Any day now, the California Supreme Court will rule on what may be one of the most significant cases affecting pension reform in California history. The case, CalFire Local 2881 vs. CalPERS, challenges one of the provisions of PEPRA (Public Employee Pension Reform Act) Governor Brown’s 2013 pension reform legislation. The plaintiffs argue that PEPRA’s abolition of purchases of “air-time,” where employees who are about to retire can make a payment in exchange for more years of service applied to their pensions, is illegal. They cite the “California Rule,” an interpretation of California contract law that requires any reduction in pension benefits to be offset by providing some new benefit of equal value.
The stakes couldn’t be higher. Even though pension benefit formulas have been changed for new employees, and are now somewhat more financially sustainable, the California Rule prevents any significant pension reform for existing employees, even for work not yet performed. Changing pension benefit formulas for new employees, while helpful, are not enough. If the California Supreme Court overturns the California Rule, it will not affect the pension benefits that existing employees have earned to-date, but will allow changes going forward. For example, if a public employee has worked 15 years, and earns 3 percent per year towards their pension, if they retired tomorrow their pension would be 15 (years) times 3 percent = 45 percent times their final salary. This would not change. But if they worked another 15 years, and their pension benefit was reduced going forward, they might only earn 2 percent per year for the second half of their career.
The impact of such a change would be dramatic, since less than 20 percent of California’s public sector workforce was hired after the PEPRA reforms took effect for new employees. Reforming the rate of pension benefit accrual for future work for 80 percent of California’s workforce would have a decisive impact on the financial sustainability of the pension systems.
There are many possible ways to further reform California’s public employee pensions, and they cannot come too soon. California’s public sector employers will contribute an estimated $31 billion to the pension systems this year. Extrapolating from officially announced pension rate hikes from CalPERS, California’s largest pension system, by 2024 those payments are projected to increase to $59 billion. According to the State Controller’s office, the unfunded liability for California’s state and local public employee pension systems totaled over $250 billion in 2016. That number could be grossly understated, because one of the biggest variables affecting the amount by which a pension system is unfunded is how much a pension fund’s invested assets will earn. If pension fund earnings don’t meet projections, annual contributions have to rise to make up the difference.
Pension systems have made well publicized reductions to the amount they claim they will earn, touting these reductions as proof of their commitment to cautious, prudent management of their funds. But as reported recently by Andrew Biggs, writing for Forbes, these pension funds have quietly lowered their inflation assumption at the same time, meaning they are still claiming their investments will achieve nearly the same real rate of return. As anyone saving for retirement – or funding a pension – knows without any doubt, the real rate of return is all that matters.
California’s pension systems currently rely on a real rates of return, i.e., the nominal return less the rate of inflation, of approximately 4.5 percent. They have not substantially altered that target, despite the hoopla surrounding the reduction they made in their nominal rate of return projections. The aggressive increases the pension systems are requiring to the contribution rate are a reflection more of their crackdown on the terms of the “catch up” payments employers must make to reduce the unfunded liability than on a genuine reduction to their expected real rate of return. But can pension systems continue to earn real rates of return in excess of 4 percent per year?
For over ten years, pension systems have been the beneficiaries of the longest sustained bull market in U.S. stocks in history. From its nadir in 7,063 in February 2009, to its high of 26,743 in September 2018, the Dow Jones Industrial Average more than tripled. The compounded annual increase was 15.9 percent, while at the same time the rate of inflation averaged 1.8 percent. But trough to peak is a misleading trend. The last peak for the Dow was September 2007, when it had risen to 13,895. This more appropriate peak to peak evaluation has the Dow increasing by 90 percent over 11 years, for an annual average rate of return of 6.1 percent; adjusted for inflation, the return was 4.3 percent. Since September 2018, of course, the Dow has given up 11 percent, and who knows where it’s headed.
Because the Dow Jones Industrial Average generates returns that are nearly always in synch with the other major indexes, these results matter. In the coming years, will inflation adjusted returns on equity investments remain around 4 percent? More important, why is it that after the longest bull run in stock market history, California’s pension systems are underfunded by several hundred billion dollars? Healthy, well managed pension systems should be overfunded at a time like this.
This is the context in which California’s Supreme Court Justices will make a huge decision. The boom in investment returns could well be over, with the pension funds now facing several years of doldrums. The PEPRA reforms weren’t enough to restore financial sustainability in an economic downturn. The required pension contribution rates are already set to double, and California’s cities and counties are unlikely to all be able to handle the stress of pouring additional billions into pension systems. During the last era of pension fund surpluses, pension benefits were increased retroactively. It seems hardly unfair that contract law might also permit them to be reduced, but only from now on.
* * *
On its surface, the case heard last Wednesday by the California Supreme Court in CalFire Local 2881 vs. CalPERS doesn’t seem that important. At issue is the so-called “California Rule,” an obscure legal doctrine relating to public employee pensions. But for California’s beleaguered taxpayers, the case is one of extraordinary importance because its outcome will determine the extent to which the local governments will look to taxpayers to shore up failing pension plans even more than they already do.
Labor interests have argued that under the “California Rule,” no pension benefit provided to public employees by statute can ever be withdrawn without replacement with some “comparable” benefit, even if it’s deferred compensation for services not yet provided, and even if the Legislature determines that citizens who are not public employees are unfairly suffering as a result of prior legislatures’ mistakes.
More than a decade ago, California politicians, seeking to curry favor with public-sector labor, began enacting laws to significantly increase public employee compensation. Among these enhanced benefits were a series of laws which allowed public employees to spike their pensions. For example, a 2004 state law allowed employees with at least five years of service to purchase up to five years of additional credits — commonly labeled “airtime” — before they retire. Under this plan, a 20-year employee could receive a pension based on 25 years of contributions.
When the recession hit and many pension funds were looking at billions in unfunded liability, it was clear that the party was over. To his credit, Governor Jerry Brown presented a 12-point comprehensive pension reform plan which, had it been enacted, would have solved virtually all of California’s public pension problems. Although the California legislature rejected most of the proposals, they did address some of the more egregious abuses including the airtime benefit law which was repealed in 2013.
One has to give credit to the public-sector unions for their tenacity. Once they have secured some perceived advantage, you’d have better luck taking a steak out of the mouth of a lion than have them give it up without a fight, no matter how unjustified that advantage is.
But reasonable people living in the real world can recognize unsustainable levels of benefits when they see them. This includes local government leaders and Democrats, not just fiscal conservatives and reformers. And apparently, if Wednesday’s hearing is any indication, the courts are equally as perceptive. Several justices of the Supreme Court were openly skeptical of the union’s position that the benefit of an airtime option could never be changed, and they further appeared open to other legislatively approved reductions in future retirement benefits.
The Howard Jarvis Taxpayers Association filed an friend-of-the-court brief in the Supreme Court on behalf of itself as well as the Ventura County Taxpayers Association, advocating the interests of those who are ultimately responsible to pay the billions of dollars necessary to maintain the solvency of public pension funds – the taxpayers. Regrettably, due to mismanagement and corruption, the state’s largest pension funds have served neither public employees nor the public at large. Pension obligations at the state and local level are “crowding out” other public spending and, as a result, schools, highways and public-safety needs have been short-changed.
A ruling in support of the legislature’s ability to make modest reductions in future pension benefits would go a long way toward saving California from fiscal disaster. But more than that, it would be an important first step in correcting the imbalance between ordinary California citizens and well-funded a special interests.
Jon Coupal is president of the Howard Jarvis Taxpayers Association.