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FOR PUBLICATION: Ed Ring Response to CalPERS' disastrous 2015-16 earnings report

For Immediate Publication
July 18, 2016
California Policy Center
Contact: Will Swaim
Will@CalPolicyCenter.org
(714) 573-2231

Latest earnings report is more evidence California retirement agency will reform or die

By Ed Ring | California Policy Center

The officials who run California’s public-employee retirement system should have released today’s earnings report with sound effects – a flugelhorn, maybe, or horror-movie screams.

Through the year ending June 30, the California Public Employee Retirement System earned just 0.61% on its investments – not even close to it 7.5% projection.

CalPERS is the nation’s largest public employee pension fund. Like all such funds, it relies on investment earnings to pay retired public employees far more in retirement benefits than those employees – along with their employers – deposited into those funds during their careers. The better the market, the less CalPERS has to lean on local government employers and employees for cash. But when the market goes south, as it has, CalPERs has to push its contributors for more cash.

Today’s report includes grim warnings about future earnings too. And that means everyday Californians should expect government service cuts, higher taxes, delayed maintenance of critical infrastructure, and a push to take on great government debt.

The earnings report directly contracts the system’s recent bullish assessments of fund performance. When the Orange County Register in January asked why CalPERS was still predicting a return of 7.5% when the stock market was producing more anemic results, fund officials offered a political rather than responsible financial response: even a modest downward estimate would force them to demand that local officials bail out the fund. That “would have caused financial strain on many of California’s local municipalities that are still recovering from the financial crisis,” CalPERS officials said in a press release.

In March, the agency was at it again, arguing that its projection of 7.5% returns was “not unrealistic” – is in fact historically reasonable because CalPERS has occasionally hit that number.

Then, reality began to set in. Last month, Ted Eliopoulos, the system’s Chief Investment Officer, warned the public that the next five years will be “a challenging market environment for us. It is going to test us.”

Our own recent analysis shows Eliopoulos is right.

Our analysis relies on three measures of stock-market health: ratios of price/earnings, price/sales, and price/GDP. They show the stock market is overvalued by about 50 percent, suggesting that pension funds are headed for a major correction.

At the moment, California’s state and local agencies contribute an average of about 33 percent of their payroll to CalPERS and other state/local pension funds. In the event of a market slide of 50 percent, followed by annual returns of 5 percent per year, with no changes to retirement benefits, we estimate the required annual contribution from local governments would rise to a crushing 80 percent of payroll. The total cost to California’s taxpayers of keeping CalPERS and the other state/local pension systems afloat: an additional $50 billion per year.

If market returns are just one point lower – 4 percent instead of 5 percent – we estimate local governments having to make annual payments equal to a staggering 113 percent of their payroll. That’s an additional $86 billion per year.

There are ways to preserve the retirement funds and protect taxpayers. But if investment performance falters, reducing the formulas used to calculate defined benefit pensions will have to be part of the solution. Lowering or even suspending cost-of-living increases for retirees and reducing the rate at which pension benefits are earned by new and existing employees would be a good start, as would capping pension benefits and raising the age of eligibility.

But implementing reforms is a political impossibility – unless the people running CalPERS and the other pension systems stop fighting to preserve the status quo. They need to work their client agencies and their union-dominated boards of directors to accept benefit reductions that will restore financial sustainability to these funds without crushing taxpayers. They might even exercise true creativity, and explore new portfolio strategies such as investing in California’s neglected infrastructure.

There’s little chance of that so long as denial characterizes the agency’s response. CalPERS officials accompanied today’s weak earnings report with cheery language. The near-zero return rate was a “positive net return” that the agency “achieved” “despite volatile financial markets and challenging global economic conditions.”

For his part, Eliopoulos, the fund’s top investment officer, expressed a kind of optimism about the future. So be it. But if he and his CalPERS colleagues truly want to prove their optimism – if they are so sure they can hit their numbers – they should freeze the amount they demand from cities and other agencies at a fixed percent of payroll.

That would mean putting an end to the blank checks Californians have sent to Sacramento. And that news could be heralded by something like a trumpet blast of angels or a marching band.

 

ABOUT THE AUTHOR
Ed Ring is president of the California Policy Center. He directs the organization’s research projects and is also the editor of the email newsletters Prosperity Digest and UnionWatch Digest. His work has been cited in the Los Angeles Times, Sacramento Bee, Wall Street Journal, Forbes, and other national and regional publications.

ABOUT THE CALIFORNIA POLICY CENTER
The California Policy Center is a non-partisan public policy think tank providing information that elevates the public dialogue on vital issues facing Californians, with the goal of helping to foster constructive progress towards more equitable and sustainable management of California’s public institutions. Learn more at CaliforniaPolicyCenter.org.

Public Safety Unions and the Financial Apocalypse

Imagine for a moment that two premises are beyond serious debate: (1) That there will be another financial crisis within the next five years that will equal or exceed the severity of the one experienced in 2009, and (2) That the political power of public safety unions will prevent local governments from enacting pension reforms sufficient to avert a financial disaster when and if the next financial crisis hits.

What will these public safety unions do?

It’s distressingly easy for politicians to dismiss both of these premises, but since for the moment we’re not, imagine the following: Major European banks have declared insolvency because their debtors have all defaulted on payments, the Chinese stock market has collapsed because their export markets are shrinking instead of growing, and the deflationary contagion reaches American shores. Across the nation, speculative buying is replaced by panic selling. Housing prices fall, defaults accumulate, and the pension funds lose half their value overnight. In a cascading cycle reminiscent of 1929, deflation sweeps the global economy.

Meanwhile, pension reform has been limited to incremental adjustments to the pension benefits for new employees. Millions of retirees and active public safety workers still expect pensions that are roughly equivalent to the amount they made at the peak of their careers. But the money won’t be there.

How will public safety unions use their political power to address this challenge?

If the present is any indication, the solutions won’t be pretty. In San Jose and San Diego, public safety unions lead the charge to roll back local pension reforms enacted by voters. In counties across California, public safety unions lead the charge to undermine in court the reforms enacted by the State Legislature in the Public Employee Retirement Act of 2014. That’s all fine while the economic bubble continues to inflate. But what do we do when it pops? What do we do when there’s no money?

When challenging public safety unions to exercise their political power to advocate on issues other than law and order or their own compensation and benefits, a reasonable response is that public safety unions, like any government union, shouldn’t be involved in politics. The problem with that response is that they already are. Government unions, and their partners in the financial community, are a major cause of the economic bubble we’re experiencing. Their insatiable appetite for high returns, 7% or more, compels the financial engineering that creates unsustainable economic growth. When the crash comes, government unions will blame “Wall Street.” But in reality, they will share the blame, because they didn’t want to admit that their pension benefits relied on unsustainable rates of economic growth.

If there is another economic crash, public safety unions will face a choice. They can use their political power to strip away every remaining service that local government performs that isn’t related to public safety, raise taxes, and support “fees” on everything from green lawns to vehicle miles driven. They can support the creation of an authoritarian, oppressive state, raising revenue through rationing and regulating our water, energy, land use, home improvement, etc., at levels that make today’s annoying excesses seem trivial. They can hide behind environmentalism and egalitarianism to tax the last bits of vitality and freedom out of ordinary productive citizens. They can even hide behind faux libertarian ethics to charge exorbitant fees for rescue services, or profit from draconian applications of asset forfeiture laws. If they do this, it may be enough for them. But the price on society will be hideous.

There is an alternative.

Public safety unions can recognize that sustainable economic growth occurs when people have fewer impediments to running their private businesses. They can recognize that large corporations use regulations to eliminate their smaller competitors, and that excessive regulations of land, energy and water are the reasons that California has such a high cost of living. They can recognize that competitive resource development and cost-effective infrastructure development can only be achieved when the environmentalist lobby and their allies – the corporate and financial elites – are confronted and forced to accept less crippling restrictions.

Better yet, public safety unions can begin to recognize these political precepts NOW, before the financial apocalypse. Along with hopefully accepting more pension reforms instead of always fighting them, these unions can also protect their members’ futures by fighting for economic reform and more rational environmentalist restrictions. The sooner these reforms are adopted at the state and local level, the more resilient our economy will be when the economic implosion occurs. If pension benefit cuts are inevitable, because the money isn’t there anymore, with economic and environmentalist reforms the cost-of-living will also be cut.

America’s excessive public employee pension benefits have created a four trillion dollar monster, pension funds ravaging the world in search of high returns during the late stages of a credit expansion that has granted present growth at the expense of future growth. The day of reckoning is coming. Public safety unions can help prepare, for their own sake as well as for the sake of the citizens they are sworn to protect.

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Ed Ring is the president of the California Policy Center.

RELATED POST:
The Coming Public Pension Apocalypse, and What to Do About It

Aggregate U.S. Pension Data Shows Grim Outlook

Editor’s Note:  This analysis by economics blogger Mike Shedlock clearly shows why government employee pensions are taking an awful risk by continuing to forecast annual investment returns of 7.0% or more per year. In his first chart Shedlock points out how between 2008 and 2014 the aggregate value of state and local government worker pension system assets only increased 12.7% – a return of 1.9% per year. If one extends the horizon back to 2003 – i.e., if one backs up to include the stock market run-up from 2003 through 2008 – that annual return improves, to a still paltry 4.3%. The headwinds facing global investment portfolios include an aging population, which means there will be a higher percentage of retirees selling their assets which drives down prices and returns, as well as interest rates, everywhere, now at historic lows, which means that debt stimulated economic growth is more problematic than ever. What do the pension systems intend to do, if they can’t hit their 7.0% per year annual returns over the next several years? The answer to-date is to raise every tax and fee in sight to feed the pension systems, which along with incremental benefit adjustments is claimed to be sufficient. But only if 7.0% returns are forthcoming. What if they are not forthcoming? What then?

One of my constant themes over the past few years is the underfunding of state and local pension plans. Illinois is particularly bad, but let’s look at some aggregate data.

The National Association of State Retirement Administrators (NASRA) provides this grim-looking annual picture in their most recent annual update:

State and Local Defined Benefit Plan Assets at Year-End
2003-2014 ($ = Trillions)
20150831-UW-Shedlock1

Between the end of 2007 and end of 2014, pension plan assets rose from $3.29 trillion to $3.71 trillion. That’s a total rise of 12.76%.

Plan assumptions are generally between 7.5% to 8.25% per year!

S&P 500 2007-12-31 to 2014-12-31
20150831-UW-Shedlock2

In the same timeframe, the S&P 500 rose from 1489.36 to 2058.90.

That’s a total gain of 590.54 points. Percentage wise that’s a total gain of 40.22%. It’s also an average gain of approximately 5.75% per year.

Analysis

  • In spite of the miraculous rally from the low, total returns for anyone who held an index throughout has been rather ordinary.
  • The first chart is not a reflection of stocks vs. bonds because bonds did exceptionally well during the same period.

Drawdowns Kill!

To be fair, the first chart only shows assets, not liabilities, but we do know that pensions in general are still enormously underfunded, with Chicago and Illinois leading the way.

Negative Flow

Reader Don pinged me with this comment the other day: “Nearly all public pension funds have a negative cash flow, meaning they pay out in benefits each year more than they receive in contributions. For all public pension funds, the negative cash flow is approximately 3% of assets, which means an average fund needs to produce an annual return of 3% to maintain a stable asset value.

That’s fine if assets have kept up with future payout liabilities and plans are close to fully funded.

However, it is 100% safe to suggest that neither condition is true.

So here we are, after a massive 200% rally from the March 2009 low, and pension plans are still in miserable shape.

And plan assumptions are still an enormous 8% per year. Let me state emphatically, that’s not going to happen.

Stocks and junk bonds are enormously overvalued here.

GMO Investments Forecast

20150831-UW-Shedlock3

“The chart represents real return forecasts for several asset classes and not for any GMO fund or strategy. These forecasts are forward‐looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Forward‐looking statements speak only as of the date they are made, and GMO assumes no duty to and does not undertake to update forward‐looking statements. Forward‐looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially from those anticipated in forwardlooking statements. U.S. inflation is assumed to mean revert to long‐term inflation of 2.2% over 15 years.”

Over the next 7 years GMO believes US stocks will lose money (on average), every year. Those are in real terms, but returns are at best break even, assuming 2% inflation.

Bonds are certainly no safe haven either. I strongly believe GMO has this correct.

Assume GMO Wildly Off

Even if one assumes those GMO estimated returns are wildly off to the tune of four percentage points per year, pension plans needing 8% per year will be further in the hole with 4% per year annualized returns.

Illinois Non-Answer

Illinois house speaker Michael Madigan and Chicago governor Rahm Emanuel believe tax hikes are the answer.

Both are sorely mistaken. Here are a few viewpoints to consider.

The only way out of this mess is a pension restructuring coupled with municipal defaults.

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Mike Shedlock is the editor of the top-rated global economics blog Mish’s Global Economic Trend Analysis, offering insightful commentary every day of the week. He is also a contributing “professor” on Minyanville, a community site focused on economic and financial education, and a senior fellow with the Illinois Policy Institute.

Desalination Plants vs. Bullet Trains and Pensions

Current policy solutions enacted to address California’s water crisis provide an object lesson in how corruption masquerading as virtue is impoverishing the general population to enrich a handful of elites. Instead of building freeways, expanding ports, restoring bridges and aqueducts, and constructing dams, desalination plants, and power stations, California’s taxpayers are pouring tens of billions each year into public sector pension funds – who invest 90% of the proceeds out-of-state, and the one big construction project on the table, the $100B+ “bullet train,” fails to justify itself under virtually any credible cost/benefit analysis. Why?

The reason is because infrastructure, genuinely conceived in the public interest, lowers the cost of living. This in-turn causes artificially inflated asset values to fall, imperiling the solvency of pension funds – something that would force them to reduce benefits. Beneficial infrastructure is also a threat to crony capitalists who don’t want a business climate that attracts competitors. Affordable land, energy, and water encourage economic growth. Crony capitalists and public sector unions alike hide behind environmentalists, who oppose growth and development, all of it, everywhere – because no new developments, anywhere, suits their monopolistic interests. No wonder the only infrastructure vision still alive in California, the “bullet train,” is nothing more than a gigantic, tragic farce.

Urban Water Consumption is a Small Fraction of Total Water Use

Returning to the topic of water, a basic examination of the facts reveals the current drought to be a problem that could be easily solved, if it weren’t for powerful special interests who don’t want it to be solved, ever. Here’s a rough summary of California’s annual water use. In a dry year, around 150 million acre feet (MAF) fall onto California’s watersheds in the form of rain or snow, in a wet year, we get about twice that much. [1] Most of that water either evaporates, percolates, or eventually runs into the ocean. In terms of net water withdrawals, each year around 31 MAF are diverted for the environment, such as to guarantee fresh water inflow into the delta, 27 MAF are diverted for agriculture, and 6.6 MAF are diverted for urban use. [2] Of the 6.6 MAF that is diverted for urban use, 3.7 MAF is used by residential customers, and the rest is used by industrial, commercial and government customers. [3]

Put another way, we divert 65 million acre feet of water each year in California for environmental, agricultural and urban uses, and a 25% reduction in water usage by residential customers will save exactly 0.9 million acre feet – or 1.4% of our total statewide water usage. One good storm easily dumps ten times as much water onto California’s watersheds as we’ll save via a 25% reduction in annual residential water consumption.

California’s politicians can impose utterly draconian curbs on residential water consumption, and it won’t make more than a small dent in the problem. We have to increase the supply of water.

Desalination is An Affordable Option

One way to increase California’s supply of fresh water is to build desalination plants. This technology is already in widespread use throughout the world, deployed at massive scale in Singapore, Israel, Saudi Arabia, Australia, and elsewhere. One of the newest plants worldwide, the Sorek plant in Israel, cost $500 million to build and desalinates 627,000 cubic meters of water per day. [4] That means that five of these plants, costing $2.5 billion to build, could desalinate 1.0 million acre feet per year. And since these modern plants, using 16″ diameter reverse osmosis filtration tubes, only require 5 kWh per cubic meter of desalinated water, it would only require a 700 megawatt power plant to provide sufficient energy to desalinate 1.0 million acre feet per year. [5] Currently it takes about 300 megawatts for the Edmonston Pumping Plant to lift one MAF of water from the California aqueduct 1,926 ft (587 m) over the Tehachapi Mountains into the Los Angeles basin. And that’s just the biggest lift, the California aqueduct uses several pumping stations to transport water from north to south. So the net energy costs to desalinate water on location vs transporting it hundreds of miles are not that far apart. [6]

The entire net urban water consumption on California’s “South Coast” (this includes all of Los Angeles and Orange County – over 13 million people) is 3.5 MAF. [7] Desalination plants with capacity to supply 100% of the urban water required by Los Angeles and Orange counties would cost under $10 billion, and require 2.5 gigawatts of electric power. These power stations could also be built for under $10 billion. [8]

Imagine that. For $20 billion in capital investment we could provide 100% of the fresh water required by nearly all of Southern California’s urban water users. For around $50 billion, 100% of California’s urban water requirements, statewide, could be financed – the desalination plants and the power stations.

California’s taxpayers are currently condemned to shell out at least 500 billion dollars over the next 20-30 years so a train that hardly anyone will ride will careen through expropriated land, and pension funds can invest 90% of their assets out-of-state so public sector employees can retire 10-15 years early with pensions that are 3-5 times greater than Social Security. For less than one-tenth of that amount, we can solve our water crisis by investing in desalination. Why not, environmentalists? We’re willing to carpet the land with solar farms, exterminate raptors with the blades of wind turbines, and incinerate the rain forests to grow palm oil – all financed by selling carbon emission permits. Why not disburse brine offshore, where the California current will disburse it far more efficiently than any desalination plant situated on the Mediterranean Sea?

Another way to solve California’s urban water crisis is to recycle 100% of indoor water. Quaternary treatment, where water from sewage is purified and sent back upstream for reuse, is another proven technology already in limited use throughout California. In theory, not one drop of indoor water use can be wasted, since all of it can be reused.

And, of course, imagine how quickly California’s water crisis could be solved if farmers could sell their water allotments to urban water agencies. As it is, myriad restrictions largely prevent them from exercising this option, even though many of them could profitably sell their water allotments and make more than they make farming the crop. Do we really need to grow rice in the Mojave desert to export to China?

Environmentalists alone are not powerful enough to stop Californians from acting to increase water supply. Powerful government unions, pension funds, and anti-competitive corporate interests all have a stake in perpetuating artificial scarcity and authoritarian remedies. It suits them because it consolidates their power, and ensures they get a bigger slice of a smaller pie.

*   *   *

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

FOOTNOTES

(1) Total Precipitation in California during wet, average, and dry years:
California Water Supply and Demand: Technical Report
Stockholm Environment Institute
Table 2: Baseline Annual Values by Water Year Type and Climate-Scenario (MAF)
http://sei-us.org/Publications_PDF/SEI-WesternWater-CWSD-0211.pdf

(2) California water use by sector:
California Water Today
Public Policy Institute of California
Table 2.2, Average annual water use by sector, 1998–2005
http://www.ppic.org/content/pubs/report/R_211EHChapter2R.pdf

(3) California urban water use by sector:
California Dept. of Water Resources
2010 Urban Water Management Plan Data – Tables
Download spreadsheet “DOST Tables 3, 4, 5, 6, 7a, 7b, & 7c: Water Deliveries – Actual and Projected, 2005-2035”
http://www.water.ca.gov/urbanwatermanagement/2010_Urban_Water_Management_Plan_Data.cfm

(4) Cost of modern reverse osmosis desalination plant:
Technology Review
Megascale Desalination: The world’s largest and cheapest reverse-osmosis desalination plant is up and running in Israel.
http://www.technologyreview.com/featuredstory/534996/megascale-desalination/

(5) Energy required to desalinate seawater using reverse osmosis technology:
Encyclopedia of Desalination and Water Resources
“Energy Requirements of Desalination Process”
Table 1. Energy requirements of four industrial desalination processes.
http://www.desware.net/desa4.aspx

(6) part one – Tehachapi lift of 1,926 feet:
Wikipedia, California Aqueduct
http://en.wikipedia.org/wiki/California_Aqueduct

(6) part two – energy required to lift water:
University of California, Energy Required to Lift Water
Table 1. The Amount of Energy in Kilowatt-Hours (kWh) Required to Lift One Acre-foot of Water (325,851 gallons) One Foot of Elevation
http://cetulare.ucanr.edu/files/82040.pdf

(7) California water use by sector:
California Water Today
Public Policy Institute of California
Table 2.2, Average annual water use by sector, 1998–2005, ref. “South Coast”
http://www.ppic.org/content/pubs/report/R_211EHChapter2R.pdf

(8) The cost to construct a modern natural gas power plant:
U.S. Energy Information Administration, Capital Costs for Electricity Plants
Download Table 1, “Updated Estimates of Power Plant Capital and Operating Costs” (ref. Natural Gas – the most modern and expensive version)
http://www.eia.gov/forecasts/capitalcost/

*   *   *

Pension Funds and the Ultimate Hedge, Taxpayers

“We’re trying to make these guys’ money toxic because, as we’ve seen, their money is toxic,” Jonathan Westin, the director of New York Communities for Change, told Business Insider on Thursday. “I think it’s connecting the dots that many people don’t always connect.”
–  “Activists think they found a way to convince Democrats to stay away from ‘toxic’ hedge fund money,” March 13, 2015

There’s nothing new about this talking point, courtesy of the labor funded ACORN successor “New York Communities for Change.” If you don’t like an idea, don’t attack by arguing its merits. Just attack the “dark money,” or the “toxic money,” that funded whomever had the inspiration and did the work to develop the idea.

The long list of causes whose advocates may or may not have accepted “toxic money” just got longer, since the New York Communities for Change – and their inevitable spawn in other states – are now accusing Charter Schools of being financed by “hedge fund billionaires.”

Here in California, charter school advocacy, and, more significantly, charter schools themselves, are indeed supported by many wealthy individuals, but the vast majority of them are self-made entrepreneurs who earned their riches by actually creating something of value to society, from high-tech innovations to office parks and housing developments. Others earned their money in the entertainment business, or through providing legitimate financial services including managing investments on behalf of clients. The idea that “hedge fund billionaires” are the primary force behind the charter school movement is a convenient myth.

With that out of the way, let’s “connect the dots that many people don’t always connect.”

When union activists accuse the financial industry of being overbuilt and riddled with corruption, they’re right. But they are unable to distinguish between honest advisers who manage investments for their clients with integrity and prudence, and rapacious predators whose unchecked greed and insatiable appetite for risk literally threatens to crash the global economy. And the most salient method to distinguish between good and bad investment managers? The good ones are personally accountable for their losses, and the bad ones depend on government bailouts.

There’s no defense for investment managers who use supposedly risk free, low yield consumer deposits as collateral to make high risk investments, and then collect taxpayer bailouts to restore solvency to their client accounts when their schemes fail. Financial bailouts are bad. Financial firms that take risks because they know they will get bailed out are bad. We agree. So why are the pension funds for government workers not included? Why aren’t they at the top of the list? Why aren’t the unions who pay for reinvented former ACORN activists to identify “toxic money” not including pension funds among their targets?

Why aren’t those dots being connected?

Back in 1999, California’s pension funds lobbied California’s politicians to increase pension benefits. California’s all-powerful government unions were quick to hop on that bandwagon. Pension benefits weren’t just enhanced, they were enhanced retroactively. And since the market was roaring, nobody thought it would cost a penny more to fund all of this.

Fast forward to 2015, after years of market volatility, pension funds in California, collectively, are only about 75% funded. With the debt fueled bull market of the past few years beginning to sputter, pension funds are midway through imposing a roughly 100% increase in required contributions by cities and counties. That is, by taxpayers.

Pension funds, which control over $4.0 trillion in assets on behalf of state and local government employees in the United States, are the biggest players in American finance. They invest in anything that will get them a rate of return, after inflation, that averages 4.5% per year – that’s currently 7.5% before taking inflation into account. They invest in hedge funds, they invest in private equity, along with real estate and public equities. And when they don’t hit their numbers, taxpayers bail them out.

Why aren’t those dots being connected? Pension funds rely on taxpayers to hedge their bets. They can make whatever promises they want, take whatever risks they wish, indulge in optimistic projections and lobby for excessive benefit formulas, because taxpayers will bail them out. How deep is the hole? We’re talking trillions, not billions.

Connect the dots. Government pension funds and “hedge fund billionaires” are cut of the same toxic cloth. Perhaps taking money from taxpayers to fund government unions and their activist “volunteers,” and taking money from taxpayers to bail out government pensions are the bigger “toxic” threats to our democracy and our economy.

*   *   *

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

The Amazing, Obscure, Complicated and Gigantic Pension Loophole

“The bottom line is that claiming the unfunded liability cost as part of an officer’s compensation is grossly and deliberately misleading.”
– LAPPL Board of Directors on 08/07/2014, in their post “Misuse of statistics behind erroneous LA police officer salary claims.”

This assertion, one that is widely held among representatives of public employees, lies at the heart of the debate over how much public employees really make, and greatly skews the related debate over how much pension funds can legitimately expect to earn on their invested assets.

Pension fund contributions have two components, the “normal contribution” and the “unfunded contribution.” The normal contribution represents the present value of future retirement pension income that is earned in any current year. For example, if an actively working participant in a pension plan earns “3% at 55,” then each year, another 3% is added to the total percentage that is multiplied by their final year of earnings in order to determine their pension benefit. That slice, 3% of their final salary, paid each year of their retirement as a portion of their total pension benefit, has a net present value today – and that is funded in advance through the “normal contribution” to the pension system each year. But if the net present value of a pension fund’s total future pension payments to current and future retirees exceeds the value of their actual invested assets, that “unfunded liability” must be reduced through additional regular annual payments.

Without going further into the obscure and complicated weeds of pension finance, this means that if you claim your pension plan can earn 7.5% per year, then your “normal contribution” is going to be a lot less than if you claim your pension plan can only earn 5.0% per year. By insisting that only the cost for the normal contribution is something that must be shared by employees through paycheck withholding, there is no incentive for pension participants, or the unions who represent them, to accept a realistic, conservative rate of return for these pension funds.

This is an amazing and gigantic loophole, with far reaching implications for the future solvency of pension plans, the growing burden on taxpayers, the publicly represented alleged financial health of public employee pension systems, the impetus for reform, and the overall economic health of America.

Governor Brown’s Public Employee Reform Act (PEPRA) calls for public employees to eventually pay 50% of the costs to fund their pensions, this phases in over the next several years. But this 50% share only applies to the “normal costs.”

In a 2013 California Policy Center analysis of the Orange County Employee Retirement System, it was shown that if they reduced their projected annual rate of return from the officially recognized 7.50% to 4.81%, the normal contribution would increase from $410 million per year to $606 million per year. In a 2014 CPC analysis of CalSTRS, it was shown that if they reduced their projected annual rate of return from the officially recognized 7.50% to 4.81%, the normal contribution would increase from $4.7 billion per year to $7.2 billion per year.

The rate of 4.81% used in these analyses was not selected by accident. It refers to the Citibank Liability Index, which currently stands at 4.19%. This is the rate that represents the “risk free” rate of return for a pension fund. It is the rate that Moody’s Investor Services, joined by the Government Accounting Standards Board, intends to require government agencies to use when calculating their pension liability. As can be seen, going from aggressive return projections of 7.5% down to slightly below 5.0% results in a 50% increase to the normal contribution.

No wonder there is no pressure from participants to lower the projected rate of return of their pension funds. If under PEPRA, a public employee will eventually have to contribute, say, 20% of their pay via withholding in order to cover half of the “normal contribution,” were the pension system to use conservative investment assumptions, they would have to contribute 30% of their pay to the pension fund.

Moreover, these are best case examples, because the formulas provided by Moody’s, used in these studies, make conservative assumptions that understate the financial impact.

In another California Policy Center study, “A Pension Analysis Tool for Everyone,” the normal contribution as a percent of pay is calculated on a per individual basis. One of the baseline cases (Table 2) is for a “3.0% at 55” public safety employee, assuming a 30 year career, retirement at age 55, collecting a pension for 25 years of retirement. At a projected rate of return of 7.75% per year, this employee’s pension fund would require 19.6% of their pay for the normal contribution. Under PEPRA, half of that would be about 10% via withholding from their paychecks. But at a rate of return of 6.0%, that contribution goes up to 31%. Download the spreadsheet and see for yourself – at a rate of return of 5.0%, the contribution goes up to 41%. That is, instead of having to pay 10% via withholding to make the normal contribution at a 7.75% assumed annual return, this employee would have to pay 20% via withholding at a 5.0% assumed annual return. The amount of the normal contribution doubles.

This why not holding public employees accountable for paying a portion of the unfunded contribution creates a perverse incentive for public employees, their unions, the pension systems, and the investment firms that make aggressive investments on behalf of the pension systems. Aggressive rate of return projections guarantee the actual share the employee has to pay is minimized, even as the unfunded liability swells every time returns fall short of projections. But if only the taxpayer is required to pick up the tab, so what?

Adopt misleadingly high return assumptions to minimize the employee’s normal contribution, and let taxpayers cover the inevitable shortfalls. Brilliant.

Public employee pension funds are unique in their ability to get away with this. Private sector pensions were reformed back in 1973 under ERISA rules such that the rate of return is limited to “market rates currently applicable for settling the benefit obligation or rates of return on high quality fixed income securities,” i.e., 5.0% would be considered an aggressive annual rate of return projection. If all public employee pension funds had to do were follow the rules that apply to private sector pension funds, there would not be any public sector pension crisis. And when public employees are liable through withholding for 50% of all contributions, funded and unfunded, that basic reform would become possible.

This is indeed an obscure, complicated, amazing and gigantic loophole. And it is time for more politicians and pundits to get into the weeds and fight this fight. Especially those who want to preserve the defined benefit. Until incentives for public employees and taxpayers are aligned, pension funds will cling to the delusion of high returns forever, until it all comes crashing down.

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

Public Pension Solvency Requires Asset Bubbles

The title of this post expresses what is probably the greatest example of a monstrous hypocrisy – that public employee unions, and the pension funds they control, are supposedly helping the American economy, and protecting the American people from “the bankers.” Overpriced “bubble” assets caused by banks offering low interest rates hurt ordinary working people in two ways – they cannot afford to buy homes, and they are denied any sort of viable low risk investment opportunity. But without an endlessly appreciating asset bubble, every public employee pension fund in the United States would go broke.

The inspiration for this post is a guest column published on April 27th in the Huffington Post entitled “The Real Retirement Crisis,” authored by Randi Weingarten, the president of the American Federation of Teachers. The totality of Weingarten’s column, a depressing plethora of misleading statistics and questionable assertions, compels a response:

Weingarten writes: “America has a retirement crisis, but it’s not what some people want you to believe it is. It’s not the defined benefit pension plans that public employees pay into over a lifetime of work, which provide retirees an average of $23,400 annually…”

Here we go again. This claim is one of the biggest distortions coming out of the public sector union PR machine, and despite repeated clarification even in the mainstream press, they keep using it, faithfully counting on low-information voters to believe them. “An average of $23,400 annually.” Not in California. In the golden state, public employee pensions average well over $60,000 annually (ref. “How Much Do CalSTRS Retirees Really Make?“), if you adjust for a 30 year career working in public service. And in most cases public employees also receive supplemental retirement health benefits worth additional thousands each year.

With respect to the causes of the 2007-2008 financial crisis, Weingarten continues: “It’s not the cost of such [defined benefit] plans, which may ultimately cost taxpayers far less than risky, inadequate and increasingly prevalent 401(k) plans.”

What! Exactly how can 401K plans ever cost taxpayers more than defined benefit plans? This is absurd. Public sector defined benefit plans represent fixed payment obligations regardless of levels of funding. When they’re underfunded, the taxpayer makes up the difference. A 401K plan that is underfunded creates no lingering obligation to the taxpayer. If someone from the public sector has an underfunded 401K plan, then they will get whatever government assistance or lack of assistance that someone from the private sector might get. That’s tough, but fair. It is hypocritical to pretend to care about workers, but put the welfare of public sector workers above the welfare of private sector workers. If we are to spend taxes on government administered retirement programs, then everyone should earn benefits according to the same formulas and incentives – whatever they are.

Weingarten then suggests we expand Social Security:  “Social Security, which is the healthiest part of our retirement system, keeps tens of millions of seniors out of poverty and could help even more if it were expanded.”

This is a great idea. Why not give every public employee Social Security? Why not insist on this? Social Security is progressive, meaning that high income people get far less back than low income people. Since the public sector workers make far more, on average, than private sector workers, their participation in Social Security will have a significant positive impact on the solvency of Social Security (ref. “Add ALL Public Workers to Social Security“). Why aren’t public sector unions insisting they participate? Don’t they value the progressive benefit formulas? Don’t they want to expand the system? Could it be they are hypocrites?

Here’s a macroeconomic “big picture” quote from Weingarten:  “And while the stock market and many pension investments have rebounded, for numerous Americans the lingering economic downturn, soaring student debt, diminished home values, the responsibility of caring for aging parents and other financial demands have made it hard, if not impossible, to save for retirement.”

What Weingarten doesn’t acknowledge is the shared agenda that public sector unions and union controlled pension funds have to perpetuate the asset bubble that’s killing middle class families (ref. “Pension Funds and the “Asset” Economy“). California’s artificially inflated home prices are driving young families out of the state where they were born, preventing them from living near their aging parents, depriving their children of a relationship with their grandparents. But pension fund solvency requires ongoing appreciation of real estate and publicly traded stock even if they are already overpriced. As for student debt – if middle class families didn’t have built into their tuition payments the costs for overpaid, over-pensioned, and under-worked unionized faculty, a bloated workforce of unionized college administrators, and subsidies that make college virtually free for low income students, their “student debt” would be manageable because their rates of tuition would be far lower. Does Weingarten care about the “middle class,” or might hypocrisy be at work here?

Here’s another Weingarten quote that invites a rebuttal:  “Defined benefit plans not only help keep retirees out of poverty, every $1 in pension benefits generates $2.37 in economic activity in communities.”

The problem here is that ALL investments generate economic activity. You don’t have to run it through a pension fund. If taxpayers get to keep the money they would have paid to fund a public employee’s pension, they’ll invest it or spend it too. In California’s case, as is proudly proclaimed in, for example, CalPERS press releases, “9.5% of CalPERS investment portfolio is reinvested in California.” Nine-point-five percent. The other more than ninety percent goes to other states and countries, presumably places with business climates that aren’t poisoned by the policy agenda of public sector unions. How does that help California’s economy?

Finally, Weingarten alludes to a new initiative being advocated by public sector unions to provide enhanced retirement security to private sector workers. She writes:  “The AFT is engaged in a broad-based effort with a bipartisan group of state treasurers, other unions, asset managers and even some large Wall Street firms to vastly expand retirement security through pooled, professional asset management.”

Here is shameful hypocrisy disguised, once again, as altruism. Because these private sector defined benefit plans will not guarantee participants a 7.5% return on investment. They will have to conform to ERISA, meaning the future retirement liabilities that will be offset by invested assets will have their present value calculated at conservative rates. This double standard guarantees the “normal contribution” for public employees in order to generate a given defined benefit will be remain far less than that required of private citizens. Some observers have even suggested these private defined benefit plans, where the assets will be co-mingled with public sector defined benefit plans, will be used as piggy banks to shore up the public sector plans. After all, if the assets are co-invested and earn a rate of return that exceeds the discount rate used to value the future liabilities for the private retirees, but falls short of the discount rate used to value the future liabilities for the public sector retirees, then the surplus from the private sector’s fund will be applied to the deficit in the public sector fund. Why not? It is easy to be diabolical, and hypocritical, when your critics have to dive so far into the weeds to challenge your logic or your morality.

Weingarten doesn’t have to deal with weeds, however, or wonks, or the tough realizations that are the reward of complex analyses. She just has to say things that are emotionally resonant, then let her multi-million dollar PR machine feed it to the masses.

When interest rates were lowered in the 1990’s, stock prices soared, forming what was later called the internet bubble. When that bubble popped in 2000, interest rates – and credit criteria – were lowered even further, forming the real estate bubble. Through it all, pension funds banked profits on artificially inflated asset values, ordinary citizens went into debt to their eyeballs to buy homes and pay tuition for their children, and the unions that controlled the pension funds negotiated massive increases to pay and pension benefits as if these bubbles could last forever. When reality finally returned in 2008, the government unions and their banker allies handed struggling taxpayers the bill, holding onto their excessive pay, benefits, bonuses and pensions, and engaged in quantitative easing and other fiscal shenanigans calculated to perennially inflate new asset bubbles, and the pensions that depend on them.

That is the real story, Ms. Weingarten.

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Ed Ring is the executive director of the California Policy Center

Government Unions Attack Free-Market Nonprofits via Pension Funds

“The AFT [American Federation of Teachers] will be looking more closely at those who are supporting the dismantling of defined benefit plans at the state and municipal level.”
–  Ranking Asset Managers, A Retirement Security Report on Money Managers for Pension Fund Trustees, March 5, 2014

As reported in a Washington Examiner editorial on April 4th, the American Federation of Teachers – that’s “teachers union” in plain English – has circulated a pamphlet that:

“Calls on pension fund trustees to drop any investment managers that are tainted by connection to free-market nonprofits. They also want those same trustees to force any potential new managers to have to disclose any donations they may have made to the groups on AFT’s blacklist.”

That the AFT can circulate a document like this without generating an uproar in the media reflects a monstrous and tragic double-standard. Money supporting “free-market non-profits” is tainted, which – not entirely logically – also taints any analysis they may produce, or policies they may advocate. But the money supporting public sector unions, involuntarily and automatically taken from their paychecks, ultimately funded by taxpayers, is pristine. Whatever analysis or policies they come up with, including “blacklists,” are beyond criticism.

What the AFT just did may be more explicit than usual, but it’s nothing new. In states like California, politically dominated by public sector unions, almost no businessperson or financial professional is going to identify themselves as supporting a free-market candidate or free-market nonprofit that dares criticize public sector unions or question the sustainability of public sector pensions. They risk retaliatory legislation, official harassment, strikes or “slowdowns,” character assassination, sit-ins and other orchestrated protests, shareholder revolts and boycotts. And if they represent a sufficient threat, their partners, customers, investors and vendors will get similar treatment.

In the financial community, as AFT’s document verifies, union critics stand to lose their biggest customers – the government agencies who come to them to underwrite bonds, and the pension funds whose investments fuel their fees and commissions. Just in California, billions are at stake every year.

Since the American Federation of Teachers fired this latest salvo against the free market, here are a few facts about CalSTRS, the California State Teachers Retirement System:

Three of the nine current CalSTRS board members are union officials:  The Chairperson of CalSTRS, Dana Dillon, “has been active in the California Teachers Association for more than 26 years… and was recently elected to the board of directors.” Their Vice Chair, Harry M. Keiley, is “chair of the California Teachers Association Political Involvement Committee.” Another board director, Sharon Hendricks, “also serves as president of the American Federation of Teachers, local 1521 chapter at Los Angeles City College.”

Most of the remaining six active CalSTRS board members are beholden to unions:  Tom Torlakson serves while also serving as California’s Superintendent of Public Instruction, an office he was elected to with substantial support from public sector unions. Two more board members come from the financial community; Paul Rosenstiel from a municipal bond investment bank, Thomas Unterman from a venture capital firm. Three other members come from government, Michael Cohen from the California Dept. of Finance, John Chiang, the State Controller, and Bill Lockyer, the State Treasurer.

Would it be more than reckless speculation to say the unions have four votes locked, and only need one of the other five in any given decision they make? And who is going to support Lockyer or Chiang if they run for another political office if they cross the unions? The financial community? Unlikely, given the pressure they’re under from the unions.

At this point the reader may be reminded that without reform, without tough, responsible decisions, public sector pension funds are going to crash, and when they do they’re going to take down with them entire cities and states, if not the global economy. The obliteration of defined benefits will be a mere footnote.

CalSTRS pays hundreds of millions each year to financial professionals:  Take a look at page 83 of CalSTRS Annual Report for the fiscal year ended June 30, 2013, under the bland heading of “Other Supplemental Information.” Here’s what’s on the table for the financial community, every year, from a fund that only represents about 30% of the public sector pension fund assets under management in California:  Administrative expenses, $139 million (page 84). Investment expenses including management fees, advisors, consultants, research services, risk management systems, trading systems, etc., $310 million (pages 85-88). Don’t forget “Global Equity Broker Commissions” whose payees include the infamous Goldman Sachs, $25 million (page 104).

CalSTRS invests in companies and financial instruments they supposedly detest:  Skip along in the CalSTRS Annual Report to page 101 and take a look at their “largest equity holdings.” They include Exxon Mobil Corp at the #1 position, and Chevron Crop at #5.  Go back to page 45 to see where CalSTRS has $22 billion in “Private Equity Investments.” How many Wall Street wolves fatten themselves on that rather substantial hunk of fresh meat?

What more does it take to make clear there is a phony war going on between public sector unions and the financial community? This isn’t an ideological battle, it’s an intramural struggle for dominance between two groups who are both elitist and privileged, who need each other far more than they need taxpayers.

“Dark money,” or money that doesn’t pass the “smell test,” seems to be a favored meme of public sector unions these days. Especially if that money is used to fund challenges to their interests, hence, a new “blacklist.” But why does public sector union money, sourced involuntarily, falling into their accounts automatically by the millions and billions, emanating directly from taxpayers, used to intimidate opponents, fund political campaigns and academic studies, organize activist groups, and feed Wall Street financiers, get a pass?

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Ed Ring is the executive director of the California Policy Center

Editor’s Note:  Since this was posted on April 8th, the list of CalSTRS board members, as posted on their website, has been updated to include Joy Higa, appointed by Gov. Brown on January 27, 2014. Here is her biography:

“Joy Higa is the vice president, regulatory affairs, for UnitedHealthcare, where she manages federal health reform policy and implementation. She previously served as deputy chief of staff to the State Controller from 2004 to 2006 and chief deputy cabinet secretary in the Office of the Governor during 2003. She received her bachelor of arts degree from Cornell University.”