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

January 28, 2013

By John G. Dickerson

About the Author:  John Dickerson is a financial professional living in Mendocino County who is involved in public sector pension analysis and reform. Since 2008 Dickerson has been the publisher of the influential website and newsletter www.YourPublicMoney.com. He focuses on the impact of unfunded pension debt on the 21 California counties that operate their own independent Pension Funds. He is a financial and organizational planner and analyst with 30 years of experience. He earned his MBA in Strategic Planning from the University of Texas at Austin. The original version of this study was published on October 5, 2012 by Dickerson and can be downloaded from his website. This version, incorporating updates provided by the author on January 24, 2013, is presented here in html or as a PDF document to download and print by the California Policy Center.

ABSTRACT

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

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

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

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

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

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

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

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

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

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

*   *   *

Gina Raimundo
State General Treasurer, Rhode Island

Dickerson_Raimundo_Study_GR-portrait

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

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

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

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

OUTLINE

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

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I.  RHODE ISLAND COMPARED TO CALIFORNIA

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

A.  Major Differences

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

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

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

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

B.  Strong Public Unions & Democratic

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

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

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

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

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

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

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

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

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

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

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

Dickerson_Raimundo_Study_truth-in-numbers
1.  Introduction

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

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

This report is organized around four key objectives:

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

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

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

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

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

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

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

2.  Estimating the Price Tag for Past Service:

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

3.  Diagnosing the Key Drivers of the Structural Pension Deficit

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

4. Understanding the Implications of Further Inaction

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

5.  Providing a Framework for Solutions

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

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

a) Accurate and Transparent Assumptions

Retirees, employees and taxpayers rely on government leaders to be honest about the system’s liabilities and to have safeguards in place that require accurate accounting. Public employees depend upon their union leadership to insist on conservative, realistic assumptions. Using overly optimistic assumptions hurts everyone because these assumptions underestimate the true cost of pensions and increase the risk that not enough money will be set aside.

b) Equitable and Reasonable Changes

Any reform impacting only new employees will not affect the existing $7 billion to $9 billion unfunded liability for past service. This problem is decades in the making and all stakeholders must now share in the solution. The following, among many other ideas, should be analyzed as possible areas of reform:

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

c) Intergenerational Fairness

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

d) Comprehensive and Self-Correcting Processes

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

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

The pension system is extremely underfunded today and any solution must address the unfunded liability – the bill for past service. It is likely that any solution will require both an infusion of assets and a change to benefits.

6.  The Time To Act is Now

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

C.  Development and Passage of Pension Reform

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

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

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

Dickerson_Raimundo_Study_three-central-goals

D.  Raimondo’s Public Outreach – 100 Community Meetings

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

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

*   *   *

III.  CHANGES TO RHODE ISLAND’S PENSIONS

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

A.  Retirees

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

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

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

B.  Current and Future Employees

1.  Current Employees – Past Service

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

2.  Future Service including New Employees

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

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

3.  Retirement Age

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

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

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

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

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

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

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

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

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

*   *   *

V.  FINANCIAL IMPACT OF RHODE ISLAND’S PENSION REFORM

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

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

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

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

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VII.  RAIMONDO, DEMOCRATS AND THE UNIONS

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

*   *   *

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

*   *   *

Download Print Version

FOOTNOTES

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

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

[3] Available at

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

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

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

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

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

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

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

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

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

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

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

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

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

January 8, 2013

By John G. Dickerson

About the Author:  John Dickerson is a financial professional living in Mendocino County who is involved in public sector pension analysis and reform. Since 2008 Dickerson has been the publisher of the influential website and newsletter www.YourPublicMoney.com. He focuses on the impact of unfunded pension debt on the 21 California counties that operate their own independent Pension Funds. He is a financial and organizational planner and analyst with 30 years of experience. He earned his MBA in Strategic Planning from the University of Texas at Austin. The original version of this study was published on January 3, 2012 by Dickerson and can be downloaded from his website. This version, incorporating minor changes to the original, is presented here in html or as a PDF document to download and print by the California Policy Center.

ABSTRACT

On July 2, 2012 Moody’s Investors Services published a “Request for Comment” titled Adjustments to US State and Local Government Reported Pension Data. Moody’s is one of the nation’s major credit-rating agencies for state and local governments. As such, while Moody’s doesn’t have authority to make governments change their financial statements or fund pensions differently, they do control how they analyze and report government credit-worthiness. Moody’s has concluded that published government employee pension financial data greatly understates the credit risks created by unfunded pensions. Moody’s proposed adjustments are likely to lead to reductions in credit ratings for many governments which could cause them to pay more interest expense and/or reduce access to credit and loans.

The main importance of Moody’s proposals to concerned citizens is they strongly support the view that unfunded pensions put state and local government finances at great risk, much more than is reported to the people. They help explain how unfunded pensions produce much greater risk and by implication what to do about it.

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

Moody’s would make four adjustments – two are very significant. First, pension debt would be adjusted using a high-grade long term corporate bond rate (5.5% for 2010-2011) instead of a Pension Fund’s target rate of return (7.75% more or less). Second, government payments to Pension Funds would be adjusted to reflect the lower discount rate, the need to fully fund pensions by the time employees retire, and a 17 year level-dollar amortization of unfunded pensions.

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

These County Pension Funds reported total unfunded pension obligations were a little over $4 billion. Moody’s adjustments would increase these unfunded pension obligations by about another $6 billion which would reduce average reported pension funding ratios from 78% to 58%.

Under today’s accounting rules governments don’t report unfunded pensions as debt directly in their financial statements. (New government accounting rules will make them to do so in two years.) Moody’s would include the restated $10.2 billion unfunded pension debt in its credit rating process. In addition these six counties reported Pension Obligation Bond (POB) debt as of June, 2011 of $1.7 billion. They borrowed that money to pay down earlier large unfunded pension deficits. Therefore, including Pension Obligation Bonds, the total unfunded pension-created debt using Moody’s adjustments would be close to $12 billion. All other reported debt (not including unfunded retiree healthcare and other post-employment benefits) was $2.8 billion. Thus Moody’s adjustments would increase the total debt for these counties used in their credit rating analysis from the reported $4.5 billion to $14.6 billion – slightly more than triple what is currently reported.

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

Moody’s stated they would recalculate total debt for both state and local governments but would calculate what “prudent” government payments to pension funds should be only for states. I strongly urged Moody’s to apply their “prudent payment” adjustments to local governments as well. Moody’s has not yet announced their final decision.

OUTLINE

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

*   *   *

I.  INTRODUCTION

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

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

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

*   *   *

II.  MOODY’S FOUR ADJUSTMENTS OF GOVERNMENT CREDIT ANALYSIS

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

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

2. Accrued actuarial liabilities will be adjusted based on a high-grade long-term corporate bond index discount rate (5.5% for 2010 and 2011)

3. Asset smoothing will be replaced with reported market or fair value as of the actuarial reporting date

4. Annual pension contributions will be adjusted to reflect the foregoing changes as well as a common amortization period

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

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

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

*   *   *

III.  FIRST MAJOR IMPACT – INCREASED UNFUNDED PENSION DEBT

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

A.  Pension Fund Asset Value

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

1.  How Actuaries Calculate Pension Fund Asset Value:

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

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

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

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

Dickenson-Moody-table-1

B.  Total Pension Liability

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

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

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

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

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

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

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

Dickenson-Moody-table-2

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

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

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

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

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

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

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

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

Moody’s doesn’t have the complex projections made by Actuaries for each Pension Fund – they only have the final value reported as the “(Total) Actuarially Accrued Liability”. Moody’s therefore can’t perform a recalculation based on the specific data – so they must come up with a “simplifying calculation” to estimate what the recalculated Net Present Value of the Total Pension Liability would be. They will take the reported “Actuarially Accrued Liability,” project them forward for 13 years using the Pension Fund’s target rate of return, then “discount” the resulting value back 13 years using the high-quality corporate bond rate which was 5.5% for 2010. Moody’s states “a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.”

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

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

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

Dickenson-Moody-figure-1

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

Dickenson-Moody-table-4

D.  Two Further Considerations

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

1. The Myth that “80% Funding is OK”:

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

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

Dickenson-Moody-table-5

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

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

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

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

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

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

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

*   *   *

IV.  SECOND MAJOR IMPACT – GOVERNMENT PAYMENTS TO PENSION FUNDS

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

A. Two Main Types of Government Payments to Pension Funds

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

1. Normal Yearly Contributions:

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

2. Unfunded Pension Amortization Payments:

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

3. Other Payments:

a) Pension Obligation Bonds are Unfunded Pension Debt Payments:

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

b) Other Types of Payments:

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

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

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

1. Many Local Governments are Larger than Many States:

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

2. Availability of Data:

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

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

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

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

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

C.  How Actuaries Calculate Payments to Pension Funds

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

a)  Payment #1, Calculating the Normal Yearly Contribution

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

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

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

Dickenson-Moody-table-7

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

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

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

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

The “Level Dollar” method is basically the same as the traditional 30 year fixed interest rate & payment home mortgage except the number of years can be shorter. You borrow money to buy a house and pay it back by making equal payments every month for 30 years. Most of the early payments are interest but the last payments mostly reduce debt.

Under the “Level Percent of Payroll” method the Actuary first estimates how much the government’s total payroll will
be in each year of the amortization period assuming it will grow the same percent each year. Four percent yearly growth
is often assumed. Then the Actuary calculates a fixed percentage of each year’s payroll the government needs to pay to
eliminate the unfunded pension debt by the end of the amortization period. That fixed – or “level” percent of each
future year’s projected payroll is projected to be each future year’s payment.

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

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

(1) Level Dollar Amortization:

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

(2) Level Percent of Payroll Amortization:

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

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

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

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

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

Dickenson-Moody-figure-2

(b) Percent of Payroll – Negative Amortization Increases Debt

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

Dickenson-Moody-figure-3

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

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

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

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

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

Dickenson-Moody-table-8

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Dickenson-Moody-table-11

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

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

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

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

a) Government Payments to Pension Funds:

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

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

Dickenson-Moody-figure-4

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

Dickenson-Moody-table-13

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

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

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

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

Dickenson-Moody-table-14

c) Overall Impact on County Budgets:

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

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

Dickenson-Moody-table-15

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

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

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

*   *   *

V.  CONCLUSION – WHAT THIS SHOULD MEAN TO CONCERNED CITIZENS

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

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

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

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

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

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

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

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Download Print Version

VI.  DATA SOURCES

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

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

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

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

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

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

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

In addition the most recent available Actuarial Valuations were downloaded in early fall, 2012. They are for these counties “County Employees Retirement Associations” – as in “Alameda County Employees Retirement Association”.

Dickenson-Moody-data-sources

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

Alameda County Actuarial Valuation

Contra Costa County Actuarial Valuation

Marin County Actuarial Valuation

Mendocino County Actuarial Valuation

San Mateo County Actuarial Valuation

Sonoma County Actuarial Valuation

There are three kinds of Pension Funds that offer “guaranteed pension benefits” to state and local government employees”

Single Employer Funds – The Pension Fund is for only one government employer. Therefore all the financial balances and activity in the Pension Fund impact that one government.

Then there are two types of “Multi-Employer” Pension Funds in which the Pension Fund provides pension benefits to retirees of more than one governments.

Agent Funds – the Pension Fund maintains its books so that the obligations and balances of each employer government can be specifically identified. Therefore one government may have a lower relative level of unfunded pension obligation than another.

Cost-Sharing Funds – Balances are not maintained for individual governments. As a result unfunded pension obligations are shared among all participating governments even though some governments may have paid a higher portion of its obligations than others. Balances are allocated to individual governments based on the portion of that government’s payments to the Pension Fund relative to all other governments’ payments.

FOOTNOTES

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

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

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

[4] Moody’s, ibid, page 1

[5] Moody’s, ibid, page 2

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

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

[8] Moody’s, ibid, pages 5 – 6

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

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

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

[12] In an email exchange the author of Moody’s paper indicated Moody’s believes the “correct” method of calculating interest expense is “beginning of period” rather than “end of period”. Also they are simplifying the amortization schedules by assuming annual payments. I and several other financial professionals don’t understand the idea that “one payment per year” wouldn’t incur interest expense in the first year. It would have to be made on the first day of the first year in order to have no interest expense – it would all go to reduce debt principal. Payments are generally made to Pension Funds when governments make payrolls or shortly thereafter. Government paydays are sometimes once a month, or twice a month, and sometimes every two weeks or 26 times a year. In any of these “real world” systems there would be at most only one payment for anywhere from a two-week to one-month period that doesn’t accrue interest expense and then only if that payday occurs on the first day of the first fiscal year. However – since this is Moody’s assumption the analysis in this paper uses that assumption – even though we don’t think it’s realistic.

[13] Moody’s, ibid, page 8

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

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

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

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The California Budget Crisis – Causes and Recommendations

December 31, 2012

Download Printable Version

By William D. Fletcher

INTRODUCTION

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

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

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

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

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

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

Slide01
WHERE ARE WE HEADED?

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

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

Slide02

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

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

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

Slide03

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

Slide04

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

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

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

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

Slide05

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

Slide06

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

Slide07

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

Slide08

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

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

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

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

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

Slide09

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

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

Slide10

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

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

Slide11

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

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

Slide12

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

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

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

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

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

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

Slide13

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

STATE-BY-STATE COMPARISONS

How does California compare to other states?

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

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

What is Texas doing right?

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

Slide14

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

Slide15

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

Slide16

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

Slide17

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

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

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

Slide18

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

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

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

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

Slide19

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

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

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

Slide20

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

Slide21

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

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

Slide22

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

Slide23

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

Slide24

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

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

Slide25

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

Slide26

HOW DOES IT END?

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

Slide27

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

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

RECOMMENDATIONS

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

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

Grow the economy:

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

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

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

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

Balance the budget:

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

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

Reform retirement programs:

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

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

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

*   *   *

About the author:
William (Bill) Fletcher retired as Senior Vice President at Rockwell International. During most of his time there he was responsible for international operations and business development for Rockwell Automation. Before joining Rockwell, he worked for Bechtel Corporation, McKinsey and Company, Inc., and Combustion Engineering’s Nuclear Power Division, and was an officer and engineer in the U.S. Navy’s nuclear program. His international experience includes expatriate assignments in Hong Kong, Europe, the Middle East, Africa and Canada. In addition to his interest in California’s finances, he is involved in oganizations dealing with national security and international relations. The author retains all rights to the text and charts in this report.  He can be reached at cafinances@cox.net.

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

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

Costa Mesa, California – City Employee Compensation Analysis

October 3, 2012

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

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

The methods employed in this study mirror those used in the two prior studies. The format in which we analyze and report the data also closely follows that of the earlier studies. The source data was a spreadsheet showing compensation by category for every employee in Costa Mesa. The original spreadsheet, along with tabs that have been added to perform the necessary analysis, can be downloaded and reviewed by clicking on this link: Costa_Mesa_Total_Employee_Cost_2011.xlsx. The original spreadsheet is on the tab designated “original.” The only alteration that we have made to the original spreadsheet provided by the city of Costa Mesa’s payroll department was to delete the names of the employees in order to respect their privacy. Their job titles and departments have been retained, along with all available details regarding their compensation.

The goal of this study is to report average and median annual income for Costa Mesa’s full time city employees by department. Here is a summary of the key assumptions:

    • In order to develop representative averages, employees who retired or were terminated during the calendar year were not considered in the calculation.
    • Similarly, employees who were classified as part-time were not included in the calculation. This included city council members and their assistants, recreation staff, and other interns and part-time employees. The first three columns added on the “analysis” and “median” tabs of the spreadsheet clearly indicate which employees were excluded from the calculations based on these criteria.

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

It is clear from reviewing Table #1 that “Base Pay” would be a highly misleading number to report as representative, even for current year earnings. Because as can be seen, the current pay earned in 2011, when base pay and “other pay” are combined, averaged $128,650 for Costa Mesa’s police officers, $154,767 for their firefighters, and $80,327 for the 216 full time employees comprising the rest of their workforce. But no analysis of an employee’s true earnings is complete without taking into account the employer paid costs for their current health benefits, as well as the employer paid current year costs to fund their retirement benefits.

When the cost of benefits are included, as can be seen, the average total compensation in 2011 for Costa Mesa’s police officers was $181,709, for their firefighters it was $208,401, and for the rest of the workforce it was $103,755. When the payroll records for employees of all departments are consolidated, the average total compensation for an employee of the city of Costa Mesa in 2011 was $146,863.

Table #2 compares average to median total compensation for employees of the city of Costa Mesa. This comparison is important because an average, which merely divides the payroll for an entire department by the number of employees working in that department, can potentially be skewed upwards due to the presence of a small and unrepresentative handful of highly compensated managers. To determine whether or not this is the case in Costa Mesa, we calculated the median total compensation for the police department employees, the fire department employees, and all other employees. Because a properly calculated median compensation amount must have an equal number of individuals making more than the median as those making less than the median, when the median is significantly less than the average, you may infer that the average is unrepresentative of the typical employee.

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

Table #3 examines Costa Mesa’s base pay averages compared to U.S. Census figures reporting average base pay for employees of local governments in California in 2010 (the most recent year of data available, ref. CA Local Government Payroll 2010). As can be seen, Costa Mesa’s employees enjoy rates of base pay that significantly exceed the reported averages for local government employees in California.

There are several possible reasons for this, but primary among them is the probability that “other pay” and other categories of direct compensation are not reported to the U.S. Census Bureau as base pay. Costa Mesa’s firefighters, for example, on average received “other pay” of $56,395 each in 2011; the police on average received “other pay” of $28,181 each in 2011. Another reason for the significant difference for the disparity in average individual pay for the entire workforce is because U.S. Census data shows a much lower percentage of police and firefighters working for local governments in California in general compared to Costa Mesa in particular. Since, in general, police and firefighters receive far greater average compensation than all other employees, this pulls Costa Mesa’s averages way up.

What appears unlikely as an explanation for this disparity, however, is that Costa Mesa actually has unusually high rates of pay for their city employees compared to other cities in California, as indicated by our recently published analyses of San Jose and Anaheim’s payroll and our examination of payroll for several other California cities and counties.


Table #4 shows how total compensation breaks down between base pay and direct overhead, which must be included in any calculation of how much an employee actually makes. Direct overhead refers to all benefits enjoyed by the employee that are paid for by the employer, including insurance premiums, payments to fund future retirement pensions and retirement health benefits, and any other employer paid benefits, such as accrued vacation reimbursement, accrued sick leave reimbursement, tuition reimbursement, housing allowance, uniform allowance, car allowance, etc.

The idea that total compensation, including benefits, must be what one uses when comparing public sector rates of pay to private sector rates of pay should be beyond serious debate. As any self-employed individual understands all too well, the difference in their case between total compensation and base pay is zero. Any benefits they enjoy, they pay for themselves.

To better understand the relationship between base pay and total compensation, Table #4 calculates payroll overhead as a percent of base pay, by treating the total employer paid benefits as the numerator, and base pay as the denominator. As can be seen, the overhead, i.e., the employer paid benefits as a percent of base pay, for employees of the city of Costa Mesa, varies between 29% and 41%. As the next table will demonstrate, this significantly exceeds the rate of payroll overhead paid under even the most generous plans available in the private sector.


Table #5 calculates what the total compensation would be for the average private sector worker in Costa Mesa, using two exceedingly generous assumptions: (1) Base pay is assumed to be the average household income for Costa Mesa (ref. City-Data.com, Costa Mesa), and, (2) payroll overhead is assumed to comprise the best set of employer provided benefits available anywhere. Since more than one wage earner occupies the typical household, and since only about 20% of all employers (if that), offer benefits this rich, we are clearly overstating how much the private sector worker in Costa Mesa actually makes. And yet, even using these absurdly generous assumptions, the total compensation for the average employee working for the city of Costa Mesa exceeds that of a private sector resident of Costa Mesa by 82%, nearly twice as much.

No discussion of public sector employee total compensation is complete without a mention of pension benefits, which must be pre-funded during the years an employee works. Currently the city of Costa Mesa pays 20.3% of their total compensation budget into pension funds. Put another way, as a percent of base pay, Costa Mesa contributes 34.4% into pension funds. Costa Mesa’s employees contribute via payroll withholding an additional 3.8 percent of their total compensation (6.4% of their base pay) to their pensions. But as we prove in our study “A Pension Analysis Tool for Everyone,” which includes a downloadable Pension Analysis Model, for every 1.0% that a pension fund’s long-term rate of return goes down, the annual contribution to the pension fund must go up by 10% of base pay. Because the pensions are currently underfunded, and because pension benefits are being accrued or paid out to employees who are about to retire or have already retired, this rough estimate of how much more payments will rise per each 1.0% drop in returns is definitely on the low side.

To refrain a passage from our recent studies of San Jose and Anaheim’s city payroll, to properly assess how much Costa Mesa’s city employees really make in total compensation, one needs to rebuke the preposterous notion that pension funds will reliably earn 7.5% per year for the next several decades, and instead assume they will only earn somewhere between 3.0% and 5.0% per year. CalPERS themselves discount pension liabilities at a rate of 3.8% for any participant who wants to opt out of their program, a telling indication of what they consider the “risk free” rate of return. At a 3.8% rate of return, you would have to increase the average total compensation for the typical employee of the city of Costa Mesa from the current $146,863 per year to around $175,000 per year. The typical firefighter’s pay would have to increase from the current $208,401 average per year to around $250,000 per year.

It is important to emphasize that the employment packages Costa Mesa has awarded their unionized city workforce are not unique. In much larger cities, San Jose and Anaheim, analysis of original and comprehensive payroll data has yielded very similar results:

San Jose: Average total compensation, all workers = $149,907
Anaheim: Average total compensation, all workers = $146,551
Costa Mesa: Average total compensation, all workers = $146,863

Workers employed by local governments in California are earning total compensation that averages about $150,000 per year. And this is without taking into account the looming impact of lower earnings forecasts from the pension funds. It is in this context that the ongoing debate between Costa Mesa’s union representatives and Costa Mesa’s elected officials must be viewed. By any objective analysis, Costa Mesa’s city employees earn more than twice as much as the local residents they serve.

Journalists who dutifully report “base pay” rates for city workers that sound somewhat high, but not ridiculously unreasonable, are ignoring glaring facts about compensation: (1) “Other pay” now adds more than 50% to the current earnings of many city workers, and (2) The only honest measure of how much someone earns is their total compensation, i.e., everything the employer pays each year in direct pay and benefits for an employee. That is what they earn. That is what they cost taxpayers. That is the number that should be compared to what taxpayers themselves earn. In Costa Mesa, the average employee’s total compensation of $146,863 adds 69% on top of their base pay. This is real money, and journalists who continue to ignore total compensation statistics in favor reporting only base pay are doing their public a disservice.

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

Anaheim, California – City Employee Compensation Analysis

August 29, 2012

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

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

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

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

Table #1 provides a summary by department of both the number of employees in each department and their average pay. As can be readily ascertained, the average base pay is highest, at $118,373 per year, for the 24 full time employees of the City Attorney department. They are followed, at $102,029 per year, by the 17 employees of the City Administration. When the cost of benefits are included however, the 257 employees of Anaheim’s fire department have the highest average total compensation, at $193,516 per year. In terms of total compensation, the fire department is followed the 24 employees of the City Attorney’s office at $180,042, then the 523 employees of the police department at $170,866. As a whole, Anaheim’s full time workforce’s average annual base pay is $84,158, and their average total compensation is $146,551.

Table #2 compares average to median total compensation for employees of the city of Anaheim. This comparison is important because an average, which merely divides the payroll for an entire department by the number of employees working in that department, can potentially be skewed upwards due to the presence of a small and unrepresentative handful of highly compensated managers. To determine whether or not this is the case in Anaheim, we calculated the median total compensation for the police department employees, the fire department employees, and all other employees. Because a properly calculated median compensation amount must have an equal number of individuals making more than the media as those making less than the median, when the median is significantly less than the average, you may infer that the average is unrepresentative of the typical employee.

As can be seen, however, the median income for police employees is actually higher than the average, meaning that if anything, the average total compensation is unrepresentative of the typical officer because it is too low. In the case of Anaheim’s firefighters, the median and the average are almost exactly the same, strongly suggesting that the average total compensation is entirely representative of a typical firefighter’s pay. And even for the rest of the workforce, the average only exceeds the median by 11%. Clearly the average total compensation figures developed in this analysis are not being skewed by the presence of highly compensated members of city management.

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

Table #4 shows how total compensation breaks down between base pay and direct overhead, which must be included in any calculation of how much an employee actually makes. Direct overhead refers to all benefits enjoyed by the employee that are paid for by the employer, including insurance premiums, payments to fund future retirement pensions and retirement health benefits, and any other employer paid benefits, such as accrued vacation reimbursement, accrued sick leave reimbursement, tuition reimbursement, housing allowance, uniform allowance, car allowance, etc.

The idea that total compensation, including benefits, must be what one uses when comparing public sector rates of pay to private sector rates of pay should be beyond serious debate. As any self-employed individual understands all too well, the difference in their case between total compensation and base pay is zero. Any benefits they enjoy, they pay for themselves. To better understand the relationship between base pay and total compensation, Table #4 calculates payroll overhead as a percent of base pay, by treating the total employer paid benefits as the numerator, and base pay as the denominator. As can be seen, the overhead, i.e., the employer paid benefits as a percent of base pay, for employees of the city of Anaheim, varies between 48% and 56%. As the next table will demonstrate, this is more than twice the rate of payroll overhead paid under even the most generous plans available in the private sector.

Table #5 calculates what the total compensation would be for the average private sector worker in Anaheim, using two exceedingly generous assumptions: (1) Base pay is assumed to be the average household income for Anaheim (ref. City-Data.com, Anaheim), and payroll overhead is assumed to comprise the best set of employer provided benefits available anywhere. Since more than one wage earner occupies the typical household, and since only about 20% of all employers (if that), offer benefits this rich, we are clearly overstating how much the private sector worker in Anaheim actually makes. And yet, even using these absurdly generous assumptions, the total compensation for the average employee working for the city of Anaheim is more than twice that of a private sector resident of Anaheim.

No discussion of public sector employee total compensation is complete without a mention of pension benefits, which must be pre-funded during the years an employee works. Currently the city of Anaheim pays 17.3% of their total compensation budget into pension funds. Presumably some additional percentage is paid by the employees via payroll withholding. But as we prove in our study “A Pension Analysis Tool for Everyone,” which includes a downloadable Pension Analysis Model, for every 1.0% that a pension fund’s long-term rate of return goes down, the annual contribution to the pension fund must go up by 10% of base pay. Because the pensions are currently underfunded, and because pension benefits are being accrued or paid out to employees who are about to retire or have already retired, this rough estimate of how much more payments will rise per each 1.0% drop in returns is definitely on the low side.

To properly assess how much Anaheim’s city employees really make in total compensation, therefore, one needs to rebuke the preposterous notion that pension funds will reliably earn 7.5% per year for the next several decades, and instead assume they will only earn somewhere between 3.0% and 5.0% per year. CalPERS themselves discount pension liabilities at a rate of 3.8% for any participant who wants to opt out of their program, a telling indication of what they consider the “risk free” rate of return. At a 3.8% rate of return, you would have to increase the average total compensation for the typical employee of the city of Anaheim from the current $146,551 per year to at least around $190,000 per year. The typical firefighter’s pay would have to increase from the current $193,516 average per year to at least around $235,000 per year.

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

San Jose, California – City Employee Total Compensation Analysis

August 10, 2012

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

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

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

Method:

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

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

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

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

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

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

Findings:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Understanding the Financial Disclosure Requirements of Public Sector Unions

June 12, 2012

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

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

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

Financial Reporting Requirements of Public Sector Unions

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

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

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

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

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

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

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

Collecting the Data

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

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

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

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

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

Summary of 990 Data on Major California Public Sector Unions

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

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

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

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

REFERENCES

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

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

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

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

[5] 29. U.S.C.A. §402(j)

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

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

[8]  29. U.S.C.A § 431(b)

[9] Id. § 431 (c)

[10] Id.

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

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

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

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

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

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

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

LINKS TO FEDERAL 990 FORMS FOR MAJOR CALIFORNIA PUBLIC SECTOR UNIONS

California Teachers Association (2009 data)

United Teachers Los Angeles (CTA Chapter)

California School Employees Association

California Federation of Teachers

California Professional Firefighters

California Correctional Peace Officers Association

Association for Los Angeles County Deputy Sheriffs

Los Angeles Police Protective League

California Peace Officers Association

AFSCME Sacramento

AFSCME Oakland

AFSCME San Diego

SEIU Local 1000

California State Employees Association

Why Lower Rates of Return Will Destroy Pension Funds

May 18, 2012

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

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

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

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

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

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

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

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

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

There’s one more big gotcha.

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

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

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


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

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

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

A Pension Analysis Tool for Everyone

April 2, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Public Sector Unions Spend $4.0 Billion per Year in U.S.

March 23, 2012

In an earlier post, “Public Sector Unions & Political Spending,” we tried to estimate political spending by public sector unions in California. The top-down analysis used was straight-forward and conservative: assume 1.0 million unionized public sector workers, times average dues of $750 per year, times one-third (the proportion of dues used for political activity), and voila, public sector unions spend $250 million per year in California to influence elections at the federal, state, and local level. No wonder the politicians in California do whatever they’re told to do by the very government workers they are supposedly elected to manage. And no wonder California is broke.

One might challenge the estimate that one-third of public sector union dues in California go to support political activity. But for public sector unions, the distinction between political and non-political spending is largely irrelevant. Because virtually every expenditure by a public sector union, whether it is collective bargaining, lobbying, contributions to candidates, independent expenditures, or educational outreach, has one primary goal: The expansion of their membership and the expansion of the pay and benefits for their members.

From this perspective, California’s public sector unions are not deploying $250 million per year to influence the political process in support of their agenda, they are deploying at least $750 million per year. How much is being spent across the United States by public sector unions to pursue this same agenda?

According to the U.S. Census Bureau, there are 12.2 million local government employees across the United States. There are 4.4 million state government employees, and there are 2.6 million non-military federal government employees. In all, 19.2 million American’s, excluding military, work for the government.

According to a report released in January 2012 by the U.S. Dept. of Labor’s Bureau of Labor Statistics that surveyed union membership in the United States in 2011, there are 7.6 million government workers belonging to labor unions, about 39%. If you include those government workers who are required to belong to a bargaining unit as a condition of their employment, but managed to opt-out of full union membership, there are 8.3 million government workers who belong to unions in the United States.

Determining the total revenue available to public sector unions in the United States each year is a simple matter of multiplying the total number of government union members in the U.S. by the average dues they are required to pay each year. An excellent recent study authored by Daniel DiSalvo, a senior fellow at the Manhattan Institute and professor of political science at The City College of New York, entitled “Dues and Deep Pockets: Public-Sector Unions’ Money Machine,” provides several sources of data on this question. Based on analysis of several representative samples from across the U.S. and across job descriptions, DiSalvo estimates the average annual dues for a government union member at $500, an amount he acknowledges is probably conservative. This means, at the least, public sector unions in the United States are collecting and spending $4.0 billion per year to pursue their agenda.

Because these unions represent public sector workers, their agenda is explicitly political. Whether they are bargaining over work rules, pay and benefits, or actually engaging in political lobbying and campaigning, they are deploying $4.0 billion per year to influence how our government is operated.

The consequences of this level of influence are manifold. Government workers, despite having greater job security, greater access to health care, and far more generous paid vacation benefits than private sector taxpayers, now make as much or more than private sector workers; in fact, the average base pay for a government worker – not including benefits – now exceeds private sector averages by over 50%. For California, we have documented this in previous California Policy Center studies such as “Calculating Public Employee Total Compensation,” and similar disparities exist across the U.S. And probably the most obvious, and biggest, disparity between public sector and private sector compensation is with respect to pensions, where the average government worker retires 10-15 years earlier than the average private sector worker, and receives a pension that averages 2-3x more per year than what a private sector worker can expect from social security.

There is nothing wrong with paying government workers well. But disparities of this magnitude carry a crippling economic cost, and can’t possibly be extended to all workers. For example, in California there are approximately 10 million people over the age of 55. If all of them received the average pension currently issued to state and local workers in California after 30 years of work, which is over $65,000 per year, that would cost $650 billion per year, nearly 40% of California’s entire gross domestic product.

Public sector unions have quietly become the most powerful force in politics in the United States, not only because they spend more than any other significant actor, but because until recently, their efforts have been completely unopposed. Corporate political expenditures are almost always limited to the narrow economic interests of each corporation or industry, and almost always balanced by expenditures by a competing corporation or competing industry. Historically, no special interest group has ever arisen to effectively oppose public sector unions.

Over the past century the character of unions in the United States has changed completely. They have converted from being the courageous underdog, representing the downtrodden and underpaid working class, to the biggest, meanest dog in the pit, representing the overpaid political ruling class. The core agenda of government worker unions, backed by at least $4.0 billion per year in cold hard cash that, ultimately, originates from taxpayers, is intrinsically oriented towards bigger government – more programs, more regulations, more pay and benefits, more workers – regardless of the cost or benefit to society.

Self-Employed Workers vs. Government Workers – A Financial Comparison

February 24, 2012

When discussing what level of compensation is appropriate and affordable for government workers, it is helpful to make apples-to-apples comparisons between public and private sector workers. In this analysis, the ultimate private sector taxpayer, the self-employed worker, is compared to the typical state or local government employee in California. In both cases, the annual compensation used for comparison is $70,000, which is the average base salary paid to state and local government employees in California (ref. U.S. Census data for California: State, and Local). But the impact of benefits paid by the government employer, combined with the impact of mandatory employee contributions (taxes, retirement set-asides, and healthcare costs), yield dramatically different end results in terms of total net compensation. Both the self-employed worker and the government worker make $70,000 per year. But to say they make the same amount of money is grossly misleading.

The table below, “Total Compensation – Gov’t vs. Self-Employed Worker,” begins to illustrate this disparity. The difference between total compensation and gross earnings in the case of the self-employed worker is zero. There is nobody paying for benefits beyond what the self-employed person earns. Whatever amenities they need to purchase, they have to pay for out of their gross earnings.

In the case of the government worker, there are a host of employer funded benefits; only the basic ones are covered here, using conservative assumptions. If it is assumed the average household health insurance coverage is $500 per month, and the employer pays 50% of that, this adds $3,000 per year to the total compensation of a government worker. In reality, factoring in employer coverages of medical, dental and vision plans, it is very unlikely the average government worker doesn’t get well in excess of $3,000 per year in employer health care benefits.

Current expenses for health care, however, are not the only health expenses that governments pay for their workers. Typically there are provisions for retirement health care coverage that are taken on as obligations by the government for their workers. For example, there are “medigap” plans, with all or part of the premiums paid for by the government. In some cases, such as with most safety employees and management employees, the government pays 100% of the premiums for lifetime premium health insurance plans. These future obligations must be funded during current employment. To estimate another $2,000 per year for this cost, or, more generally, to estimate $5,000 per year per employee for the average government contribution to current and retirement health care, is definitely conservative.

In addition to healthcare costs, state and local government employers cover pension benefits for which much of the costs – and in many cases 100% of the costs – are paid by the government, not the employee. If one assumes a contribution by the government employer of only 12% of gross salary per year – clearly lower than reality – this adds another $8,400 to the total compensation of a government worker.

A simmering question regarding pensions for government workers – how much can these pension funds really earn each year in interest – generates the next estimate. In our analysis “How Much Could California’s Government Pensions Cost Taxpayers,” along with “What Payroll Contribution Will Keep Pensions Solvent,” we have explored the underlying calculations in depth. The reader is invited to review those calculations and assumptions. But the bottom line is this: If pension funds have to lower their long-term expected rate of return by 2.0%, and they will, this will add at least $11,200 per year to the cost of funding the average pension. These obligations may be scaled back, but until they are, this amount must be included when adding up the total compensation of the average government employee in California.

Taking all of this into account, a self-employed person making $70,000 per year makes $70,000 per year. A government worker making $70,000 per year in base pay is actually making $94,600 per year in total compensation, 35% more. But it doesn’t end there.

The next table, below, examines the impact of what might best be described as “mandatory employee contributions,” taking the form of the employee share of health insurance coverage, retirement pensions and social security, along with state and local taxes. Once these mandatory contributions are deducted from the income (before tax in the case of health care and retirement contributions) of both the self-employed and the government worker, and the employer provided benefits – which are tax-free – are added back to the income of the government worker, the disparity between their actual net total compensation becomes even more dramatic.

If one assumes that the self-employed person is going to purchase health insurance for their household, they will pay 100% of the premium. Using the same assumptions, this means they will spend $6,000 per year for these benefits, whereas the government worker, paying 50% of the premium, will only spend $3,000 per year.

By participating in social security and medicare as a self-employed person, they are obligated to pay both the employee and the employer share of those assessments, which at a gross annual income of $70,000 will cost them $10,500 per year. By contrast, even if the government worker pays 10% of their salary into their pension – a level that is still fairly unusual to see among government workers – this will only cost them $7,000 per year.

In the above table, “Net Total Compensation – Gov’t vs. Self-Employed Worker,” these before tax deductions are subtracted from their base annual salary to arrive at their taxable annual salary. This taxable amount then has deducted from it what a California household in 2011 would have to pay in state and federal taxes. Finally, the non-taxable employer contributions are added back to the actual take-home pay to yield the net total compensation after mandatory contributions.

This is the apples-to-apples result: A self-employed person making $70,000 per year, once they’ve paid their taxes. social security and insurance premiums, will enjoy compensation of $45,021 per year. A government worker making $70,000 per year, once they’ve paid their taxes, pension contribution and insurance premiums, with the value of their current and deferred benefits added back, will enjoy compensation of $74,781 per year, 66% more.

It doesn’t end there. As shown on the next table, “Retirement Security – Gov’t vs. Self-Employed Worker,” the self-employed worker, who must pay $10,500 per year for social security and medicare, can expect to retire at the age of 66 with a social security benefit of $20,144 per year. The government worker, who must pay $7,000 per year for their pension, can expect to retire at the age of 60 with a pension of $46,666 per year. The total value of these respective retirement benefits, based on a life-span of 80, is $282,016 for the self-employed worker, and $933,324 for the government worker.

It is important to emphasize how conservative these numbers are. While the average pay of a government worker in California is only about $70,000 per year, the average pension for state and local government workers in California is not $46K per year, but nearly $70K per year. For state and local government workers who retire at age 66 and spend their careers in government service, the average pension is nearly $100K per year (ref. CalPERS Annual Report FYE 6-30-11, page 153, and CalSTRS Annual Report FYE 6-30-11, page 149). This means the assumptions used to calculate pension contributions at various rates of return, which assumed pensions equivalent to 66% of average salary, are obviously inadequate. This is because pensions aren’t calculated on average salary, they’re calculated on final salary. The assumptions underlying our pension contribution estimates also don’t take into account the current state of underfunding for pensions.

For a self-employed person to enjoy a net total compensation equivalent to the average government employee who makes “only” $70,000 per year, they would have to earn well in excess of $100,000 per year, particularly since as they climb in gross income, they encounter higher and higher tax brackets. A self employed person who makes less than $108,000 per year and more than $74,000 per year, because their income is still under the social security withholding ceiling, actually pays taxes at the margin of over 50%. But that is a topic for another post.

How Much Could California's Government Pensions Cost Taxpayers?

January 27, 2012

This week both of California’s largest government employee pension funds, CalPERS and CalSTRS, released their portfolio earnings numbers for the most recent twelve months. In a statement released on January 24th, “CalSTRS Calendar Year-End Investment Returns Show Slight Gains,” CalSTRS disclosed “Investment returns for the California State Teachers’ Retirement System (CalSTRS) ended the 2011 calendar year posting a 2.3 percent gain.” CalPER’s statement released on January 23rd, was titled “[CalPERS} Pension Fund earns 1.1 percent return for 2011 calendar year.”

These funds, and the rest of California’s many local government employee pension funds, are still clinging to long-term rate of return assumptions of between 7.5% and 7.75% per year. So how much would taxpayers be on the hook for if rates of return stay this low?

The first step towards determining this would be to estimate the average pension paid out to a state or local worker in California, based on recent retirees who have worked a full 30 year career. Despite the claim that “The average CalPERS pension is $2,220 per month” (made yet again in the final paragraph of their above-referenced press release), for a more accurate figure, one must look at the average pension awarded recent retirees, based on a full 30+ year career. The problem with the low figure used by CalPERS and others is that it includes people who retired decades ago when salaries and pension benefit formulas were much lower, and it includes people who may have only worked a few years for the government. Since we will be multiplying this average pension by the number of full time state and local government workers in California, we have to assume a full career when calculating the average pension, since for every worker who only worked 10 years, for example, two additional retirees will also be in the system who have themselves also only worked 10 years. To calculate the cost of a full-career pension, you have to add all three of these part-career retirees together. Here is what these pensions really average, based on CalPERS Annual Report FYE 6-30-11 (page 153), and CalSTRS Annual Report FYE 6-30-11, (page 149):

CalPERS average final salary for 30 years work, retiring 2010: $82,884
CalPERS average pension for 30 years work, retiring 2010: $60,894  –
Pension equals 73% of final salary (average of 25-30 year and 30+ year stats)

CalSTRS average final salary for 30 years work, retiring 2010: $88,164
CalSTRS average pension for 30 years work, retiring 2010: $59,580  –
Pension equals 68% of final salary (average of 25-30 year and 30-35 year stats)

If one extrapolates the CalPERS and CalSTRS data to the many independent pension funds serving local agencies – many of these are quite large, such as the one for Los Angeles County employees – it is probably conservative to peg the average pension going forward for full-career government workers in California at at least $60,000 per year, and at least 70% of final salary.

The next step in figuring out how much state and local government worker pensions could cost California’s taxpayers in the future is to establish the sensitivity of pension contribution rates to changes in the rate of return of pension funds. The California Policy Center has explored this question repeatedly, with a good summary in the July 2011 study entitled “What Payroll Contribution Will Keep Pensions Solvent?” Using the same financial assumptions as were used in that analysis, here is how the required pension contribution rates – expressed as a percent of payroll – change in response to lower earning rates for the pension funds. This is based on pensions averaging 70% of final salary, and assumes 30 years working, 25 years retired, and salary (in real dollars) eventually doubling between hire date and retirement date:

If the pension fund’s return is 7.75%, the contribution rate is 22% of payroll.
If the pension fund’s return is 6.75%, the contribution rate is 28% of payroll.
If the pension fund’s return is 5.75%, the contribution rate is 37% of payroll.
If the pension fund’s return is 4.75%, the contribution rate is 48% of payroll.
If the pension fund’s return is 3.75%, the contribution rate is 63% of payroll.

What the above figures quickly indicate is not only that the required payroll contributions go up sharply when projected rates of investment return come down, but that the lower the rate of return goes, the more sharply the required contribution rises.

To complete this analysis, one only needs to multiply the number of full time state and local government employees in California by the average payroll for these employees, and multiply that result by the various required contribution rates. Using 2010 U.S. Census data for California’s State Employees and for California’s Local Government Employees, one can quickly determine that there are 339,430 state workers earning on average $68,880 in base annual salary, and there are 1,185,935 local government workers earning on average $69,399 in base annual salary.

To sum this up, there are currently 1,525,365 full time (not “full-time equivalent,” which would be an even higher number, but those part-time employees may or may not have pension benefits) state and local government employees in California. They earn, on average, $69,284 per year in base pay. Here is how much pensions will cost for these workers each year based on various rates of return:

If the pension fund’s return is 7.75%, the state pays $23 billion to pension funds each year.
If the pension fund’s return is 6.75%, the state pays $29 billion to pension funds each year.
If the pension fund’s return is 5.75%, the state pays $39 billion to pension funds each year.
If the pension fund’s return is 4.75%, the state pays $51 billion to pension funds each year.
If the pension fund’s return is 3.75%, the state pays $66 billion to pension funds each year.

It is interesting to note that both CalPERS and CalSTRS failed to even achieve a 3.75% return in calendar year 2011, the lowest amount used in these examples and the lowest amount that can even keep pace with inflation.

When one takes into account the fact that only about five million households in California pay net taxes, the impact of the pension con job Wall Street brokerages have enlisted the support of public sector unions to foist onto taxpayers is even more dramatic. Because if, during the great deleveraging that likely will consume this economy for at least another decade, California’s pension funds only deliver 3.75% per year, instead of 7.75% per year, that will translate into $8,600 per year in new taxes for each and every taxpaying California household.

Which Special Interests Are Partisan?

December 15, 2011

An analysis we published earlier this year, “Is Union Reform Partisan,” documented the fact that about 95% of political contributions by unions go to the Democratic party. But is corporate political spending is less partisan than union political spending? Equally important, to what extent does corporate political spending outweigh political spending by unions?

Parsing data from OpenSecrets.org, again, “a nonpartisan, independent and nonprofit research group tracking money in U.S. politics,” what follows is information on all of the top 100 political spenders during the eleven election cycles between 1990 through 2010. These top 100 are divided into four categories; corporate, financial, union, and grassroots. The results were quite surprising, as summarized on the chart below:

The data used to generate these numbers comes from OpenSecrets.org’s “Top All-Time Donors, 1990-2010” table, which were downloaded onto spreadsheets and sorted into the four categories noted, while retaining in the far left column the rank of each contributor within the top 100. So the reader may view the assumptions, all four of these tables constitute the remainder of this post.

Readers are invited to mull the implications of these findings regarding the top 100 political spenders of the last 20 years in America:

1 – The corporate and financial sectors combined did outspend unions, by a ratio of almost exactly 2-to-1.

2 – Unions spent 95% of their contributions on Democrats.

3 – The corporate sector spent 56% of their contributions on Republicans, and the financial sector spent 53% of their contributions on Republicans. Their spending between the two parties was essentially nonpartisan.

4 – Overall, among the top 100 political spenders of the last 20 years, Democrats collected 62% of the takings, and Republicans only collected 38%.

It remains open to interpretation which party might be more beholden to special interests…

Here is the data:

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California's Public Safety Compensation Trends, 2000-2010

Today’s Wall Street Journal published an article by Phil Izzo entitled “Bleak News for Americans’ Income,” where, citing U.S. Census Data, it was reported that U.S. median household income – adjusted for inflation – fell by 7% over the past ten years. In constant 2010 dollars, the average household in the U.S. saw their income drop from about $54,000 per year in 2000 to just under $50,000 today.

When debating what level of compensation is appropriate and affordable for public safety personnel, the average income of private sector workers is an important baseline. It provides context for determining whether or not the premium paid to public safety employees – for the risks they take – is exorbitant or fair. The trend of the past ten years is also an important baseline when making this comparison. For example, if the level of risk, the value we place on safety and security, and the degree of training required for public safety personnel have all elevated over the past decade – and they have – does this justify their pay increases exceeding the rate of inflation? Even over this past decade, when ordinary private sector workers have seen their total pay and benefits decrease by 7% relative to inflation?

Here then, also relying on U.S. Census data (ref. 2010 Public Employment and Payroll Data, State Governments, California, and 2010 Public Employment and Payroll Data, Local Governments, California, along with 2000 Public Employment and Payroll Data, State Governments, California, and 2000 Public Employment and Payroll Data, Local Governments, California), are the rates of base pay and pension obligations for California’s public safety personnel in 2000 (adjusted for inflation and expressed in 2010 dollars), and 2010, starting with Firefighters:

Several points on the table above bear explanation. These numbers reference firefighters who, typically, work 24 hour fire suppression shifts, and do not include administrative personnel. These work schedules usually involve three 24 hour shifts on duty, followed by six days off. If a firefighter works more than three out of every nine days, they receive overtime, which is included in these numbers. Worth noting is that when adjusting for vacation, the average mid-career firefighter in California works two 24 hours shifts every seven days, earning overtime for whatever extra days they work beyond that. Not included in these figures are any current benefits, including health insurance, or funding set-asides to cover retirement health insurance. We published a complete work-up of the total compensation of firefighters in August 2010 in a post entitled “California Firefighter Compensation.” In that analysis, the total compensation of the average Sacramento firefighter was estimated at $180,000 per year.

It is also important to explain the rationale behind the higher pension costs (as a percent of salary) between 2000 and 2010. It was around 2000, and for several years afterward, that the “2.0% at 50″ benefit for public safety personnel was changed to the current “3.0% at 50″ formula – retroactively. The so-called “2.0% at 50″ formula meant that a firefighter was eligible to retire at any time after turning 50 years old, and would receive a pension equivalent to the number of years they worked, times 2.0%, times the salary they earned in their final year working. The “3.0% at 50″ formula increased this benefit, logically, by 50%. A firefighter now can retire any time after turning 50 years of age with a pension equivalent to the number of years they worked, times 3.0%, times the salary they earned in their final year working. The numbers shown on this table and the others, which represent the funding requirements per year expressed as a percent of salary, reflect the 50% increase required. These percentages assume 30 years working and 25 years retired, and they assume CalPERS will continue to earn 7.75% per year on their investments – 4.75% after adjusting for inflation. These are very conservative numbers, and indeed, most government agencies already set aside more than this into public safety pension funds. For much more on these calculations, refer to our analysis “What Payroll Contribution Will Keep Pensions Solvent?,” posted in July 2011.

Here are pay and pension trends between 2000 and 2010 for California’s police officers:


And here they are for California’s correctional officers:

Here is a summary of this data: During the decade between 2000 and 2010, a period when, adjusting for inflation, household income for private sector workers fell by 7.0%, California’s firefighters saw their pay and pension benefits (after adjusting for inflation) increase by 33%, police officers saw their pay and pension benefits increase by 28%, and corrections officers saw their pay and pension benefits increase by 19%.

The next table attempts to quantify these costs in terms of their impact on California’s taxpaying households. While there are 12 million households in California, once you eliminate the nearly 50% of households who pay no net taxes, and the 15% (estimate) of households whose primary income comes from a government job, you’re down to about 5 million households.  Corporate taxes, which presumably could cover some of these costs, are passed onto consumers in the form of higher prices. And these costs do not include anything other than pay and pensions – none of the other payroll overhead.

The above figures, all extrapolated from the data presented on the previous charts or from the U.S. Census Bureau’s tables linked to earlier, show salary and pension costs for California’s nearly 200,000 public safety personnel, expressed in billions. The first figure, $21.8 billion, is the estimated amount currently expended per year for base pay (including overtime) plus pension funding. The second figure, $25.2 billion, shows how much that amount will increase if CalPERS lowers their pension fund return on investment projection from 7.75% to 5.75%. The third figure, $17.4 billion, is how much base pay and pension funding for public safety employees would cost taxpayers in California if their base pay and pension benefits had merely kept pace with inflation, instead of escalating at a rate between 19% (correctional officers), 28% (police officers), or 33% (firefighters) greater than the past decade’s inflation. Finally, the fourth figure, $16.2 billion, shows how much taxpayers would pay to fund public safety base pay and benefits in California if, instead of increasing their pay and benefits during a period when everyone else was getting paid less, they took 7% cuts to their pay and benefits – i.e., did not see their income rise quite as fast as the rate of inflation.

Between 2000 and 2010, not only public safety personnel, but all state and local employees in California saw increases to their pay and benefits that exceeded the rate of inflation. The reasons for the decline in real income in the private sector are many and complex; globalization, increased productivity and overcapacity, the obsolescence of middle-management and skilled jobs – lost to office automation and robotic manufacturing – unsustainable and maxed debt accumulation, over-regulation, under-regulation, and of course, insufficiently progressive taxation and insufficient taxes on wealthy individuals and corporations – or is it the lack of a universal flat tax and excessive taxes on everyone. It depends on who you ask. But for the five million households in California who do pay taxes, it is fair to wonder what level of compensation is equitable for public safety personnel, and why their compensation has increased by double-digits (after inflation) during a time when private sector incomes have gone down.

The Impact of Tax Exempt Disability Pensions

September 2, 2011

It is surprisingly difficult to gather data on just how many public safety employees claim disability in their retirements, but this should not prevent us from estimating what the benefits bestowed on disability claimants cost taxpayers.

A common program to compensate public safety workers for job-related disabilities is to grant them a tax exemption, whereby 50% of their retirement pension is exempt from state and federal taxes. While it is virtually impossible to collect data from pension fund administrators on exactly how many retired public safety workers have retired with this benefit, a 2004 investigative report by the Sacramento Bee found that among retired members of the California Highway Patrol, 66% of the rank and file officers, and 82% of the chiefs retired with service disabilities. Similarly, a 2006 investigative report by the San Jose Mercury found that two-thirds of San Jose Firefighters retired with service disabilities. Neither of these reports remain available online, although a Google search on the term “Chief’s Disease” (a term coined by the Sacramento Bee) will find dozens of secondary references to these studies; you can start here, and here.

The point of this analysis, other than to point out the shocking lack of comprehensive data on this issue, is to perform a what-if, based on assumptions that might be reasonably extrapolated from the available data.

The first section of the table below, “Impact per Worker,” shows what a person receiving a service disability tax exemption is really making annually, based on normalizing the take-home, after-tax earnings between the case with a 50% tax exemption vs. one with no tax exemption. Column one shows an average annual pension for a recently retired California public safety employee – probably low – of $75,000 per year. It then shows what their tax burden would be based on 50% of that income being exempt from taxes – leaving a taxable income of only $37,500, which invokes far lower withholding percentages. As can be seen, someone with a gross income of $75K per year who only pays taxes on $37.5K will have an after-tax income of $67,999 per year.

Still examining the “Impact per Worker” section of the table below, column two shows that in order to collect an after tax income of $67,999 per year, if one pays taxes on 100% of their income, would require an income of $90K per year, a 20% increase in gross income. This is the true value of the service disability 50% tax exemption. As retirement incomes increase, the disparity actually widens, because the tax brackets invoke higher withholding percentages. For example, a pension income of $100K – quite common among retired public safety workers – paying income taxes on only $50K, would deliver a take-home, after-tax income of $88,858. To earn this much while paying normal taxes without special exemptions would require an annual income of $128,363, a 28% increase. The reader is invited to verify these figures by referring to 2011 Federal Income Tax Brackets, and 2011 California Income Tax Brackets.

The second half of the above table, “Impact for California Taxpayers,” attempts to quantify what the prolific granting of service disability tax exemptions to retired public safety workers costs taxpayers. Based on updated 2010 data from the U.S. Census Bureau for California State Worker Payroll and California Local Government Worker Payroll, there were 222,898 full-time police, firefighters, and correctional officers working at the state and local level in California in March 2010. This amount does not include “full-time equivalents” who brought the total up to nearly 230,000 employees. On average, these full-time public safety workers earned $84,929 per year. Among firefighters, the average was $113,057 per year. Because public safety workers have life-expectancies that – according to CalPERS own actuarial data – meet or exceed national averages, and because they are eligible for retirement at age 50 (in some cases earlier), the calculations on the above table assume we are on track to have one retired public safety worker for every active public safety worker.

As can be seen, based on these assumptions – and the pension estimate of $75K per year is almost certainly quite a bit lower than the reality, since the average mid-career earnings of public safety workers is currently $85,000 per year, and pensions are calculated on end-of-career earnings – if 50% of public safety workers retire on service disability tax exemptions, the cost to California’s taxpayers is $1.7 billion per year.

Whether or not this is an accurate estimate, and available data suggests that this estimate is, if anything, on the low side, is almost beside the point. Where is this data? Why doesn’t CalPERS, and the other pension funds managing public safety employee retirement assets, release this data?

Nobody seriously questions that public safety workers deserve to make a premium for the work they do. The level of sophistication required to work in law enforcement and fire suppression today is far greater than it was 20 or 30 years ago. The value we place on life and personal security is also greater today than ever before. There is a price for this, and it is one taxpayers should pay without resentment. The question is how much of a premium is equitable, and how much of a premium is financially sustainable. A related question is how much of this premium paid to public safety workers, to the extent it is excessive, the result of powerful government worker unions who pool taxpayer’s money to control local elections with massive campaign contributions. How much is this pay premium elevated because public safety worker unions, and their PR firms, exploited their deserved hero status in inappropriate ways to manipulate the electorate to ignore fiscal reality?

When the question turns to pensions, however, the issue of whether or not a premium is appropriate for service in public safety may not be as justifiable. If public safety workers deserve a premium, it should be paid as part of their current compensation. This way they may share, along with all public employees, the same obligations to financially prepare for their retirement that face working private sector taxpayers. As for disability pensions, it strains credulity to think that over 80% of police chiefs and fire captains, and over 60% of other public safety workers are disabled in the course of their jobs. And even if they are, these disabilities can be remedied through far less expensive private disability insurance, not through the granting of service disability tax exemptions that increase the effective gross amount of their pensions by 20-30%.

Questioning whether or not we should offer pensions in excess of $75K per year to workers who retire in their early 50s, or then offer as many as half of these retirees with service disability tax exemptions, goes beyond questions of financial sustainability. It goes beyond questioning how much of a premium they deserve for the risks they take to protect the public. A deeper question is not how much we value the lives of those who protect us, but how much we value everyone’s life. Dozens of jobs are more dangerous than those in public safety. Logging, fishing, agriculture, and mining occupations claim thousands of lives every year, and maim thousands more. Few if any of these workers retire in their early 50s with pensions of $75K or more, and none of them receive service disability tax exemptions. Do we consume the products that these workers lose their lives and endure disabling injuries to provide for us? Can we live without those products? Are their lives any less significant than the lives of others who wear badges? For that matter, are the millions who toil in factories or in front of computers any less likely to wear out and become disabled through repetitive motions and eye strain? Are their injuries less debilitating? Is their life’s work undeserving of commensurate dignity?

Ultimately, we all share the fate of our mortality, the ultimate disability. We age, we wear out, we are progressively disabled, and then we die. Nobody escapes this verdict, whether our professions are public or private, intellectual or physical, noble or profane. This common denominator – tempered by considerations of what is financially realistic – should govern our common response to the challenges of disabilities, not privilege, nor political power, nor manipulative emotional appeals.

What Payroll Contribution Will Keep Pensions Solvent?

July 25, 2011

In a previous post “Pension Contributions Aren’t Enough,” the point is made that for every percentage point that an investment fund lowers their projected rate of return, the required annual pension fund contribution as a percent of salary goes up by over 10%. The assumptions underlying that analysis were 30 years working, 30 years retired, a pension equivalent to 90% of final salary, with the salary doubling (in inflation adjusted dollars) between the first year of employment and the final year of employment. Using the same assumptions, but for a pension equivalent to 60% of final annual salary, for every percentage point that an investment fund lowers their projected rate of return, the required annual pension fund contribution as a percent of salary goes up by a bit less than 10%. The implications of these facts should be clear to anyone involved in the issue of public employee pension benefits.

This post is in response to an email received from someone who, after reading the previous post, asked what the impact might be on required annual contributions to pensions if the assumptions are changed so that the years retired are shortened. The implication was that a 30 year working, 30 year retired scenario is an unlikely average, since on average, employees who log 30 years of government service do not survive an additional 30 years in retirement. But when analyzing the variability of required pension fund contributions based on 20 year and 25 year retirements, while assuming 30 years of work, the results are still noteworthy. Here they are:


In the above table, the first set of four rows show various scenarios based on a pension equivalent to 90% of final salary, the second set of four rows show various scenarios based on a pension equivalent to 60% of final salary. One might suggest the first set of rows depicts public safety workers, representing approximately 15% of California’s 1.85 million state and local government workers, and the second set of rows depicts everyone else working for state and local government agencies in California.

For each pension example, the fund return is calculated at a best case of 4.75% per year, which is the official rate used by CalPERS currently, and is the rate used by most public employee pension funds across the U.S. That return is then dropped by 1.0% in each of the next three rows. It is important to note that these are “real” returns, after inflation, which is typically projected at 3.0% per year. In nominal terms, CalPERS official long-term projected rate of return is 7.75% per year. So in nominal (before adjusting for inflation) terms, the four returns evaluated on this table are 7.75%, 6.75%, 5.75%, and 4.75%. To keep this in perspective, the “risk-free,” nominal rate of return on the 10 year Treasury Bill is 3.0% per year, nearly two percent lower than our worst case scenario in this analysis.

As can be seen by reviewing the first column in the boxed set of data on the table, when someone works 30 years and is retired 30 years, and has a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 10.1% of salary – from 30.3% per year to 40.4% per year. But if you want to be more realistic (notwithstanding pension spiking, staggering losses to the funds over the past 10 years, or retroactive pension benefit increases, which this analysis does not take into account, and which make the required contributions much higher), you may consider the next two columns in the boxed area on the table.

If someone works 30 years and retires for 25 years, with a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 8.6% of salary, from 27.7% per year to 36.3% per year. If someone works 30 years and retires for 20 years, with a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 7.1% of salary, from 24.4% per year to 31.5% per year. Clearly increasing the proportion of years working to years retired reduces the impact of lowered rate of return assumptions, but the impact of a mere 1.0% drop in the projected long-term rate of pension fund returns on the required contribution is still quite dramatic.

Anyone who wishes to explore this further is invited to review two example charts below this post, one that shows the derivation of the required pension fund contribution based on a 90% pension, a 4.75% real rate of return, and 30 years working, 25 years retired, and the other using the same assumptions except for the real rate of return, which is lowered to 3.75%.

The hyper-sensitivity of required pension fund contributions to a lower projected rate of return for the fund is something that terrifies actuaries who are under pressure to release sanguine assessments of pension fund viability. It is further evidence as to why pension fund managers continue to claim that 7.75% returns are achievable despite the fact that we live in an era when the cost of money in real terms is literally negative. In our debt saturated global economy, bubble assets and zero real interest rate are a last, desperate ploy to stave off deflation. As the major currencies of the world – all representing economies that carry debt up to their eyeballs – compete to out-devalue each other, the debt eating panacea of inflation shall remain elusive. Yet the masters of the universe on Wall Street, and in their public employee pension fund bridgeheads throughout America, claim they can still earn the returns they earned when the credit binge was in full bloom.

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Quantifying the Impact of Pension Spiking

July 25, 2011

While much has been made of the impact of pension “spiking,” it is helpful to quantify just exactly how much pension spiking will cost taxpayers, and how ill-prepared an otherwise adequately funded pension account is for this practice. In the two sets of examples below, the same assumptions and the same analytical model is used as in the previous post “What Payroll Contribution Will Keep Pensions Solvent?“; 30 years working, 25 years retired, pay in real dollars doubling between the hire date and the retirement date, and various rates of return.

In this analysis, each block of data has three rows. The first row shows the amount by which the final pay is “spiked,” i.e., increased by a disproportionate amount through a large pay raise, cashing in of accumulated sick time, or other methods that increase pay more than it would ordinarily increase. The second row shows how much would have to be set aside as a percent of payroll each year and contributed into the employee’s pension fund, in order to ensure the fund would have sufficient assets to pay out the calculated retirement pension for 25 years. The third row puts this another way, by showing how much money would need to be in the employee’s pension fund at the time they retire. There are three sets of three rows, representing the results under three different return on investment scenarios; a 4.75% rate of return over the life of the fund (after adjusting downwards for 3.0% inflation), which is CalPERS official rate of return, along with most other public employee pension funds, then a 3.75% real rate of return, then a 2.75% real rate of return. One is encouraged to remember that a 2.75% “real” rate of return equates under these assumptions to a 5.75% actual, or nominal return. To keep this in perspective, the risk-free 10 year treasury bill earns a 3.0% annual rate of return.

In the example immediately below, this model is applied to calculate the impact of a 10%, 20% and 30% spiking of final year pay (columns 2, 3, and 4) for a public safety employee, retiring after 30 years with a pension equivalent to 90% of their final year of pay. The baseline case of zero spiking is provided in column one. This analysis is not to suggest that all public safety workers, who represent about 15% of California’s roughly 1.85 million state and local government workers engage in spiking, or, for that matter, that the other 85%, the “non-safety” government employees in California, engage in spiking. Pension spiking is a reality that is pervasive in some agencies and jurisdictions, and nonexistent in others. In some cities and counties in California it is having a dramatic impact on pension fund solvency and the rates of contribution necessary to compensate for it. The purpose of this analysis is not to identify where and when spiking is occurring, only to quantify how much it costs when it does occur. The worst case example of spiking used here of 30% is not unusual.

To understand the above table, compare the 2nd row in each three-row block of numbers, starting with the case that uses a 4.75% real rate of return for the pension fund. The impact of an employee collecting a pension equivalent to 90% of their final pay who successfully increases their final year of salary by 30%, in order to increase their pension by the same amount, is to require their employer to contribute not 27.7% of their salary into a pension fund every year for the entire 30 years they work, but 35.7%. That is, when an employee collecting a 90% pension manages to spike their final salary by 30%, it means an additional 8.0% of salary would have had to have been contributed to their pension fund every year for their entire 30 year career working. Referring to the 3rd row in each three-row block, one can see that the impact of a 30% final year spike in pay is to require the pension fund at the time of retirement to have nearly $1.7 million accumulated, vs. $1.3 million in the baseline case.

The next table provides this same information for non-safety government employees, in cases where after a 30 year career they collect a 60% pension. This would represent pretty much the absolute lowest pension a state or local government employee in California might expect after 30 years. Teachers, for example, after 30 years of service are eligible to apply a 2.5% factor to the number of years they worked, which equates to a pension equivalent to 75% of their final salary. In this example, again referring to the first three-row set of data, which represents our best case, since it utilizes CalPERS official 4.75% real rate of return on invested funds, without spiking, the employee would have to contribute 18.5% of their pay into their retirement plan for 30 years, and would have to accumulate $870K at the end of their career in order to fund a 25 year retirement. If they manage to spike their final year of pay by 30%, they would have had to contribute 23.8% of their salary into their retirement plan for 30 years, and they would have to amass $1.13 million in their retirement fund by the end of their career.

These examples indicate that the impact of spiking is dramatic. Whenever a government employee exploits loopholes in their pension formulas and rules in order to spike their final year’s pay, there is a huge cost to taxpayers. Referring to the charts again, if a retiree earning a 90% pension only spikes their final year of pay by 10%, their payroll contribution for the 30 years they worked would still need to have been increased by nearly 2.7%. If they spike their final pay by 20%, their payroll contribution for the 30 years they worked would need to have been increased by over 5.4%. In many cases, just these relatively small amounts of spiking, 10% and 20%, spell a required increase to the annual contribution to the pension fund that is greater than the entire amount they themselves contribute via payroll withholding. The taxpayer pays nearly everything.

A final disquieting observation can be had by referring to the two boxes in each example, one in the upper left corner of the data set, and one in the lower right corner. The boxed datapoints in the upper left indicate how much is typically set aside for pensions based on the official projected real rate of return, 4.75%, and zero spiking of final salary. In the case of the 90% pensioner, 27.7% of payroll must be set aside, and at retirement those accumulated set asides, plus interest, must equal $1.3 million. In the case of the 60% pensioner, 18.5% of payroll must be set aside, and at retirement those set asides, plus interest, must equal $871K. But what happens if both pension spiking occurs, and the pension fund is required – by the intervention of reality – to lower their projected real rate of return for their funds by 2.0%, down to a real rate of return of 2.75%, or a nominal rate of return of 5.75%? The compounding effect of these combined outcomes is truly frightening.

In the case of the 90% pensioner who spikes their final salary by 30% at the same time as the pension fund reduces their long-term earnings projection to 2.75%, instead of setting aside 27.7% of payroll each year, they would have had to set aside 61.4% of payroll each year. Instead of accumulating $1.3 million in their pension account by the year of their retirement, they would have had to accumulate $2.1 million.

In the case of the 60% pensioner who spikes their final salary by 30% at the same time as the pension fund reduces their long-term earnings projection to 2.75%, instead of setting aside 18.5% of payroll each year, they would have had to set aside 40.9% of payroll each year. Instead of accumulating $871K in their pension account by the year of their retirement, they would have had to accumulate $1.4 million.

This is not an extreme scenario. While pension spiking is not pervasive, it is common. And anyone who thinks the worst case investment returns contemplated here are unlikely – a nominal return of 5.75% – needs to consider how long public sector pension funds that manage over $3.0 trillion in assets can continue to rely on hedging and other high-risk Wall Street tricks to outperform the risk-free rate of the 10 year U.S. Treasury bill, which is only 3.0% per year. Pension spiking causes dramatic increases to the amount necessary to fund pensions all by itself. When viewed in combination with what may well be an inevitable reduction in the projected rate of return for pension funds, pension spiking can play a material role in making an extraordinarily challenging situation even worse.

How Rates of Return Affect Required Pension Contributions

April 27, 2011

In the post “How Rates of Return Affect Required Pension Assets,” the point is made that depending on the rate of return achievable by the pension fund, there are significant changes to what level of assets are required for that fund to remain solvent. This post takes a slightly different approach; looking at an individual pension participant, how do pension fund rates of return affect how much they will have to contribute into their pension each year?

To make this estimate, the same set of assumptions are used in this post as in the previous post; they are:

  • The participant works for 30 years and they are retired for 30 years.
  • The participant earns a pension equivalent to 66% of their final salary.
  • The participant’s salary, in real (inflation adjusted) dollars, doubles at an even rate between the time they begin working and when they retire.
  • The rate of return and the rate of inflation are held constant throughout the 60 year period under analysis.
  • The rate of inflation is assumed to be 3.0% per year (this is CalPERS official projection, and is consistent with the historical average for the last 90+ years).

Here’s what we get:

There are a lot of takeaways here, but the most important is this:  Even at a return of 7.5% per year, which is actually slightly below CalPERS official long-term projected annual return of 7.75% per year, using these assumptions there is a contribution requirement of 24% of salary per year. This is well above what most cities and state agencies contribute to their employee pension funds each year. But what if pension funds acknowledge they will NOT be earning 7.75% per year any more? What if their earnings merely keep up with inflation?

As shown on the chart, for every 1.0% the real rate of return drops, the annual pension fund contribution as a percent of salary will go up by 10% or more, i.e., if the fund’s real rate of return drops from 3.5% to 2.5%, the amount required to be contributed into the fund as a percent of salary will go from 33% to 43%.

CalPERS spokespersons love to tout the “computer models” and “investment experts” who are confident they can continue to extract a long-term 7.75% return per year. But notwithstanding the fact that these are a lot of the same experts who had computer models that predicted the Dow Jones Average would reach 35,000 by 2005, or that there “might” be a housing bubble,  their confidence ignores several factors:

– The long-term inflation adjusted performance of publicly traded equities in the United States is not quite 3.0% per year, even taking into account dividend reinvestment. The Dow Jones average in 1930 was 286 (ref. Yahoo Finance), and the CPI was 17.1 (ref. Bureau of Labor Statistics). The Dow Jones average at the end of 2010 was 10,856, but the CPI had risen to 216.7. This means the inflation adjusted long-term performance of the Dow Jones average over the past 80 years was a paltry 1.4%. Compare this to CalPERS official long-term, inflation adjusted projection of 4.75% per year.

– Don’t rely on inflation to bail out pensions. The 2.0% annual cap on COLAs automatically lifts when pensioners have lost 20% of their purchasing power; the liability will then remain proportionally intact. This means it remains the fund’s real rate of return, after inflation, that has to be maintained.

– The potential of the U.S. economy to grow over the past 60 years, fueling these higher-than-sustainable historical returns for CalPERS and other pension funds was for two reasons that will not apply today: (1) the U.S. economy 60 years ago was the world’s only intact post-WWII economy, and grew at an extraordinary rate as we exported manufactured goods to the recovering economies elsewhere in the world. Today our manufacturers face formidable competition from developed and emerging economies all over the planet, (2) as the U.S. began to encounter global competition over the more recent decades, the U.S. embarked on a debt binge that is coming to an end.

– In past decades pension funds represented a smaller slice of the economy, meaning that they could beat the market without causing distortions. Today pension funds are the single biggest source of new investment in the U.S. They can no longer expect to beat the market. They are too big.

– A related challenge is the fact that pension funds are now servicing a growing number of retirees. The ratio of pensioners to active workers who participate in pension funds is approaching 1-to-1, meaning that fund withdrawals to make pension payments is reducing demand for equities because the pension funds are doing more selling than ever before. This, too, puts downward pressure on equities.

– The recent rise in equity values has to be viewed in the context of the above factors, which means what goes up may be coming down, but also in the context of the strength of the dollar. As the dollar devalues, the real value of U.S. equities shrinks apace. But if the underlying viability of these companies has not changed, their dollar denominated equity value has to adjust upwards in order for their value to stay neutral when compared to foreign currencies. And if the dollar strengthens (since all nations are competing to devalue their currencies these days), the value of U.S. equities – all else being equal – will fall again. And, to complete the thought, if the dollar doesn’t eventually rebound against foreign currencies, domestic inflation will offset any gains in equity values driven by dollar devaluation.

A serious discussion about what rate of return gigantic pension funds can really earn in America in this era, as opposed to previous eras, has not yet taken place. The performances of massive government worker pension funds hold dire implications for taxpayers who are on the hook to cover the difference whenever expectations do not meet reality. For these reasons, it would behoove CalPERS and other pension funds to trot their economists into the limelight to defend their assumptions, instead of hiding behind soundbites uttered by public relations specialists with well-modulated voices.

How Rates of Return Affect Required Pension Assets

April 15, 2011

While pension finance is a relatively obscure discipline that requires of its practitioners expertise both in investments and actuarial calculations, it is a mistake to think the fundamentals are beyond the average policymaker or journalist. One policy question of extreme importance to discussions about the future of public worker pensions is how much pension funds can legitimately expect to earn over the long term. The reason this question is critical is because the more the pension fund earns, the lower the annual contribution will have to be. Just how much lower each percentage point gain offers is startling.

In the first table (below), conservative assumptions are offered towards estimating how much the pension funds of California’s state and local workers must earn each year. The number of active state and local government workers is fairly well documented at 1.85 million (including K-12 and higher education). The $68,000 per year annual salary is actually low, since that is the average salary, and pension fund calculations are based on the higher final salary. This means the $68,000 figure is accurate for estimating the money flowing into the pension system, but will understate the amount of money flowing out of the pension system to retirees. Similarly, the 33% average pension fund contribution is on the high side – typically only public safety employees, who are only about 15% of the state and local government workforce, receive employer contributions equivalent to over 30% of their salary into the pension funds. But based on these numbers, each year California’s state and local workers pour $41.5 billion into the state and local government worker pension funds.

The second half of the table (above) estimates how much money comes out of the state and local government pension funds each year. This projection shows a ratio of retirees to active workers of 1-to-1, based on the assumption that – using full-career-equivalent workers and retirees – the average worker is employed for 30 years, and is then retired for 30 years. This is an important concept to linger on, because the concept of “full-career-equivalent” is crucial to understanding why CalPERS spokepeople are accurately able to claim the “average” pension is only $25,000. In reality, that is only true when considering all employees who ever passed through the CalPERS system – even if they only worked for five years and barely vested a pension.

This concept also applies when calculating the “average pension as percent of salary,” where based on existing pension formulas, 67% is on the low side when dealing with full-career-equivalent numbers. Typical government pensions in California accrue between 2.0% and 3.0% per year – teachers, who are 40% of the public workforce, who work 30 years receive 2.5% per year, public safety workers, who are 15% of the workforce, receive 3.0% per year. It is common for public utility workers to receive 2.7% per year. So estimating an average pension of $45K per year, based on 67% of $68K, is almost certainly on the low side. This means California is projected to pay out $83 billion per year to their retired state and local workers. In reality, current formulas and data suggest they will pay out a lot more than that.

The point of the first chart is that the money going into the government worker pension funds in California is estimated to be $41.5 billion per year, and the amount of money being paid out of these pension funds to retired state and local government workers is projected to be $83.8 billion per year. This means $42.3 billion per year will have to be earned on the market through investment returns.

The second chart (below) shows what the necessary asset balance is based on various rates of return. The calculation is extremely straightforward – take the amount that has to be earned each year, and divide that amount by the rate of return the fund is going to deliver:

As can be seen, at a rate of return of 7.75%, which is CalPERS (and most other government worker pension funds) official long-term projected rate of return, “only” $545 billion in assets are necessary for these funds to be “fully funded.” But if this rate of return is dropped by a few percentage points, the necessary assets mushroom. What if pension funds were required to stop making risky investments and instead had to buy treasury bills? Don’t be surprised if that is necessary someday – for example when nobody else will buy T-bills… What an elegant solution to the challenges posed by quantitative easing. But California’s pension funds would go from being fully funded at $545 billion to being only 39% funded – and the necessary asset balance would increase by $864 billion to $1.4 trillion.

The reason we don’t hear more about the serious discussions over what the real long-term rate of return should be for these massive funds is because they are occurring behind closed doors, and the reason for that should be clear by studying the above table. How on earth would Californian taxpayers cough up $864 billion? How and when will the actuaries and investment experts deliver this shock to the system?

Because current pension benefits have a cost-of-living-adjustment cap of 2% that is lifted as soon as the purchasing power of the pension benefit erodes to between 75% and 80% of the original award, don’t expect inflation to bail out the government worker pension system. Even more alarming than the nominal projection of 7.75% used by CalPERS is their real rate of return – they assume 3.0% inflation and expect an inflation-adjusted return of 4.75%. That may have been possible in the days when asset bubbles were inflating which collateralized what is now $50 trillion in debt (commercial, household and government combined) in the U.S., but those days are done.

Even if pension funds – that in aggregate in the U.S. currently manage about $3.0 trillion in assets – could earn a 4.75% (long-term, after inflation) return, they would do so by beating the market. This means other market participants, i.e., individual small investors with their 401Ks, would lose. This predatory relationship between large public sector pension funds and the small investors is ignored by apologists for public sector pension funds, who both claim “Wall Street” is to blame for the 2007 market crash, yet rely on Wall Street to deliver for them, decade after decade, higher than market rates of return.

Finally, if taxpayers are to fund market investments for the purposes of augmenting the retirement assets available to workers in the United States, it should be for ALL workers, not just government workers. As it is, however, the existence of gigantic, aggressively managed funds whose entire risk is borne by taxpayers creates a dangerous distortion in the investment market. It is ridiculous that in an era of unavoidable debt reduction, when the federal composite borrowing rate is less than 1% per year, taxpayer supported Wall Street entities – i.e., government worker pension funds – are claiming they can earn 7.75% per year. The longer they cling to this fiction, elevating their portfolio risk to achieve the unachievable, the more volatile the entire market will become.

Policymakers have to face the fact that when these projected rates of return come down, and they will, government worker pensions as they are currently formulated will disappear. Hiding behind the “complexity” of this issue, and instead echoing the sanguine talking points of CalPERS spokespersons who have not sat in the closed door meetings, is simply irresponsible.

California Voter Attitudes Towards Reforming Special Interests

March 11, 2011

The California Policy Center has completed another survey of California voters to measure attitudes towards special interest politics, with an emphasis on the influence of big corporations and public employee unions. Here are the principal findings and conclusions. Interviews with 605 randomly selected individuals were conducted between February 27th and March 3rd, 2011. The margin of error associated with the results is +/- 4.0%.

General voter attitudes towards Sacramento and special interests:

  • 60% of voters believe “things in California have gotten off on the wrong track,” 21% believe “things in California are going in the right direction,” and 20% aren’t sure.
  • Asked to note the “top three” issues in California of most concern, the following top issues were selected: state government spending 40%, unemployment 38%, education 36%, health care 18%, state taxes 16%, crime 8%, the environment 5%.
  • 78% of voters believe “major changes” are needed in the way state government is run.

The survey found voter attitudes strongly in favor of reforming all special interests, evidenced by 81% of respondents agreeing with the following: “Corporations and unions are spending millions of dollars to get their way in Sacramento; we need to cut off campaign contributions so politicians will pay attention to the voters instead of catering to special interests.”

Surprisingly, California voters appeared quite open-minded about whether or not Republicans could fix the problem of special interests, shown by only 43% agreeing with, and 53% disagreeing with the following statement: “Corporations and Republicans can’t be trusted to write a proposal that would limit their own influence; this proposal is really about hurting the Democratic party by crippling labor unions who represent average working families.”

It is also interesting that even in California, a significant number of voters, 40%, believe that collective bargaining should be banned in the public sector. Only 50% of California voters currently support collective bargaining for government workers.

Voter attitudes towards specific special interest reform options:

(1) A proposition to prohibit state and local governments from collecting union dues used for political purposes through paycheck withholding?

Favor 46%
Oppose 51%
Undecided 3%

(2) A proposition to ban all corporate and labor union contributions to candidates and political parties, and prohibit government employers from deducting from employees’ paychecks any amount used for political purposes?

Favor 65%
Oppose 31%
Undecided 4%

(3) A proposition to make all political contributions by government employees voluntary, and prohibit government employers from deducting from employees’ paycheck any amount used for political purposes?

Favor 75%
Oppose 23%
Undecided 2%

(4) A proposition to prohibit collective bargaining by labor unions on behalf of state and local public employees?

Favor 40%
Oppose 50%
Undecided 10%

To view the entire survey results, click here. To read about the earlier surveys, click here and here.

What Percent of California's State and Local Budgets Are Employee Compensation?

February 11, 2011

Earlier this week the California Policy Center posted an analysis that estimated about two-thirds of California’s state budget covers state employee compensation expenses. This was in response to a widely quoted estimate that the number was only about 12%. Due to the huge disparity in these claims, and the implications having the correct number may have on the debate over public employee compensation, we decided to dig a little deeper.

For expert information, we talked with two individuals at the California Office of Legislative Analyst, Jason Sisney, the Director of State Finance, and Nick Schroeder, Public Employment and Fiscal Oversight. Both of them confirmed that state government employees compensation consumes about 12% of the state general fund budget. But the devil is in the details.

Probably the best source for information on state expenditures in California is available at “California Budget Information,” produced by the state Dept. of Finance. Using this data, and corroborating this data with other sources, this post will produce another, more in-depth estimate of what percentage of the state budget is consumed by personnel expense, as well as what percentage of state and local budgets combined are consumed by personnel expenses. Both Sisney and Schroeder, who ought to know, stated that arriving at a meaningful figure is “nearly impossible,” but they agreed with the rough percentages that will be arrived at in this analysis.

Beginning with how much state employees make in average salary; sources of information include the following:

State Finance Department: Personnel Years and Salary Cost Estimates, 2009-2010, which shows 345,777 full-time state employees in that year, collectively paid $23,104,763,000 in that year, which averages $66,820 each. This does not include benefits.

U.S. Census Bureau: California State Government Employment Data, March 2008, which shows 338,725 full-time employees who were collectively paid in that month $2,002,723,495, which averages $70,950 per year each, not including benefits. This page includes important additional information, the “full-time equivalent” number of part-time employees, 48,212, collectively making an additional $2,798,685,61, which averages $58,050 each. Using this data, the composite average of full-time plus full-time equivalent employees working directly for the state of California is $68,102 per year for 393,989 employees, which costs $26.8 billion per year. What about benefits?

To reprise the data presented in our last post, the overhead rate we used came from a 2010 study entitled “The Truth about Public Employees in California: They are Neither Overpaid nor Overcompensated,” from the Institute for Research on Labor and Employment at the University of California, Berkeley. In this study, the authors found “Public employers underwrite 35.7% of employee compensation in benefits.” If 35.7% of compensation is in the form of benefits, this means 64.3% of compensation is in the form of wages. To develop an overhead rate, you would determine what percentage 35.7 is of 64.3, i.e., the value of state employee benefits is equal to 55.5% of their compensation. This means total state worker compensation is $26.8 billion plus 55.5% of that number ($14.9 billion), which equals $41.7 billion.

What percentage of the total state budget does this represent? Here the numbers become even more subjective, because the state budget includes vast categories of “pass throughs” which are monies not used by the state, but passed on to local governments and agencies. A breakdown of the major categories of state revenues can be found at the Dept. of Finance’s “Chart B, Historical Data, Budget Expenditures,” where for the 2009-2010 year they report total revenue of $206.1 billion, breaking down into $87.2 billion into the General Fund, $23.5 billion into “Special Funds,” $6.3 in Bond Funds, and 89.1 of Federal Funds.

When speaking with Jason Sisney at the California Dept. of Finance, he claimed that virtually 100% of the Bond Funds and Federal Funds were pass-throughs to local governments and agencies, and that about 70% of the General Fund are passed through to local governments and agencies. This leaves between 30% of the General Fund and 100% of the Special Funds to pay for state employees, i.e., $49.7 billion. Using these numbers, state employee compensation consumes 84% of the state revenues that are retained by the state and not passed through to local governments.

To remain fair, the amount that employee overhead truly costs the state is debatable. One may argue it is overstated here, since it is applied to full-time equivalent figures for part-time employees. But typically part-time state employees accrue benefits at the rate they work; if they work 50% of the time, for example, their pension benefits accrue at half the rate they might accrue if they were working full time. One may also argue the Berkeley study was estimating an overhead rate of 37.5%, not that benefits consume 37.5% of compensation – which is what they said. But even if that is the case, realistic reductions to the estimated long-term returns on pension funds will pump that overhead rate right back up from 37.5% to 55.5%.

While this analysis attempts to estimate the percent of state spending consumed by employee compensation, the discussion would not be complete without at least considering what costs the state imposes on taxpayers by virtue of better-than-market benefits that are so-called soft costs. For example, if the state did away with the “9/80″ program, a benefit that is, after all, unheard of by the ordinary private sector worker, how many fewer bureaucrats (40% of the state workforce) could they hire? The 9/80 program essentially provides state bureaucrats with an extra 26 days off per year, which means if all of them got this benefit and it were eliminated, the state could eliminate 10% of their bureaucrats, or 4% of the entire state workforce. This is just one example of hidden costs of staggering magnitude.

Since such a high percentage of state revenues are passed directly through to the local governments and agencies in California, what percentage of their spending is to compensate local government employees? This is a very difficult question to answer, since there are over 400 incorporated cities, 58 counties, and countless administrative districts for, for example, K-12 schools and public utilities. But let’s try:

The average local government worker, using the Census Bureau as the source; Public Employment Data 2008, Local Governments, indicates 1,451,619 (full time equivalent) local government workers made on average $64,285 per year, which totals $93.3 billion. Add 55.5% benefits overhead to that amount and you have a total of $145.1 billion in local government employee compensation per year in California. How much did local governments spend?

For this data it is again necessary to rely on census data, referencing compilations put together by analyst Chris Cantrill on the website USGovernmentSpending.com. His chart (click the tab “Local”), Local Government Spending California, 2009 estimate, shows local government spending totaling $270 billion. This suggests that spending for employees in local governments in California, on average, consumes about 54% of the total local government budgets.

With respect to local government, however, a collective figure can be quite misleading. At the county level where social services agencies issue direct payments to needy citizens, or in the case of public utilities and construction projects where there is substantial allocations for capital investments, the percentage of funds allocated to employee compensation may be relatively minute. In smaller incorporated cities, on the other hand, the percentage of funds used for employee compensation may be 90% or more.

Readers are invited to review these calculations and the underlying assumptions. But given California’s state and local governments combined spend nearly $200 billion per year to compensate state and local workers, a discussion of whether or not their compensation might be reduced to market rates is not only relevant from the standpoint of fairness, but may also be a meaningful option towards reducing budget deficits.

State Politics and Right to Work Laws

January 24, 2011

While much analysis has been forthcoming on the impact of the November 2010 election on the U.S. Senate and U.S. House of Representatives, it is harder to get compiled information on how that election affected political control of 50 states. An excellent source for this much larger body of data comes from the American Legislative Exchange Council, who just released the report Political Profiles of State Legislatures 2011, which, when compared to their report from last year, Political Profiles of State Legislatures 2010, provides dramatic evidence of the changes wrought by the November election.

A brief summary of what November 2010 did to the political landscape of the 50 state legislatures is this: Before the election the Republicans controlled both houses of 16 state legislatures (counting Nebraska, which only has a Senate), the Democrats controlled both houses of 27 state legislatures, and 7 states had one party controlling each house. After the election the Republicans controlled both houses of 26 legislatures, the Democrats controlled both houses of 15 state legislatures, and 9 states had one party controlling each house. If you simply total up the number of state legislators affiliated with the major parties, in state senates the totals changed from 1,025-897 in favor of Democrats before the election to 1,023-889 in favor of Republicans afterward, and in state houses the totals changed from 3,023-2,354 in favor of Democrats before the election to 2,916-2,466 in favor of Republicans afterward

There was an equally dramatic shift in Governor’s races, changing from 26-24 in favor of Democrats before the November election, to 29-20 in favor of Republicans afterward (Rhode Island’s Lincoln Chafee is an independent).

The three tables below put the shift in America’s political landscape into a more detailed perspective, dividing the states into three groups; Republican controlled states, Democratic controlled states, and so-called “battleground” states. The tables and sub-tables progress, somewhat subjectively, in a progression from solidly Republican to solidly Democratic.


In the above table it can be seen that in ten states, with a total population of 40 million, there are not only Republican governors and Republican control of both houses, but in both legislative houses the Republicans hold a 2/3rds majority (Nebraska’s unicameral senate has 2/3rds of the legislators self-identifying as Republicans). In another eleven states, with a total population of 98 million, there are Republican governors and Republicans control both houses, with three state senates and one state assembly having 2/3rds Republican majorities. It is interesting to note that all of the ten most solidly Republican states are right-to-work states, and five of the eleven next most solidly Republican states are right-to-work states. It is also interesting to note that at least three of these states, Texas, Florida and Arizona, with combined populations totaling over 50 million, have substantial percentages of ethnic minorities. Probably the most significant factor on this table is the presence of the big industrial states of Michigan, Ohio and Pennsylvania, totalling 34 million people, which have moved out of the battleground category – if not the solidly Democratic category – and come under the decisive control of Republican politicians.

The next table displays battleground states, where neither political party exercises clear dominance. These states are separated into two groups, the first with Republican governors, and the second with Democratic governors.


In the first group of eight states, totaling 33 million in population, four of the Republican governors have a Republican assembly and, with the exception of Alaska whose senate is split equally, a Democratic state senate. In the other four, the Republican governors confront a state legislature where both houses are Democratic. Five of these states are right-to-work states. The second group of eight states, totaling 52 million in population, have Democratic governors – with five of those governors confronting state legislatures where both houses are Republican. Only one of these states is a right-to-work state. Probably the most interesting battle ahead is New York, where a Republican senate faces off against an overwhelmingly Democratic assembly, with a Democratic governor whose positions on some issues are becoming, if not nonpartisan, emblematic of a schism developing between Democrats who are controlled by public sector unions who simply want to raise taxes, and those who are realistically trying to confront fiscal realities – and save their party – through reinventing social programs and reducing public employee compensation packages.

The next table shows those states remaining solidly under Democratic party control. Leading the list are the colossal states of California and Illinois, with a combined population of over 50 million people, and a colossal set of financial challenges.


If one compares the total population of states that have Democratic governors and 2/3rd majorities in both state houses, 15 million, with the total population of states that have Republican governors and 2/3rd majorities in both state houses, 40 million – and the total population of states that have Democratic governors and simple majorities in both state houses, 70 million, with the total population of states that have Republican governors and simple majorities in both state houses, nearly 100 million – the true size of the Republican victory last November can be readily apprehended – as well as what this portends for 2012.

Another interesting correlation – because it is nearly absolute, is the presence or absence of right-to-work laws in states that are either solidly Republican, 10 for 10, or solidly Democratic, 0 for 4. As one picks their way through the states in between these extremes the correlation continues to apply – the more Republican a state is, the more likely it is to be one of the 22 states who have right-to-work laws. A good source of information on right-to-work can be found on the Labor Union Report website in an article entitled “Advancing the Right to Work.” And if one wonders whether or not the presence of right-to-work laws is the cause or the effect of Republican political control in various states, it is helpful to consider precisely what these laws mean. Here is the definition of right-to-work, in summary:

A “Right-to-Work” state forbids workers from being fired for non-payment of union dues or fees.

A “Non-Right-to-Work” (or forced unionism) state, allows unions to negotiate contracts with companies that require union dues and/or fees to be paid. If a worker refuses to pay union dues or fees (often referred to as agency fees), or falls behind, the union can demand that the worker be fired from the company. The company, by contract, must comply and fire the worker.

Looking at these definitions in the light of day, it is difficult to understand what possible justification there is for forcing someone to join a union if they don’t want to. Compulsory unionism, especially in the public sector, provides unions with the ability to pretty much force their membership to pay union dues. In turn, union dues are used, especially in the public sector, to elect politicians who will create and expand government programs in order to increase the number of unionized government workers, as well as increase pay and benefits to government workers. In most states where Democrats still wield formidable control – New York, Illinois, and California – the source of their power is the absence of right-to-work laws combined with the power of public sector unions.

Ultimately, the solution to the financial crises facing state and local governments lies in how politicians and voters respond to the power of public sector unions. In this regard, the political landscape which has suddenly turned blue states into red states in unprecedented numbers could be short-lived. Because the Democrats themselves have realized their party is controlled by unions, especially public sector unions. They have realized that because they are paying unionized government workers total compensation packages that dwarf what ordinary private sector taxpayers can ever hope to make, there is no longer any money left to continue worthy social programs or infrastructure projects. How Democrats resolve this dilemma, that they have created a unionized government monster that is consuming the productive resources of this country for its own gain, instead of the public interest, yet this monster is the source of nearly all the money they have available for their political campaigns, is the key to what happens in American politics in the elections of 2012.

Calculating Public Employee Total Compensation

December 19, 2010

A study released late last year, sponsored by U.C. Berkeley’s “Institute for Research on Labor and Employment” entitled “The Truth about Public Employees in California: They are Neither Overpaid nor Overcompensated,” contains its conclusion in its title, but whether or not this study is presenting the “truth” or not is worthy of further discussion.

According to this study, “the wages received by California public employees are about 7% lower, on average, than wages received by comparable private sector workers; however, public employees do receive more generous benefits. An apples to apples comparison, or one that controls for education, experience, and other factors that may influence pay, reveals no significant difference in the level of employee compensation costs…”

While the study goes on to explain the variables they evaluate in order to arrive at an “apples to apples” comparison, it never actually estimates the actual amount of wage disparity between the average compensation packages for California’s public employees compared to California’s private sector employees, so here goes:

Using California’s Employment Development Department’s 2010 report “Labor Market Trends,” (ref. figure 1) it is evident there are 2.4 million Federal, State and Local employees in California, 12.2 million full-time private sector employees who work for an employer, and another 1.4 million “self-employed” private sector workers. Worker compensation as reported by the Bureau of Labor Statistics don’t include estimates for California’s 1.4 million self-employed workers, nor does the U.C. Berkeley study. If these estimates were included, they would almost certainly skew average private sector compensation downwards, since according to California’s Employment Development Dept., self-employment does not include anyone working for a Corporation or LLC, even their own, meaning that more highly-compensated professionals fall within the BLS statistics for California’s 12.2 million private sector employees, whereas the remaining self-employed include part-time workers, independent contractors; in aggregate, a marginally compensated multitude who have to cover 100% of their benefits  – a 2x payment for social security, and zero paid time off, or free insurance of any kind, or automatic pay for sick time and retirement.

Returning to the 14.6 million people in California who either work for the government or are employed by private sector firms, according to the Bureau of Labor Statistics report “May 2009 State Occupational Employment and Wage Estimates California,” their average annual compensation (not including employer funded benefits) in 2009 was $49,550. In order to extract from that average the compensation for the 2.4 million government workers in California, one may refer to Census Bureau data for 2009 as follows – for 394,000 state workers ref. State Government Employment Data, and for 1,451,619 local government workers ref. Local Government Employment Data. If you combine and average the compensation data for these two groups, you will arrive at an annual average pay – before any employer funded benefits – of $65,000 per year.

Making just one assumption, that California’s 500,000 federal workers not included in these statistics are earning the same average salary as the state and local workers, it is possible to subtract the figures for government workers from the pool of 14.6 million workers, who, according to the BLS earn an average of $49,500 per year, in order to calculate an average private sector (not including self-employed) compensation of $46,528 per year. This means that the Berkeley study has “normalized” for education, experience, and “other factors” to turn a 40% disparity between public and private sector compensation into a 7% disparity.

Before accepting the conclusion of this study, there are several assumptions it makes, both factual and subjective, that should be questioned; starting with this: “The average age of a typical worker in state and local government is 44 compared to 40 in the private sector.” The benefit of coming up with a “fact” like this, of course, is because by combining this fact with the assumption that compensation increases with seniority, the researchers are able to normalize downwards the average compensation of public employees significantly. For example, if one assumes an average career of 30 years, and that a worker’s inflation-adjusted salary will double between when their career begins and when they retire, than one might reasonably conclude a “normalized” compensation average for the public sector worker must be adjusted downwards by 13.3% in order to represent an “apples-to-apples” comparison with the younger private sector workers. Here again, it is serendipitous for the Berkeley study to exclude self-employed individuals, since according to California’s EDD, for workers over forty years of age, fully 50% of the civilian workforce is self-employed (ref. EDD’s California’s Self-Employed Workforce,” figure 6).

Another normalizing factor used by the researchers is gender, wherein they claim 55% of the state and local government workers are women, compared with 40% of the private sector. This is partially skewed, again, by the fact that 60% of self-employed people are men, but even adjusting for that, this fact, if accurate, represents another huge opportunity for the researchers to “normalize” compensation statistics in favor of reducing the disparity between private and public sector pay. Without having access to the work-papers used by the researchers, one can only speculate, but here’s the logic that could have been used: If women make 30% less than what men make for comparable work requiring comparable credentials, and if women represent 55% of the government workforce compared to 40% of the private sector workforce, this means an “apples-to-apples” comparison would require adjusting the public sector compensation upwards by  17% (55% x 30%) vs. an upwards adjustment of only 12% (40% x 30%) for the private sector workforce. Voila, another 5% of pay disparity is vaporized. The problem here is whether or not the “30%” pay differential rests on valid assumptions. When one normalizes for technical degrees vs. non-technical degrees, and the actual supply and demand parameters for jobs that might be deemed “comparable,” as well as for the significant percentage of women who opt out of full-time work in favor of being moms, much of this gender disparity may disappear. Whether or not there remains a gender bias in employee compensation is certainly open to debate, but the researchers should be transparent regarding how significant this factor was in their calculations.

The other major normalizing factor employed by the researchers is education, because the researchers have determined that 35% of the private sector workforce have earned at least a bachelors degree, compared with 55% of the public sector workforce. The researchers also claim the “return to education,” wherein people who have higher educational attainment should earn more, is skewed; that is, they claim private industry rewards education more than the public sector. What the study ignores here, however, is the fact that educational attainment yields qualitative dividends – what degrees are being compared? Is a sociology degree from Sonoma State the equivalent of a computer science degree from Stanford? Is it appropriate to pay more to employees with advanced degrees even if the job they do doesn’t require that level of education? The study doesn’t address this.

In any event, by excluding 1.4 million self-employed and part-time workers, and “normalizing” for seniority, gender and education, the Berkeley study has concluded that an average public sector salary in California is not 40% more than an average private sector salary – and without any normalizing adjustments, 40% higher wages for public sector vs. private sector workers appears to be a conservative estimate – but instead, that public sector wages are 7% less than private sector wages.

When turning to comparing benefits for public employees vs. private sector workers, it is important to understand that salary is the base on which the most significant benefits are calculated. In particular, the largest benefit category in the public sector is retirement pensions, which are calculated based on final salary earned. This means that even if public employee pension benefits were calculated in the same parsimonious manner as social security, they would apply to an average compensation base that is 40% larger for public employees. Moreover, public sector pensions are linear, meaning the benefit increases exactly proportionally to the amount of base salary without limit, whereas social security benefits increase at progressively lower rates, meaning that the more one makes, the lower percentage of their final salary will actually be realized in a social security benefit. These sound like nuances, but have enormous financial consequences.

Before independently estimating the disparity between public employee and private sector employee benefits, here is the Berkeley study’s specific conclusion: “public employers contribute on average 35.7% of employee compensation expenses to benefits, whereas private employers devote 30% of compensation to benefits.

By far the biggest single cost for employee benefits in both the public and private sector is the cost of retirement security. The calculation in the private sector is relatively straightforward – the employer withholds 6.2% for social security and 1.45% for medicare from employee paychecks, and contributes an equivalent amount themselves as a benefit – 7.65%. Some private sector employers will match a 401K contribution up to 6.0%, but the percentage of private sector employers who do this, combined with the number of private sector employees who take full advantage of this, is probably under 25%, which means the average overall retirement benefit paid by private sector employers is probably 10% (or less) of total wages.

For the public sector in California, the cost of retirement security borne by the employer is something else entirely. The typical formula for non-safety employees (about 85% of the public sector workforce) is to multiply the number of years they work by 2.0%, and apply the resulting percentage to their earnings in their final year of active employment. For example, if a non-safety employee works for 30 years, then 60% of their final salary will be the amount of their retirement pension. For safety employees, the typical formula is the same, but based on a 3.0% per year accrual. In the public sector, unlike with social security, the money contributed each year to fund the future retirement benefit is invested by a pension fund, which means the value of this benefit – and the funding required each year to ensure the pension fund remains solvent – must be calculated based on the expected investment returns of the pension fund. This is a matter of great controversy.

In the California Policy Center study “What Payroll Contribution Will Keep Pensions Solvent?,” a best-case and realistic-case set of scenarios are offered:

(1) At a real rate of return of 4.75% per year, a worker would need to set aside an additional 20% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 60% of their paycheck.

(2) At a real rate of return of 4.75% per year, a worker would need to set aside an additional 30% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 90% of their paycheck.

(3) At a real rate of return of 2.75% per year, a worker would need to set aside an additional 36% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 60% of their paycheck.

(4) At a real rate of return of 2.75% per year, a worker would need to set aside an additional 54% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 90% of their paycheck.

For this independent estimate of the value of public sector employee pension benefits, using an assumption that 15% of public employees receive the enhanced “safety” pension, and assuming that the real rate of pension fund returns going forward will be 3.0% per year (still quite optimistic), it is necessary to contribute an amount equivalent to 38% of the average public employee’s pay in order to keep their pension solvent. Since, on average, public employees contribute about 5% of this amount in the form of withholding, an additional 33% has to be contributed by the employer. Many public employees receive supplemental retirement health insurance, for which few of them contribute anything at all in the form of withholding. It is certainly accurate to value this additional benefit as at least twice the amount of medicare, which adds another 3.0% per year.

Adding this all up, using conservative assumptions, the employer contribution to retirement security in the private sector is at most 10% of average salary, whereas in the public sector the employer contribution is at least 36% of average salary.

When assessing the value of current benefits granted public employees, most reviews of public sector benefit schedules suggest the standard package is a comprehensive set of benefits – for example, if one refers to the State of California’s Dept. of Personnel Administration, some of the current benefits include health insurance, dental benefits, a vision program, long-term care insurance, and long-term disability insurance. While these benefits are partially funded through employee withholding, the amounts withheld almost never exceed 50% of the premium, even for dependent coverage. To suggest that current benefits for public employees are, on average, less generous than the average current benefit for private sector employees strains credulity. What about the millions of part-time workers and self-employed people, who have to pay 100% of whatever health insurance they can afford – at premium rates that aren’t discounted and guaranteed by the insurance companies the way they are for the huge state employee bargaining units? What about all the small companies out there, employing at least 50% of full-time private sector workers, who can barely afford to offer basic health insurance, much less dental, vision, long-term care and long-term disability? It would be conservative indeed to simply assume the cost of current health insurance and other current benefits paid for by the employer is the same for both public and private sector workers, at approximately 5.0% of payroll.

The other significant factor to assess when estimating the value of public sector benefits is the amount of paid time off enjoyed by public sector employees vs. private sector employees. On this matter the Berkeley study makes a claim that they simply must substantiate; they state: “public employees receive considerably less supplemental pay and vacation time.

Perhaps to rebut this preposterous claim one must revert to anecdotes, but here at least are some quantitative considerations: there are 723,000 teachers in California who work for the government either in primary and secondary school or in higher education. Every one of these instructors and administrators works about 180 days per year, which when one considers there are 260 weekdays in a year (52 weeks x five days per week), indicates that teachers in California get 16 weeks of paid days off each year. What about college professors who only teach one class per week, yet enjoy total compensation packages worth $138K per year (ref. The Real Reason for College Tuition Increases). If you review compensation studies for safety employees in the city of Costa Mesa (ref. The Price of Public Safety), or firefighters in Sacramento (ref. California Firefighter Compensation), you can see, for example, that before overtime, full-time service for a veteran firefighter in Sacramento requires them to work, on average, two 24 hour shifts per week. Does the Berkeley study normalize for any of this? Compare vacation time in any public entity in California against private sector norms – the average vacation days awarded in the public sector allocate employees after about 10-15 years of service 20 days of vacation per year, and by the end of their careers, up to 30 days of vacation per year (ref. CA Dept. of Personnel Administration, Leave Benefits). This amount of paid vacation is rarely offered to employees in the private sector – with many small companies offering virtually no vacation to their employees, a generous assumption might be 10 days, half as much as public sector vacation benefits. With respect to paid holidays, the typical public sector benefit is at least 12 days, while small private companies often only award six (Christmas, New Year, Memorial Day, July 4th, Labor Day and Thanksgiving), if that. In addition to vacation and holidays, many local governments and various state units also offer paid “personal days,” something nearly unheard of in the private sector. It is also common for sick time to be accrued without limit in the public sector, also something nearly unheard of in the private sector. And self-employed workers, of course, get nothing.

In order to continue to make conservative assumptions, however, one may estimate the average number of paid days off in the private sector to be 20 per year (probably high) and the average number of paid days off in the public sector to be 30 per year (probably low). How does this all add up?

The average public sector worker makes $65,000 per year, with the employer contributing an additional 21,450 for their retirement pension, $1,950 for their retirement health insurance, $3,250 for their current health insurance and other benefits, and they earn vacation worth an additional $10,575 – making their average total compensation $102,225 per year. It is interesting to note that the benefits as a percent of total compensation in this analysis agree with the Berkeley study – 36.4% vs. 35.7%, because the Berkeley study has almost certainly understated the value of the required pension fund contribution, which is another reason why the assumptions made here to estimate the value of all the other public employee non-pension benefits are probably conservative.

The average private sector worker makes $46,500 per year, with the employer contributing an additional $4,650 for their social security, medicare, and 401K, $2,325 for their current health insurance and other benefits, and they earn vacation worth an additional $4,113 – making their average total compensation $57,558 per year. The average private sector worker’s benefits as a percent of total compensation in this analysis is 19%, not 30% as claimed in the Berkeley study. And again, the Berkeley study failed to consider any of California’s 1.4 million self-employed and part-time workers in the pool they evaluated .

It is left to the reader to decide which numbers are more accurate, the numbers put forward here, or the numbers put forward by the Berkeley research team. Similarly, it is left to the reader – and the voter – to decide whether or not the services provided by California’s state and local governments, and the skills required to render them, entitle California’s public servants to earn, on average, $102K per year, compared to average annual earnings of $57K by those of us whose taxes sustain them.

California Voter Attitudes Towards Public Sector Unions

December 13, 2010

UnionWatch recently commissioned a survey of 800 voters in California to explore public support for measures to rein in the power of public employee unions. Here are the principal findings and conclusions. The interviews were conducted between September 29th and October 5th, 2010. The margin of error associated with the results is +/- 3.5%. To summarize some of these:

Do California Voters View Public Employee Unions as Having Too Much Influence?

People tend to view public employee unions as very influential: The survey looked at this in some detail and found the same: 51% of the voters believe labor unions representing public employees have too much influence in state and local government.

Questions about specific public employee unions only yielded the result that the CTA is seen as too influential, followed by the Correctional Peace Officers. Even those two specific unions are less likely to be seen as influential than the generic phrase ‘labor unions representing public employees.

For the most part all subgroups of the electorate agreed with this question; we found some differences but they were relatively small. Significantly more likely to feel public employee unions have too much influence are:

√ Males over 45: this group is both more likely to pay attention to the news and more informed of current affairs, and is more conservative particularly on fiscal issues.

√ Conservative Republicans

√ Males who are political independents; in the last few years this has been a fairly conservative group on fiscal issues

Significantly less likely to feel this way are

√ Union members

√ Younger women (under 45)

√ African Americans

Other salient union issues raised with voters were inability to fire, followed by pension abuse, followed by salary disparity. Here are the survey results on these topics:

√ 62% feel it is accurate to say that unions make it impossible to for a government employee who is not doing his or her job

√ 64% feel it is accurate to say that unions use their political influence to get pay and benefits for public employees that we simply cannot afford.

Also:

√ 43% feel public employees make more than people in comparable positions in the private sector, 19% about the same amount and 16% feel they make less. Twenty-two percent did not know enough to say.

√ 62% feels public employees get more generous pensions than people in the private sector, 13% about the same and 9% feel public employee pensions are less generous. We asked a different version of this question which included a more complete description of benefits, mentioning health and dental, paid vacations and sick leave. The results were the same, however.

More information does make a difference. Respondents were asked relatively early in the questionnaire whether people felt something needed to be done to limit the influence of public employee unions, and asked a similar question at the end of the questionnaire; in between our respondents were exposed to a large number of the pro’s and con’s of doing so. The later question shows a substantially higher level of support for limiting the influence of public employees:

Question 15: is legislation needed to limit the influence of unions representing public employee?  Needed 45 Not needed 45

Question 60: Would you support or would you oppose passing laws to limit the influence of public employee unions? Support 60 Oppose 34

The most problematic question is what to do. Here are responses to three options:

A follow up question asking people to select which proposal they liked best provided a slightly different view of things, this one suggesting voluntary membership is a somewhat stronger candidate:

People don’t ‘get’ the connection between union dues and excessive pay and benefits.

When we asked questions connecting the dots between union influence and pay and benefits people agree the questions were accurate by 2 to 1 margins.

People don’t want to deal with part of the problem (union contributions) they want to deal with all campaign contributions (and include corporate contributions). The survey confirmed this finding. As we reported earlier, 59% of the voters support a measure to no longer allow government to withhold that portion of dues that is used for political purposes. We half sampled this question with a different version that banned both government withholding and corporations withholding political contributions from their paychecks. We found substantially stronger support for the version of the question that included the language on corporations (70%) then the language that did not (59%).

A different question on this issue looked at it from the opposite angle, by looking at the impact of the argument unions have used against previous reform efforts. A clear majority finds it convincing that it is unfair to restrict public employee unions without also doing something about the influence of corporations:

The survey also looked at the context in which this issue is likely to be debated. The findings of these questions generated few if any surprises. The dissatisfaction of the voters with the direction California is going in has been document in many other surveys; also well known is that this dissatisfaction goes well beyond a concern about the economy, but also includes governance. Our look at this confirmed this, finding in addition that there is a large difference between state government and local government. People are far more likely to think that state government in Sacramento needs to change than that their local government needs to change:

The same difference was found for the extent to which people feel decision making is driven by special interests, rather than made to the benefit of the citizenry. When it came to state government, 72% felt decisions are made to benefit special interests. In the case of their region’s local government 46% felt this was the case, while 45% felt decisions are made for the most part to benefit residents.

The pension crisis in particular is likely to be an on-going problem that will provide support for the argument that change is needed to limit the influence of public employee unions. As we have mentioned most people are aware that public employee pensions are too rich and agree that you can connect union influence to excessive pensions. In addition to these we found substantial support for pension reform, even when questions were asked the ‘pushed back’ with the opposing point of view:

√ 67% supports a proposal to shift new hires to a 401K plan, while keeping current employees on the retirement system that is in place today.

√ Support for this proposal was dramatically lower (48%) when a carve-out was included for police and fire fighters. People who want pension reform want to reform all pensions. The open ends suggest that there is some awareness of the contracts with the prison guards, although very few people mentioned it.

√ 48% agreed reform is needed in view of the $500 billion unfunded liability, while 39% agreed there was a problem, but that we should not reduce pensions, for police and fire fighters in particular.

Fundamental attitudes:

Our previous work on attitudes towards labor unions has found consistently that the voting public can be divided into 3 groups. First a group of hard core union supporters, typically on the left or members of union families. Second a group of hard core anti-union folks, typically conservative men. The 3rd is an in between group which does not have strong feelings one way or the other.

The problem with union reform measures is that the core anti-union group is well short of 50% of the vote, and unions have been successful in persuading the middle group to vote with union supporters.

It may be that as a result of the pension scandal the math is changing a bit, at least as far as California is concerned. When at the end of the questionnaire we attempted to do such a segmentation we found that the size of the anti union group was well over 50% of the vote. This is not to say that this is true in California today. We used questions at the end of the sample to conduct this segmentation, and found it after our sample had heard about and been asked about a variety of pension / budget etc., and that our questions were focused specifically on public employee unions. In other words, the data suggest that with some education a coalition greater than 50% of the vote can be built.

It continues to be true that majorities of the voters agree with both sides of the debate; for instance:

√ 60% agree that unions are doing to government what they did to the airline, auto and steel industries.

√ 65% agree police officers need strong union protections

However, the current fiscal crisis and news coverage of the pension abuses have created an opportunity in which a majority of the voters supports reforms. A question (Q39) that best summarizes the relative balance of opinion found the 54% agrees with the premise that reform is needed, while 37% feels it is unfair to limit public employee unions without also limiting the influence of corporations.

This question also allows us to look at demographic segmentation:

√ Political ideology appears to be the most significant driver: liberals oppose reform, while conservatives support it. Partisan differences match ideological differences as do regional differences.

√ Other demographics don’t have much of an effect; age and gender differences are minimal, for instance.

√ Among people who are currently union members 40% agrees reforms are needed, while 50% agree with the union point of view. Former union members and people who have never been union members agree with the case for reform 60% of the time.

Persuasion:

We tested a variety of arguments for their persuasive effect and found there were some with a reasonably good impact. We use a scale that asks people how convincing they find an argument; our rule of thumb is that to pack some punch at least 30% should find something very convincing. If 40% responds that way you’ve got something and scores of 50% or higher are very powerful. Most of the arguments we tested (Q40 to Q48) hit the 30% benchmark and a few hit the 40% level:

√ Public employee unions spend $250M / year on political activities

√ Double dipping on pensions, make more in retirement then when they were working

√ LA unfired spends millions on teachers it cannot fire

Conclusions:

1. Because of the budget crisis and publicity covering the pension abuses a measure to limit the influence of public employees has good odds of passing. Core attitudes are not violently anti-union, but there are enough people who see problems with public employee unions. It is important to remember that we only got a clear majority of support for reform at the end of the questionnaire. In the early portions of our interview our sample split down the middle on the question whether reform is needed.

2. There are good arguments to support reform, mostly highlighting the magnitude of the influence of unions and the abuses that have resulted. The pension issue is a big one, but the public is impressed by other problems as well.

3. While the impact of arguments is good, it is our belief that it is more important to get the correct measure. The differences in support levels between the various options we tested is very large; although this is an apples to oranges comparison the differences in support for policies is larger than the differences in impact of various arguments. To put this point differently, there is a majority support for reform, but the specifics of reform will be at least as important as the arguments in determining the ultimate outcome;

a. Easiest to sell is making union membership voluntary.

b. Hardest to sell (probably) is a measure to ban government collection of dues for political purposes.

c. It will be a lot easier to sell a measure that deals with both corporate and union contributions than with one that only deals with union contributions.

To view the entire survey results, click here.

Public Sector Unions & Political Spending

September 23, 2010

Working from the bottom up, it is virtually impossible to extract accurate figures to quantify just how much money public sector unions spend on political activity. For example, money spent at the state level on politics, as tracked by the National Institute on Money in State Politics, or, in California, as tracked by the California Fair Political Practices Commission, only track one subset of political spending. These figures, staggering though they may be, don’t show data for local races (every city council, county board of supervisors, water board, school board, police commission, fire commission, etc.) – and, equally significant, these databases are unable to clearly identify the source of donations that have been run through foundations or independent expenditure campaigns, or political parties – often several times – before appearing on a candidate or issue campaign’s disclosure report.

For these reasons, in order to get a good idea of what public sector unions are really spending on political activity, you have to work from the top down. Using California as an example, you can estimate how much public sector unions spend on state and local politics each year if you can accurately identify three variables: (1) How many public sector workers are members of unions, (2) what the average annual union dues payment is per worker per year, and (3) what percentage of union dues are used by the unions for political activity.

Answering the first question is probably the easiest. According to the U.S. Census Bureau, in California in 2008 there were approximately 400,000 state government workers (ref. 2008 Public Employment Data, State) and approximately 1,450,000 local government workers (ref. 2008 Public Employment Data, Local). This means there are about 1.85 million state and local government workers in California.

To determine how many of these workers are unionized, there are at least two sources available, one is an authoritative study from around 2002 entitled “California Union Membership, A Turn of the Century Portrait,” which references data from the California Dept. of Industrial Relations, as well as data from the U.S. Census Bureau, and corroborates this data with a series of surveys administered to union locals throughout California. This study determined that, at that time, 53.8% of California’s public sector workers were unionized.

Another more recent source of information comes from UnionStats.com, an online database, updated annually, that tracks union membership and coverage, constructed by Barry Hirsch (Andrew Young School of Policy Studies, Georgia State University) and David Macpherson (Department of Economics, Trinity University). Using data from the U.S. Census Bureau and the Bureau of Labor Statistics, they have compiled a variety of interesting data, including “Union Membership, Coverage, Density, and Employment by State and Sector, 1983-2009.” By clicking on the 2009 link provided under this section on the left column of their home page, a spreadsheet comes up with a number consistent with the earlier 2003 findings, that is, 55.8% of California’s state and local government workers are now unionized. This means there are just over 1.0 million unionized state and local government workers in California. How much do they pay each year in dues?

According to a July 7th, 2010 guest editorial published in the San Jose Mercury entitled “Teachers’ unions political funding inappropriate,” authored by reform activist Larry Sand, “Teachers’ dues in California average about $1,000 per teacher per year, with about 30 percent of it going for political spending.”

What about police, firefighters, corrections officers, and other public safety personnel – virtually all of whom are now unionized in California – who comprise about 13% of the state and local government workforces – about 240,000 employees? How much do they pay annually in union dues? According to information provided by Vallejo, California’s post-bankruptcy City Manager, Joseph Tanner, and as reported by George Will in a Sept. 11th, 2008 Washington Post column entitled “Pension Time Bomb,” “using fiscal 2007 figures, each of the 100 firefighters paid $230 a month in union dues and each of the 140 police officers paid $254 a month, giving their unions enormous sums to purchase a compliant city council.” If this is typical, it would equate to at least $2,750 per year in union dues for police and firefighters in California. Even if the Vallejo situation is far from typical, it’s probably accurate to estimate California’s public safety workers pay their unions at least $1,000 per year in union dues.

Between teachers and public safety employees you have accounted for about 55% of California’s unionized public employees. Getting information on each of the unions may yield more startling total union revenues, but if you simply assume that public employees who are bureaucrats, nurses, administrators, maintenance employees, etc., are paying on average $500 each year in dues to their unions, then you can calculate the average payment for the entire 1.0 million unionized California state and local public employees is $750 per year. This is probably a conservative estimate, but using this number yields a total dues revenue to California’s public sector unions of $750 million per year. How much of this is used for political activity?

Returning to Larry Sand’s commentary, 30% of CTA funds are allegedly used for political activity. Most inside observers I’ve talked with suggest the percentage is higher than this, for a variety of reasons. If you review the California Fair Political Practices Commission website, don’t just look for data on election financing. Review the public disclosures by lobbying firms, and click on the pages that list their clients. Despite the unceasing uproar over the pernicious influence of “corporate lobbyists,” estimates of how much of the overall revenue to lobbying firms come from the public sector nearly always exceed 50%, and the source of this money is not just public sector unions, and their many political action committees and other organizations, but also from public agencies themselves! If one considers the level of power exercised by union operatives over public agencies – where the political appointees who supposedly manage these agencies come and go, but union power is a continuous reality – you can begin to imagine how the political agenda of taxpayer-funded public agencies and the public sector unions who influence these agencies are usually one and the same.

Another argument supporting the estimate that at least a third of union dues go to support political activity – if not much more – is the ability of the unions to reallocate money to political activity from their general fund when they choose. A recent example, reported on July 7th, 2010 in the Education Intelligence Agency blog post entitled “California Teachers Association Shifts $2 Million of Dues Money to PAC,” states the following:  “CTA very much wants Jerry Brown elected governor and Tom Torlakson as state superintendent of public instruction. So, for a single year, they increased the PAC allocation to $26.30 [per month, up from $18.30 per month], without raising total dues any additional amount. This maneuver will generate an additional $2 million or more for the PAC.” How this loophole works in California is also explained, “This sleight-of-hand would not be permitted at the federal level. But because state law allows the union to collect dues and PAC money in the same lump sum, CTA can claim that the general fund money is not the exact same money being added to the PAC coffers.”

There’s more. When assessing public sector union influence on politics, there are in-kind contributions that, while reportable, cannot be objectively quantified. What would it cost a private sector interest to send busloads of activists to events to demonstrate for the TV cameras, or use other assets such as existing office resources, in order to wage a political campaign? Whenever a public entity does this, they are required to register this as an “in-kind” donation, and assign a monetary value to this. But these in-kind values can be understated in the mandatory disclosures, and more significantly, these are contributions that are in addition to the hard costs that are funded through collection of union dues.

Finally, what about the indirect influence of public sector unions, the way they trade on the credibility of public servants – firefighters and police officers in particular – to advance their agenda in political campaigning? What about the influence of activist teachers in our public schools and universities, who advocate ideologies consistent with their union leadership when teaching impressionable young students, even when these ideologies may be counter to mainstream political sentiment?

Taking all this into account, the calculations that come out of this exercise are probably conservative – California’s 1.0 million unionized public sector employees times dues of $750 per year times one-third equals $255 million per year, over $20 million per month. This is what public sector unions are probably spending on politics, and for the many reasons detailed here, this number is probably quite low compared to reality.

The implications of this are clear: In California, public sector unions enjoy an overwhelming financial advantage in virtually every political cause or candidate they support. They have used this advantage to take over California’s State Senate and State Assembly, as well as many of California’s City Councils, County Boards of Supervisors, and various local administrative districts, especially in the major urban areas. In turn, this has resulted in years of relentless and unwarranted increases to public sector employee pay and benefits, to the point where public sector employees in California now easily enjoy pay and benefits that are, on average, at least twice what people earn on average in the private sector. Union control of California’s state and local governments has also resulted in a big-government agenda being successfully advanced for decades, meaning the number of government jobs and programs is swollen well beyond what might be optimal for California’s economy and private taxpayers.

If none of this seems compelling given the alleged power of California’s corporate interests, one may consider the following: (1) Corporations are reluctant to fight the unions – whenever corporate interests begin to support public sector union reform, the unions threaten retaliatory legislation and initiatives. To-date, corporations have consistently backed down in the face of these threats. (2) Many corporations don’t care if the state government is inefficient via unionization. In some respects, they actually welcome the tax burden and the increased regulations, because large corporations are better able to withstand the higher overhead, and better able to employ lobbyists to garner a share of the spoils in the form of subsidies or special exemptions. Their smaller emerging competitors, however, cannot withstand these impacts, and hence are undermined as competitors. To think California’s public sector unions provide “balance” to corporate interests is naive.

Anyone who thinks it will be easy to rescue California from the grip of public sector unions is encouraged to go out and raise campaign donations from people and organizations who don’t have to give you a dime if they don’t want to. Then compare this to the $20 million per month that perpetually flows into the political coffers of California’s public sector unions through automatic withholding of union member dues. And never forget, as a taxpayer, this is your money they have used to take control and bankrupt our state.