUSD Alliance charter schools.

The second section of this study will analyze the educational performance of LAUSD traditional schools vs. LAUSD Alliance charter schools. We will look at SAT scores, API scores, dropout rates, and rates of college admission. A critical element of this analysis will be to reduce the data for LAUSD to those traditional schools that are in the same neighborhoods as the LAUSD Alliance charter schools. A district-wide LAUSD performance score would be distorted upwards by (1) the performance in many of the wealthier neighborhoods in the San Fernando Valley and elsewhere, and by (2) the upward skew represented by the presence of the three charter school operators within LAUSD (many of them in wealthier neighborhoods), enrolling nearly 40,000 students in 59 senior high schools [1], since they are formally part of LAUSD.

PREVIOUS STUDIES OF PER PUPIL COSTS

As Tom Rutten and Richard Riordan argue in a 2013 Los Angeles Daily News column entitled “The mysterious case of LAUSD’s finances,” LAUSD per pupil spending estimates vary widely [2]. They quote a district “baseline” estimate of $7,000, going on to discuss how that baseline is supplemented by numerous earmarked funds and categorical grants aimed at various segments of the student population.  And at the other extreme, Adam Schaeffer, in a 2010 Cato Institute study entitled “They Spend WHAT? The Real Cost of Public Schools,” reported that the “real” cost of public education per pupil at LAUSD was $25,208 [3].

We believe that Schaeffer’s number is overstated for three reasons. The first factor is the simple passage of time. His estimates were based on 2008 data. Between the 2008-2009 school year and the 2013-2014 school year, authorized expenditures in the LAUSD budget fell from almost $18 billion [4] to just over $13 billion [5]. Although part of this reduction can be attributed to declining enrollment, much of it is due to state spending cuts in the aftermath of the Great Recession that are just now being reversed. Second, Schaeffer uses authorized budget figures rather than actual expenditures. As we will see in the next section, LAUSD spends far less than its budgetary authority, and so it is more accurate to use actual instead of budgeted amounts. Finally, the budget figures referenced by Schaeffer includes some double-counting as we also discuss below.

Perhaps the closest thing we have to an official number is the 2013-14 “Current Expense per ADA” reported by the California Department of Education [6], which is $10,442. ADA stands for Average Daily Attendance which means the number of students marked “present” at all LAUSD’s schools on an average day. ADA is less than enrollment because some students are absent on any given day. To us, enrollment seems to be a more appropriate denominator for a cost per pupil calculation. If a student is absent 18 days during a 180-day school year, the district is still educating a student – and not nine-tenths of one.

On the other hand, “Current Expense” does not include all the costs school districts incur. Among the items excluded from current expense are facilities construction and retiree health benefits [7]. Since schools require buildings and teachers unions often demand post-employment benefits, public education cannot be provided by LAUSD without these types of expenditures. We thus find that both the numerator and denominator of the “Current Expense per ADA” are understated if the purpose is to calculate the cost of educating a single pupil.

In the analysis that follows, we use fully loaded numerators and denominators, finding that the two alterations largely cancel out. However, as will be seen, further adjustments needed to make LAUSD’s costs comparable to those of Alliance, significantly raise our LAUSD cost per pupil estimate.

PER PUPIL COSTS FOR LAUSD TRADITIONAL VS. CHARTER

In this section, we estimate per pupil costs for LAUSD traditional vs. Alliance charter. Because LAUSD is a complex entity and because we wish to fully justify our calculations, this section is quite long. While we believe policy specialists will find this discussion rewarding, more casual readers may wish to skip to the end of this section to see our bottom line.

As discussed in the previous section, cost analysis is more properly based on actual expenditures in audited financial statements rather than on budgets. Actual expenditures may vary substantially from budgeted amounts in either direction. In the case of LAUSD, the budget total substantially overstates actual expenditures.

For the fiscal year ending June 30, 2014, LAUSD’s budget (available at http://laschoolboard.org/sites/default/files/LAUSD2013-14FinalBudget.pdf) shows total authorized amounts of just over $13 billion [8]. This contrasts with actual expenditures of less than $8 billion [9] in the district’s audited financial statements. The audited statements are included in the district’s Comprehensive Annual Financial Report (CAFR) available at http://emma.msrb.org/EA696060-EA545171-EA941437.pdf.

This large discrepancy between the budget and audited financial statement amounts has two main causes. First, the budget total double-counts over $1 billion of Internal Service Fund expenditures. Quoting from page 19 of the budget:

Internal Services Funds, which total approximately $1.08 billion, account for the payment of employee health & welfare benefits, workers’ compensation, and liability insurance. These funds are for accounting purposes as required by State law. They serve as “pass-through” accounts. In other words, the $1.08 billion in expenditures here already show up in other funds, and to count them in addition to the other funds would be counting them twice. For this reason, Internal Service Funds should not be considered as part of the funds that help operate District schools.

Second, actual spending in all major governmental funds was substantially below authorized amounts in the budget. The biggest discrepancy occurred in district capital funds which had total authorized expenditures of $3.2 billion and actual expenditures of $0.7 billion. Operating and debt service funds also saw substantially less spending than authorized [10].

The audited financial statements contain two expenditure totals – one in the Statement of Activities and the other in the Governmental Fund Statement of Revenues, Expenditures and Fund Balances. Although they are not substantially different – $7.98 billion and $7.83 billion respectively – the relatively small discrepancy masks fairly large differences in how they are calculated. These differences warrant our attention.

Expenses in the Statement of Activities are presented according to the accrual basis of accounting while Governmental Fund presentation uses the modified accrual basis – an accounting style that is much closer to the cash basis. Cash accounting focuses on the actual expenditure of funds during the fiscal year, while accrual accounting focuses on the financial obligations accrued by the district during the year.

A reconciliation of the modified accrual and full accrual expenditure totals for LAUSD follows (amounts shown are in thousands of dollars):

Table 1 – LAUSD 2013-14 Expenditure Reconciliation,
Modified Accrual vs. Full Accrual Bases [11]

20150515-CPC_LAUSD-1b

Under the accrual basis, the repayment of bond principal is not considered an expenditure nor are capital outlays. However, the accrual method involves depreciating assets, which largely offsets the absence of capital expenditures.

It may be argued that capital outlays and/or bond principal should be added back to LAUSD’s total. The cost of building facilities is part of the overall cost of education and should not be excluded from per pupil costs. However, including both capital outlays and bond principal repayments in the total would be a form of double-counting, because the capital outlays are made with borrowed funds. The money should be captured either when it is borrowed and spent, or when it is repaid – not both times. Inclusion of the depreciation amount in the accrual expenditures serves the purpose of incorporating capital expenditures. Since LAUSD does not issue pension obligation bonds, virtually all of its borrowing supports capital expenditure. Thus everything financed with LAUSD’s bonds will be depreciated on the district’s books. Inclusion of the depreciation amount thus provides a reasonable proxy for capital expenditure, and we do not see a strong case for altering LAUSD’s accrual accounting expenditures for our calculations.

LAUSD’s accrual basis expenditures also include retiree healthcare benefits that current employees have earned but will not claim until they retire. These OPEB accruals are excluded from the modified accrual totals. Alliance does not offer retiree healthcare benefits – providing it with a significant cost saving relative to LAUSD. (Both LAUSD and Alliance offer pension benefits largely through CalSTRS – so accruals for cash retirement benefits should not be a major differentiating factor between Alliance and LAUSD).

Because Alliance only reports expenditures in accordance with the accrual method of accounting, we use LAUSD’s accrual method expenditure total of $7,967,671,000 for our comparisons. Alliance’s total expenditures for the fiscal year ending June 30, 2014 were $102,789,813 as shown on page 5 of its audited financial statements available at http://emma.msrb.org/ER822375-ER640652-ER1042507.pdf.

LAUSD reports total enrollment of 726,371 on page 157 of its CAFR, yielding a per pupil cost of $10,969. Alliance reports total enrollment of 10,020 students in its 2013-14 performance dashboard available at http://www.laalliance.org/performance/13-14/dashboards/Alliance-wide%20Performance%20Dashboard%202013-2014.pdf, yielding a per pupil cost of $10,258.

Thus, before making adjustments, we find that per pupil expenditures using the accrual basis, are $711 higher for LAUSD traditional than for Alliance charter – a difference of almost 7%. The calculations are summarized below.

Table 2 – Alliance Charter/LAUSD Traditional Expenditure per Enrolled Student Comparison (Initial)

20150515-CPC_LAUSD-2b

LAUSD’s enrollment total of 726,371 includes 95,381 students [12] enrolled in independent charter Schools. However, LAUSD expenditures shown in its financial audit do not include charter school expenses. As noted on page ii of the CAFR: “This report includes all funds of the District with the exception of the fiscally independent charter schools, which are required to submit their own individual audited financial statements”. Thus the 95,381 charter school students should be removed from the denominator of the cost per pupil calculation.We now make adjustments to these reported totals to increase their comparability.

LAUSD provides adult education while Alliance does not. By removing the adult education cost and enrollment from LAUSD data, we can more nearly achieve an apples to apples comparison. LAUSD’s audit reports adult enrollment of 32,267 and adult education costs of $75,993,000 [13].

Similarly, LAUSD provides early education services to pre-kindergarten children and infants. Alliance does not provide similar services. Consequently, we remove 12,829 early education enrollees and $128,407,000 in Child Development Fund expenditures [14] from the LAUSD totals.

In addition to Adult Education, LAUSD offers Career Technical Education (CTE) and Regional Occupational Programs (ROP). These two programs had combined enrollment of 29,779 and a total budget of $43.6 million [15], implying a per-student cost of $1464. The CAFR does not provide actual expenditures for these two vocational programs which are not offered by Alliance. But unless actual expenditures were far greater than budget, the two programs are much less expensive on a per student basis than LAUSD’s traditional K-12 program. Since LAUSD’s actual spending overall was below budget, using budgeted expenditures for the two programs is a conservative approach.

The adjustments made to LAUSD to eliminate enrollees and costs not associated with K-12 traditional public school students are summarized below. The Adult Education and Pre-K expenditure totals are based on the modified accrual accounting method; governmental financial statements do not break down accrual accounting data to the fund level.

Table 3 – Adjustments to LAUSD Amounts to Improve Comparability with Alliance

20150515-CPC_LAUSD-3b

After these adjustments, LAUSD per pupil costs rise to $13,881 or about 35% higher than the Alliance amount.

The adjusted cost comparison is summarized in the table below.

Table 4 – Alliance/LAUSD Expenditure per Enrolled Student Comparison (Adjusted)

20150515-CPC_LAUSD-4b

A further adjustment to these numbers is needed to reflect differences in grade profiles and differences in educational costs between elementary and high schools.

LAUSD and Alliance have substantially different grade profiles, because Alliance does not operate elementary schools. In the 2013-14 school year, all of Alliance students were in grades 6-12. Because most Alliance facilities are high schools, 72% of Alliance students were in grades 9-12 [16]. By contrast, 49% of LAUSD students were enrolled in elementary schools and only 23% were enrolled in high schools [17].

High school education is more expensive on a per pupil basis than elementary school education, largely due to the many extra programs that high schools offer. Although, per pupil costs within LAUSD are hard to obtain, we were able to find comparative data elsewhere[18]. Our review of Texas public school data showed per pupil expenditures averaging $6,654 in elementary schools and $10,323 in high schools [19]. The California Department of Education reports current expense per ADA for elementary and high school districts, i.e. districts which consist of all elementary schools or all high schools, respectively. For 2013-2014, California elementary school districts had an expense of $8,336 per ADA while high school districts had an expense of $9,569 per ADA [20].

This last observation suggests that educating a high school student in California is about 15% more expensive than educating an elementary school student. If we apply this differential to LAUSD and Alliance and if we assume that elementary and middle school students have equivalent costs, we can infer costs per high school student at LAUSD and Alliance from the overall per student costs presented in Table 4 above. The results of this calculation are shown in the table below.

Table 5 – LAUSD Traditional / Alliance Charter Expenditure per Student by Grade Level

20150515-CPC_LAUSD-new5

Taking into account the grade profile and assuming that high school students are 15% more expensive to educate than elementary and middle school students, we find a per pupil cost differential of 44% in favor of Alliance charter.

One other potential adjustment would benefit LAUSD in per pupil cost comparisons. Although we do not have enough data to quantity this adjustment, we describe it here. The issue involves special education students – those who require special accommodations due to various disabilities, and are thus more expensive to educate than children learning in traditional classroom environments.

A recent report on KPCC [21] states that LAUSD has 82,000 special education students and a $1.4 billion special education department budget – implying a per pupil cost of about $17,000. The LAUSD CAFR shows a somewhat lower expenditure amount – $1.318 billion [22] – and does not provide a figure for total special education enrollment [23].

Assuming the 82,000 special education enrollment figure is correct, that number accounts for about 15% of the district’s K-12 enrollment [24]. By contrast, Alliance reports that 9% of its students are in special education [25]. The organization does not break out costs for special education students in its financial reporting.

Thus, we can conclude that a comparison of costs aside from those associated with special education would be more favorable to LAUSD, but it is not clear how large the adjustment would be.

In conclusion, we find that LAUSD spends 44% more to educate each high school student than Alliance, but that a part of this differential may be explained by the greater proportion of special education students at LAUSD.

*   *   *

ACADEMIC PERFORMANCE COMPARISONS

While cost per pupil is a key variable in comparing the effectiveness of differing approaches to public education, it is not the whole story. The quality of various educational solutions, measured in terms of outcomes for students, taking into account various degrees of preexisting adversity faced by the students, forms an essential part of any comparative analysis.

When comparing academic performance in LAUSD traditional high schools vs. LAUSD Alliance charter high schools, district-wide comparisons are easy enough to gather, and offer some insights. But a more meaningful set of comparisons may be derived by presenting academic results between individual LAUSD traditional and LAUSD Alliance charter high schools that are located in close proximity to each other. This is based on the assumption that schools in the same neighborhoods will have student bodies that have similar characteristics, which we will attempt to verify using available data.

Accordingly, we have identified 18 high schools, nine that are part of the LAUSD Alliance charter network and nine that are LAUSD traditional public schools, organized into seven matches, where schools that are in the same neighborhoods are considered to be a match. In four cases, one Alliance charter high school is compared to one traditional high school located in the vicinity. In two cases (#4 and #5 on the list below), there are two traditional high schools that are both located very close to an Alliance charter high school, so both of them are considered. In one case (#3), there are two Alliance charter high schools that are both located very close to a traditional high school; both Alliance schools are considered. The maximum distance for any comparison is 3.4 miles, in most cases the schools being compared are about 2.0 miles apart.

List of LAUSD Traditional and Alliance Charter High Schools in Close Proximity:

(1) Alliance High School, Cindy and Bill Simon Technology High School, 10770 Wilmington Ave., Los Angeles. LAUSD High Schools, 1.6 miles away: South East Senior High, 2720 Tweedy Blvd., South Gate, and, 2.9 miles away, South Gate Senior High, 3351 Firestone Blvd, South Gate.

(2) Alliance High School, Patti & Peter Neuwirth Leadership Academy, 4610 South Main St., Los Angeles. LAUSD High School, 0.7 miles away, Dr. Maya Angelou Community High School, 300 E 53rd St, Los Angeles.

(3) Alliance High School, Collins Family College-Ready High School, 2071 Saturn Ave., Huntington Park. LAUSD High Schools, 2.8 miles away, Bell Senior High, 4328 Bell Ave, Bell, and, Maywood Academy Senior High, 3.3 miles away, 6125 Pine Ave., Maywood.

(4) Alliance High Schools, Environmental Science & Technology High School, 2930 Fletcher Drive, Los Angeles, and, Tennenbaum Family Technology High School, 2050 North San Fernando Road, Los Angeles. LAUSD High School, 2.4 miles and 3.4 miles away, respectively, John Marshall Senior High, 3939 Tracy St., Los Angeles.

(5) Alliance High Schools, Health Services Academy High School, 10616 South Western Ave., Los Angeles, and, Judy Ivie Burton Technology High School, 10101 South Broadway, Los Angeles. LAUSD High School, Middle College High School, 0.8 miles and 2.7 miles away, respectively, 1600 Imperial Highway, Los Angeles.

(6) Alliance High School, Marc & Eva Stern Math and Science High School, 5151 State University Drive, Los Angeles. LAUSD High School, 1.6 miles away, Woodrow Wilson Senior High, 4500 Multnomah St., Los Angeles.

(7) Alliance High School, Media Arts and Entertainment Design High School, 113 South Rowan Ave., Los Angeles. LAUSD High School, 3.2 miles away, James A Garfield Senior High, 5101 E Sixth St., Los Angeles.

Alliance (green) and LAUSD (red) High Schools

20150515-CPC_LAUSD-map1

Demographic Comparisons for LAUSD Traditional and LAUSD Alliance Charter High Schools in Close Proximity

The fact that two high schools are in the same neighborhood doesn’t prove they have a demographically similar student body. Before making academic comparisons it is important to review other variables. The next two tables examine the demographics of the 18 high schools, comparing the Alliance charter high schools to the LAUSD traditional high schools.

As can be seen in Table 6, the ethnic makeup is very similar between LAUSD Alliance charter and LAUSD traditional schools. Both groups of student bodies are 91% Latino. Of the remaining students, the Alliance schools are 5% African American compared with 2% in the Traditional schools, and the traditional schools have slightly more Asian (2% vs. 1%) and White (2% vs. 1%) students compared to Alliance [26].

Table 6 – Ethnic Composition of Alliance vs. LAUSD Students

20150515-CPC_LAUSD-6n

The other primary demographic variables that are relevant when assessing the similarity of student bodies are those that may present challenges to individual students. Using available per high school data, the next table attempts to make this assessment by examining the percentages in each group of schools of students who have learning disabilities, students who are English language learners, and students who are on the free or reduced lunch program (in both LAUSD Alliance and LAUSD traditional the percentage of students on the lunch program who get a free lunch vs. a reduced lunch are around 90%).

As shown in Table 7, LAUSD traditional has slightly more English language learners, at 17% vs. 16%. LAUSD Alliance has more students on the free/reduced meal program, 90% vs. 85%. LAUSD traditional, on the other hand, has significantly more students who are identified as having learning disabilities, 13% for LAUSD traditional vs. 8% for LAUSD Alliance charter.  It is difficult to conclude too much from this data. It would probably be reasonable to conclude that overall the student bodies at these 18 schools are very similar ethnically and demographically [27].

Table 7 – Other Demographic Characteristics of LAUSD Alliance vs. LAUSD Traditional Students

20150515-CPC_LAUSD-7n

Educational Outcomes:  LAUSD Alliance Charter Schools vs. LAUSD Traditional Schools

To evaluate the academic performance of students in LAUSD Alliance charter schools compared to LAUSD traditional high schools located in the same neighborhoods with similar student demographics, we focus on four variables, each school’s rate of attendance, their API (Academic Performance Index) score, the average SAT score per school, and the graduation rate per school.

These comparisons are displayed on Table 8. As can be seen, the reported average attendance at the LAUSD traditional schools, 95%, was nearly identical to the reported average attendance at the Alliance schools, 96%. On the other hand, the LAUSD Alliance schools display a distinct edge in their average API scores, 762 vs. 701, and in their graduation rates, 91.5% vs. 84.1%. With respect to average SAT scores, the raw data for the LAUSD traditional schools actually shows them outperforming the Alliance schools, 1299 for LAUSD vs. 1122 for the Alliance schools [28]. But this bears further analysis.

Table 8 – Academic Performance Indicators, Alliance vs. LAUSD

20150515-CPC_LAUSD-8n

To accurately compare the SAT scores of students in LAUSD Alliance charter schools with those attending LAUSD traditional high schools located in the same neighborhoods with similar student demographics, it is necessary to consider the relative proportions of students taking the test. While the LAUSD traditional students averaged 1299 on their SAT vs. 1122 for the Alliance charter students, outperforming them by 177 points, a much lower percentage of LAUSD traditional juniors and seniors actually took the test. As reported on Table 9, only 31% of the juniors and seniors enrolled in the LAUSD traditional schools took the SAT, vs. 72% of the Alliance charter school students.

To appreciate what an apples-to-apples comparison might reveal, imagine what the average SAT score would be in the LAUSD traditional schools if 72% of the juniors and seniors took the test. In this hypothetical example, also consider the fact that because the LAUSD traditional schools have a drop-out rate of 15.9% vs. 8.5% at LAUSD Alliance, an apples-to-apples comparison would have to actually assume a cohort of juniors and seniors whose numbers have not succumbed to a much higher rate of attrition. Put another way, taking into account attrition, more than 72% of LAUSD’s traditional still-enrolled juniors and seniors would have to take the SAT to properly compare their performance to LAUSD Alliance’s.

While data cannot exist for tests that were not taken, we can achieve something closer to an apples-to-apples comparison by excluding a portion of the LAUSD Alliance test results. If we assume that LAUSD traditional students who didn’t take the SAT would have had lower scores than the LAUSD students who did take the test, we can match up the LAUSD traditional and LAUSD Alliance charter samples by dropping the lower scores from Alliance. Since the LAUSD traditional schools had a test participation rate of 31%, we can get a comparable Alliance SAT average by only considering the top 686 scores – which corresponds to 31% of the 2189 enrolled juniors and seniors (see Table 9). According to data provided by Alliance, the top 686 SAT scores at the eight Alliance schools was 1417 – 118 points higher than the LAUSD traditional average [29].

Table 9 – SAT Performance Comparisons, Normalized Based on Rate of Participation20150515-CPC_LAUSD-8

 

CONCLUSION

Overall, we conclude that LAUSD Alliance charter high schools provide better outcomes at lower costs than comparable LAUSD traditional operated public schools in the same area. We estimated the per pupil costs for Alliance charter high school students to be $10,649 per year, compared to $15,372 per year for students at traditional public high schools within LAUSD, that is, we find a per pupil cost differential of 44% in favor of LAUSD Alliance charter schools.

Academically, comparing LAUSD Alliance charter high schools to LAUSD traditional high schools located in the same communities, we found the Alliance schools to have decisively higher API scores, 762 vs. 701, and measurably higher graduation rates, 91.5% vs. 84.1%. With respect to SAT scores, when we normalized the comparison between the LAUSD Alliance and LAUSD traditional schools under consideration to equalize the rate of participation, we found that the LAUSD Alliance students outperformed the LAUSD traditional students with average scores of 1417 vs. 1299. This differential is significant. Among college bound students, an SAT score of 1299 puts the student in the bottom 27% nationally. A score of 1417, by contrast, places the student at 41% nationally [30]. Alliance high schools have succeeded in producing academic achievers in the upper 1/3rd of their student body whose SAT scores are within striking distance of the national average, despite operating in some of the most disadvantaged communities in the United States.

We have reached these conclusions by collecting district and school level data, and making common-sense adjustments where appropriate, and as noted in the text. Throughout this report, and especially in the footnotes, we have explained and documented our sources and calculations. We invite other researchers to conduct similar analysis and believe they will come to similar conclusions.

Finally, we want to reiterate that the academic comparisons we have made are fairly narrow, involving 18 high schools, nine LAUSD Alliance charter high schools, and nine LAUSD traditional high schools. Our financial comparisons are somewhat broader in scope – involving the cost per high school pupil attending one of the largest public school districts in the nation and those attending a large charter school system. Because the sample size is still relatively limited, our study thus cannot support a categorical conclusion that charter schools are always better than public schools, or vice versa, but we can conclude from this data that an effective charter school operator can deliver better learning outcomes at lower cost than traditional public schools serving a similar population. Ultimately, this finding supports the educational choice concept: by replacing a “one size fits all” solution with an array of educational choices, we can provide better results for California’s children and taxpayers.

 

About the Authors:

Marc Joffe is a policy analyst for the California Policy Center. He is also the founder Public Sector Credit Solutions, established in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

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

FOOTNOTES

1 – For a list of LAUSD charter Schools, refer to Los Angeles Unified School District, Charter Schools Division, “2014-15 Charter Schools Directory:
http://notebook.lausd.net/pls/ptl/docs/PAGE/CA_LAUSD/LAUSDNET/SCHOOLS/ADD_SCH_DOCS/CHARTER%20SCHOOLS%20DIRECTORY%202014-15%20PARENTS.PDF

For enrollment by LAUSD High School refer to California Department of Education, Analysis, Measurement, and Accountability Reporting Division (this table also includes SAT scores by school):
http://dq.cde.ca.gov/dataquest/satactap/sat.aspx?cyear=2013-14&cchoice=SAT3b&year=1314&cdscode=19647330000000&clevel=District&ctopic=sat&level=District

2 – Richard J. Riordan and Tim Rutten (November 1, 2013). The mysterious case of LAUSD’s finances. Los Angeles Daily News, http://www.dailynews.com/opinion/20131101/the-mysterious-case-of-lausds-finances-richard-j-riordan-and-tim-rutten

3 – Adam Schaeffer (March 10, 2010), They Spend What? Cato Institute Policy Analysis Number 662. http://object.cato.org/sites/cato.org/files/pubs/pdf/pa662.pdf

4 – LAUSD 2008-2009 Final Budget. Page I-51. http://notebook.lausd.net/pls/ptl/docs/PAGE/CA_LAUSD/LAUSDNET/OFFICES/CFO_HOME/ALL%20SECTIONS%20091108.PDF.

5 – LAUSD 2013-2014 Final Budget. Page 49. http://laschoolboard.org/sites/default/files/LAUSD2013-14FinalBudget.pdf.

6 – California Department of Education, 2013-14 Cost Per ADA spreadsheet, http://www.cde.ca.gov/ds/fd/ec/documents/currentexpense1314.xls.

7 – California Department of Education, Current Expense of Education. http://www.cde.ca.gov/ds/fd/ec/currentexpense.asp.

8 – LAUSD 2013-14 Budget, Page 49.

9 – LAUSD 2013-14 Comprehensive Annual Financial Report, Pages 15 and 18.

10 – The CAFR contains budget to actual comparisons for most funds at Page 20 and Pages 66-89.

11 – Adjustments described here were gathered from Pages 15, 18 and 19 of the LAUSD CAFR.

12 – This and other LAUSD enrollment numbers cited below are on page 157 of LAUSD’s CAFR.

13 – LAUSD CAFR page 74.

14 – LAUSD CAFR, Page 165.

15 – LAUSD Budget, Pages 25 and 29.

16 – Derived from the Alliance Performance Dashboard referenced earlier.

17 – Enrollment data by type of school is included in the LAUSD CAFR on Page 157. About 11% of LAUSD students are enrolled in K-12 schools, so the actual proportions of elementary and high school students are slightly higher than the numbers provided above. Later, we use an estimate of 26% high school students in LAUSD by proportionately allocating back those enrolled in K-12 schools.

18 – As this study was being completed, the authors found a set of LAUSD School Accountability Report Cards that contain per pupil costs by school site. Our preliminary analysis of these report cards shows average per pupil costs of $7,854 for elementary schools and $8,407 for high schools. These amounts generally exclude special education schools which have much higher costs and typically offer grades K-12.

19 – Author’s analysis of data downloaded from Texas Education Agency’s Academic Excellence Information System. http://ritter.tea.state.tx.us/perfreport/aeis/2012/xplore/DownloadSelData.html.

20 – California Department of Education, Cost per ADA Spreadsheet 2013-2014, ref. summary tab “Average by LEA Type.”
http://www.cde.ca.gov/ds/fd/ec/documents/currentexpense1314.xls

21 – Annie Gilbertson, Costs for LAUSD special ed services climb as parents feel the pinch, 89.3 KPCC, December 19, 2014. http://www.scpr.org/blogs/education/2014/12/19/17698/costs-for-lausd-special-ed-services-climb-as-paren/

22 – LAUSD CAFR Page 121.

23 – The CAFR only shows the number of children in special education schools, but does not include the number of special education students enrolled in traditional schools.

24 – K-12 enrollment totaled 556,115 as shown on Page 157 of the LAUSD CAFR. This is the 585,894 LAUSD students net of early education, adult education and independent charter schools shown in Table 3 above minus the 29.779 students in Career Technical Education and the Regional Occupational Program.

25 – 2013-14 Alliance-Wide Performance Dashboard, http://www.laalliance.org/performance/13-14/dashboards/Alliance-wide%20Performance%20Dashboard%202013-2014.pdf.

26 – The ethnic breakdown of the enrolled students at each of LAUSD high school, including the charter high schools, can be found from the CA Dept. of Education,
Educational Demographics Unit:
http://dq.cde.ca.gov/dataquest/Enrollment/EthnicEnr.aspx?cType=ALL&cGender=B&cYear=2013-14&Level=School&cSelect=Alliance+Gertz-Ressl–Los+Angeles+Uni–1964733-0106864&cChoice=SchEnrEth

27 – English Language Learner:
CA Dept. of Education, Selected District Level Data, Los Angeles Unified for the year 2013-2014
http://dq.cde.ca.gov/dataquest/cbeds3.asp?FreeLunch=on&PctEL=on&cChoice=DstProf2&cYear=2013-14&cTopic=Profile&myTimeFrame=S&cSelect=1964733–Los^Angeles^Unified

Free/Reduced Lunch Program:
CA Dept. of Education, Selected District Level Data, Los Angeles Unified for the year 2013-2014
http://dq.cde.ca.gov/dataquest/cbeds3.asp?FreeLunch=on&cChoice=DstProf2&cYear=2013-14&cTopic=Profile&myTimeFrame=S&cSelect=1964733–Los^Angeles^Unified

Students with disabilities data was provided by Alliance and LAUSD’s Office of Data and Accountability
http://notebook.lausd.net/portal/page?_pageid=33,131762&_dad=ptl

28 – CA Dept. of Education, API Reports
http://www.cde.ca.gov/ta/ac/ap/apireports.asp

CA Dept. of Education, SAT Scores
http://dq.cde.ca.gov/dataquest/satactap/sat.aspx?cyear=2013-14&cchoice=SAT4b&year=1314&cdscode=19647330111658&clevel=School&ctopic=sat&level=School

CA Dept. of Education, Cohort Graduation Rate
http://dq.cde.ca.gov/dataquest/CohortRates/GradRates.aspx?Agg=S&Topic=Graduates&TheYear=2013-14&cds=19647330106864&RC=School&Subgroup=Ethnic/Racial

Daily attendance data was provided directly by Alliance and LAUSD’s Office of Data and Accountability
http://notebook.lausd.net/portal/page?_pageid=33,131762&_dad=ptl

29 – Individual SAT scores for the nine schools under analysis were provided by Alliance. The overall averages were corroborated with CA Dept. of Education data. The top 686 scores, as calculated, were then extracted from that data.

30 – National percentile rankings for SAT 2014 for College Bound Seniors
https://secure-media.collegeboard.org/digitalServices/pdf/sat/sat-percentile-ranks-composite-crit-reading-math-writing-2014.pdf

Rolls Royce Health Care Plans for L.A. County Public Agencies

SUMMARY:  The price of health insurance in America has consistently risen faster than the rate of inflation and, despite the intentions of the Affordable Care Act (ACA), is projected to continue to do so for the foreseeable future.

A provision of the ACA known as the ‘Cadillac Tax’ is designed to discourage employers from purchasing excessively priced health insurance plans; which is intended to reduce at least one of the factors that contribute to the dramatic increase of price.

This paper draws on a wide array of research that demonstrates government employers are most likely to be affected by the ‘Cadillac Tax’ due to their propensity to purchase the most expensive forms of health insurance available for their employees.

A particularly striking form of excess – a $42,942 plan – for an employee of a small water district in Los Angeles County prompted an inquiry into the health costs for other public agencies in the County.

This analysis reveals that the largest Los Angeles County public employers are paying approximately 71% more for their employees’ health insurance than private employers, at an estimated cost of $676 million a year.

*  *  *

INTRODUCTION

Despite the warning from the Government Accountability Office (GAO) of the impending burden to state and local governments from rising healthcare costs, many Los Angeles governments are purchasing wildly exorbitant health insurance for their employees, at taxpayers’ expense.

Last year the Water Replenishment District of Southern California (WRD) paid $42,942 for a single employee’s health insurance plan. Nearly half of the District’s full-time employees received a plan that cost at least $30,000 apiece.

In 2011, the WRD had four employees receiving plans that cost at least $30,000. By 2014, that number increased three-fold, demonstrating the $42,942 plan is not a remote outlier, but part of an agency-wide practice of vastly overpaying for health insurance.

Surprisingly, WRD employees are also part of the coveted “3% @ 60” pension plan – which calculates the retirement benefit by multiplying the number of years worked by 3 percent, and then multiplying that number by the employee’s highest salary.

Typically, plans with the generous 3% multiplier are reserved for police and fire employees. In fact, the 3% plan is so expensive that the Pension Reform Act of 2013 eliminated it completely for new hires. New employees at the WRD would be under the reduced, but sustainable, “2% @ 62” formula.

The total compensation package for WRD employees is quite generous as well – full-time WRD employees received an average $180,636 in 2013.

As the data available on TransparentCalifornia.com is making clearer, it is in the often-overlooked smaller, local government agencies where the most dramatic levels of excessive public compensation can occur.

Table 1: Water Replenishment District of Southern California Employee Compensation

Healthcare Graph 2

The problem is widespread

Unfortunately, California governments overpaying on health insurance goes well beyond the WRD. Transparent California previously reported on the numerous $20k+ health plans in Corte Madera and the Contra Costa Community College District, as well as the $30k+ plans found in the cities of Beverly Hills and Sierra Madre.

Pew Research confirms that the problem is nationwide – over the past 25 years, state and local government spending on health insurance increased 447% in inflation-adjusted dollars, and is projected to rise further.

This dramatic increase can be attributed, in part, to government wastefulness – government employers not only purchase the most expensive plans, they also ask their employees to contribute the least to help fund them.

In California’s public sector, this problem is accelerating at an alarming rate. From 2011-2013 the amount spent on health insurance by the State increased by 8% as compared to the average 1% decrease nationwide, according to Pew Research.

While the WRD’s excess is the highest in absolute terms, its impact is limited due to their small size. As such, it is more meaningful to analyze the larger districts in the state.

This analysis will incorporate data from the State of California and the largest government agencies in Los Angeles County – home to both the largest city and county in the state.

Table 2 compares two of the biggest special districts – the Los Angeles County Sanitation Districts and the Metropolitan Water District of Southern California – as well as the Los Angeles Department of Water and Power, the City of Los Angeles and the Los Angeles County government.

The Bureau of Labor and Statistics (BLS) provides comparable information for private employers. However, the information is only reported by geographical region, not individual state. As such, the Pacific regional data, of which California is the largest component, is used in this comparison.

The BLS data is by coverage type only. Therefore, the average employer cost is estimated assuming a 50/50 split between employees selecting single or family coverage plans, consistent with the trend found by the Medical Expenditure Panel Survey.

Table 2: Average Employer Cost of Health Insurance
Healthcare 1 Graph

Consistent with the nationwide data, Los Angeles governments pay significantly more for health insurance than the average private sector employer.

For just the five Los Angeles governments analyzed, the total amount paid in excess of the average private employer’s cost is approximately $676M, as shown in Table 3 below.

Table 3: Average Public vs Private Cost of Health Insurance and Total Cost of Public Excess, Los Angeles

Healthcare Graph 3


A bad problem gets worse

The forthcoming ‘Cadillac tax‘ provision of the Affordable Care Act is expected to pose a significant burden to government employers – due to their propensity to purchase Cadillac-style plans for their employees. Beginning in 2018, employers must pay a 40 percent tax on the excess of plans that cost more than $10,200 for single coverage and $27,500 for family coverage.

It must be noted that the threshold for the Cadillac Tax applies to the total cost of the plan. The values reported here are only the employer costs. If employees also contribute towards the cost – meaning the total cost is higher than just the employer’s share – the number of plans affected will rise significantly.

The WRD, for example, will have to pay at least $41,000 a year in penalty taxes for just the twelve employees with health care plans over the $27,500 cap at their current rates. Virtually the entire full-time staff – over 1,400 employees – of the Metropolitan Water District of Southern California received health plans that cost more than $10,200; if any of those plans are for single coverage only, they would be hit by the tax too.

Los Angeles County had 56,366 employees – about 67% of staff – who received health insurance that cost at least $10,200. Outside of the WRD, the County had the greatest individual cost – with 192 plans costing $37,148 each. For just these 192 employees, the County would have to pay a penalty tax of at least $740,966 a year beginning in 2018.

Given the recent, and projected, double digit increases in health insurance premiums, merely holding costs to the present level by 2018 would be a remarkable feat.

Finally, the City of Los Angeles appears best positioned to avoid being affected by the tax. In addition to having the lowest average cost, there was not a single plan with a cost of more than $16,400.

CONCLUSION

The increasing cost of healthcare is certainly much more complex than merely being the result of government wastefulness. A comprehensive solution would require an entire rethinking of how healthcare should be provided. Still, having a consumer as big as government routinely overpay for a product will contribute to its rising cost.

As taxpayers are struggling to pay their own health insurance premiums, government should be doing all it can to rein in costs. As bad as the healthcare situation is at the moment, there is simply no justification for a government agency to consistently pay over $20,000 a year, or more, for their employees’ health insurance.

*  *  *

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

*  *  *

Unrecognized Legacy of Prop 39: $137 Billion in Payments Due for Money Already Borrowed and Spent

How much debt has accumulated as the State of California and its local K-12 school and community college districts relentlessly borrow money for school construction by selling bonds to investors?

No one seems to know. In April 2013, the California Policy Center published a report entitled Calculating California’s Total State and Local Government Debt, which attempted to calculate a reasonable estimate of debt obligations of the State of California and its local governments. The report estimated an astonishing debt total of $1.1 trillion, but researchers could not identify any recent sources to estimate the debt from general obligation bonds issued to finance educational construction.

There is a way to determine the amount of debt service (principal + interest) outstanding for educational districts. Researchers for the California Policy Center were able to add up total aggregate debt service for almost all California local educational districts in which voters approved a bond measure since the November 7, 2000 election.

Debt service for those California local educational districts is $136,500,250,898 as of January 2015.

Put in plain English, between now and 2055, California’s taxpayers will make $137 billion in principal and interest payments to pay back funds that have already been borrowed and spent.

Add this number to the $56,668,673,695 in debt service resulting from the three statewide bond measures for educational construction approved by voters, and the total debt service is $193,168,924,593.

See Appendix I – All California Educational Bond Measures Approved by Voters Since November 2000 Enactment of Proposition 39 – Ranked by Aggregate Debt Service

Obviously this debt is substantial, even after accounting for all of the caveats listed below.

As noted below in “Limitations on Using Debt Service Data for Educational Construction,” debt service for some school districts could not be determined, which makes the number determined by the California Policy Center to be lower than exact. In addition, numerous districts are now calling their bonds and issuing refunding bonds, which makes the number determined by the California Policy Center to be higher than exact. We believe these circumstances balance each other out.

Total debt service is about $137 billion for local educational districts where voters approved bond measures since the November 7, 2000 election. Including the three statewide bonds that voters approved since the November 7, 2000 election brings the total debt service to $193 billion.

How Were These Numbers Determined?

Municipal bonds are not bought and sold on Wall Street. Instead of using a centralized place (such as an “exchange”), issuers and investors buy and sell bonds “over the counter” through dealers and brokers registered with the Municipal Securities Rulemaking Board (MSRB), a quasi-governmental organization overseen by the U.S. Security and Exchange Commission. These dealers and brokers act as underwriters or intermediaries between issuers and investors.

Federal law generally requires underwriters in a primary offering of municipal bonds of $1 million or more to obtain and review an “Official Statement” from the issuer of those bonds. Those statements disclose financial information meant to inform a potential buyer and reduce the chance of “fraudulent, deceptive, or manipulative acts or practices.” By law these statements have to be posted on a publicly-accessible and free-to-use website: the Municipal Securities Rulemaking Board Electronic Municipal Market Access system, or EMMA.

Official statements include a chart that indicates how much aggregate principal and interest the issuer of the bonds would owe each year if the bonds weren’t refunded (called in so new bonds can be issued at a lower interest rate) or paid off early. Different official statements may place the aggregate debt service chart in different locations in an Official Statement. Charts may differ in title, format, or details of content. A few charts may not even total up the annual debt service. But the information is usually available. (Issuers of bonds through “private placement” do not need to post official statements on EMMA, because the information is provided directly to the private buyers.)

California Policy Center researchers used the EMMA database to determine debt service for each educational district where voters approved borrowing money for construction through bond sales after November 7, 2000. (That is the election date when California voters approved Proposition 39 and reduced the threshold for voter approval of bond measures for construction from two-thirds to 55 percent.) Researchers entered each district name into the EMMA system, identified the most recent bond offering or bond refunding from the list of bond issues, downloaded the associated Official Statement, located the aggregate debt service chart, and calculated the total debt service for 2015 and/or later years.

Limitations on Using Debt Service Data for Educational Construction

This data is a big step forward in informing Californians about the tremendous debt accumulated by educational districts that borrowed money for school construction by selling bonds. Nevertheless, the data has limitations. Here are 14 warnings about assessing the data out of context:

1. Some local educational districts have not yet borrowed any money as authorized by voters. Other districts have issued some bonds and plan to issue more bonds soon. Some districts have issued all of their bond authority. This means that debt service may be deceptively low in some districts that haven’t yet begun borrowing with gusto.

2. As mentioned above, educational districts in some circumstances can call in existing bonds and issue refunding bonds at a lower interest rate, thus reducing debt service. For this reason, school districts can argue that they intend to regularly issue refunding bonds, and therefore the amount that taxpayers will end up paying is somewhat less than what is listed for the current debt service.

3. For some educational districts, the current debt service will be paid off in a few years. For other school districts, the current debt service will be paid off in 40 years, thus allowing for a presumption that a long period of steady inflation and substantial increase in total assessed property value will mitigate the debt burden on property owners.

4. An argument can be made that borrowing a lot of money now at currently low interest rates is wise financial management, and debt service therefore is not an important issue to consider.

5. An educational district in a wealthy area can have significant debt service but also have high and stable total assessed property value. That debt service may be foolish, but it is not as dangerous as the same debt service in an less affluent educational district with unstable property values and an uncertain economic future.

6. Debt service becomes foolhardy and dangerous as the amount of interest owed increases relative to the amount of principal owed. Educational districts that issued a lot of Capital Appreciation Bonds in the past 15 years have debt service out of proportion to what they obtained through their construction program.

7. As mentioned above, some California educational districts are now issuing bonds through negotiated placement or private placement, which do not require official statements because the investors are qualified to perform their own assessment of the district’s financial status. Keep in mind that official statements are intended for the benefit of potential public investors, not for the benefit of taxpayers or other interested parties.

Private placements seem to be growing in popularity. Researchers were unable to determine current debt service for several small school districts without official statements on EMMA, and at least two of them (and probably all of them) used private placement for their most recent bond sales. It’s notable that the West Contra Costa Unified School District – perhaps the California educational district taking the most risks with school construction finance – apparently issued $135 million in bonds – including bonds with 40-year maturities – in February 2015 through private placement.

8. Debt service can accumulate from bond issues that occurred decades ago. California’s educational districts were winning approval for bond sales under the Proposition 13 two-thirds threshold for 20 years before Proposition 39, and some of that borrowed money is still being repaid back, with interest. For those school districts, debt service may look disproportionately high relative to the amount of money borrowed from 2001 to 2014.

9. There are a handful of local educational districts that have debt service from bond measures approved in 2000 or earlier but have not asked voters to authorize additional borrowing since the November 7, 2000 election. That debt service is not included in the total reported here. In addition, there are statewide bond measures for educational construction approved before November 7, 2000, including a $9.2 billion bond measure approved by voters in 1998 that included $6.7 billion for K-12 school districts and $2.5 billion for community college districts and California State University and the University of California campuses. The actual total debt service for all statewide bond measures and all local educational districts likely exceeds $200 billion.

10. Several K-12 school districts have merged in the past 15 years. Some official statements segregate debt service for the districts before they merged, and some combine the debt service.

11. Several community college district and K-12 school districts have created “School Facilities Improvement Districts” embedded within the complete jurisdiction of the districts. Some official statements segregate debt service for these subdistricts, and some combine the debt service for the subdistricts with the debt service for the complete district.

12. Certificates of participation, lease revenue bonds, and other schemes for educational districts to borrow money while evading Proposition 13 and Proposition 39 requirements are not included in official statements.

13. Community Facilities Districts funded by Mello-Roos bonds are not included in official statements.

14. Debt service is best considered in conjunction with information in annual financial statements prepared for the educational districts.

Despite these limitations, the debt service amounts available through the official statements posted on EMMA provide new insight into the debt owed by California local educational districts. Voters need to know that borrowing additional money via bond sales for school construction is adding to already existing debt.

How Much Have California Voters Recently Authorized to Borrow for School Construction?

Next year California voters may be asked to authorize the State of California to borrow another $9 billion to help K-12 school and community college districts pay for more educational construction. This $9 billion would be obtained by selling bonds to investors and paying it back – with interest – over several decades using the state’s general fund.

Polling has allowed the backers of this initiative to identify the most effective arguments for winning support among voters. Those arguments are listed as “findings and declarations” in the language of the bond measure itself. (See the Request for Title and Summary for Proposed Initiative.) They are cited in various opinion pieces that have appeared in newspapers. And the arguments are heard in the promotional patter of professional signature gatherers at shopping centers.

Most of the arguments are platitudes, facts presented without context, or anecdotes. And no one would know from the arguments that California voters have already approved borrowing about $150 billion in recent years for educational construction.

Voters have approved borrowing about $150 billion for California school construction since Prop 39 passed in 2000. This virtually unknown fact is worthy of highlighting in future public debates.

Recognizing that a lack of balanced factual information compromises the democratic process, the California Policy Center continues to collect, synthesize, and analyze data regarding California educational construction finance. “It’s for the kids and the veterans” is no longer sufficient information for voters considering authorization for the state to borrow another $9 billion.

The State of California alone has $56.7 billion in debt service accumulated from the last three statewide educational bond measures that authorized borrowing a total of $35,766,000,000. Community college districts and K-12 school districts have accumulated an additional $137 billion in debt service. The public needs to know what has already happened before deciding what will happen next.

Part of that understanding includes the impact of Proposition 39. Prop 39 inaugurated a new era of generous borrowing for educational construction in California. Approved by 53.4% of voters in the November 7, 2000 election, it reduced the voter approval threshold for educational construction bond measures (under certain conditions) from two-thirds to 55 percent.

This lowered obstacle encouraged local educational districts to take the risk of proposing many more bond measures at much higher amounts for voters to approve. As shown by the data below, dropping the voter threshold from 66.67% to 55% transformed the approval of educational bond measures from a 50-50 chance to a commonplace outcome.

The California Policy Center believes it is the first and only entity to painstakingly research and present an accurate and comprehensive record of all state and local educational construction bond measures considered by voters from 2001 through 2014.

Some Facts on Voter Consideration of Local and State Bond Measures for Educational Construction

See Appendix A – All California Educational Bond Measures Considered by Voters Since November 2000 Enactment of Proposition 39 – Ranked by Percentage of Voter Approval

See Appendix F – All California Educational Bond Measures Repurposed or Reauthorized Since November 2000 Enactment of Proposition 39 – Listed by Election Year

1. Since the passage of Proposition 39, voters in California have been asked 1147 times to authorize local K-12 school districts and community college districts to borrow a total of $124,350,056,744 for educational construction.

2. Of those 1147 bond measures, sixteen (16) were to reauthorize already approved bond authority totaling $730,365,000. If those bond measures are included with the 1131 bond measures to authorize new borrowing authority, the total amount California voters have been asked to authorize or reauthorize is $125,080,421,744.

In most of these 16 cases, school districts reauthorized bond measures during the late 2000s-early 2010s decline in assessed property values in order to circumvent tax and debt limits in state law and allow the further sales of bonds. These reauthorizations were usually depicted in a simple way to voters as continuing an already-approved construction program without increasing debt.

3. Since the passage of Proposition 39, voters in California have been asked three (3) times to authorize the state to borrow a total of $35,766,000,000 for educational construction.

4. What are the grand totals? Since the passage of Proposition 39, voters in California have been asked to authorize the State of California and local K-12 school districts and community college districts to borrow $160,116,056,744 for educational construction. If reauthorized bond authority is added to that amount, the total amount voters have been asked to authorize or reauthorize is $160,846,421,744. (That is $160.8 billion.)

Some Facts on Approval of Local and State Bond Measures for Educational Construction

See Appendix B – All California Educational Bond Measures Approved by Voters Since November 2000 Enactment of Proposition 39 – Ranked by Amount Authorized to Borrow

1. Voters approved 911 of the 1147 local educational bond measures, for a 79.42% approval rate for bond measures.

2. Voters approved $109,620,418,737 out of the $124,350,056,744 proposed to voters, for a 88.15% approval rate for the amount of bond authority.

The amount of authority approved by voters is a higher percentage than the number of bond measures approved by voters because larger bond measures proposed by larger educational districts passed at a higher rate than smaller bond measures proposed by smaller districts.

3. Voters approved all sixteen (16) bond measures (among the 1147 bond measures) to reauthorize bond authority that voters had already approved in early elections. If reauthorized bond authority is included, voters approved $110,350,783,737 out of the $125,080,421,744 proposed to voters, for a 88.22% approval rate for the amount of bond authority.

4. Voters approved all three (3) statewide educational bond measures, for a total of $35,766,000,000 to match with local educational bond expenditures.

5. What are the grand totals? Since the passage of Proposition 39, voters in California have authorized the State of California and local K-12 school districts and community college districts to borrow a grand total of $145,386,418,737 for educational construction. If reauthorized bond authority is added to that amount, the total amount voters have authorized or reauthorized is $146,116,783,737.

Some Facts on Rejection of Local and State Bond Measures for Educational Construction

See Appendix C – All California Educational Bond Measures Rejected by Voters Since November 2000 Enactment of Proposition 39 – Ranked by Amount NOT Authorized to Borrow

1. Voters rejected 236 of the 1147 local educational bond measures, for a 20.6% rejection rate for bond measures.

2. Voters rejected $14,729,638,007 out of the $124,350,056,744 proposed to voters, for a 11.85% rejection rate for bond authority. If reauthorization of bond authority is added to the amount proposed to voters, the rejection rate for bond authority is 11.78%.

The amount of authority rejected by voters is a lower percentage than the number of bond measures rejected by voters because, as noted above, larger bond measures proposed by larger educational districts passed at a higher rate than smaller bond measures proposed by smaller districts.

3. Of the 236 rejected local educational bond measures, 56 needed two-thirds voter approval and 180 needed 55% voter approval.

The 55% Voter Threshold Instituted by Proposition 39 Makes a Big Difference in Approving Bond Measures

See Appendix D – All California Educational Bond Measures Approved With a Two-Thirds Threshold Since November 2000 Enactment of Proposition 39 – Listed By Election Year

See Appendix E – All California Educational Bond Measures Approved With a 55 Percent Threshold Since November 2000 Enactment of Proposition 39 – Ranked by Percentage of Voter Approval

See Appendix G – All California Educational Bond Measures Approved by Voters Under 55% Threshold Since November 2000 Enactment of Proposition 39 – Results if Proposition 39 Had Not Been Law

See Appendix H – All California Educational Bond Measures Approved by Voters Under 55% Threshold Since November 2000 Enactment of Proposition 39 – Failures Under Two-Thirds Threshold

1. A cumulative approval percentage of 60.8% is calculated by dividing the total number of Yes votes by the total number of recorded votes for all 1147 local educational bond measures and the three state bond measures since Proposition 39 was enacted. Obviously 60.8% is higher than 55% and lower than two-thirds.

2. Of the 911 local educational bond measures approved by voters, 857 were approved with a 55% threshold and 54 were approved with a two-thirds (66.67%) threshold. Most of these bond measures under the two-thirds threshold were approved in 2001 and 2002, during the first two years after voters approved Proposition 39. Since the November 2008 election, voters have only approved two local bond measures for educational construction under the two-thirds threshold. In 2014 elections, only one bond measure was subject to two-thirds voter approval (a bond measure for Vallejo City Unified School District that failed because it received only 61.5% voter approval.)

The few educational districts that now propose bond measures that require two-thirds approval instead of 55% approval do so only to evade certain requirements in Proposition 39 or in state law. A common motivation is avoiding legislative requirements imposed in the California Education Code that limit the amount of bonds issued as a percentage of total assessed property value of the district and limit the amount of tax required to pay off the debt from the bond measure.

12. If the 857 bond measures approved under a 55% threshold were considered under the old Proposition 13 two-thirds threshold in place before Proposition 39, only 369 of the 857 local educational bond measures approved by voters would have passed, while 488 of those bond measures would have failed. Those 488 bond measures authorized educational districts to borrow $57,628,510,725.

1147 Local Educational Bond Measures: Results If Proposition 39 Wasn’t Law

Under Prop 39

If Prop 39 Not Enacted

Total Number of Bond Measures on Ballot

1147

1147

Total Amount Authorized to Borrow on Ballot (includes reauthorizations)

$125,070,421,744

$125,070,421,744

Number of Bond Measures Approved

911

423

Percentage of Bond Measures Approved

79.42%

36.88%

Total Amount Authorized to Borrow

$110,340,783,737

$52,712,273,012

Percentage of Bond Authorization Amount Approved

88.22%

42.15%

Comparison of Election Results: 55 Percent versus Two-Thirds Voter Approval

55% Approval Under Prop 39

Two-Thirds Approval

Total

Number of Bond Measures on Ballot

1037

110

1147

Number of Bond Measures Approved

857

54

911

Number of Bond Measures Rejected

180

56

236

Percentage of Bond Measures Approved

82.64%

49.09%

79.42%

Percentage of Bond Measures Rejected

17.36%

50.91%

20.58%

Debt and Tax Limits Always Waived When School Districts Want to Borrow More Money

Research by the California Policy Center now allows the People of California to see – for the first time – a chart listing all California K-12 school district requests to the state for waivers to sell bonds for school construction. These waivers allow school districts to circumvent state laws meant to protect property owners from excessive public debt and taxes.

State law allows the California Board of Education to grant waivers from numerous sections of the California Education Code, including bond indebtedness limitations. This power is obscure but significant, and until now a compilation of the history of bond indebtedness waivers has not been available to the public.

Out of the 51 waiver requests from 2000 through 2014, only one received notable public attention. In 2013, the fourth waiver request since 2002 from the West Contra Costa Unified School District became controversial when some local taxpayer activists and a columnist for the Contra Costa Times criticized the district for repeatedly seeking waivers to borrow yet more money for construction through bond sales.

To develop a bond indebtedness waiver chart and provide the public with comprehensive information about the waivers, the California Policy Center obtained a document from the California Department of Education listing the bond indebtedness waivers granted by the California Board of Education since 2000. Staff indicated that this listing was an “internal working file and has not been reviewed or validated for accuracy.”

California Policy Center - School District Requests to California Board of Education for Waivers from Tax and Debt Limits, 2000-2014 - Listed by DistrictCalifornia Policy Center researchers checked the data, corrected various inaccuracies, and expanded on the data using meeting agendas, staff reports, and meeting minutes. Now the public finally has a useful resource for considering public policy related to bond indebtedness waivers.

The link below goes to a PDF chart detailing the complete history of school district requests to the California Board of Education for waivers from tax and debt limits in order to borrow money for school construction by selling bonds to investors. Preliminary activity in the first three months of 2015 is also included.

History of Bond Indebtedness Waivers for California K-12 School Districts

The PDF chart includes linked citations of source documents on the California Department of Education website.

At the end of this article is the same chart in JPG format.

Initial Policy Recommendations Concerning Release of Information to the Public on Bond Indebtedness Waivers

As a result of this exercise, the California Policy Center recommends that the state legislature improve government transparency by amending the section of the California Education Code that requires the California Department of Education to produce and submit an annual report about waivers.

[California Education Code Section] 33053. The State Department of Education shall annually submit a report to the Governor, Legislature, State Board of Education, and make the report available to the superintendent and board president of each school district and county office of education. This report shall include a description of the number and types of waiver requested of the board, the actions of the board on those requests, and sources of further information on existing or possible waivers.

As of April 1, 2015, the California Department of Education has only posted reports from 2010, 2011, 2012, and 2013 on its web site. And these reports have limited value because the Department of Education provides the bare minimum of information required by law. Reports provide a spreadsheet with a tally of the number of waivers requested and approved for various provisions in the California Education Code. They do not name specific school districts that requested the waivers. Reports provide annual statistics in isolation, with very limited effort to compare tallies to past years to show trends. Links to the charts are here:

California Department of Education Waiver Reports for the Years 2010 Through 2013

Waivers from the California Education Code are an obscure area of public policy, and even if people know about waivers, they must perform time-consuming research to determine what is going on in their school district or statewide. If the California legislature chooses not to amend this inadequate law, the California Department of Education could (and should) choose to make an administrative decision to provide more details about the waivers in the annual reports.

What the California Policy Center Discovered

From 2000 through 2014, California K-12 school districts have requested 51 waivers from sections of the California Education Code that do the following:

  1. Prohibit the total amount of bonds issued (the total amount of principal) from exceeding 1.25 percent or 2.50 percent of the most recent assessed aggregate value of taxable property in the district. (Elementary and high school districts have a 1.25% limit; unified school districts have a 2.5% limit.)
  2. Prohibit the total amount of bonds issued as authorized by one bond measure from requiring a property tax that exceeded $30 or $60 per year per one hundred thousand dollars ($100,000) of taxable property.  (Elementary and high school districts have a $30 limit; unified school districts have a $60 limit.)

Out of these 51 waiver requests, school districts ended up withdrawing three of them. The State Board of Education approved all 48 other waiver requests, without one dissenting board vote.

The 100% approval rate for waiver requests is not surprising. In 2013, the State Board of Education took action on 518 waiver requests for all sections of the California Education Code and approved 97% of them. Under state law, the California Board of Education is generally obligated to grant such waivers as long as the request is submitted correctly and the waiver doesn’t violate seven criteria specifically listed in state law:

  1. The educational needs of the pupils are not adequately addressed.
  2. The waiver affects a program that requires the existence of a schoolsite council and the schoolsite council did not approve the request.
  3. The appropriate councils or advisory committees, including bilingual advisory committees, did not have an adequate opportunity to review the request and the request did not include a written summary of any objections to the request by the councils or advisory committees.
  4. Pupil or school personnel protections are jeopardized.
  5. Guarantees of parental involvement are jeopardized.
  6. The request would substantially increase state costs.
  7. The exclusive representative of employees, if any…was not a participant in the development of the waiver.

None of those seven criteria relate to local fiscal policies, meaning there is no obvious justification in state law for the Board of Education to deny a waiver from state laws related to bond indebtedness. Nonetheless, the Board of Education has chosen to impose conditions on bond indebtedness waivers and sometimes incorporated changes from the original requests at the recommendation of California Department of Education personnel. But the Board of Education has also rejected recommendations from the Department of Education, most notably in 2013 when the board repeatedly rejected a staff recommendation that school districts applying for waivers should not be permitted to sell Capital Appreciation Bonds.

More Comprehensive Reform Is Needed for the Process for Bond Indebtedness Waivers

Some people would describe these waivers as appropriate; others would condemn them as evasions. Whichever perspective is accurate, California law is inadequate in its current requirements regarding bond indebtedness waivers for school districts. The process for considering waivers is flawed and the results of that consideration are not transparent.

The California Policy Center is preparing a large, comprehensive report for publication about the astonishing bond indebtedness that has resulted from educational construction in California. This report will include numerous public policy recommendations, including several related to bond indebtedness waivers.

One obvious recommendation is shifting responsibility for approving bond indebtedness waivers from the California Board of Education to the State Allocation Board, which makes decisions for state funding of school district construction and directs the Office of Public School Construction. Of course, there also needs to be serious deliberation about whether school districts should even have the right to request and get waivers from state limits on debt and taxes.

Since the enactment of Proposition 39 in 2000, California voters have approved borrowing $142.4 billion for school construction, including $35.8 billion through three statewide ballot measures. And as of March 1, 2015, the State of California and almost 600 local educational districts have borrowed enough money since the enactment of Proposition 39 to accumulate approximately $188 billion in debt service – that is principal and interest owed to bond investors over the full term of the bonds – including $56.7 billion through three statewide ballot measures.

Before California voters approve another proposed statewide bond measure or more local bond measures for school construction, they need to be better informed about the current state of bond indebtedness. Rhetoric about “helping the kids” needs to be balanced with fiscal reality.


California Policy Center - School District Complete Waiver History from Tax and Debt Limits, 2000-March 2015

California Policy Center – School District Complete Waiver History from Tax and Debt Limits, 2000-March 2015

Examining Public Pay in California: The Los Angeles Department of Water and Power

Summary:  The Los Angeles Department of Water and Power (DWP) is the nation’s largest municipal utility, but it may also be one of the clearest examples of excessive public pay driven by powerful public sector unions. This paper analyzes the pay received by DWP employees to their non-DWP counterparts and finds that the average DWP employee receives total compensation that is 155% greater than their non-DWP counterpart.

The largest premiums are found in generic jobs such as custodians, garage attendants, security officers, and the like. The average DWP security officer, for instance, makes 288% more than a non-DWP security officer working in the Los Angeles Metropolitan area. Overall, the weighted average wage premium for DWP employees performing generic jobs was 90% over their counterparts in the Los Angeles area. For all jobs, and including the value of benefits such as pensions and employer paid health insurance costs, the premium for DWP employees as estimated to be 155% higher – that is, 2.5 times as much – than for employees performing work with similar job descriptions in the Los Angeles area.

Applying these premiums to the number of employees at the DWP, the total cost to rate-payers of the DWP paying above market wages is estimated to be $392.8M a year.

*   *   *

INTRODUCTION

The issue of comparing public pay to private pay has challenged academics and sparked fierce debate for years. A serious gap in the academic literature was filled by Andrew Biggs and Jason Richwine’s groundbreaking paper, Overpaid or Underpaid? A State-by-State Ranking of Public-Employee Compensation. Biggs and Richwine found that California State employees receive a total compensation premium of 33% versus their private sector counterpart. Given the scope of their paper, their analysis was limited to state employees only.

However, roughly 90% of all public employees in California work for local agencies. Further, state employees are paid less in wages and receive less generous benefits than local public employees do, suggesting that the bulk of public employees in California receive compensation greater than the 33% premium found at the state level. This paper is the first in a series that will analyze the level of pay for individual public agencies in an attempt to fill this gap.

The Los Angeles Department of Water and Power (DWP) is the nation’s largest municipal utility, serving over four million residents. It is also a powerful example of the above market wages received by California’s public employees. The DWP made national headlines in 2012 and 2013 when Bloomberg reported that their garage attendants were making nearly four times the national average. The Los Angeles Times found that the average total pay for DWP employees was over $100,000 in 2012, approximately 50% higher than other city employees. With recently published 2013 data available on TransparentCalifornia.com, this analysis will update and expand upon the Times’ previous findings.

First, DWP pay is compared to the market in general, as represented by the Bureau of Labor and Statistics (BLS) average wage for the same or similar job, not merely to other government agencies. Secondly, the weighted average of the pay premium found is used to project the total cost associated with the systemic practice of paying above market wages for the department as a whole.

Finally, the value of retirement and health benefits provided to the DWP employee are contrasted to the comparable retirement and health benefits received by a non-DWP employee.

*   *   *

METHODS

The methodology used is known as the “positions approach” in the economics literature. This approach searches for matching job descriptions and then compares the pay between each. Adjusting for the traits of the underlying people holding the position, also known as the human-capital model, is not utilized. Given the extremely narrow focus of this paper to a single agency in a specific region, as opposed to a state or nation-wide analysis, the “positions approach” is sufficient.

Additionally, the singular focus allows for findings that are based on the actual wages paid, not an estimate based off of a regression analysis.

The DWP employs just over 10,000 people. However, this paper only analyzes employees who worked for a full-year by eliminating any employee with a base salary less than the reported annual salary minimum, leaving 8,318 full-time, year-round employees in 2013.

Twenty-three DWP job titles were selected for analysis, accounting for a total of 3,476 employees. This sample size represents 42% of 2013 full-time, year-round employees and 39% of total payroll expenditures. Job titles were selected by the degree of total employment they represented as well as the ability to reasonably identify a corresponding job title in the BLS report. While identical or similar job title names served as a starting point, the determination in matching a DWP job title to a corresponding BLS title was made entirely on whether or not the job description and responsibilities reasonably corresponded to each.

Modifications were made in the following two cases. First, while the DWP job of customer service representative correlated to the BLS job of the same name, the required skills and job responsibilities for the DWP position appeared much higher than average. Consequently, the corresponding BLS wage was increased to the BLS 75th percentile wage.

A similar adjustment was made for the job of “senior clerk typist.” The DWP job description for both “clerk typist” and “senior clerk typist” correlated to the BLS job of “office clerks, general.” The BLS average wage was used as the comparison for the DWP job of “clerk typist” and the 90th percentile wage was used for the comparison against the DWP’s “senior clerk typist” position.

An appendix listing the exact comparisons made is included at the end of the paper. The analysis was able to incorporate the seven most populated job titles held within the DWP, along with 16 additional job titles of various sizes.

*   *   *

COMPENSATION COMPARISONS

Regular Pay

The DWP wage is compared to the average wage for the same or comparable job as reported in the May 2013 wage estimates by the Bureau of Labor and Statistics for the Los Angeles Metropolitan area.

The BLS wage does not include overtime pay, but does include a variety of additional pays such as longevity, hazard, and incentive pay. As such, only the DWP wages without overtime pay (Regular Pay) should be considered as analogous to the BLS wage. Regular Pay is defined as base pay plus the multitude forms of routine “other pay” that DWP employees receive. In 2013, the average non-OT earnings (Regular Pay) of a DWP employee were $99,900.

 Table 1  –  Average DWP Regular Pay vs Average BLS Wage by Job Title

20150318-CPC_Fellner_LADWP-1

Overtime Pay

Overtime pay was excluded from this analysis to create parity between the DWP wage and BLS estimates. However, the DWP provides overtime pay at a higher rate than even firefighters or police, which casts serious doubts about the management structure and the necessity of the overtime pay issued. Including overtime pay increases the average 2013 total earnings of a DWP employee by 15% – to $114,941.

Additionally, an incomprehensible 92% of DWP employees receive overtime pay of some kind. The Los AngelesTimes discovered at least one particular example which confirms that at least some of the overtime pay is the result of union-friendly contracts, not necessity, when they revealed that DWP employees receive overtime pay for work that an outside contractor performs. This bears repeating: DWP employees can receive overtime pay for work that others do. Such a provision is unheard of in typical labor contracts, according to the expert cited in their article.

Despite the fact that the overtime pay at the DWP is at least partially excessive and not reflective of a genuine staffing need, it is impossible to quantify the proportion that is driven by abuse, as compared to that which is driven by legitimate need. Consequently, overtime pay is omitted from this comparison. Still, it must be noted that the average DWP employee receives a non-trivial benefit, averaging 15% in 2013, from the department’s atypically generous overtime policy.

A 90% pay premium for regular jobs

Many of the jobs with the smallest degree of DWP premiums are likely due to the fact that the DWP essentially is the market for that position in the Los Angeles Metropolitan area. Electric distribution and electrical mechanics and their comparable BLS job titles (listed in the Appendix) are jobs unique to a utility company. Obviously the DWP is, by far, the largest utility in the Los Angeles Metropolitan area. Consequently, the BLS comparable wages are going to be overwhelmingly represented by DWP employees, making a comparison less meaningful.

To have a more accurate picture of the above market wages paid by the DWP it is necessary analyze generic jobs that have a robust, non-DWP market such as custodians, security officers, and the like. When filtering for jobs not unique to a utility company, the Regular Pay received by a DWP employee is 90% greater than the market average.

Table 2  –  Average DWP Regular Pay vs BLS Wage for Generic Jobs Only

20150318-CPC_Fellner_LADWP-2

Benefits

It is well documented that public sector defined benefit plans provide more generous benefits than a defined contribution plan; typically the public employee shares in the cost of funding this plan to some extent. In CalPERS, for instance, many public employees pay half of the required contribution rate, which can range from 10-30% of salary, depending on the individual employing agency.

DWP employees, however, participate in their own pension plan and contribute only a maximum of 6% of salary towards their defined benefit plan, with earlier employees paying even less than that. While the DWP plan offers benefits slightly lower than CalPERS in absolute terms, the ability to receive these benefits at a reduced cost to the employee greatly increases the net value of the DWP pension plan.

However, most employees, particularly private employees, participate in a defined contribution plan, which is vastly less generous than the defined benefits plans California’s public employees participate in. A comparison to the type of benefits typically received from a contribution of 6% of salary is illustrative in that regard.

Given private employees must contribute 6.2% of their salary in Social Security taxes, any 401(k) style matching retirement benefits available to the non-DWP employee are only available if they incur an additional cost. Consequently, the following will compare the retirement benefits available based on the assumption that each employee is contributing the same level of salary (6%) towards their retirement.

Take, for instance, the average DWP custodian receiving an average base pay of $52,734 vs. the BLS average wage of $26,810. Many custodial positions outside of the DWP are hourly and do not offer benefits of any kind. However, the DWP custodian receives employer-paid medical benefits and is enrolled in a “2.3% @ 55” defined benefit plan. Assuming the DWP custodian retires at the age of 60 with 30 years of service, they will begin receiving an annual pension of $36,386. By contrast, the private sector custodian will not be able to receive anything from Social Security until the age of 62, at which point they will receive a yearly benefit of $8,880 based on a wage of $26,810.

Using an average life expectancy of 85, a discount rate of 3.75%, and an annual Cost of Living Adjustment (COLA) of 2%, the net present value of the DWP custodian’s pension benefit is $706,841. The net present value of the non-DWP custodian’s Social Security benefit is $161,250. This represents a retirement benefit for the DWP employee nearly 340% greater than that of what their non-DWP counterpart can expect to receive, despite having contributed the same percentage of salary towards their retirement plan.

The wages used to compute the DWP’s pension are base salary only and do not include the various forms of “other pay” that are included in Regular Pay for the salary comparisons done above.

The table below displays the results of the same analysis for five of the most populated job titles in the DWP.

Table 3 – Net Present Value of Avg Full-Career DWP
Retirement Benefit vs Comparable Social Security Benefit

 20150318-CPC_Fellner_LADWP-3

While it may seem initially counterintuitive that the largest pension premium is not found in the position with the largest wage premium, it makes sense when you remember there is a cap on the maximum Social Security benefit. As such, the key driver is the absolute value of the wages used for the DWP employee.

The comparison in Table 3 assumes an employee had worked 30 years and retired at the average wage reported, which is unlikely. Granted, this weakness applies to both sides equally in that both the DWP and non-DWP employee would likely retire at a higher wage than the average. Still, it is sufficient to illustrate the enormous disparity in pension benefits offered to DWP employees in relation to the cost of an annual contribution of no more than 6% of salary.

Total Compensation Premium

An alternative and more robust measure of comparison would be to calculate the value of employer-paid benefits as a percentage of annual wages.

To do so, we rely on the model pioneered by one of the nation’s leading experts on public sector pay and pensions, Andrew Biggs. An explanation as to how we calculated the value of the DWP’s defined pension benefits can be found starting on page 26, with an explanation on how we treated the value of the Social Security benefit beginning on page 40. The most pertinent section is reprinted below:

“To calculate pension compensation paid from state government pensions, we must convert normal costs as published by those plans to a measure using risk-appropriate discount rates. To do so, we gathered data on over 20 plans from California, Florida, Colorado, Washington, and Rhode Island in which pensions’ own actuaries have calculated pension costs under different discount rates. The median result indicates that a 1 percentage point reduction in the discount rate raises the normal cost of a plan by around 36 percent. As a check, we performed our own calculations using workers stylized to be typical of state government employees, which produced similar results.

The factor to convert a normal cost would equal 1.36(re – rra), where re equals the expected return on plan assets and rra the risk-adjusted discount rate. For instance, the factor to convert a normal cost calculated at 8 percent to a 4 percent discount rate would be 1.364, = 3.42. From this risk-adjusted total normal cost we subtract the value of employee contributions to arrive at net pension compensation. For instance, a plan with a total normal cost of 10 percent of wages at an 8 percent discount rate would have a normal cost of 34.2 percent of pay using a 4 percent discount rate. If the employee contributes 5 percent of pay to the plan, his net pension compensation would be equal to 29.2 percent of wages.”

In a nutshell, public pension systems understate the true cost, and value, of their benefits by using an inappropriately high discount rate in their actuarial calculations. Experts from the Congressional Budget Office, Federal Reserve Board, federal Bureau of Economic Analysis, Moody’s Investment Services, and across academia agree that an appropriate discount rate is one that matches the risk characteristics of the benefit (sidebar 1.)

The most commonly used discount rate for benefits that have little to no risk is the yield on a 20 year Treasury. Currently, the 20 year Treasury rate is at historic lows in the low 2 percent range. Therefore, we will again follow Biggs’ lead and use 4 percent as our discount rate, roughly the average yield over the past decade of a 20-year Treasury.

The DWP pension plan has a normal cost of 23.85% of wages (page 12.) The plan also uses a discount rate of 7.5% for its actuarial calculations (page 40.)  However, given the DWP’s pension benefits are guaranteed, and thus have no risk, it is necessary to adjust this cost to a 4 percent discount rate for the reasons outlined above. This represents a discount rate reduction of 3.5%. Per Biggs, every 1 percent point reduction increases the normal cost of a plan by around 36%. Therefore, the factor to convert to a risk-adjusted total normal cost would be 1.363.5,= 2.93. Multiplying 2.93 by the normal cost of 23.85% = 69.96%. After subtracting the contribution rate for DWP employees of 6%, the net pension compensation is worth 63.96% of wages.

For health benefits, the DWP’s 2013 payroll report stated the average cost per employee was $16,230. Therefore the total compensation for the DWP employee is: (Regular Pay * 1.6396 + $16,320.)

For the BLS counterpart, data from the BLS Employer Costs for Employee Compensation (ECEC) Survey was used to estimate the cost of employer-paid health insurance at 11% of wages. The total cost of Social Security and employer contributions towards a matching 401(k) was estimated at 9% of wages, also using data from the ECEC Survey. The formula for BLS Total Compensation is: (BLS Wage * 1.2.)

The chart below is a graphical representation of the total compensation premium for 10 of the most heavily populated positions in the DWP. Table 4 documents the total compensation premium found for all job titles analyzed in this paper. The average DWP employee receives compensation that is 155% greater than their non-DWP counterpart.

  20150318-CPC_Fellner_LADWP-4

 

Table 4  –  Total Compensation for DWP Employee vs. BLS Counterpart

20150318-CPC_Fellner_LADWP-5

*   *   *

LIMITATIONS

This paper is limited in that no attempt to compare the value of retiree health benefits, fringe benefits, or job security is made. However, it is extremely likely that doing so would only inflate the compensation premium already found.

These benefits, particularly things like job security, a generous (unlimited until mid-2013) sick day policy, and so forth are all extremely likely to weigh in favor of the DWP employee.

Another limitation was that many jobs in the DWP do not have a meaningful non-DWP counterpart in the Los Angeles area. Most notably, the jobs of “Water Utility Worker” and “Electric Station Operator” were omitted, despite being the eighth and ninth most populated jobs in the DWP, given the lack of a suitable BLS counterpart.

*   *   *

THE COST TO RATE-PAYERS

In order to project the total cost estimated with the DWP’s routine policy of paying above market wages, it is necessary to look at the actual dollar cost found as a percentage of total payroll.

For instance, the actual total cost of the pay premium received by the 3,476 DWP employees analyzed in this paper was: $116,668,950. This number was created by multiplying the difference between the BLS wage and the DWP Regular Pay by the total number of employees for each job title, as displayed in Table 1.  After which, one can simply sum the actual cost found for each of the 23 job titles for a total cost.

The total non-OT payroll for these employees is $323.8 million. As such, the total pay premium found represents 36.02% of payroll. If we assume these findings hold true for the rest of the DWP, the total cost can be estimated by multiplying the total (including PT employees) non-OT payroll of $927.6 million by 36.02% for a total cost of $334.1 million.

Further, the savings associated with reducing pay to the market average would expand beyond the immediate reduction in payroll expenditures; as doing so would simultaneously reduce the cost of pension benefits.

The DWP estimates their total normal cost for 2014 to be 17.56% of payroll (page 12.) As a result, every dollar reduction of payroll would save the DWP an extra 17.56 cents in pension contributions.

Assuming the DWP was to pay market wages, the total savings would rise to $392.8M when including the savings from the reduced pension contributions.

New Salary Contract

The public pressure from the Los Angeles Times’ exhaustive work in exposing the DWP’s unlimited sick day policy, overtime pay abuse, and high levels of pay led to a new contract being signed in late 2013.

Revealingly, the “concession” by the DWP only further demonstrates the power of their union. The deal slightly reduced benefits for new hires only; salaries were not reduced at all. Current employees received no benefits or pay reduction of any kind and merely saw their yearly base salary raise delayed until 2016.

As mentioned above, the DWP employee receives over 600 forms of other pay beyond their base salary, not to mention overtime pay that accounted for an average 15% increase in total earnings in 2013. The deal did not touch any of these forms of pay.

*   *   *

CONCLUSION

The above analysis makes clear the DWP’s primary motivation in setting employee compensation is political in nature – specifically, to accommodate the union and its members at the expense of ratepayers.

Particularly alarming is that the DWP is funded via what amounts to a regressive tax by being able to set the cost of water and power for their over 4 million customers. Consequently, Los Angeles area residents are being forced to subsidize lavish compensation packages that dwarf their own incomes.

The theoretical case against public sector unions is strong, with many of the Left’s greatest heroes having previously warned of the danger and impossibility of collectively bargaining with the public at large. The DWP offers a specific, real-world example of just how egregiously public sector unions can enrich themselves at the expense of the public.

*   *   *

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

*   *   *

APPENDIX

Please click here to go to the BLS’ Los Angeles Metropolitan Area May 2013 overview page, which contains the wage estimates listed below. Clicking the link for the individual job titles provides a description of the job’s duties and responsibilities, but wage data on a national level only.

DWP Job TitleBLS WageBLS Job Title
Senior Clerk Typist$45,960Office Clerks, General (90th percentile)
Customer Service Representative$44,800Customer Service Representatives (75th percentile)
Electric Distribution Mechanic$97,210Electrical Power-Line Installers and Repairers
Electrical Engineering Associate$61,530Electrical and Electronics Engineering Technicians
Electrical Mechanic$88,680Electrical and Electronics Repairers, Powerhouse, Substation, and Relay
Civil Engineering Associate$62,080Civil Engineering Technicians
Security Officer$26,640Security Officers
Meter Reader$46,930Meter Readers, Utilities
Custodian$26,810Janitors and Cleaners, Except Maids and Housekeeping Cleaners
Heavy Duty Truck Operator$42,210Heavy and Tractor-Trailer Truck Drivers
Clerk Typist$31,350Office Clerks, General
Electrical Engineer$110,620Electrical Engineers
Secretary Legal$54,010Legal Secretaries
Plumber$65,350Plumbers, Pipefitters, and Steamfitters
Air Conditioning Mechanic$54,690Heating, Air Conditioning, and Refrigeration Mechanics and Installers
Truck Operator$42,210Heavy and Tractor-Trailer Truck Drivers
Civil Engineer$95,250Civil Engineers
Custodian Supervisor$42,210First-Line Supervisors of Housekeeping and Janitorial Workers
Garage Attendant$29,175Approximated this value*
Mechanical Engineer$98,330Mechanical Engineers
Management Analyst$90,040Management Analysts
Maintenance and Construction Helper$44,930Helpers, Construction Trades, All Others
Mechanical Engineering Associate$62,520Mechanical Engineering Technicians

*The BLS reported a mean wage of $21,320 for a parking lot attendant. However, the Garage Attendant for the DWP entails additional non-skilled auto mechanic responsibilities and the wage was increased to reflect that by averaging the wage for a parking attendant and automotive service mechanic.

Alameda County Water District Rate Increase Driven by Labor Costs, Not Drought

With California facing a significant drought, many water districts are raising rates on customers who have been asked to significantly reduce water use.   Water districts cite the lack of rainfall, the rising cost of imported water, and reduced demand as reasons why customers must pay more.  However, many districts fail to explain the role labor costs play in the rising cost of water.

On February 12, 2015, the Alameda County Water District (“ACWD”), a special district serving the southern Alameda County cities of Fremont, Union City, and Newark and governed by a publicly elected Board of Directors, proposed to increase the service charge portion of most water bills by 30%.  A public hearing has been set for April 14. This will be at least the 16th consecutive year of rate increase and the third rate increase in the last 15 months. [1]

In 2010, the bimonthly service charge for a single family residence with a 3/4” meter (the most common) was $11.62. [2] The ACWD Board is proposing to increase the service charge to $41.54, a 257.5% increase in just five years.

The service charge is the fixed portion of the water bill all customers pay regardless of water use.  Raising the service charge does not create any incentive for customers to save water, which is what most water districts are encouraging their customers to do during this drought.  According to ACWD, customers who use 30 ccf (hundred cubic feet) of water will see their bill increase 6.2%.  However, customers who use only 5 ccf of water will see their bill increase 19.6%. [3]

Increasing this fee disproportionately harms low income households and households who use less water, including many seniors living on fixed income.  Given that households most impacted by this rate increase are the ones who can least afford it, ACWD has a high burden to justify its increased expenses that necessitates this rate increase.

ACWD’s expenses are budgeted to increase $6.0 million in fiscal year 2015. [4] On several occasions, ACWD said that its water supply costs are the main reasons for the increased expenses. In December 2014, ACWD’s Budget and Financial Analysis Manager said, “The primary reason for the [increase in operating budget] is the increase in water supply costs during this drought period.” [5] In a presentation to the public, ACWD said that 70% of their increased expense are due to water supply costs. [6] In a notice mailed to all property owners detailing the proposed rate increase, ACWD again said that 70% of the $6.0 million of increased expenses are due to water supply costs. [7] However, ACWD has been misleading the public for months by failing to mention that labor costs are included in the 70% water supply figure.

To separately examine labor costs, one must compare ACWD’s fiscal year 2014 actual labor costs and its fiscal year 2015 budgeted labor costs. In 2014, ACWD’s actual labor costs were $38.4 million. For 2015, ACWD budgeted $42.9 million, a $4.5 million increase (or 11.6% increase), for labor costs. [8] In other words, 75% of ACWD’s $6.0 million budgeted increase in expenses are due to labor costs. It is clear that the main reason for this 30% increase on the service charge will be used to pay for the significant increase in labor costs and not to help alleviate water supply costs as ACWD would like customers to believe.

To understand whether a budgeted $4.5 million increase in labor costs is justified, here are some facts about ACWD’s employee compensation:

–          More than half of employees received at least $150,000 in total compensation in 2013. [9]

–          Employees have received annual raises since at least 2003. [10]

–          Employees received a cumulative 21.7% raise during the Great Recession years of 2008 through 2012 (tied for the highest raise given in Alameda County government agencies). [11]

–          Employees will receive a 2.5% raise in 2015, a 3% raise in 2016, and a 3% raise in 2017. [10]

–          Up until July 2014, employees received free medical, dental, and vision insurance for their entire family.  Employees currently pay only one quarter of one percent of their salary for full insurance. [12]

–          Management employees are reimbursed 2.5% of the employee’s share of the CalPERS retirement contribution. [13]

–          Management employees are reimbursed $500 a year for personal Internet and cell phone bills. [14]

–          Employees can earn an unlimited number of sick hours, which can then be converted to pension credit at retirement. [15]

–          ACWD has $66.4 million of unfunded pension liability. [16]

–          ACWD has $37.1 million of unfunded retiree health care liability. [17]

In addition to employee compensation, ACWD gave $6,500 to a slush fund for employees to use how they please, including to attend baseball games, and paid $1,140 for employees to enter a sports tournament, which included 9 holes of golf. [18] Although inconsequential to its finances, both payments were made after ACWD implemented a drought surcharge.  Also, ACWD’s former General Manager, who receives an annual pension of about $250,000 a year, will receive $60,000 to write a book about ACWD’s 100 year history. [19]

When a government agency faces a difficult financial situation, some citizens are willing to share in the sacrifice to ease the financial burden.  In early 2014, ACWD declared a water shortage emergency [20] and asked customers to reduce water usage by 20% [21], which customers have done. [22] In mid 2014, ACWD implemented a drought surcharge.  Ratepayers, who have reduced water use and faced higher water rates, have done their part to share in the sacrifice during this drought.

ACWD employees, on the other hand, have done nothing to share in the sacrifice during this drought (and during the Great Recession).  Employees are generously compensated, receive generous benefits, have received annual raises for over a decade, and will continue receiving raises through 2017.

Yet, ACWD is still seeking to raise the service charge by 30% on the backs of the most financially vulnerable, including seniors living on fixed income, families collecting food stamps, families living paycheck to paycheck, the unemployed, and households who strive to conserve water, to pay for a 11.6% increase in labor costs.

If ACWD believes water rates must rise to support higher labor costs, ACWD needs to make the case on its merits rather than using the drought and water supply issues as a distraction.  It is dishonest to ratepayers and especially those who can least afford another significant rate increase.

About the Author:  Eric Tsai is a Fremont resident.

FOOTNOTES

(1)  See “Tsai-1_Rate-Increases.pdf” for history of rate increases.  From 2009 and 2014 CAFRs.

(2)  See “Tsai-2_2010-Service-Charge.pdf” for service charge fee in 2010.

(3)  See “Tsai-3_Rate-Proposal-Presentation.pdf” for rate increases by water use (page 19).

(4)  See “Tsai-4_Budgeted-Expenses.jpg” for budgeted expenses for fiscal year 2015.  From Public Records Act request.

(5)  Dec. 2014 article about consideration of rate increase: http://www.insidebayarea.com/news/ci_27156807/fremont-water-district-considering-another-rate-hike

(6)  Feb. 2015 presentation about rate increase (page 7): http://acwd.org/DocumentCenter/View/923

(7)  Notice mailed to all property owners about rate increase (page 2): http://acwd.org/DocumentCenter/View/927

(8)  See “Tsai-8_Budget.pdf” for 2015 budgeted labor costs.

(9)  See “Tsai-9_2013-Payroll-Records.xlsx” for calendar year 2013 employee compensation data.  The first and last names were removed from the file.  128 employees earned over $150,000 in total compensation while ACWD had 215 employees as of the end of 2013.

(10)  See “Tsai-10_Employee-Pay-Increases.pdf” for history of employee raises.  From three previous MOUs.

(11)  See “Tsai-11_Survey-Pay-Increases.pdf” for survey of 30 government agencies. From 2014 Alameda County Grand Jury final report.

(12)  See “Tsai-12_Employee-Health-Insurance.pdf” for employee medical coverage information.  First page is from prior MOU stating employee will receive full coverage and second page is from most recent MOU stating employee contribution for coverage.

(13)  See “Tsai-13_Management-Benefits.pdf” for employer pick up of employee retirement contribution (page 2, Retirement).

(14)  See “Tsai-13_ Management-Benefits.pdf” for employee allowance for personal Internet and cell phone bills (page 1, Management Allowance).

(15)  See “Tsai-13_ Management-Benefits.pdf” for management employee sick leave policy (page 3, Sick Leave) and “Tsai-15_Union-Benefits.pdf” for union employee sick leave policy (page 2, Sick Leave).

(16)  See “Tsai-16_Unfunded-Pension-Liability.pdf” for unfunded pension liability as of June 30, 2013 (page 12).

(17)  See “Tsai-17_Unfunded-OPEB-Liablity.pdf” for unfunded OPEB liability as of June 30, 2013 (page 10).

(18)  See “Tsai-18_Employee-Association.pdf” for payment to a slush fund and “Tsai-18_Sports-Reimbursement.pdf” for payment for employees to enter a sports tournament.

(19)  Jan. 2014 article about history book: http://www.insidebayarea.com/news/ci_24912579/fremont-based-water-district-paying-280-000-history

(20)  See “Tsai-20_Water-Shortage-Emergency.pdf” for water shortage emergency ordinance.

(21)  See “Tsai-21_Reduce-Water-Use.pdf” for request asking customers to reduce water use.

(22)  Confirmation from ACWD’s Twitter page stating ACWD water use is down 20%.

California City Pension Burdens

SUMMARY:  This study estimates the burden of pension costs on 459 California municipalities. The primary measure we consider is the ratio of required pension contributions to estimated total revenue for each city.  We also look at contribution rates per employee and at pension funding levels.  We find a wide variation in the impact of pension costs on city finances. While several cities spend more than one-eighth of their revenues on pension contributions, many spend far lower proportions and ten municipalities have no defined benefit pension plans at all.

The most heavily burdened cities are San Rafael, Costa Mesa and San Jose, which have pension cost / revenue ratios estimated at 17.58%, 14.36% and 13.88% respectively. As we discuss in the study, all three of these cities are taking measures to reduce future pension costs, so their rankings are not necessarily a reflection on currently sitting elected officials. Using an alternative measurement of total pension debt (unfunded liability plus pension bonds outstanding) / revenue, the most heavily burdened cities are Oakland, Costa Mesa, and Richmond, which have pension debt / revenue ratios of 203.3%, 182.0%, and 180.9%, respectively.

Prospectively, using data from recently released CalPERS actuarial reports, we project pension costs for most cities through to fiscal year 2020, identifying two cities – Monrovia and Fremont – that may face troubles in the years ahead. Monrovia and Fremont have 2015 pension cost / revenue ratios greater than 10% AND they will both experience dramatic cost growth.  Between 2015 and 2020 and assuming a 7.5% CalPERS return, Monrovia is projected to see a 64.15% cumulative increase in pension costs, while for Fremont, the number is 46.51%. 

The weighted average funding ratio across all 459 cities was just over 75% as of June 30, 2013. Given strong stock market performance since that time, it is likely that the funding situation improved significantly over the last 18 months. Overall, CalPERS reported that its assets increased by 15% between June 30, 2013 and June 30, 2014. Its actuarial liabilities probably rose during this period as well, but likely at a slower rate.

Download Print Version of Study

*   *   *

INTRODUCTION

California cities that participate in defined benefit pension plans are expected to make a total of $5.1 billion in contributions during fiscal 2015, accounting for nearly 7% of their total revenue. As of June 30, 2013, the average funded ratio for these plans was 75%. Underneath these averages, we observe a great diversity of pension cost burdens and funding rates.

Study data by city and by plan may be found here. This Google Spreadsheet model contains multiple tabs including a city summary and plan details.

California City Pension Burdens – City Summaries
(click on image to view GoogleDoc spreadsheet, select tab “city_summary”)

20150205-CPC_Joffe_City-Summary

California City Pension Burdens – Plan Details by City
(click on image to view GoogleDoc spreadsheet, select tab “plan detail”)

20150205-CPC_Joffe_Plan-Detail

*   *   *

The city level data can also be viewed on a map:

California City Pension Burdens – Plan Summary by City
(click on image to view Google Map, then click circles to view individual summaries)

20150205-CPC_Joffe_CA-Map

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METHODS

We collected most of the cost and funding data for this study from CalPERS plan-specific actuarial valuations. The vast majority of city pension plans are administered by CalPERS, but several large California cities operate their own plans. In these cases, we gathered data from actuarial valuations and audited financial statements published by the plans themselves, and from the State Controller’s Office retirement plan data set. Large cities that maintain their own plans include Los Angeles, San Diego, San Jose, San Francisco, Fresno, Oakland and Sacramento (some of these cities have both internally administered plans and CalPERS plans). A few cities participate in county pension systems. In these cases, we consulted actuarial reports and financial statements provided by these county plans.

In all cases, we derived revenue estimates from State Controller Office data posted at http://bythenumbers.sco.ca.gov. We used the total of general and functional revenues reported in the controller’s data set.  This provides a larger denominator and thus lower pension/revenue ratios than one might derive from considering only general fund revenue. Dividing pension costs by general fund revenue is inappropriate because public employees may be paid from special governmental funds or enterprise funds controlled by the municipal government. When evaluating total pension costs, it is best to consider total governmental revenue.

Total 2015 revenues were estimated by adding 6.25% to 2014 city revenue data recently published by the State Controller.  According to the SCO data set, the median city’s revenue increased by 6.25% between 2013 and 2014.  We applied this rate of increase to the 2014 data as a proxy for fiscal 2015 actuals, which won’t be available until late this year.  Ideally, the 2015 revenues would be taken from individual municipal budgets, but many cities do not forecast total revenues. Budgets often include only general fund projections.

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FINDINGS

In general, pension costs do not represent a near-term threat to municipal solvency, but in many cities, the burden of financing pension benefits is crowding out other spending priorities or adding to pressure for tax increases. A number of cities are spending more than 12% of total revenue on pension contributions.

A city’s pension burden relative to revenues is a product of a number of factors including:  (1) the generosity of plan benefits, (2) the size of the municipal workforce relative to the city’s size and wealth, (3) growth rates and (4) tax rates. Thus, a city may be able to support very generous pension benefits if it has a small workforce, has rapidly growing revenue and/or imposes additional sales taxes.

The study includes data for 459 of the state’s 482 towns and cities. Of the 23 cities not in our list, ten offer retirement plans that do not provide defined benefits. As discussed later, these cities provide employees with defined contribution and/or deferred compensation plans. Most of the remaining 13 are small towns that do not issue audited financial statements or provide retirement plan information on their web sites.

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MOST HEAVILY BURDENED CITIES

Cities with the highest pension expenses relative to revenue are listed below:

Rank City or Town County 2015 Pension Contributions 2015 Estimated Revenue Pension Cost / Revenue Ratio
1 San Rafael Marin County 18,422,967 104,823,893 17.58%
2 Costa Mesa Orange County 18,997,065 132,253,907 14.36%
3 San Jose Santa Clara County 253,967,345 1,829,814,350 13.88%
4 San Gabriel Los Angeles County 5,124,429 38,198,183 13.42%
5 Sonora Tuolumne County 892,361 7,108,772 12.55%
6 West Covina Los Angeles County 10,304,114 84,893,591 12.14%
7 El Cerrito Contra Costa County 4,837,781 40,189,354 12.04%
8 Hemet Riverside County 7,083,161 60,907,403 11.63%
9 Montclair San Bernardino County 4,267,343 36,721,464 11.62%
10 Eureka Humboldt County 5,507,187 48,722,417 11.30%
11 Corona Riverside County 20,593,975 183,906,784 11.20%
12 El Cajon San Diego County 11,781,843 105,802,628 11.14%
13 Hermosa Beach Los Angeles County 4,330,474 39,374,676 11.00%
14 Foster City San Mateo County 5,185,144 48,319,867 10.73%
15 Richmond Contra Costa County 24,795,689 234,178,451 10.59%
16 Orange Orange County 17,353,503 164,072,449 10.58%
17 Los Gatos Santa Clara County 4,566,479 43,225,331 10.56%
18 Chico Butte County 10,017,258 94,967,151 10.55%
19 Monrovia Los Angeles County 6,231,567 59,132,054 10.54%
20 Fremont Alameda County 26,777,512 255,758,600 10.47%

Cities with the highest burdens typically have responsibility for both safety and non-safety employee pensions. Cities with relatively low burdens generally do not have a safety plan, perhaps because they rely on the County or another authority for police and fire services.

The city with the highest pension contribution/revenue ratio is San Rafael, which spends more than one-sixth of its revenue on retirement fund contributions.  This burden is partially a legacy of generous retirement benefits. Police officers and firefighters were entitled to pensions equal to 3% of salary per year employed with a retirement age of 55. Miscellaneous employees – those who are not uniformed public safety officers – received 2.7% per year at age 55. While San Rafael’s pension formula for safety employees is not unusual (in fact, some cities provide 3% of salary per year at age 50), the formula for miscellaneous employees is more generous than most California cities. As of June 30, 2013 the city had 220 active and 202 retired employees in the miscellaneous category.

Recent reforms have resulted in less generous benefits for new employees. The city has documented its efforts at pension reform at http://www.cityofsanrafael.org/pensions/.

In 2011, San Rafael lowered the benefit for new miscellaneous employees from 2.7% to 2%. It did not lower the benefit rate for new public safety employees, but reduced their cost of living allowance (COLA) in retirement from 3% to 2%. It also changed the Final Average Pay (FAP) used for to calculate the pension benefit from the last year’s salary to the average of the final three years’ salary. This reform reduces pension spiking, a practice under which employees work substantial overtime in their final year or are awarded extraordinary salary increases to maximize their pension benefits.

In 2013, the city further reduced new employee benefits after the implementation of California’s Public Employees’ Pension Reform Act (PERPA).  New miscellaneous employees must wait until age 62 to receive benefits, which continue to be based on 2% per year times final average pay. For new safety employees, the rate is now 2.7% instead of 3% while the retirement age has risen from 55 to 57.

It is worth emphasizing that these changes apply only to new employees – hired from 2011 onwards. Most employees will be eligible for the more generous, pre-2011 retirement benefits for many years to come, implying that San Rafael’s high pension burden will be a fact of life for some time.

Also contributing to San Rafael’s relatively high annual pension costs is the aggressive approach its plan administrator, the Marin County Employee Retirement Agency (MCERA) is taking toward paying down unfunded liabilities. Most plans, including those administered by CalPERS and other county systems, amortize their unfunded balances over a period of 30 years; MCERA has implemented a 17-year amortization period. More rapidly amortizing UAAL promotes fiscal sustainability, so, at least to this extent, San Rafael’s high pension contributions could be seen as positive.

The second most burdened city is Costa Mesa. Like San Rafael, the city has a legacy of generous benefits. By 2011, police and fire employees were in plans that paid 3% at age 50, while miscellaneous employees received 2.5% at 55. In some cases, existing employees had benefitted from plan enhancements after being hired. For example, in 2010, the fire union negotiated a reduction in retirement age from 55 to 50. This change applied to current employees even though the enhanced benefit had not been funded by previous contributions made by the firefighters or the city.

The City’s Mayor Pro Tem, Jim Righeimer, noted that another factor contributing to Costa Mesa’s high pension burden is its inability to outsource services to the private sector. California cities fall into two legal categories under state law:  chartered and general law. As a general law city, Costa Mesa, operates under many more rules specified under the state’s government code (section 34000).  In Costa Mesa City Employees Assn. v. City of Costa Mesa, 209 Cal. App. 4th 298 (Cal. App. 4th Dist. 2012), the Court of Appeals found that Costa Mesa could not outsource services to private companies, unless these services required specialized training or expertise. The ruling only applies to general law cities; charter cities have the flexibility to reduce future pension costs by outsourcing basic functions like street sweeping and animal control.

Although the city has been unable to outsource miscellaneous positions, it has taken some steps to limit pension costs. The council made some reductions for new employees starting after March 2012, and made further cuts after PERPA took effect in 2013. The benefit formula for new safety employees is 2.7% at 57; new miscellaneous employees receive 2% at 62.

Costa Mesa has also established a Pension Oversight Committee whose work is documented at http://www.costamesaca.gov/index.aspx?page=1603.

The city with the third highest pension burden is San Jose, with fiscal 2015 contributions of over $250 million accounting for almost 14% of total revenue. Public employee retirement costs have been an issue in San Jose for a number of years now, and the city’s experience illustrates the difficulty municipalities encounter when they try to limit these expenditures.

According to a city presentation, total retirement costs for San Jose have quadrupled since fiscal 2003. In that year, San Jose contributed $72 million to pension contributions and retiree health benefits. In the current fiscal year, that cost has risen to over $300 million (including $50 million in health costs).

In 2012, Mayor Chuck Reed placed Measure B on the ballot. Among other changes, the proposal gave currently employed city workers the option of accepting lower pension benefits or substantially increasing their own contributions to retain existing benefits. Most proposed reforms only apply to new employees, because there is a presumption that existing employees have a contractual right to the pension benefit formula available at the time of hire (unless the formula is enhanced as we saw in Costa Mesa’s case). Because the San Jose reform threatened to reduce the benefits of existing employees, it drew substantial union opposition.

Despite this opposition, Measure B passed with a 69% majority. Unions and other opponents then attempted to overturn the measure in court. In December 2013, Superior Court Judge Patricia Lucas ruled that the increased employee contributions were unlawful. But the judge agreed that the city could obtain the same cost savings by reducing employee pay. As of this writing, the city has not attempted to implement such a pay cut.

*   *   *

FUNDING LEVELS

There was less variation in funding levels across cities and differences appeared to be idiosyncratic. The vast majority of plans are administered by CalPERS, which requires all member cities to pay the full Actuarially Required Cost (ARC) it computes each year. CalPERS uses the same calculation procedures for each member. Thus there should not be issues with deliberately skipped or reduced payments, as we see in other states. Cities with large non-CalPERS plans also appear to pay their full ARCs each year.

The weighted average funding ratio across all 459 cities was just over 75% as of June 30, 2013. Given strong stock market performance since that time, it is likely that the funding situation improved significantly over the last 18 months. Overall, CalPERS reported that its assets increased by 15% between June 30, 2013 and June 30, 2014. Its actuarial liabilities probably rose during this period as well, but likely at a slower rate.

*   *   *

CITIES WITHOUT DEFINED BENEFIT PLANS

A review of audited financial statements identified ten California cities that rely exclusively upon defined contribution and deferred compensation plans to provide for their employees retirement needs. Because the city makes its contribution upfront or makes no contribution at all, it cannot have an unfunded actuarially accrued liability. Further, it could be argued that many of these cities do not have a pension burden at all, because matching contributions can be suspended during a fiscal emergency.

The list of cities relying exclusively upon defined contribution and/or deferred compensation plans is as follows:

City County
Danville Contra Costa County
Holtville Imperial County
Huron Fresno County
Lafayette Contra Costa County
McFarland Kern County
Mendota Fresno County
Orinda Contra Costa County
Rio Dell Humboldt County
San Juan Bautista San Benito County
Trinidad Humboldt County

While most of these cities are small, Danville and Lafayette have populations of 43,000 and 25,000 respectively, suggesting that medium sized cities can attract employees without offering defined benefit retirement programs.

Steven Falk, City Manager for Lafayette told us via e-mail:

“… Lafayette’s non-PERS status has little or no apparent impact on the City’s ability to hire and retain lower-skilled and administrative employees, such as caretakers, landscape workers, recreation workers, administrative assistants, etc. The lack of a PERS program, however, does appear to have some impact on the City’s ability to attract and retain higher level professionals with skill sets that are particular to the municipal operation, such as urban planners, civil engineers, transportation planners, community development employees, etc. We have had occasions where candidates have retracted their job applications upon learning that Lafayette does not participate in PERS.”

The city contacts out public safety services to Contra Costa County, so it has not had to test whether it could recruit police officers and firefighters without the benefit of PERS membership.

*   *   *

EMPLOYER CONTRIBUTION RATES

Thus far our analysis has focused on total employer contribution amounts. Historically, CalPERS and other multi-employer plans have quoted contribution rates. The contribution rate is the percentage of current employee payroll that must be contributed to the pension plan. For example, if a public employee has a salary of $100,000 and the employer’s contribution rate is 40%, the city must pay CalPERS $40,000 to keep the covered employee in the defined benefit plan. This rate excludes employee contributions, which are typically withheld from each employee’s salary but have been paid –partially or fully – by municipal employers.

The plans with the highest contribution rates tend to be smaller plans with declining balances. In these cases, contributions are primarily funding pension payments to members that have already retired and there is a small, declining numbers of active employees across which these payments may be allocated. For example, Taft’s First Tier Police plan has a 227.5% contribution rate. As of June 30, 2013, the plan had only one active member and 28 retirees.

Among larger plans, Rialto’s Safety Plan has one of the highest contribution rates:  48.8% in fiscal 2015, with a projected increase to 50.3% in fiscal 2016. The city’s contribution rate appears to be especially high because of a 2008 decision to increase the plan’s benefit formula to 3% at 50. Because the increase applied to existing employees (whose contributions had been based on less generous benefits), the plan has required catch-up contributions to avoid greater underfunding. After the new formula took effect in 2011, the employer contribution rate jumped from 19.3% to 38.3% and has continued to rise.

Another large plan with a relatively high contribution rate is Berkeley’s police plan with a 2015 rate of 46.6% rising to 48.6% in 2016. Police have been eligible for the 3% at 50 benefit formula for several years. A new contract negotiated in 2012 scaled back the formula for new hires to 3% at 55.  This change should slow the increase in contribution rates as more new hires join the force. One aspect of the Berkeley plan that pushes up contribution rates is the provision of a “sick leave credit”. This plan feature allows retirees to add unused sick pay to their length of service at retirement. Each sick day adds 0.004 years to the employee’s service period for purposes of calculating his or her pension benefit rate.  For example, if a police officer retires with 100 sick days and a $100,000 final average pay, she would be entitled to an extra 100 x 0.004 x 3% x $100,000 = $1200 per year.

As one might expect, the most heavily burdened cities also have plans with high contribution rates. San Rafael’s overall contribution rate is 57.7%, Costa Mesa’s fire plan has a 47.5% rate and San Jose’s public safety plan has a 70.8% rate.

*   *   *

MOST HEAVILY INDEBTED CITIES (INCLUDING PENSION OBLIGATION BONDS)

No discussion of California’s city pension burdens would be complete without taking into account Pension Obligation Bonds. This is the practice of borrowing money to make an annual employer contribution to the pension system, on the assumption that the interest rate paid on the bond will be less than the earnings that will accrue to investing the bond proceeds in the pension fund. We have identified 58 cities that had outstanding pension obligation as of June 30, 2013. These cities are listed below along with the face value of POBs they issued. These amounts include principal that has already been repaid.  Also, some cities, including Oakland and Richmond, have issued zero coupon capital appreciation pension obligation bonds that do not pay any interest. The issuance amounts shown below often reflect the maturity value of these zero coupon bonds rather than the proceeds each city received.

City County Amount Issued
Auburn Placer County 4,965,000
Azusa Los Angeles County 7,215,000
Baldwin Park Los Angeles County 12,810,000
Bell Los Angeles County 9,225,000
Benicia Solano County 13,972,596
Berkeley Alameda County 12,415,000
Brisbane San Mateo County 4,745,000
Burlingame San Mateo County 32,975,000
Capitola Santa Cruz County 5,170,000
Carmel-By-The-Sea Monterey County 6,280,000
Claremont Los Angeles County 6,000,000
Colton San Bernardino County 31,149,399
Daly City San Mateo County 36,235,000
Fairfield Solano County 36,865,000
Fresno Fresno County 205,335,000
Hawthorne Los Angeles County 30,700,000
Huntington Park Los Angeles County 23,000,000
Inglewood Los Angeles County 64,986,301
La Verne Los Angeles County 8,380,000
Long Beach Los Angeles County 164,500,000
Marina Monterey County 4,315,000
Merced Merced County 7,355,000
Mill Valley Marin County 6,775,000
Millbrae San Mateo County 11,521,660
Monrovia Los Angeles County 12,750,000
Monterey Park Los Angeles County 17,405,000
Novato Marin County 18,296,066
Oakland Alameda County 757,930,000
Oceanside San Diego County 42,780,000
Oroville Butte County 7,260,000
Pacific Grove Monterey County 19,365,355
Pacifica San Mateo County 20,510,000
Palm Springs Riverside County 19,832,588
Paradise Butte County 10,918,154
Pasadena Los Angeles County 159,380,000
Pinole Contra Costa County 16,800,000
Pittsburg Contra Costa County 39,566,055
Pomona Los Angeles County 42,280,684
Port Hueneme Ventura County 10,679,956
Porterville Tulare County 3,765,000
Redlands San Bernardino County 25,862,392
Richmond Contra Costa County 239,500,729
Riverside Riverside County 150,480,000
Sacramento Sacramento County 183,365,000
San Bruno San Mateo County 13,175,000
San Leandro Alameda County 18,305,000
San Marino Los Angeles County 7,095,000
San Rafael Marin County 4,490,000
San Ramon Contra Costa County 17,650,000
Santa Cruz Santa Cruz County 24,150,000
Santa Rosa Sonoma County 32,715,000
Scotts Valley Santa Cruz County 4,460,000
Seaside Monterey County 6,880,000
Sonoma Sonoma County 2,925,000
South Gate Los Angeles County 24,400,000
Stockton San Joaquin County 125,310,000
Union City Alameda County 22,997,973
Yuba City Sutter County 7,685,000

Finally by combining unfunded actuarially accrued liabilities and outstanding pension obligation bond debt, we find the cities that have the highest overall pension debt burden – based on 2013 total revenue. In the table that follows, we have used 2013 revenues from the State Controller’s Office, except in the case of Oakland which had an anomalous value in the SCO data set. The 2013 POB column reflects our calculation of unpaid principal plus unamortized premia on zero coupon bonds as of June 30, 2013.

California Cities, Ranked by Pension Debt as Percent of Total Revenue – Top 20

Rank City 2013 Total Revenue 2013 UAAL 2013 POB Outstanding Total Pension Debt Debt / Revenue
1 OAKLAND 902,343,411 1,336,731,344 497,326,504 1,834,057,848 203.3%
2 COSTA MESA 120,941,625 220,088,382 220,088,382 182.0%
3 RICHMOND 229,667,716 213,851,021 201,590,579 415,441,600 180.9%
4 WEST COVINA 75,202,992 129,009,677 129,009,677 171.5%
5 SAN RAFAEL 98,069,848 161,297,000 4,490,000 165,787,000 169.0%
6 NEWARK 42,011,267 70,674,444 70,674,444 168.2%
7 PARADISE 16,283,406 13,598,638 11,809,914 25,408,552 156.0%
8 PACIFIC GROVE 24,393,663 24,510,771 12,451,649 36,962,420 151.5%
9 FOSTER CITY 36,608,718 52,461,839 52,461,839 143.3%
10 INGLEWOOD 159,019,773 166,164,169 58,076,302 224,240,471 141.0%
11 MAYWOOD 9,228,259 12,978,485 12,978,485 140.6%
12 EL CAJON 99,209,121 137,565,731 137,565,731 138.7%
13 STOCKTON 362,091,530 370,970,850 125,310,000 496,280,850 137.1%
14 BERKELEY 296,093,704 401,733,284 1,865,000 403,598,284 136.3%
15 PLEASANT HILL 25,049,832 33,041,047 33,041,047 131.9%
16 WHITTIER 66,526,402 86,998,800 86,998,800 130.8%
17 FREMONT 211,801,362 275,568,580 275,568,580 130.1%
18 DOWNEY 100,912,444 130,989,072 130,989,072 129.8%
19 ORANGE 147,030,133 190,178,031 190,178,031 129.3%
20 CONCORD 111,190,625 142,421,844 142,421,844 128.1%

*   *   *

As can be seen on the above table, some cities, such as Richmond, actually have more debt carried in the form of pension obligation bonds than they have in the form of an unfunded pension liability. Omitting consideration of pension bond debt clearly favors a city like Richmond, but in reality their pension contributions are significantly understated unless the pension bond debt is taken into account. Using this ratio also validates the precarious situation Costa Mesa finds themselves in, since even though they have no pension bond debt, their unfunded liability is 66% greater than their entire annual revenue. It is also interesting to see that some of California’s larger cities, including Oakland and Stockton, have relied heavily on the use of pension obligation bonds to finance their annual pension fund contributions.

WHAT THE FUTURE HOLDS

In February, 2014 CalPERS adjusted its actuarial assumptions with the effect of further increasing employer contribution rates.  The rate increase will be phased in over five fiscal years.  When the change is fully implemented, in fiscal 2020-21, CalPERS projects a further increase in safety officer contribution rates of between 5.3% and 9.3%.

In addition to listing contribution rates for the upcoming fiscal year, CalPERS actuarial valuation reports have also provided projected rates for future fiscal years to assist agencies with multi-year financial planning. In theory, this data could be used to compare projected future burdens among cities.

Unfortunately, there are complexities inherent in creating such a comparison and these challenges have been exacerbated by a change in this year’s CalPERS actuarial reporting.  In some cases, the reports provide an employer contribution rate, but, in most others, they list both a normal cost rate and a lump sum Unfunded Actuarial Liability (UAL) payment. This makes comparisons across plans more difficult. Further, non-CalPERS plans often do not provide projected rates at all. Consequently, a systematic comparison of contribution rates across plans and cities is impossible, but we can consider some specific cases.

One city that can expect to face sharply increased pension burdens is Monrovia, a medium-sized community northeast of Los Angeles. Between fiscal 2016 and 2020, the city’s UAL payment is projected to rise from $1.6 million to $2.9 million. During the same period, contribution rates for the city’s miscellaneous plan are projected to rise from 30.9% to 38.8%.

Assuming that CalPERS estimated 2016 covered payroll increases three percent annually, Monrovia’s actuarially required contribution is projected to rise from $6.2 million in fiscal 2015 to $10.2 million in fiscal 2020.  Since the city’s 2015 pension burden already exceeds 10%, the city will be hard pressed to find this additional $4 million.

CalPERS projections assume a 7.5% annual increase in the value of system assets. This assumption – which is closely related to the discount rate applied to unfunded liabilities – is controversial.  However, the system easily exceeded this rate in four of the last five years – benefitting from the bull market in stocks that followed the Great Recession.

Since future portfolio returns are unpredictable, CalPERS provides a sensitivity analysis that shows contribution rates (or UAL payments) under different return scenarios.  The worst scenario reflects a -3.8% annual return between July 1, 2014 and June 30, 2017. Under this scenario and using a 3% covered payroll growth assumption, Monrovia’s fiscal 2020 contribution would rise to almost $12.5 million.

Of course, the city’s pension burden would not grow as much if the market continues to do well.  CalPERS most rosy scenario calls from an 18.9% annualized returns during the same period. If this were to happen, Monrovia’s fiscal 2020 ARC would be $6.4 million – little changed from the fiscal 2015 level.

A larger city facing a sharp increase in an already heavy pension burden is Fremont in Alameda County. The city’s safety plan has a contribution rate of 40.7%.  In fiscal 2016 this will rise to 44.7%, and by fiscal 2020, the rate will reach 55.3% assuming median CalPERS returns. If CalPERS underperforms, the 2020 rate will stabilize at 43.0%; in the event of underperformance the rate will escalate to 65.8%.

The city’s miscellaneous plan has an employer contribution rate of 24.1%.  This is expected to rise to 25.8% in fiscal 2016 and 31.3% in fiscal 2020.  Once again, the range of potential 2020 outcomes is wide: from 23.3% under bull market conditions and 38.1% if the bears prevail.

In absolute dollars and assuming 3% covered payroll growth, Fremont’s pension cost is expected to rise from $26.8 million in fiscal 2015 to $39.2 million in fiscal 2020. Under the bull market scenario, the 2020 cost would be $30.0 million; while it would reach $47.1 million in the bear market case.

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CONCLUSION

The impacts of public employee pension costs vary widely across California cities. By offering new employees defined contribution plans or more modest defined benefit formulas, heavily burdened municipalities can gradually reduce the share of their budgets devoted to this legacy cost. Substantial towns including Lafayette and Orinda show that it is possible to fill openings – at least among non-safety employees – without offering defined pension benefits.

There are cautionary lessons as well. As San Jose has learned, it is very difficult to pare back generous pension benefit packages once they have been granted.  And, as Costa Mesa has discovered, sweetening benefits for existing employees is a recipe for trouble.

Given prevailing court rulings to date, there is little municipalities can do to lighten their pension loads in the near term. By projecting pension contributions for the next several fiscal years, CalPERS has provided a way for cities to anticipate and hopefully reserve for the obligations they face shortly beyond the current budget year. We hope that systems outside CalPERS will provide similar multi-year projections in their own actuarial valuation reports.

The CalPERS projections are buried deep inside plan-specific valuation reports available only in PDF form. By extracting the relevant data from these valuation reports and then aggregating them by city, we hope we have provided policymakers and citizens with an accessible tool that they can use to assess and address growing pension costs in their respective communities.

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Marc Joffe founded Public Sector Credit Solutions in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

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California Healthcare Districts in Crisis

INTRODUCTION

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

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

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

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

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

BANKRUPTCY FILINGS BY CALIFORNIA HEALTHCARE DISTRICTS

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

Healthcare District Bankruptcies – 1996 to 2014

Year

Health Care District Court

Case Number

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

 

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

FINANCIALLY CHALLENGED CALIFORNIA HEALTHCARE DISTRICTS

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

California Health Care Districts – Positive vs. Negative Equity

 

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

Sources:

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

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

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

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

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

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Eden Township Healthcare District (ETHD), Alameda County

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

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

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

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

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

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

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

Sources:

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

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

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

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

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

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

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

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Palo Verde Health Care District, Riverside County

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

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

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

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

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

Sources:

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

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

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

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

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

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Kern Valley Healthcare District, Kern County

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

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

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

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

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

Sources:

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

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

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

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

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

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John C. Fremont Hospital District, Mariposa County

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

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

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

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

Sources:

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

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

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

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Lindsay Local Hospital District, Tulare County

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

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

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

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

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

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

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

Sources:

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

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

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

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CONCLUSION

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

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

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

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Marc Joffe founded Public Sector Credit Solutions in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

Analysis of the Reasons for San Diego Police Department Employee Departures

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

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

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

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

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

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

*   *   *

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

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

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

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

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

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

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

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

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

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

THE DATA

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

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

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

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

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

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

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

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

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

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

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

20150114-CPC_Fellner_SDPD-1a

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

THE THEORY

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

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

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

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

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

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

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

CONCLUSION

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

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

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

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

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

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

*   *   *

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

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

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

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

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

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

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

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

20150102_Fellner_PvsSS-1

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

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

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

20150102_Fellner_PvsSS-2b

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

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

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

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

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

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

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

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

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

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

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

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

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

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

*   *   *

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

California's Most Financially Stressed Cities and Counties

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

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

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

*   *   *

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

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

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

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

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

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

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

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

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

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

*   *   *

LOCAL GOVERNMENTS MOST AT RISK – THE UNLUCKY 13

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

(1)  COMPTON  –  Default Probability, 4.01%

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

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

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

Sources:

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

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

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

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

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

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

(2)  KING CITY  –  Default Probability, 3.38%

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

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

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

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

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

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

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

(3)  SUTTER CREEK  –  Default Probability, 2.79%

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

Sources:

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

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

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

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

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

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

(4)  IONE  –  Default Probability, 2.17%

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

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

Sources:

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

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

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

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

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

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

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

(5) MAYWOOD  –  Default Probability, 1.46%

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

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

Sources:

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

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

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

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

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

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

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

(6)  ATWATER  –  Default Probability, 1.22%

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

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

Sources:

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

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

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

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

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

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

(7)  HURON  –  Default Probability, 1.08%

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

Sources:

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

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

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

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

(8)  CHICO  –  Default Probability, 0.88%

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

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

Sources:

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

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

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

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

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

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

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

(9)  CALIPATRIA  –  Default Probability, 0.84%

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

Sources:

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

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

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

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

(10)  RIDGECREST  –  Default Probability, 0.76%

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

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

Sources:

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

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

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

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

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

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

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

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

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

(11)  SAN FERNANDO  –  Default Probability, 0.75%

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

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

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

Sources:

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

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

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

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

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

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

(12)  BLYTHE  –  Default Probability, 0.74%

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

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

Sources:

Blythe City Council Continuing Meeting Agenda, March 2, 2009

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

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

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

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

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

(13)  FIREBAUGH  –  Default Probability, 0.74%

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

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

Sources:

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

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

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

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

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

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

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

*   *   *

COMPLETE CITY AND COUNTY RANKINGS

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

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

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

*   *   *

20141029-2_Joffe

*   *   *

CONCLUSION

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

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

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

*   *   *

About the Authors:

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

Marc Joffe founded Public Sector Credit Solutions in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

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

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

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

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

*   *   *

Introduction and Methodology:

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

*   *   *

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Observations and Recommendations

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(1) Make it possible to increase employee contributions – Social Security withholding can be increased or decreased at the option of the federal government. If collections into public employee pension funds are inadequate, increase the withholding from employee paychecks – not only for the normal contribution, but also to help pay the unfunded contribution.

(2) Make it possible to decrease benefits – nothing in Social Security is guaranteed. Benefits can be cut at any time to preserve solvency. Decreasing benefits may be the only way to preserve defined benefit pensions. Equitable ways to do this must be spread over as many participant classes as possible. For example, the reform passed by voters in San Jose (tied up in court by the unions) called for suspending cost-of-living increases for retirees, and prospectively lowering the annual rates of benefit accruals for existing workers.

(3) Increase the retirement age. This has already been done several times with Social Security. Pension reforms to-date have also increased the age of eligibility for benefits.

(4) Calculate benefits based on lifetime earnings. Social Security calculates a participant’s benefit based on the 35 years during which they made the most. Public sector pensions, inexplicably, apply benefit formulas to the final year of earnings, or the final few years. These pension benefits should be calculated based on lifetime earnings.

(5) Make the benefit progressive. The more you make and contribute into Social Security, the less you get back. At the least, applying a ceiling to pension benefits should be considered. But it would serve both the goals of solvency and social justice to implement a comprehensive system of tiers whereby highly compensated public servants, who make enough to save themselves for retirement, get progressively less back in the form of a pension depending on how much they make.

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

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

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

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

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FOOTNOTES

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

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

The Case for Adjustable Defined Benefits

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

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

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

Here are summaries of what these plans do:

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

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

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

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

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

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

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

Evaluating Total Unfunded Public Employee Retirement Liabilities in 20 California Counties

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

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

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

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

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INTRODUCTION

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

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

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

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

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

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

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

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

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TOTAL UNFUNDED PUBLIC EMPLOYEE RETIREMENT LIABILITY

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

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

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

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

20140506_Churchill-Monnett_1

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

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

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

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

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

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

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

*   *   *

PAYING DOWN THE TOTAL UNFUNDED RETIREMENT LIABILITY

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

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

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

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

20140506_Churchill-Monnett_2b

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

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

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

*   *   *

THE IMPACT OF THE TOTAL UNFUNDED RETIREMENT LIABILITY ON INDIVIDUAL TAXPAYERS

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

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

20140506_Churchill-Monnett_3

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

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

*   *   *

About the Authors:

Ken Churchill is the director of New Sonoma, an organization of financial and business experts and concerned citizens dedicated to working together to solve Sonoma County’s serious financial problems. Churchill has over 40 years of business and financial management experience as founder, CEO and CFO of a solar energy company and environmental consulting firm. He sold both companies and now grows wine grapes and produces wines under his Churchill Cellars label. For the past three years, Churchill has been actively researching and studying the pension crisis and published a report titled The Sonoma County Pension Crisis – How Soaring Salaries, Retroactive Pension Increases and Poor Management Have Destroyed the County’s Finances. Churchill is currently running for supervisor, 4th district, in Sonoma County.

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

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

*   *   *

FOOTNOTES

(source data for counties listed in alphabetical order)

Alameda County

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

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

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

Contra Costa County

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

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

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

Fresno County

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

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

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

Imperial County

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

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

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

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

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

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

Los Angeles County

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

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

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

Marin County

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

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

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

Mendocino County

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

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

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

Merced County

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

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

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

Orange County

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

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

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

Sacramento County

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

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

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

San Bernardino County

Pension Assets and Liabilities:

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

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

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

San Diego County

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

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

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

San Joaquin County

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

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

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

San Mateo County

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

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

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

Santa Barbara County

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

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

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

Sonoma County

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

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

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

Stanislaus County

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

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

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

Tulare County

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

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

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

Ventura County

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

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

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

Evaluating Public Safety Pensions in California

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

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

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

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

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

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

*   *   * 

INTRODUCTION

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

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

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

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

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

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

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

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

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

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

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

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

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

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

*   *   *

METHOD AND ASSUMPTIONS

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

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

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

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

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

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

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

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

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

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

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

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PUBLIC SAFETY PENSIONS – CalPERS

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

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

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

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

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

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

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 PUBLIC SAFETY PENSIONS – SAN JOSE

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

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

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

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

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

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PUBLIC SAFETY PENSIONS – LOS ANGELES

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

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

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

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

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TOTAL RETIREMENT BENEFITS – LOS ANGELES

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

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

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

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

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

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CONCLUSION

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

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

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

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

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

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 FOOTNOTES

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

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

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

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

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

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

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

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

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

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

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About the Authors:

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

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

The Benefits and Costs of Oil and Gas Development in California

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

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

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

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

20140320_Considine_01_TableES1

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1.  INTRODUCTION

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

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

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

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

*   *   *

2.  OIL AND GAS RESOURCES IN CALIFORNIA

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

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

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

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

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

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

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

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

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3.  DEVELOPMENT SCENARIOS

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

3.1  Offshore Development

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

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

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

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

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

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

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

3.2  Development of Monterey Shale

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

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

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

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

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

Figure 4: Assumptions for Estimated Recoverable Reserves
20140320_Considine_06_Figure04

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

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

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

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

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

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

3.3  Total Development Potential

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

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

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

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

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

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

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

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

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

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4.  ECONOMIC IMPACTS

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

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

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

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

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

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

Table 5: Impacts on Value Added by Sector
20140320_Considine_14_Table05

4.1   Economic Impacts of Offshore Development

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

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

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

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

4.2  Economic Impacts from Developing the Monterey Shale

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

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

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

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

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

4.3  Total Potential Economic Impacts

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

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

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

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

*   *   *

5.  ENVIRONMENTAL IMPACTS

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

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

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

5.1  Greenhouse Gas Emissions

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

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

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

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

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

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

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

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

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

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

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

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

5.2  Oil Spills

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

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

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

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

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

5.3  Impacts on Land and Water

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

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

Table 12: Expected Value of Other Environmental Impacts
20140320_Considine_24_Table12

5.4  Total Environmental Impacts

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

Table 13: Total Expected Value of Environmental Impacts
20140320_Considine_25_Table13

 

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6.  CONCLUSION

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

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

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

*   *   *

Appendix A: Analysis of Supply and Demand Adjustments

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

20140320_Considine_27_Equation1

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

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

20140320_Considine_28_Equation2

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

20140320_Considine_29_Equation3

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

20140320_Considine_30_Equation4

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

20140320_Considine_31_Equation5

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

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

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

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

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REFERENCES

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Minnesota IMPLAN Group (2011) .

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

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

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

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

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

Is the Stock Market Over-Stimulated and Overpriced?

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

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

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

20140325_Chaudhary-1

Past performance does not guarantee future results.

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

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

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

20140325_Chaudhary-2

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

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

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

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

20140325_Chaudhary-3

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

3) U.S. STOCK PRICES VS. GDP

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

20140325_Chaudhary-4

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

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

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

20140325_Chaudhary-5

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

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

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

20140325_Chaudhary-6

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

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

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

20140325_Chaudhary-7

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

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

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

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

IN CONCLUSION

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

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

How Much Do CalSTRS Retirees Really Make?

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

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

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

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

INTRODUCTION

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

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

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

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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

20140228_CalSTRS_normalized-pensions_Table01-bar-chart

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

20140228_CalSTRS_normalized-pensions_Table03

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

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

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

About the Authors:

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

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

Comparing CalSTRS Pensions to Social Security Retirement Benefits

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

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

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

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

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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.

*   *   *

(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.

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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.

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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.

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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

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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.

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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.”

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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