The typical analysis of state and local government finances is that they are primarily a function of the economy. When the economy is growing well, and especially when it is growing faster than expected, local and state government finances prosper. When the economy grows, more people are employed and employees have larger paychecks. State income and sales tax revenues increase. Property tax receipts go up because the price of housing increases. Irrespective of government policies–whether of the right or the left–a “rising tide lifts all boats,” or at least all government boats. Historically, the state of the economy usually has driven government tax revenues in good times and bad.
The conventional analysis may be changing–and in a way that may lead to unanticipated fiscal shortfalls in many state and local government agencies even in the coming, 2019-20, fiscal year. The first problem is that the stock market is headed lower. Though historically local and state government budgets have been mostly influenced by the economy, now the stock market may play as large, if not a larger, role.
Every public employee pension fund in the United States is actuarially unsound. Within California, CalPERS, CalSTRS, and the many county public employee pension plans all project continuing, year in and year out, returns on investment of approximately 7%. This means that the stock market would have to double every 10 years for already underfunded public employee pension funds to remain able to pay their guaranteed benefits.
There is no way this is going to happen. The current projected actuarial return of 7% means that the stock market would have to be close to 100,000 in 2038 for pension funds to be able to pay their benefits, which is very unlikely. In the short run, the emerging bear market will require state and local pension funds to reduce their anticipated rates of return, and this will cause every government agency in the state to feel pain. A long-term diminishment in the return on investment of even one half of one percent has been estimated to cost state and local governments $5 to 10 billion per year. It is already projected–assuming an actuarial return of 7% per year on investments–that the cost of public employee retirement contributions will close to double for state and local agencies between now and 2024. If the rate of return declines as well, these costs will grow even higher.
But it gets worse. Among the elements of the federal tax reform act of 2017 was to cap the amount of a home mortgage the interest for which can be deducted at $750,000 (the amount previously had been $1 million). This makes home purchases above $750,000 effectively, after taxes, more expensive. Moreover, another aspect of the 2017 tax reform was to cap deduction of state and local taxes at $10,000, which also makes the effective cost of owning property more, since property taxes above this amount can no longer be deducted. Finally, although increasing interest rates affect all sectors of the economy, they may influence housing the most. Moreover, increased interest rates will also have a negative effect on real estate prices, thereby resulting in lower property tax revenues than projected.
There remains, finally, the overall state of the economy, apart from the stock market and real estate prices. Here, too, in large part as a result of increasing interest rates and the trade war and general instability fostered by President Trump, the rate of economic growth appears to be declining to about half of what it recently has been–from about three to three and a half percent annual growth to about one and a half to one and three quarters percent annual growth. This, too, will diminish local and state government income.
The days of fiscal wine and roses for local and state governments are over. Long term trends are finally catching up with state and local government spending and receipts. Reform of public employee pensions is long overdue and general tightening of government expenditures will also be required–starting in the 2019-20 fiscal year. Further increases in state and local taxes are unlikely in a diminishing economy.
Lanny Ebenstein teaches in the Department of Economics at UCSB. He is the author of the first biographies of Milton Friedman and Friedrich Hayek. His most recent book, Chicagonomics: The Evolution of Chicago Free Market Economics (2015), was an “Editors’ Choice Selection” in the New York Times Book Review.
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“It’s the economy, stupid.”
– Campaign slogan, Clinton campaign, 1992
To paraphrase America’s 42nd president, when it comes to public sector pensions – their financial health and the policies that govern them – it’s the unfunded liability, stupid.
The misunderstood, obfuscated, unaccountable, underrecognized, undervalued, underpaid, unfunded pension liabilities.
According to CalPERS own data, California’s cities that are part of the CalPERS system will make “normal” contributions this year totaling $1.3 billion. Their “unfunded” contributions will be 41% greater, $1.8 billion. As for counties that participate in CalPERS, this year their “normal” contributions will total $586 million, and their “unfunded” contributions will be 36% greater at $607 million.
That’s nothing, however. Again using CalPERS own estimates, in just six years the unfunded contribution for cities will more than double, from $1.8 billion today, to $3.9 billion in 2024. The unfunded contribution for counties will nearly triple, from $607 million today to $1.5 billion in 2024 (download spreadsheet summary for all CalPERS cities and counties).
Put another way, by 2024, “normal contribution” payments by cities and counties to CalPERS are estimated to total $2.8 billion, and the “unfunded contribution” payments are estimated to total almost exactly twice as much, $5.5 billion.
For starters, every pension reform that has ever made it through the state legislature, including the Public Employee Pension Reform Act of 2013 (PEPRA), does NOT require public employees to share in the cost to pay the unfunded liability. The implications are profound. As public agency press releases crow over the phasing in of a “50% employee share” of the costs of pensions, not mentioned is the fact that this 50% only applies to 1/3 of what’s being paid. Public employees are only required to share, via payroll withholding, in the “normal cost” of the pension.
Now if the “normal cost” were ever estimated at anywhere near the actual cost to fund a pension, this wouldn’t matter. But CalPERS, according to their own most recent financial report, is only 68% funded. That is, they have investments totaling $326 billion, and liabilities totaling $477 billion. This gap, $151 billion, is how much more CalPERS needs to have invested in order for their pension system to be fully funded.
A pension system’s “liability” refers to the present value of every future pension payment that every current participant – active or retired – has earned so far. In a 100% funded system, if every active employee retired tomorrow and no more payments ever went into the system, if the invested assets were equal to that liability, those assets plus the estimated future earnings on those invested assets would be enough to pay 100% of the estimated pension payments in the future, until every individual beneficiary died.
A pension system’s “normal payment” refers to the amount of money that has to be paid into a fully funded system each year to fund the present value of additional pension benefits earned by active employees in that year. When the normal payment isn’t enough, the unfunded liability grows.
And wow, has it grown.
CalPERS is $151 billion in the hole. All of California’s state and local pension systems combined, CalPERS, CalSTRS, and the many city and county independent systems, are estimated to be $326 billion in the hole. And that’s extrapolated from estimates recognized by the pension funds themselves. Scenarios that employ more conservative earnings assumptions calculate total unfunded liabilities that are easily double that amount.
With respect to CalPERS, how did this unfunded liability get so big?
An earlier CPC analysis released earlier this year attempts to answer this. Theories include the following: (1) Letting the agencies decide which type of asset smoothing they’d like to employ, (2) permitting the agencies to make minimal payments on the unfunded liability so the liability would actually increase despite the payments, (3) making overly optimistic actuarial assumptions, (4) not taking action sooner so the unfunded payment wouldn’t end up being more than twice as much as the normal payment.
One final alarming point.
CalPERS recently announced that for any future increases to the unfunded liability, the unfunded payment will have to be calculated based on a 20 year, straight-line amortization. This is a positive development, since the more aggressively participants pay down the unfunded liability, the less likely it is that these pension systems will experience a financial collapse if there is a sustained downturn in investment performance. But it begs the question – why, if only increases to the unfunded liability have to be paid down more aggressively, is the unfunded payment nonetheless predicted to double within the next six years?
CalPERS information officer Tara Gallegos, when presented with this question, offered the following answers:
(1) The discount rate (equal to the projected rate-of-return on invested assets) is being lowered from 7.5% to 7.0% per year. But this lowering is being phased in over five years, so it will not impact the 2018 unfunded contribution. Whenever the return-on-investment assumption is lowered, the amount of the unfunded liability goes up. By 2024, the full impact of the lowered discount rate will have been applied, significantly increasing the required unfunded contribution.
(2) Investment returns were lower than the projected rate of return for the years ending 6/30/2015 (2.4%) and 6/30/2016 (0.6%). Lower than projected actual returns also increases the unfunded liability, and hence the amount of the unfunded payment, but this too is being phased-in over five years. Therefore it will not impact the unfunded payment in 2018, but will be fully impacting the unfunded payment by 2024.
(3) The unfunded payment automatically increases by 3% per year to reflect the payroll growth assumption of 3% per year. This alone accounts, over six years, for 20% of the increase to the unfunded payment. The reason for this is because most current unfunded payments are calculated by cities and counties using the so-called “percent of payroll” method, where payments are structured to increase each year. CalPERS is going to require new unfunded payments to not only be on a 20 year payback schedule, but to use a “level payment” structure which prevents negative amortization in the early years of the term. Unfortunately, up to now, cities and counties were permitted to backload their payments on the unfunded liability, and hence each year have built in increases to their unfunded payments.
The real reason the unfunded liability has gotten so big is because nobody wanted to make conservative estimates. Everybody wanted the normal payments to be as small as possible. The public sector unions wanted to minimize how much their members would have to contribute via withholding. CalPERS and the politicians – both heavily influenced by the public sector unions – wanted to sell generous new pension enhancements to voters, and to do that they needed to make the costs appear minimal.
As a result, taxpayers are now paying 100% of an “unfunded contribution” that is already a bigger payment than the normal contribution, and within a few years is destined, best case, to be twice as much as the normal contribution.
Camouflaged by its conceptual intricacy, the cleverly obfuscated, deliberately underrecognized, creatively undervalued, chronically underpaid, belatedly rising unfunded pension liabilities payments are poised to gobble up every extra dime of California’s tax revenue. And that’s not all…
Sitting on the blistering thin skin of a debt bubble, a housing bubble, and a stock market bubble, amid rising global economic uncertainty, just one bursting jiggle will cause pension fund assets to plummet as unfunded liabilities soar.
And when that happens, cities and counties have to pay these new unfunded balances down on honest, 20 year straight-line terms. They’ll be selling the parks and libraries, starving the seniors, releasing the criminals, firing cops and firefighters, and enacting emergency, confiscatory new taxes.
Whatever it takes to feed additional billions into the maw of the pension systems.
Budget surplus? Dream on.
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Edward Ring co-founded the California Policy Center in 2010 and served as its president through 2016. He is a prolific writer on the topics of political reform and sustainable economic development.
How to Restore Financial Sustainability to Public Pensions, February 14, 2018
How to Assess Impact of a Market Correction on Pension Payments, February 7, 2018
How Much More Will Cities and Counties Pay CalPERS?, January 10, 2018
If You Think the Bull Market Rescued Pensions, Think Again, December 7, 2017
Did CalPERS Fail to Disclose Costs of Historic Bump in Pension Benefits?, October 26, 2017
Coping With the Pension Albatross, October 13, 2017
How Fraudulently Low “Normal Contributions” Wreak Havoc on Civic Finances, September 29, 2017
Pension Reform – The San Jose Model, September 6, 2017
Pension Reform – The San Diego Model, August 23, 2017
Gimmick – a concealed, usually devious aspect or feature of something, as a plan or deal.
In the past week, from Millbrae’s city hall to the inner sanctum of the CalPERS leviathan in Sacramento, defenders of pensions have been active. In particular, they have criticized the recent analysis, published by the California Policy Center, “How Much More Will Cities and Counties Pay CalPERS?” It would advance the ongoing debate over pensions to summarize the points of the CPC analysis, how CalPERS and their allies attacked those points, and how those attacks might be challenged.
On January 19th, in a report published online by Chief Investment Officer magazine entitled “CalPERS: Ring’s Flippant Claim of ‘Tricky Accounting Gimmicks’ Is False,” author Christine Giordano interviewed CalPERS spokesperson Amy Morgan. Tellingly, they did not discuss the substance of the CPC analysis, which specified, using CalPERS’ own data, how much more cities and counties are going to have to pay CalPERS. They focused instead on specific criticisms of CalPERS that followed those payment calculations.
As noted by the title of the report, CalPERS spokesperson Amy Morgan seemed to suggest the characterization of their accounting practices as employing “gimmicks” is not backed up by evidence. Morgan is invited to review the following evidence, after which she may join our readers in deciding whether or not “gimmicks” were employed.
GIMMICK #1 – THE CORRUPTION OF “ASSET SMOOTHING”
Asset smoothing is a practice whereby pension funds do not overestimate their assets after years of good returns, nor underestimate their assets after years of poor returns. It is a good way to avoid overreacting to market volatility. But in 2001, when the Dow Jones stock index had already been correcting for over a year and the Nasdaq was collapsing, CalPERS abdicated their responsibility to set the rules on smoothing.
When participating agencies in the CalPERS system were contemplating whether or not to follow the lead of the California Highway Patrol (SB 400, 1999) and retroactively increase pension benefits, CalPERS sent projections to these agencies in which a CalPERS actuary presented to elected officials three distinct values for the assets they had invested with CalPERS. Remarkably, that document gave these agency officials the liberty to choose which one they’d like to use – the higher the value they chose for their existing assets, the lower the cost from CalPERS to pay for the benefit enhancements they were contemplating. The usual disclaimers were present, but the mere fact that city officials were given three scenarios is suspect. Obviously these officials would be under pressure to pick the scenario that provided the biggest benefit enhancement for the lowest cost. Read “Did CalPERS Fail to Disclose Costs of Historic Bump in Pension Benefits?” for more details including several source documents.
One of the most revealing documents is exemplified by the “Contract Amendment Cost Analysis,” sent to Pacific Grove by CalPERS in July, 2001. Here is an excerpt from that document, showing the choices CalPERS offered Pacific Grove:
The available rate choices are offered under three different Alternatives:
Alternative 1 – No increase in Actuarial Value of Assets
Alternative 2 – Actuarial Value of Assets increased by twice the increase in the Present Value of Benefits due to the amendment, limited to 100% of Market Value of Assets
Alternative 3 – Actuarial Value of Assets increased by twice the increase in the Present Value of Benefits due to the amendment, limited to 110% of Market Value of Assets
To reiterate: CalPERS provided abundant disclaimers. They suggested that given recent “market volatility,” city officials “are strongly encouraged to have in-depth discussions with your CalPERS actuary about the financial consequences of any amendment.”
Now let’s get real: Further on in this same letter, CalPERS provides a breakdown of how much pension benefit enhancements will cost in terms of annual contributions as a percent of payroll under each of these three scenarios:
Alternative 1 – The actuarial value of the assets is not tampered with, the normal cost goes from 4.6% to 25.0%.
Alternative 2 – The actuarial value of the assets is lifted up to market value, the normal cost goes from 4.6% to 19.9%.
Alternative 3 – The actuarial value of assets goes up to 110% of the market value, the normal cost – to implement a massive, retroactive enhancement to pension benefits – goes from 4.6% to 6.2%.
What option would you choose, if you were a city manager whose own pension would be enhanced, or a city council member who has to answer to powerful unions whose members want more generous pension formulas?
The reason CalPERS was able to cram this through, in July 2001 as the market was cratering, was based on their decision to present various asset “smoothing” options to members. Why? Because the smoothing options they’d been using were understating the value of their assets because stock values had exploded in the final years of the 1990s. One can only speculate as to why they did this as late as July 2001 when it was obvious the internet stock bubble had popped. It’s possible CalPERS officials knew several agencies had already lobbied for pension benefit enhancements and the officials were under pressure to leave no agency behind. But to offer local bureaucrats and elected officials a choice of various asset smoothing methods was passing the buck.
Overnight, the CalPERS practice of asset smoothing went from being a prudent accounting guideline to a clever rationalization for disastrous policy decisions. If that’s not a gimmick, I don’t know what is.
GIMMICK #2 – CREATIVE AMORTIZATION OF UNFUNDED LIABILITY
When you talk about “tricky accounting gimmicks,” it’s hard to find one worse than the methods the participating agencies chose to amortize their unfunded liability. To be fair, final responsibility for these decisions usually rests with the cities and counties. But CalPERS should have tried to crack down on these practices a long time ago, and indeed, has recently become more aggressive in doing just that. The basic choice facing agencies with huge unfunded liabilities is whether they want to pay them off aggressively, or come up with creative accounting techniques that push the tough repayments into the future. For example, instead of using a “level payment” repayment calculation, many of them use a “percent of payroll” scheme which allows for graduated payments.
In practice, this means calculating a stream of payments that will pay off the liability in 30 years, but varying the payments so that as projected payroll increases, the payment increases. This allows agencies to make low payments in the early years of the amortization term, which frequently means the unfunded liability isn’t even being reduced in the early years of the amortization term. Then when the payments become burdensome, they refinance the new, larger unfunded liability, to get that unfunded payment down again, in a new tranche, again using the same “level percent of payroll method.”
Anyone who lost their home because a “negative amortization” loan conned them into buying something they couldn’t afford would likely call that type of loan a “gimmick.” Similarly, negative amortization payment schedules on unfunded pension liabilities are also gimmicks. To their credit, CalPERS is now recommending 20-year straight line amortization. Which begs the question, why didn’t they do this all along?
GIMMICK #3 – OVERESTIMATING LONG-TERM RATE-OF-RETURN ASSUMPTIONS
CalPERS spokesperson Morgan correctly claims that CalPERS returns have averaged an 8.4% return over the past 30 years. But Morgan conveniently selects the 30 year timeframe to capture all of the pre-1999 run-up in stocks that began in the Reagan years as interest rates were reduced from inflation-fighting highs of 16% (30 year T-bill in the early 1980s) and American consumers began piling on debt. The 20-year return for CalPERS investments through June 30, 2017 is 6.58%. And these last 20 years of returns are far more relevant, because not quite 20 years ago is when CalPERS began to offer pension benefit enhancements that were sold as affordable when they clearly are not.
But if CalPERS is exceeding its projected rates of return over the past 30 years, why is it only 68% funded (ref. CalPERS 2016-17 CAFR, page 4, “Funding”)? At the end of a prolonged bull market, pension systems should be overfunded. Being 68% funded would not be terribly alarming if we were at the end of a prolonged bear market, but we’re in the opposite place. How can CalPERS possibly claim their actuaries are doing a competent job, if the system is this underfunded at this point in the market cycle? For more on this, read “If You Think the Bull Market Rescued Pensions, Think Again.”
It is important to emphasize that even if CalPERS can get a 7.0% return on investment – and there is some chance that they can – why did the agency wait until it was 68% funded to announce the drop in its projected returns from 7.5% to 7.0%? The United States economy is in the terminal phases of a more than 60 year long-term credit cycle, and one might argue there is a stronger case to be made that even 7.0% is highly optimistic. But we like optimism, so never mind that for now. Why wait until 2018 to phase in that half-point drop? The actuaries at CalPERS are well aware how sensitive their payment schedules are to even half-point drops in long-term rate-of-return assumptions. Overstating returns understates true cost. Is this an accounting gimmick? Only if you can prove intent. But read on.
GIMMICK #4 – QUIETLY ALLOWING THE UNFUNDED PAYMENT TO DWARF THE “NORMAL” PAYMENT
Every year, each active worker who gets CalPERS benefits vests another year of service. This means that in the future, during their retirement years, they will have an incrementally greater pension benefit in recognition of one more year of work. To pay for that incrementally greater pension benefit in the future, additional money must be invested today. That amount of money is called the “normal” contribution. But when the “normal” contribution isn’t enough, and it hasn’t been for years, the so-called unfunded liability grows. This unfunded liability represents the amount by which invested pension assets need to increase in order to earn enough to eventually pay for all the future pensions that have been promised.
This “unfunded liability” may seem theoretical when a pension system has hundreds of billions in assets. But it has to get paid down, because when there aren’t enough assets in the pension system earning interest, higher contributions are inevitably required from the participating agencies. If the unfunded liability isn’t reduced via catch-up payments, it will grow even if the normal contributions are adequate to cover newly earned benefits.
This reality is corroborated using CalPERS’ own data, which announces that payments required, as a percent of payroll, are set to increase by 50% (in some cases much more) over the next six years in nearly every agency it serves. And where are these projected increases most pronounced? In the unfunded contribution – that payment to reduce the unfunded liability.
And why does the unfunded liability grow in the first place? Because the normal contribution is too low. Why is the normal contribution too low? Could it be because public employees are only required to assist (via payroll withholding) to pay the normal contribution? Could that be the reason that lifespans were underestimated and returns were overestimated? The actuaries obviously got something wrong, because CalPERS is only around 68% funded. You can download the spreadsheet that shows the impact of this on California’s cities and counties here – CalPERS-Actuarial-Report-Data-Cities-and-Counties.xlsx.
In the original CPC report, along with the term “gimmick,” the term “outrageous” was used. If you don’t think sparing the beneficiaries of these pensions any responsibility to share in the costs to pay down the unfunded liability isn’t outrageous, you aren’t paying attention. For example, by 2024, using CalPERS own data, the City of Millbrae will be paying CalPERS a normal contribution of $1.0 million, and an unfunded, or “catch-up” contribution of $5.8 million – nearly six times as much! Is Millbrae just an isolated example? Not really.
Again, using CalPERS’ own data, in 2017-18, their 426 participating cities will contribute $3.1 billion to CalPERS, an amount equal to 32% of their cumulative payroll. In 2024-25, just six years from now, they are estimated to contribute 5.8 billion, 48% of payroll. And the normal vs unfunded contributions? This year in the cities in the CalPERS system, 13% of payroll constitutes the normal contribution and 19% of payroll constitutes the unfunded contribution – for which current employees and retirees have no responsibility to help pay down. In 2024-25? The normal contribution is estimated to increase to 16% of payroll, and the unfunded contribution, rising to $4.0 billion, is estimated to increase to 33% of payroll.
Put another way, today the unfunded “catch-up” pension contribution for California’s cities, cumulatively, is 140% of the normal contribution. By 2024-25, that “catch-up” contribution is going to be 210% of the normal contribution, more than twice as much! And participating individual employees and retirees have zero obligation to help pay it down, even though that payment is now twice as much as the normal payment.
But it’s not the fault of the individual beneficiaries. The responsibility lies with CalPERS and the politicians they reassured for all these years, using gimmicks.
Let’s review these practices: (1) Letting the agencies decide which type of asset smoothing they’d like to employ, (2) permitting the agencies to make minimal payments on the unfunded liability so the liability would actually increase despite the payments, (3) making overly optimistic actuarial assumptions, (4) not taking action sooner so the unfunded payment wouldn’t end up being more than twice as much as the normal payment.
“Gimmicks”? You decide.
THE CASE OF MILLBRAE
On January 22, the San Mateo Daily Journal published an article entitled “Millbrae officials question, criticize pension cost report.”
The paper’s Austin Walsh reports that Millbrae officials told him that using staffing projections to calculate Millbrae’s future pension burden won’t work because Millbrae has fewer employees than most municipalities. Here’s how Millbrae’s Finance Director DeAnna Hilbrants put it: To limit pension costs, Millbrae contracts for positions in police, fire and public works departments. Quote: “Most notably, Hillbrants pointed to Millbrae joining the Central County Fire Department with Burlingame and Hillsborough and contracting with the San Mateo County Sheriff’s Office for law enforcement.”
What Millbrae officials are saying is that because they contract out much if not most of their personnel costs, their pension contribution is a small percent of their total budget. What they neglect to acknowledge is the fact that the Central County Fire Department and the San Mateo Sheriff’s Office themselves have pension costs, which are passed on to Millbrae to the extent Millbrae uses their services. Millbrae may have made a financially beneficial decision to outsource its public safety requirements. But they did not escape the pension albatross.
CALPERS IS NOT UNIQUE
What has been described here does not just apply to CalPERS. It is the rule, not the exception, for every one of California’s pension systems to engage in the same gimmickry. The consequences for California’s cities, counties, agencies, and system of public education are just beginning to be felt.
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One year ago the Dow Jones stock index was 19,756. Today it closed at 24,211, an increase of 23%. Pretty good for one year! When the stock market does well, pension funds do well, since that’s where these funds place most of their portfolio investments. But CalPERS, the largest public employee pension system in the United States, is not doing well. Why not?
The table below shows how well CalPERS, the California Public Employees Retirement System, has performed with its investments over the past twenty years through their most recent fiscal year ended 6/30/2017.
As can be seen, CalPERS, like the stock market, and like all pension systems that rely primarily on the stock market to drive the performance of their investments, has had good years and bad years. Back in the late 1990’s, when the stock market was roaring, CalPERS put together a string of great years, including a whopping 20.1% return in 1997 and a 19.5% return in 1998. Then in 2001, after the internet bubble burst, CalPERS lost 7.2%, followed by a 6.1% loss in 2002.
A similar up/down story can be told during the stock market recovery in the mid-2000’s, where CalPERS logged a 16.6% return in 2004, 12.3% in 2005, 11.8% in 2006, and a spectacular 19.1% in 2007. Then when the housing bubble burst, CalPERS lost 5.1% in 2008, followed by a 24.0% loss in 2009. Now the stock market has turned in eight years of positive returns. What could go wrong?
CalPERS Investment Returns, 1997-2017
One could argue that stocks rise and fall unpredictably but over the long run their positive performance is reliable. This is validated by looking at the average returns for CalPERS over the past 20 years, as shown in the next chart. As can be seen, over the past 20 years, CalPERS has generated an average return of 6.58%, very close to the average they claim they can earn, currently set at 7.0%.
CalPERS Average Return Over Various Time Spans Ending 6/30/2017
Ok, so CalPERS said they could hit 7.0% and over the last twenty years, they hit 6.58%. What’s wrong?
Actually, a lot is wrong. Here goes:
(1) It doesn’t seem like very much, but the difference between a 7.0% rate of return and a 6.58% rate of return is actually quite significant. The impact of compound interest over the multi-generational time span of pension fund investments magnifies the impact of even a small reduction in how much pension systems expect to earn. For example, the difference between 7.0% and 6.58% is 0.42%, a little less than one-half of one percent. But that 0.42% reduction increases the required annual contribution as a percent of payroll from 23.0% to 25.8% – and as a fully funded plan becomes unfunded, as will be seen, the “catch up” contributions start to pile up.
(2) While CalPERS currently assumes a long-term annual rate of return of 7.0%, back in 2001 they assumed an 8.25% rate of return (ref. CalPERS 2001 CAFR, “Economic Assumptions,” page 73). The gap between 8.25% and 6.58% is huge. If pension system actuaries predict an 8.25% annual investment return, a fully funded plan only has to receive annual contributions of 16.4% of payroll, compared to 25.8% based on a prediction of 6.58% returns. Based on this analysis, back in 2001, when CalPERS should have been collecting 25.8% of payroll, they were only collecting 16.4% of payroll.
Before all these numbers start to swim about incoherently, the next chart shows the bottom line result. Back in 1999, CalPERS had invested assets totaling $149 billion. The present value of their pension obligations to current and future retirees was estimated at $116 billion, which is to say they had a surplus of $33 billion. Put another way, their assets exceeded their liabilities by 128%. No wonder they worked with public sector unions to increase pension benefit formulas. But by 6/30/2016 – the most recent data available – CalPERS had assets of $298 billion, but they had liabilities of $436 billion. That is, they were now only 68% funded, and they had a deficit of $138 billion. The chart below dramatically illustrates this nearly twenty year decline in the financial health of CalPERS.
CalPERS Unfunded Liability by Year, 1999-2016
The financial challenges facing CalPERS are even worse than this chart indicates, because when a pension system is fully funded, it can much more easily absorb a few years of market losses. But despite earning 6.58% over the past 18 years, CalPERS has gone from 128% funded to only 68% funded. They have gone from having a $33 billion surplus to having a $138 billion deficit. When the investments that have soared over the past eight years endure the inevitable downward correction, CalPERS will be even more underfunded. Put another way, pension systems should be registering deficits like this at the end of a bear market, not after eight years of a bull market.
The bull market did not save the pension funds. If it had, CalPERS would have a surplus, not a $138 billion deficit.
Taxpayers, public servants, elected officials, pension fund management, public sector union leadership: Beware. Public sector pensions are not financially healthy, they are going to require higher contributions every year, and what precarious stability they do maintain is only a result of a bull market that is very long in the tooth.
CalPERS Annual Report 2017 (ref. page 120 for data on funded status 2007-2017)
CalPERS Annual Report 2008 (ref. page 64 for data on funded status 2006-2002)
CalPERS Annual Report 2004 (ref. page 56 for data on funded status 2001-1999)
The source for the pension contributions required at various rates of return were calculated using the downloadable Excel spreadsheet “Pension Analysis Model.” A tutorial on how to use that model is provided in the article “A Pension Analysis Tool for Everyone.” Please note this Excel model calculates the “normal contribution” only, and does not calculate required contributions as a percent of payroll for underfunded systems.
The Coming Public Pension Apocalypse, and What to Do About It, CPC Study, 2016
Marc Joffe from the Reason Foundation contributed to this article.