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Has Sacramento really balanced the state’s budget?

Thanks to Proposition 30 with its retroactive tax increase and an improving economy, the state claims that it has balanced its General Fund budget.  This may be technically correct but ignores some very unpleasant realities.

Claiming to have balanced the budget ignores the growing unfunded liabilities associated with public employee pensions and other unfunded retirement benefits, mainly health care.  This also ignores the fact that the state has fallen behind in maintenance and expansion of its infrastructure.

Ignoring these liabilities is possible because state and local governments in California use cash accounting.  Except for very small companies, private sector businesses are required to use accrual accounting under which increases in liabilities are required to be recorded in profit and loss statements and major assets have to be depreciated with depreciation showing up on the profit and loss statement.

Under cash accounting, only the year’s actual cash outlays are recorded in the budget.  If the state or local government doesn’t make a pension payment, it is not recorded as part of the year’s expenses.  For retiree health care, these expenses typically aren’t even funded. Even though these obligations accumulate indefinitely and are the obligation of future taxpayers, they are not required to be recognized on public agency balance sheets as long term liabilities. Similarly, the cost of  deteriorating roads and other infrastructure aren’t recorded anywhere in state and local governments’ financial statements.  There aren’t any depreciation schedules and the accumulating costs of deferred maintenance and essential expansion of the state’s infrastructure are not recorded.

How bad is this problem?  Until recently, it’s been very difficult to find and summarize these financial problems.  However, as highlighted in a recent Los Angeles Times article by Marc Lifsher, California Pension Funds are Running Dry, there is a new data source thanks to the efforts of the California state controller John Chiang (who was just elected state treasurer).  The Controller’s office has assembled data from 130 state and local pension funds and other data at ByTheNumbers.sco.ca.gov.

The following are two charts from the state controller’s website under the heading “Interesting Charts.” They are annotated to illustrate the problems that should concern us.

Total California Public Pension Fund Assets
Change Between 2003 and 2013

20150114_Fletcher_Pensions-1

As can be seen on the above chart, statewide defined benefit pension fund assets suffered a loss of 30 percent in the 2008 recession. Five years later, they have not even recovered to their pre-recession values. During this time pension liabilities have continued to grow.  How big is this problem?

Total California Public Pension Unfunded Liabilities (Officially Recognized Amount)
Change Between 2008 and 2013

20150114_Fletcher_Pensions-2

This second chart, above, shows that during the five year period between 2008 and 2013 the official unfunded liabilities of these defined benefit pension funds has grown 200 percent from $65 billion to $198 billion.  This is almost twice the size of the state’s current year General Fund budget of $107 billion.

Even this total understates the problem.  For example:

(1)  The state’s pension funds assume an investment return of 7.5 percent per year or higher and also assume there will be no recessions such as in 2008.  Single-employer private sector pension funds assume a more conservative rate of return closer to 5.0 percent per year.  California’s unfunded pension liability would increase by another $200 billion or more if a more conservative investment rate of return is used such as 5 percent (ref. “Calculating California’s Total State and Local Government Debt“).

(2)  Retiree health care expenses are largely unfunded but are an obligation for the state’s taxpayers just like pension benefits.  The best estimate we’ve see for unfunded retiree health care is $150 billion, approaching the value of unfunded pension obligations.

(3)  What about infrastructure maintenance and expansion to meet the state’s growth requirements?  The current year’s value of these costs would be reflected as depreciation expenses under accrual accounting that is required for private sector financial statements. In 2012 the American Society of Civil Engineers estimated the current unfunded infrastructure requirement necessary to upgrade California’s roads, bridges, ports, rail, dams, aqueducts and other civil assets at a staggering $650 billion (ref. “2012 Report Card for California’s Infrastructure“).

In addition to these state obligations we can’t ignore unfunded entitlements for federal Medicaid and welfare payments.  These are beyond the scope of this article but add to the problem we’re concerned about, rapidly growing unfunded obligations that will bury future taxpayers and crowd out other essential public spending.

We should also note that state and local government pension systems are not covered by Employee Retirement Income Security Act (ERISA) that single-employer private sector pension plans must conform to.  ERISA has strict requirements for minimum funding of pension plans, defines what is a reasonable rate of investment return in valuing pension fund assets, and dictates actions that must be taken if pension fund assets drop below a certain level.  None of these rules apply to California’s public employee pension funds.  ERISA also requires that pensions be funded during an employee’s working years. The cost of benefits earned today cannot be passed on to future pension fund contributors or taxpayers as can happen with public employee pension plans.

There is also an equity issue.  Should future taxpayers be required to pay for retiree pensions and health care that were earned years earlier?  The earlier taxpayers got the benefit of the public employees services without paying the full cost of these services.  These future costs will crowd out spending on schools, infrastructure, and other items.

Are we anti-public employee for questioning the level of post retirement benefits or their underfunding?  That’s not our intention.  Politicians and unions are not doing these employees any favors by underfunding their retirements.  Future taxpayers will not be able to cover the costs of these underfunded benefits and also maintain the schools, infrastructure, and other government services they need.  There will be a day of reckoning when it’s clear that there isn’t enough money set aside for these obligations and we can’t raise taxes enough to cover the difference.  We’ll be forced to recognize that all our debts and unfunded obligations can’t be met.  There won’t be any winners when this day arrives.  Nationwide, the amounts of unfunded retirement benefits, debts, and entitlements are too large for a federal bailout.

There is also an element of “heads I win tails you lose” to this issue.  The true cost of public employee retirement benefits, pensions and health care, are understated by using optimistic financial assumptions and by passing on a significant portion of these costs to future taxpayers.  However, as it stands today, the bill for any shortfall is totally the taxpayers responsibility.

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About the Author:

William Fletcher is a business executive with interests in public finance and national security. He retired as Senior Vice President at Rockwell International where most of his career was spent on international operations and business development for Rockwell Automation. Before joining Rockwell, he worked for Bechtel Corporation, McKinsey and Company, Inc., and Combustion Engineering’s Nuclear Power Division, and was an officer and engineer in the U.S. Navy’s nuclear program. His international experience includes expatriate assignments in Hong Kong, Europe, the Middle East, Africa and Canada. In addition to his interest in California’s finances, he is involved in organizations dealing with national security and international relations. Fletcher is a graduate of Tufts University with a BS degree in Engineering and a BA degree in Government. He also graduated from the U.S. Navy’s Bettis Reactor Engineering School.

Public Sector Pension Plans Do Not Pass the "Smell Test"

“Pew’s relationship with the Arnold Foundation does not pass the smell test,” said Meredith Williams, Denver-based executive director of the National Council on Teacher Retirement.
–  “Pension Funds Press Pew to Cut Arnold Foundation,” Philanthropy Today, March 4, 2014

If you’re looking for an example of how, increasingly, political debate in America is framed as a battle between tainted – and very powerful – special interests who harbor nefarious personal agendas, instead of a rational exchange of competing facts and logic aimed at finding optimal solutions, look no further.

Apparently, across the United States, any reputable nonprofit, from Pew and PBS to your underfunded start-up, now has to refuse gifts from major donors unless they happen to be (1) funded by public sector unions, or (2) originate from the pockets of left-wing billionaires. Everything else is tainted. Everything else fails the “smell test.”

Apart from the absurdity of tagging individuals and organizations with terms as archaic as “right-wing” and “left-wing,” when it is left-wing government unions that have joined forces with right-wing crony “capitalists” to exterminate what remains of America’s private sector middle class and small business community, the tactic of tainting the messenger results in a tragic smothering of constructive dialog.

When debate focuses on facts, the truth, and sound policy, emerges. When debate focuses on which participant stinks more, truth doesn’t matter. And the likely truth that should be debated is this: If anything doesn’t pass the “smell test,” it is the long-term financial solvency of public sector pensions as they are currently formulated. They are on a collision course with reality.

Over the past several months the California Public Policy Center has produced numerous short studies assessing public sector pension plans in California. Since the National Council on Teacher Retirement is probably concerned primarily with teachers pensions, here are two points from those studies, submitted for genuine debate, regarding CalSTRS:

CalSTRS Contributions Are Well Below Levels Necessary to Maintain Solvency

The officially recognized amount of CalSTRS unfunded liability is $71 billion. In their fiscal year ended 6-30-2012, CalSTRS made an “unfunded payment” towards reducing that liability of $1.1 billion. If CalSTRS were to adhere to the GASB and Moody’s recommended repayment schedules – which take effect later this year – that payment would have to be many times greater – to quote from the study “Are Annual Contributions Into CalSTRS Adequate?

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the “catch-up” payment is calculated based on a level payment, 20 year amortization of the $71.0 billion unfunded liability – still assuming a 7.5% rate-of-return projection – this catch-up payment should be $7.0 billion per year. The study also shows that if the CalSTRS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $107.8 billion and the catch-up payment increases to $9.6 billion per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $154.9 billion and the catch-up payment increases to $12.2 billion per year.

CalSTRS Retirees Collect Pension Benefits Far In Excess of Social Security Retirees

Here is a quote from a press release issued by CalSTRS in opposition to the proposed citizen initiative, the Pension Reform Act of 2014, (already DOA for 2014, by the way), “California’s educators do not participate in Social Security, retire on average around age 62, and earn a retirement income that replaces only about 56 percent of their salary.

The implication here seems to be that CalSTRS retirees would prefer to be part of Social Security. So here’s the comparison between a typical CalSTRS benefit and the Social Security benefit, from the study “Comparing CalSTRS Pensions to Social Security Retirement Benefits.”

“At age 62, the average CalSTRS retiree collects 56% of their final salary in the form of a pension, whereas, depending on their income, the average Social Security recipient collects between 29% and 36% of their final salary in the form of a retirement benefit. At age 65, the oldest age necessary to collect the full CalSTRS benefit, a CalSTRS retiree with 35 years experience will collect a retirement benefit equal to 84% of their final salary. At age 65 a Social Security recipient will collect a retirement benefit between 30% and 35% of their final salary.

The study then examined how much more a CalSTRS participant might have accumulated based on having 8.0% of their paycheck withheld vs. only 6.4% for a Social Security participant. For a CalSTRS paticipant retiring at age 65 with a final income of $80,000, the study estimated the value of this extra 1.6% in annual contributions to equal $138,502 after 35 years of withholding. This is equal to just over three years of the difference in the amount of a typical annual CalSTRS pension and a typical Social Security annual retirement benefit, i.e., it does not come close to closing the gap between the typical Social Security benefit vs the typical CalSTRS benefit.”

What these two points exemplify ought to be quite clear, and ought to be the topic of debate that relies on facts, logic and fairness, instead of competition to discredit the messengers – or their sources of funding: (1) Public sector pensions are not financially sustainable without major changes to contributions and benefit formulas, (2) Public sector pensions provide far more retirement security than Social Security, despite requiring comparable mandatory levels of withholding from employee paychecks.

Anyone who actually reads material from the Arnold Foundation will likely be impressed by the level of scholarship and objectivity they bring to their analyses. The open minded reader may wish to peruse this solution paper, “Creating a New Public Pension System,” authored by Arnold Foundation scholar Josh McGee, a Ph.D economist who has studied public pensions for many years.

Solving America’s public sector pension crisis, and it is a crisis, doesn’t necessarily require abandoning defined benefit plans. But they will have to be converted to “adjustable defined benefit” plans that can, for example, freeze COLAs, lower benefit formulas (at least) prospectively, and raise required employee contributions, whenever necessary, in order to preserve solvency, protect taxpayers, and spread the sacrifice among all participants – new hires, active veterans, and retirees – in order to minimize the sacrifice any single class of participants might have to experience.

Ultimately, what doesn’t pass the “smell test” is the alternative to reform: Increasing the tax burden on private sector workers and small business owners in order to subsidize public employee retirement plans that offer benefits many times better than Social Security.

Are America’s public sector pension plans financially sound, or are they are a rotting, stinking carcass, sprayed with public relations perfume and papered over with pretty ideological colors? Are they healthy financial contributors to America’s prosperity, victims of unwarranted attacks from “right-wing” ideologues, or are they an oppressive, inequitable, gargantuan, putrescent bubble that shall someday pop, pouring a reeking stench across the economic landscape of this nation?

That is the debate that ought to rage, focusing on facts, not pheromones.

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

RELATED RECENT POSTS AND STUDIES

Comparing CalSTRS Pensions to Social Security Retirement Benefits, February 28, 2014

Pension Reform Comes to Ventura County, February 25, 2014

The Fall of Pacific Grove – Conclusion: The “California Rule” Cannot Stand, February 25, 2014

Pension Funds and the “Asset” Economy, February 18, 2014

How Much Do CalPERS Retirees Really Make?, February 13, 2013

How Does “Zero-point-Eight at Sixty-Eight” Sound for a Pension Plan?, February 11, 2014

Why Middle Class Private Sector Workers Are NOT “Ripping Off the Next Generation,” December 17, 2013

How Unions and Bankers Work Together to Protect Unsustainable Defined Benefits, November 26, 2013

CalSTRS Contributions Inadequate; Unions Call Reformers “Right-Wing Ideologues,” November 12, 2013

Are Annual Contributions Into CalSTRS Adequate?, November 8, 2013

Saving Pensions Will Require Unions To Face Reality, August 27, 2013

Social Security is Healthy Compared to Public Sector Pensions, July 30, 2013

A Method to Estimate the Pension Contribution and Pension Liability for Your City or County, July 24, 2013

Calculating California’s Total State and Local Government Debt, April 26, 2013

How Lower Earnings Impact California’s Total Unfunded Pension Liability, February 18, 2013

Accounting Standards, Not Elections or Litigation, Will Finally Enable Reform

“Apres moi le deluge”
Louis XV

If accounting standards were peasants with pitchforks, then this quote from the last King of France to die with a head on his shoulders might well describe what lies before us. Because history may remember 2013 as the last year that public entities could hide their debts and deceive their taxpaying peasantry, so their unionized workforces might continue to live the lifestyles of French aristocrats.

Earlier this week the California Public Policy Center released a study that calculates California’s total unfunded pension liability using the new criteria proposed by Moody’s Investor Services for adoption in 2014. Since Moody’s is the largest bond credit rating service in the world, using their guidelines is not a mere academic exercise, at least not if California’s municipal governments hope to continue to issue bonds to cover their ongoing budget deficits.

The relevance of these calculations is compounded by the fact that GASB, the Government Accounting Standards Board, plans to require municipalities to include unfunded pension liabilities on their balance sheets starting in 2014. Moody’s and GASB: Unlikely sparks to fire a revolution.

How many billions are we talking about?

Using the data from a March 20, 2012 report from the California State Controller entitled “Public Retirement Systems Annual Report for the fiscal year ended June 30, 2010,” the CPPC study revalued the official unfunded pension fund liability – for all state and local government pension funds – exactly according to Moody’s proposed guidelines.

The result was dramatic. Instead of California’s total public employee pension plans being underfunded by $128.3 billion, which is the state controller’s official estimate, the amount of underfunding nearly tripled, to 328.6 billion.

In a UnionWatch editorial posted earlier this year “How Big Is California’s Wall of Debt,” we estimated the total debt facing California’s taxpayers at $872 billion, which equates to something like $87,000 for every household in the state. In that number we included $360 billion for the total unfunded pension AND retirement healthcare liability. This more recent and more comprehensive study merely confirms those numbers; if anything, they are still on the low side.

Skeptics are invited to read the study, entitled “How Lower Earnings Will Impact California’s Total Unfunded Pension Liability,” in its entirety. They are invited to download the spreadsheet made available so they may themselves replicate and validate the numbers. Pension finance may require a bit of browbeating, but it isn’t rocket science. Get informed, or get out of the way.

What is happening instead? Everywhere in California, unions are relentlessly pushing back against even modest reforms to pension benefits. With unlimited money and manpower, implacable resolve, and perpetual energy, they will prevail again and again – until the tsunami of financial reality finally hits the shore.

Spokespersons for public employee unions supposedly abhor the manipulations and machinations of finance capitalists. Pointing to examples ranging from Enron to Goldman Sachs, they claim the workers are fleeced and the rich get richer. But their own house is dirty. The public institutions they control, the cities and counties of California, indulge in financial chicanery in order to create an illusion of solvency. They fail to recognize unfunded pension and retirement health care liabilities on their balance sheets. They refuse to disclose total outstanding state and local government debt. They issue “capital appreciation bonds,” deferred payment scams that should be illegal. They mislead voters into believing government workers are undercompensated, when in fact they now earn total pay and benefits that are well over twice the average for the private sector workers they supposedly serve. They pretend budgets are balanced by offloading entire sections of government into “special districts,” playing a shell game of deception. They campaign for tax increases to “save our schools,” then instead give the money to their partners in oppression, the insatiable pension bankers.

A fair minded reader might protest that government workers should not be compared to the aristocracy of France in 1788. Fair enough. But the average pension for someone who works a full career in California’s state or local government is now nearly $70,000 per year. For a retiree to collect that much, risk free, in the private sector, requires millions (plural) in assets. And those multi-millionaires are precisely the people our public servants, through their unions, urge us to resent, to tax, to occupy, to overthrow. The language of revolt is theirs, not ours.

Filtered through the humble green eyeshades of proper accounting standards, shimmering in the Sacramento sunset, one does not see a skyline of government buildings staffed by benign bureaucrats. Rather one may see a Bastille, a Palace of Versailles, a Hall of Mirrors, the ornate furniture of an aristocracy ruled by the union noblesse.

2014 is going to be an interesting year.

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UnionWatch.org is edited by Ed Ring, who can be reached at editor@unionwatch.org