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California Cities Facing Huge Pension Increases from CalPERS

In their most recent actuarial reports CalPERS for the first time provided pension cost estimates for the next 8 years, from 2015 to 2023.

How high are these costs going for California’s cities who retroactively increased their pensions at CalPERS urging over the past 15 years? To answer that question I looked at the largest city in my county, Santa Rosa and this is what I found.

Data Sources for this Report

The data used to develop the spreadsheet analysis done as part of this report are NOT numbers that I calculated. The past numbers for 2002 to 2015 are taken directly from the City of Santa Rosa’s Comprehensive Annual Financial Reports found on the City’s website (This page has the links to Santa Rosa’s CAFRs from 2001 through 2015. In each of these CAFRs, the pension information is found in the section entitled “Notes to Basic Financial Statements” under the heading “Employees Retirement Plan.”). The projected growth of certain costs – such as retiree healthcare benefits (also known as “other post employment benefits,” or OPEB), the payroll and sales and property tax revenues – use inflation rates or growth rates similar to what CalPERS uses.

The future pension costs were obtained directly from the 2013 and 2015 Actuarial Reports prepared by CalPERS and found on the CalPERS website. Since the future costs are based upon CalPERS achieving a 7.5% net rate of investment return, I believe their costs are understated, but I used them anyway. But since the pension plan has $804 million worth of assets if the pension fund returns 6.5%, in a single year it will add $8 million to the City’s pension debt and a 5% return would add $20 million.

Looking at the data going back 16 years what I found is that in 2000, Santa Rosa’s pension contribution was $1.8 million and the plan was 122% funded, meaning there were $1.22 worth of invested assets in the fund for every $1.00 worth of benefits earned.

With CalPERS wholehearted support and assistance, on August 6, 2002, the Santa Rosa City Council passed a board resolution to enact a new contract with CalPERS that changed formulas from 2% per year of service at 55 years of age for non-safety Miscellaneous employees to a 3% at 60 formula.  The new formula was provided prospectively, meaning it only applied to future years of service, not past years.

For Police and Fire employees, the new contract was adopted retroactively so it applied to past and future years of service. Their formula went from 2% per year of service at 55 years of age to 3% at 50. This represents a more than 50% increase in the benefit, since along with the “multiplier” increasing from 2% to 3%, the age of eligibility dropped from 55 to 50. But it was the retroactive granting of this benefit that caused even more significant financial liability. This is because the multiplier was increased by 50% even for years already worked and raised pensions from 60% of salary to 90% of salary for 30 years of service.

These changes ended up having a serious impact on the pension costs and the unfunded liability because CalPERS used an overly optimistic rate of investment return of 8.25% compounded per year in their cost analysis. Over the past 15 years since the increase, CalPERS has only achieved a 5% compound rate of return. Many experts believe in this current low interest rate environment returns will remain at the 5% return level for the foreseeable future.

In July of 2003 the City took on $53 million worth of new debt by selling Pension Obligation Bonds (POB) and giving the proceeds to CalPERS to pay down the unfunded liability that was created by the new formulas. With interest these bonds will divert over $100 million from government services to debt service.

CalPERS Flawed Cost Analysis and Lack of Proper Disclosure

CalPERS cost analysis provided to the City in 2002 stated the cost for the new 3% at 50 formula for Safety members would be 13.27% of salary and the cost for the 3% at 60 formula for Miscellaneous members would be 9.87% of salary. However, as previously stated, these estimates were calculated assuming that pension assets would grow at 8.25% per year into the future. Since CalPERS investments have only averaged 5% over the past 15 years the increases have created $287 million in unfunded pension liabilities for the City as of 2015.

In addition, the analysis did not provide the City with any warning or disclosure regarding what would happen if the 8.25% investment return was not achieved. CalPERS simply wrote “For many plans at CalPERS the financial soundness of the plan will not be jeopardized regardless of the new formula choice made by the employer.”

The Growth of Pension Costs Since the Increase

In 2001, the City’s pension contribution was $1.5 million and in the first 4 years following the increase it grew to $11.5 million. In addition, the funding ratio dropped from 122% in 2001 to 70% in 2005 meaning the fund, instead of $63 million in excess assets now had $128 million in unfunded liabilities.

In 2006, the annual cost grew by another $5 million hitting $16.6 million and by 2015 had grown to $21 million. However, this was a very modest growth considering CalPERS lost 29% of its assets during the Great Recession in 2008 and 2009. CalPERS lowered contributions in order to help cities and counties who saw their tax revenues during the recession drop. So CalPERS extended the amortization period on the unfunded liabilities from 9 to 20 years and smoothed their investment gains and losses from 4 to 15 years into the future. Basically, these were accounting gimmicks that resulted in severe underfunding of the pension plan and these changes exist today. The chart below shows the growth of Santa Rosa public employee retirement costs (click here to see the underlying calculations).

Santa Rosa Retirement Cost Growth

However, now CalPERS is worried that the plans are not being properly funded and pension contributions need to be doubled over the next 9 years.

Projected Future Costs

In their 2015 actuarial reports, CalPERS provided the City with their normal employer contribution as a percentage of payroll and the unfunded actuarial liability (UAL) as a total cost each year from 2015 to 2023. Using a 3% payroll growth assumption and their UAL numbers, I calculated the annual costs going forward. In addition, I added the pension obligation bond debt service each year going forward along with the cost of retiree healthcare benefits using a 5% annual cost increase assumption as CalPERS does.

My analysis indicates that during the next 8 years, the cost for retiree benefits will increase from $31.0 million or 33.7% of payroll in 2015 to $59.1 million or 48% of payroll in 2023.

The nearly doubling of pension and retiree healthcare costs means the City will need to cut salaries, benefits, services and/or increase taxes each and every year going forward by $3.2 million per year to meet their retiree benefit costs.

Pension and Healthcare Costs as a Percentage of Tax Revenues

More important than pension costs as a percentage of payroll are pension costs as a percentage of tax revenues because tax revenues are what enables the City to pay for its benefits. Once retiree benefit costs exceed the City’s ability to pay them, they will no longer be able to be fully paid and at that point either they will need to be reduced in bankruptcy or through significant pension reductions. The chart below shows the growth of pension costs relative to that of general fund property tax and sales tax revenues.

churchill-2016-10-31-chart

The results of my analysis are staggering. Over the past 15 years’ sales and property tax revenues have climbed an average of 3% per year, while employee retirement costs have increased an average of 19% per year. This has led to a growth of retiree benefit costs from 3.5% of major tax revenues in 2001 to 47% in 2015 and an estimated growth to 70% of major tax revenues by 2023 (Editor’s note:  the city receives other revenues which may also be available to finance pension costs).

Growth of the Unfunded Liability

The unfunded liability of the pension plan is calculated by taking the assets in the plan minus the present value of the benefits already earned by current employees and retirees, considered the plan’s liability. The funding ratio is determined by dividing the market value of assets in the plan by the liability.

CalPERS discounts the long term liability by assuming before the money is paid to retirees, it will earn investment income. CalPERS currently uses an assumed 7.5% rate of investment return to calculate the liability and payments to the plan. So if the assumed investment return is lowered, the unfunded liability of the plan increases along with the cost of paying off the liability. Unfunded liability costs are borne by taxpayers and are not a shared expense with the employees.

Currently, using a 7.5% assumed rate of return, the pension fund has $287 million worth of unfunded liabilities and pension bond debt and is 74% funded. However, many experts believe in this low interest rate environment a lower investment return assumption should be used. Many experts think that a 5.5% to 6.5% rate should be used. Other experts believe a 3.5% rate should be used since this is about the rate private pension plans are required to use and what CalPERS uses if a City wanted to buy their way out of the CalPERS system. I won’t guess what the future investment returns will be, but here is what happens to the unfunded liability at various rates of investment return assumptions:

  • At 6.5% the unfunded liability would increase to $426 million and $50 million per year to would be added to the City’s pension costs.
  • At 5.5% the unfunded liability would increase to $585 million and $97 million per year would be added to the City’s pension costs.
  • At 4.5% the unfunded liability would increase to $755 million and $137 million per year would be added to the City’s pension costs.
  • At 3.5% the unfunded liability would increase to $967 million and $187 million per year would be added to the City’s pension cost.

Santa Rosa Analysis of Unfunded Liability at Various Rates of Investment Return

20161028-cpc-churchill1

City Pension Plan Status Using ERISA Standards

Under the Federal ERISA rules for private pensions, a high quality bond rate of return is used to determine the assumed rate of investment return. Today that is around 3.5%. ERISA also defines the health of a pension plan as follows:

  • Less than 80% funded is considered “seriously endangered”
  • Less than 70% funded is considered “at risk”
  • Less than 65% funded is considered “critical status”

So under ERISA standards, the City of Santa Rosa’s pension plan at 45% funded when assuming a 3.5% return is 20 percentage points below what ERISA would consider “critical status”. So one could more accurately describe the pension system as being on “life support”.  Also, under ERISA rules the pension benefits each year would stop being accrued until the plan becomes 60% funded to keep the hole from going deeper.

ERISA also requires the plan sponsor pay off their unfunded liabilities over 7 years. CalPERS currently allows public agencies to pay off their liability over up to 30 years. If the City was required to pay off its unfunded liability over the next 7 years, their annual contribution to the pension fund would grow from $28 million to $146 million in 2015 alone. So under ERISA rules pension costs would increase by $120 million per year and take them to 145% of payroll.

Conclusion

The City of Santa Rosa and all cities in California who retroactively increased pensions need to restructure their pension systems. Otherwise it is increasingly unlikely they will be able to afford the benefits that have already been earned and provide taxpayers with the services they deserve for their tax dollars.

City officials can no longer pretend a crisis does not exist. They would be well advised to form a Pension Advisory Committee and bring all the stakeholders to the table to look at all the options, have an actuary determine the savings for each option and make informed decisions to save the pension plan and benefits people are counting on to fund their retirement.

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About the author:  Ken Churchill is the author of numerous studies on the pension crisis in California and is also the Director of New Sonoma, an organization of financial experts and citizens concerned about Sonoma County’s finances and governance.

REFERENCES AND RELATED ARTICLES

California Court Ruling Allows Pension Changes, August 26, 2016

How CalPERS has Created a Ticking Time Bomb, November 30, 2015

The Devastating Impact of Retroactive Pension Increases in California, April 27, 2015

Evaluating Total Unfunded Public Employee Retirement Liabilities in 20 California Counties, May 6, 2014

Sonoma County’s Pension Crisis – Analysis and Recommendations, January 12, 2014

The Sonoma County Retroactive Pension Increase: Gross Incompetence or Billion Dollar Scam?, April 15, 2012

How Retroactive Benefit Increases and Lower Returns Blew Up Sonoma County’s Pensions, April 5, 2012

 

How CalPERS has Created a Ticking Time Bomb

During the Stockton bankruptcy Judge Klein called CalPERS the “bully with a glass jaw.” Klein meant that CalPERS, as a servicing company, has no standing in the bankruptcy because the pension obligation is between the public agency and their employees and retirees.
Read more

Look Out For These Pension Gimmicks

State public pension plans are the future, and often current, greatest liabilities that state governments must tackle. Promises made to employees in the past, and politicians kicking the problem further into the future have made the problem spiral out of control. Economists agree that the current discounting of liabilities leaves much to be desired. State Budget Solutions has long been an advocate for using fair market valuation.

But it isn’t just discount rates that cause these pension liabilities to climb. Here is our guide to some of the other popular tricks used by politicians and actuaries that hide the true cost of delaying pension reform.

Outdated Life Expectancy Assumptions
When public pension funds were first established, the average life expectancy was much lower than it is today. The problem is that some pension funds have not adjusted for this change. The calculations for determining liabilities take demographics into consideration. If this is not updated, it means that the pension fund is planning to pay out benefits to retirees for a shorter time. TheInternational Monetary Fund recognized this issue, concluding that “if everyone lives three years longer than now expected–the average underestimation of longevity in the past–the present discounted value of the additional living expenses of everyone during those additional years of life amounts to between 25 and 50 percent of 2010 GDP.”

  • California: CalPERS has been assuming that government employees, especially police and fire personnel, are more likely to die on the job. This allowed the system to require smaller contributions into the system. But it isn’t true, because government has expanded that definition to include several causes of death that are not directly related to the job, such as heart attack. The result is that CalPERS actuaries are now asking for a 10% increase in contributions to make up the difference for the faulty assumption.
  • New Study: How Will Longer Lifespans Affect State and Local Pension Funding?

Inflated Discount Rates
The discount rate is used to determine the amount of funding necessary in a public pension fund today in order to reach the predicted funding needed in the future to provide retiree benefits. Most public pensions use the expected investment rate of return as the discount rate. This rate is often 7-8%, and sometimes higher. This means that pension fund managers must be willing to take greater risk in order to match the discount rate and ensure that there is sufficient money in the fund at a later date. This also requires that the necessary contributions are made every year, and also requires that all actuarial assumptions are accurate. Pension benefits, however, are considered guaranteed assets to the retirees who are vested in the system and therefore must be paid. This obligation puts taxpayers on the hook for trillions of dollars if the discount rate is not met.

A study by Moody’s Investor Services showed that from 2004-2012, the top 25 public pension funds were “on-target” for rate of returns but still accrued nearly $2 trillion in unfunded liabilities. This is because using the rate of return in lieu of a market-valued discount rate is not a proper reflection on the liabilities. The discount rate should reflect similar liabilities, such as those paid out in government bonds yields. The State Budget Solutions annual report on public pensions showed that if public pension funds used a more appropriate discount rate, the collective unfunded liability of all state plans would be $4.7 trillion.

Overly Aggressive Investment Assumptions
Legislators are tempted to assume a higher annual rate of return on investments, meaning that they can put fewer dollars into pensions in the current budget. Although related to inflated discount rates, this issue is an independent problem.

Underfunding Pension Contributions
An underfunded state pension plan has more liabilities than assets. By continually underfunding pensions, pension accounts become less stable, and there is less assurance that the state can effectively cover distribution amounts when pension benefits become due. The Annual Required Contribution (ARC) is the amount of money required to sustain the pension fund based on the discount rate and other assumptions. When the ARC is skipped, or even reduced, that means that pension funds will need to make up for the lost expected growth, as well as the actual contribution in today’s dollars. This compounds the unfunded liabilities.

  • New Jersey: Governor Chris Christie has made a habit of underfunding the state pension fund, repeating the sins of many of his predecessors. Most recently, Christie’s administration is arguing that its own reforms to the pension system, which required full contributions each year, are unconstitutional. Courts have said that he must follow the 2011 law.

Pension Obligation Bonds
As more states recognize the whopping unfunded liabilities in public pension funds, some policymakers have opted to borrow money now in order to make up the difference. When interest rates are low, the logic follows that if a state borrows money today at a lower rate, it can invest that money, have a greater rate of return, and be able to pay off the bond debt and also assist in paying down unfunded liabilities. But this maneuver also allows the state to automatically assume that this new funding will hit the higher rate of returns, often at 7-8% annually. That means that even less money needs to be put into the pension funds now, or at least according to this accounting trick. Another challenge is when a state issues pension obligation bonds, they underfund the annual required contribution in the budget and in some cases (i.e. Illinois) use the pension obligation bonds to “balance” the current budget and thus not put the money into pensions.

  • Kansas: Kansas has approved a $1 billion pension bond that will put cash directly into the coffers of the system to be used for investment. Because of the investment assumptions, the state has also decided to lower the contribution to the pension plan by $64 million over two years, which will help “balance” the budget.
  • Illinois: “In just ten years, the Illinois General Assembly pushed the burden of billions in government spending onto Illinois’ future generations. Official estimates put Illinois’ unfunded pension liability at $85.6 billion. But that amount does not take into account the $25.8 billion in pension obligation bond (POB) payments still outstanding, which have a net present value of approximately $17.2 billion”

Rolling Amortization and Smoothing
In order to make the contributions by the employer–the government–more stable and predictable year over year, pension funds engage in actuarial gimmicks that allow contributions to remain low. The spirit of this idea is admirable, as it intends to ignore the potential volatility on Wall Street and still ensure proper contributions into the pension fund. In reality, the result has been the opposite. This tactic has allowed pension funds to ignore their incorrect assumptions on investment returns and discount rates and maintain contributions that do nothing to meet the true liabilities.

Liberal Vesting Requirements
In order to receive a pension benefit, government employees must meet certain requirements regarding their employment, including length of service. In some cases, state and local governments have made it easy for employees to meet those requirements, known as “vesting.” If vesting is easy, then too many retirees will be receiving benefits in the future, straining the system. Vesting requirements may also be expanded by the courts, adding greater liabilities to the pension plans. These liberal vesting requirements also make reforms more difficult. The more employees that are considered to be vested while employed, the more limited the reforms can be as it is often the case that vested employees may not have their benefits altered.

Not Planning For The Future
It is so easy for legislators to promise benefits tomorrow but not pay for them today. This is the essential flaw in the current public pension system that allows for defined benefit plans. Those who control the levels of benefits are politicians who must worry about re-election. This is not a system that rewards future planning over present results. If politicians were divorced from the process and employees and retirees had control over their retirement, a good number of these gimmicks would not be necessary to have a sustainable system.

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About the Authors:

Joe Luppino-Esposito is the editor and general counsel of State Budget Solutions. Joe’s current research focuses on public employee pensions, Medicaid expansion, state debt, budget gimmicks, and many other state budget reforms. Prior to joining SBS, Joe was a researcher for Berman and Company, and previously served as a Visiting Legal Fellow at the Heritage Foundation, specializing in criminal and constitutional law.

Bob Williams is President of State Budget Solutions. He is a former state legislator, gubernatorial candidate an auditor with the U.S. Government Accountability Office (GAO). Bob is a national expert in fiscal and tax policies, election reform and disaster preparedness. Because of his unique experience and expertise, Bob is a frequent guest on talk radio and at public forums. His commentary on state budget solutions appears frequently in newspapers, journals and online publications.

This article originally appeared on the website of State Budget Solutions and is republished here with permission.

CalPERS and Unions Win Again – Taxpayers and Bondholders Lose

In bankruptcy, the federal courts have ruled that cities can reduce pension obligations. They can, but they don’t have to. In Detroit, bondholders were sacrificed to maintain police and fire pensions with minimal haircuts.

On Monday, U.S. Bankruptcy Judge Meredith Jury ruled against bondholders in favor of Calpers in the San Bernardino bankruptcy. She acknowledged that her decision is likely to be seen as unfair to the municipal bond market and might even discourage investors from buying pension obligation bonds in the future.

Please consider Calpers’ Pension Hammer Forces ‘Unfair’ Bond Ruling by Judge.

California’s public retirement fund holds so much power over local officials that pension-bond investors can’t expect equal treatment when a city goes bankrupt, a judge said in a ruling that she acknowledged seems “unfair.”

“What I see as unfair, and might seem unfair to the outside world, does not matter under law,” Jury said, referring in part to the powerful remedies Calpers can seek if the city doesn’t honor its contract.

Monday’s ruling sticks with a pattern seen in the bankruptcies of Stockton, California, and Detroit, said Marilyn Cohen, president of Envision Capital Management in El Segundo, California.

Up to Cities

Federal bankruptcy courts have many times ruled that cities can cut pension obligation, but nothing forces them to.

For example, in the Stockton California bankruptcy, a federal judge ruled that Stockton could have tried to reduce its obligation to Calpers. However, Stockton chose not to do so, arguing that fighting Calpers would take too long and could endanger employee pensions.

Conflict of Interest

I believe Stockton’s rationale is nonsense. Instead, I propose Stockton city officials had a conflict of interest.

City officials wanted to preserve their own pensions.

Chicago Connection

So what does this have to do with Chicago and the state of Illinois in general?

Lots, so let’s tie it all together.

As a result Tuesday’s Illinois Supreme Court Ruling that the 2013 Pension Reform Law Is Unconstitutional Moody’s cut Chicago’s bond rating two notches to junk. Moody’s specifically cited Chicago’s pension crisis.

I discussed this yesterday in Chicago Bond Rating Cut to Junk; City Faces $2.2 Billion in Various Termination Fees; Irresponsible to Tell the Truth.

In light of the San Bernardino ruling today, cities that have huge pension issues will see bond yields soar.

The Chicago Board of education is already paying 285 basis points more than other cities because of pensions. If bondholders keep getting hammered, those yields will rise further.

Pass a Bankruptcy Law, Give Taxpayers a Chance

A Chicago Tribune editorial by Henry J. Feinberg, says Pass a Bankruptcy Law, Give Taxpayers a Chance.

Under federal law, state governments can’t file for bankruptcy. Local governments can do so if their states give them permission. A bill now before the Illinois legislature would extend that permission to Illinois municipalities, most of which now can’t seek protection under bankruptcy law.

The right way is to amend House Bill 298 so people who hold Illinois bonds have a “secured first lien,” the fancy words needed in the law to make sure bondholders are first in line to get their money back. Passing this amended bill would do three things that the state’s local governments have not been able to accomplish for decades.

Three Reasons to Amend Bill 298

Feinberg cites three reasons to amend the pending bankruptcy bill.

  • First, it would bring opposing sides to the table to have meaningful discussions about how to save the borrower, in this case the local government, from financial ruin.
  • Second, the government could ask the bankruptcy court to modify labor contracts and order the parties to renegotiate the terms of collective bargaining agreements.
  • Finally, a law that puts bondholders first in line to get repaid would be a stroke of fairness that would help Illinois cities, school districts and other local governments avert a short-term solution like Detroit’s. There, some people who had lent money to the city by buying its bonds lost two-thirds of their investment. Meanwhile, members of the politically powerful police and firefighter unions took no cuts to their pensions (their cost-of-living adjustment was reduced). Other workers took a 4.5 percent base cut in pensions and the elimination of an annual cost-of-living increase, The Detroit News reported.

I agree with Feinberg on all three points. Bankruptcy is the only real solution for many of these plans and many cities as well.

Beware the Tax Man

Tax hikes cannot possibly address the shortfall. As discussed on May 4, in Beware, the Tax Man Has Eyes on You, the potential hike for Illinoisans is staggering.

Nuveen estimated 50% property tax hikes would be necessary. Those hikes were just for Chicago. They did not include money to bail out other Illinois pension plans. Nor did it address the $9 billion budget deficit for the state.

Finally, Nuveen’s estimate assumed pension plans would make their plan assumption of 7% returns or higher.

Stock Market Bubble Will Hit Pensions

I believe another serious decline in the stock market is likely. So do some of the biggest fund managers in the world.

Please check out Seven Year Negative Returns in Stocks and Bonds; Fraudulent Promises.

Pension promises were not made in good faith.

Rather, pension promises were the direct result of coercion by public unions on legislators, mayors, and other officials willing to accept bribes because they shared in the ill-gotten gains of backroom deals at taxpayer expense.

About the Author:  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.

The Looming Bipartisan Backlash Against Unionized Government

Whenever discussing politically viable policy proposals to improve the quality of life in California, the imperative is to come up with ideas that strongly appeal to moderate centrists, since that is how most Californians would describe themselves. And there are two compelling issues that offer that appeal: making California’s system of K-12 education the best in the world, and restoring financial sustainability to California’s state and local governments.

While these two objectives have broad conceptual appeal, there is a clear choice between two very different sets of policies that claim to accomplish them. The first choice, promoted by public sector unions, is to spend more money. And to do that, their solution is to raise taxes, especially on corporations and wealthy individuals. The problem with that option, of course, is that California already has the highest taxes and most inhospitable business climate in the U.S.

The alternative to throwing more money at California’s troubled system of K-12 education and financially precarious cities and counties is to enact fundamental reforms. And these reforms, despite the fact that each of them arouses relentless, heavily funded opposition from government worker unions, are utterly bipartisan in character. They are practical, they are fair, and they are not ideologically driven.

Education Reforms:

  • Faithfully implement the Vergara Ruling – abolish the union work rules that (1) grant teacher tenure well before new teachers can be properly trained and evaluated, (2) protect incompetent teachers from dismissal, and (3) favor seniority over merit when implementing workforce reductions.
  • Streamline permitting for charter schools. These independent enterprises allow far greater flexibility to teachers and principals, creating laboratories where new best practices can rapidly evolve. Poorly performing charter schools can be shut down, successful ones can be emulated.
  • Enable school choice, so parents can move their students out of bad schools. Start by aggressively promoting and supporting California’s 2010 Open Enrollment Act, that empowers any parent whose child attends one of the state’s 1,000 lowest performing schools to move them to the school of their choice.

Financial Sustainability Reforms:

  • Roll back defined benefit pension formulas to restore viable funding and protect taxpayers. Adopting “triggers” that prospectively lower pension benefit accruals for existing workers and suspend COLAs for retirees, will preserve the defined benefit. One more market downturn will make this choice unavoidable – the sooner this reform is accepted, the more moderate its impact.
  • Reform public employee compensation. The average total compensation for California’s state and local government workers (taking into account all employer paid benefits including retirement benefits and annual paid vacations/holidays) is now more than twice the median compensation for private sector workers. Typically, approximately 70% (or more) of local government budgets are for personnel costs. Public sector compensation needs to be frozen – or even reduced – until the private sector can catch up.
  • Modernize and streamline public agencies. Introduce flexibility to job descriptions and eliminate unnecessary positions. Upgrade and automate information systems.
  • Improve financial management and accountability. The public sector needs to adhere to the same accounting standards that govern the private sector. If anything, public sector reporting should be more standardized, and faster, than what is required in private industry – currently the opposite applies.
  • Eliminate exploitative financing mechanisms: Outlaw capital appreciation bonds, revenue anticipation bonds, and pension obligation bonds, for starters. Nearly all of the “creative” financing instruments being foisted onto relatively unsophisticated city councils are short-term solutions that create long-term financial nightmares.

There are many other fundamental reforms that could rescue California’s K-12 educational system and rescue California’s state and local finances. But the ones listed here would be a very good start. And while there is plenty of room for debate over the particulars of each of these proposed reforms, there is only one powerful interest group that vigorously opposes all of them – public sector unions.

The reality of California’s unacceptable educational results and insolvent cities and counties will compel concerned citizens of all political persuasions to examine these issues over the next several years. And in that process, the inherent conflict between public sector unions and the public interest will become increasingly obvious. To survive, public sector unions will have to accept reforms that challenge their agenda. They will have to accept meaningful pension and compensation reform. They will have to accept smaller, more efficient workforces. They will have to embrace individual accountability and reward individual merit in public education and throughout public agencies. They will have to abandon their symbiotic relationship with financial predators that pump cash into bloated, unionized public agencies on terms that are usurious to taxpayers.

To the extent public sector unions are not willing to attenuate their power and adapt their agenda to the public interest, their recalcitrance will invite a bipartisan fury from a betrayed people. Even in California.

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

GASB Loopholes Created Illusions of Solvency

What if most of the public employee compensation enhancements of the past decade or more in California were based on inaccurately optimistic government financial statements? Or to be blunt, what if government decision makers thought they could afford these compensation enhancements, because the information they relied on used accounting gimmicks that would land a person in private industry in jail for fraud?

Back in February the California Public Policy Center (CPPC) published a study entitled “How Lower Earnings Will Impact California’s Unfunded Pension Liability,” where, using various rates of annual investment earnings, the number ranged between $128 billion and $576 billion. This study and others highlighted the fact that starting in 2014, not only will Moody’s Investors Services begin using a much lower investment projection in their credit analysis, but GASB – the Government Accounting Standards Board – will require government entities to recognize this liability on their balance sheets.

Earlier this week, the CPPC published a new study entitled “Unmasking Staggering Pension Debt and Hidden Expense,” that took a look at seven California counties, Alameda, Contra Costa, Marin, Mendocino, Orange, San Mateo, and Sonoma, and restated their balance sheets based on the new GASB financial reporting standards and the new Moody’s credit evaluation criteria. In his analysis of these seven California counties, researcher John Dickerson calculated that the new GASB rules will lower their combined net worth by a factor of ten, from a current reported $10.2 billion to less than $1.0 billion. And all of these losses, in any private enterprise, would have already been recognized.

Starting in 2014, GASB (Government Accounting Standards Board) will require state and local governments to report their unfunded pension obligation as a liability on their balance sheets, eliminating a loophole in their current regulations. It’s about time. The loopholes being plugged by GASB 68 have permitted California’s cities and counties to declare balanced budgets when in fact they were failing to report billions in pension expense.

The study not only calculates the impact of GASB 68, but goes on to estimate the impact of GASB’s new ruling combined with Moody’s new credit evaluation criteria on government financial statements. As Dickerson writes: “These seven counties all together would drop from $10.2 billion of Net Assets down to a negative $8.3 billion hole – $19 billion less. On average, they would have more unfunded pension debt than assets.”

One may argue heatedly as to whether or not Moody’s 5.5% discount rate is too low, but for the moment, let’s forget about the discount rate. Let’s go ahead and accept the long-term earnings projection of 7.5% per year as realistic. This still means that the seven counties analyzed had failed to report over $10.2 billion in liabilities. This still means that across all of California, the state and local governments had failed to report over $128 billion in liabilities. Because $128 billion is the State Controller’s officially acknowledged amount of unfunded pension liabilities.

When financial analysts warn us that the steps GASB and Moody’s are taking will make it harder for cities and counties to acquire credit by erasing most (or all) of their net worth, and will hasten awareness of the need for compensation reform, they’re right. But that’s only half the story: For the last decade or more, as cities and counties were negotiating enhancements to public employee pension plans, and other compensation enhancements – sometimes in council meetings packed with indignant public workers, other times in binding arbitration – they were basing their decisions on financial statements that were inaccurate. Would pension formulas have been enhanced from 2.5% at 55 to 3.0% at 50, for example, if everyone at the negotiating table had been examining city or county financial statements that were correctly recording these billions in losses?

No business can survive for long with bad financial information. Any auditor whose picked apart a few balance sheets, or any general ledger accountant whose closed a few fiscal years, understands how easy it is to commit fraud. If bankers and investors are wary of a company’s financial performance and need to see more profit, an unscrupulous entrepreneur might revalue their inventory to “market value,” and voila, a loss turns into a profit. What GASB 68 is going to prevent might only excite an accountant, but since its consequences affect us all, it’s still a story worth trying to tell.

When many of California’s cities and counties fell behind in their payments to the pension funds, they didn’t record a payable on their balance sheet – because GASB didn’t have a standard in place to force them to. Then when the time came to make the payment, they needed to borrow the money, but they didn’t want to ask voters to approve a pension obligation bond. So they essentially sued themselves, securing a court ruling that documented the fact that they owed the money. This allowed them to characterize the pension obligation bond’s issuance as a refinancing of existing debt, avoiding the need to submit the bond to voters for approval. Then (accounting wonks, pay attention here), when they put the pension obligation bond debt onto their balance sheet as a liability, because they had not recorded a preexisting payable to the pension fund, instead they put the debit onto the top of the balance sheet as an offsetting asset, which they are slowly amortizing. GASB 68 will wipe all of this out, creating billions in extraordinary losses that will mostly be declared in prior period adjustments of past financial statements.

This sort of behavior violates fundamental accounting concepts, most particularly, matching expenses to the time they are incurred. But during the 1990’s and since, it allowed cities and counties to avoid placing billions in losses on their income statements. And that allowed public employee unions, politicians, and arbitrators, to all make decisions based on flawed, overly optimistic financial information. And it enabled what is now a legacy of contracted compensation enhancements that are considered by their supporters to be beyond even the power of a bankruptcy court to amend.

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

The Misleading and Incomplete Financial Disclosures of Public Institutions

Last week the California Public Policy Center published a study assessing the impact of new regulations issued by the Government Accounting Standards Board. The new ruling will require public entities to recognize unfunded pension liabilities on their balance sheets. This is a major reform. But it points to a larger issue. California’s state and local government entities and their closest financial collaborators – public sector unions, bond underwriters and pension funds – have an incentive to overstate their financial health, and understate the significance of many of the root causes of their financial distress. Here are a few examples, with links to reports that provide more detail:

(1) They mislead voters into believing government workers are underpaid, when in fact they now earn total pay and benefits that are well over twice the average for private sector workers.
“Work in Progress” Government Employee Pay Tracker Still Grossly Inaccurate
December 3, 2013, UnionWatch

(2) They claim personnel costs are only a small fraction of state and local government budgets, when in fact they usually comprise 65% to 80% of total government spending.
What Percent of California’s State and Local Budgets are Employee Compensation?
February 11, 2011, UnionWatch

(3) They campaign for tax increases to “save our schools,” then instead give the money to their pension funds.
Editorial: Prop. 30’s pension boost
November 28, 2012, Orange County Register

(4) They fail to recognize unfunded pension and retirement health care liabilities on their balance sheets.
Accounting Standards, Not Elections or Litigation, Will Finally Enable Reform
February 19, 2013, UnionWatch

(5) They mislead voters into thinking the average government pension is only $25,000 per year, when in fact, a government worker who puts in a 30 year career and retires today can expect a pension that averages over $60,000 per year.
CSEA Understates Average State Pension
May 31, 2011, UnionWatch

(6) They issue “pension obligation bonds,” borrowing money in order to make their annual pension fund contributions.
Pension Obligation Bonds: Borrowing Our Way to Prosperity?
February 9, 2010, Mackinac Center

(7) They issue “capital appreciation bonds,” deferred payment, “negative amortization” scams that should be illegal.
School bond terms more like payday loans
February 1, 2013, Orange County Register

(8) They fail to disclose total outstanding state and local government debt.
State Treasurer Doesn’t Know How Much California Owes in Bond Debt
December 4, 2012, UnionWatch
How Big is California’s “Wall of Debt”?
January 15, 2012, UnionWatch

The primary impact of all of these examples is the same; more deficit spending, and more outstanding debt. In each of them, by misleading the public and by failing to disclose clear summaries of financial realities, the beneficiaries are public sector unions and financial firms. The irony is staggering. At the same time as public sector unions relentlessly accuse “Wall Street” of enriching themselves through financial chicanery, they collude with financial interests to drag America’s public institutions deeper into a mire of debt. And they get away with it because cities, counties, government agencies, government employee pension funds, and public sector unions – are not held to the same disclosure rules or accounting standards as the private sector, nor subject to the same financial reforms.

The irony runs even deeper. Because it is debt formation itself that enables stratification of wealth and privatization. The only sector of the economy that reaps perennial benefit from government debt issuances and outstanding government debt are the Wall Street brokerages who collect the fees and their wealthy clients who collect the interest. The more encumbered local government entities are with debt, the more they are compelled to pass new regulations and attendant fees, as well as raise taxes, in order to pay the bankers. This undermines the prospects of the upwardly mobile, the emerging companies, the middle class private sector taxpayers, at the same time as it empowers established wealthy elites and corporate monopolies.

The connection between government insolvency and the destruction of public institutions cannot be overstated. When governments can’t afford to maintain basic services because too much of their revenues are used to service bond debt and feed pension funds – i.e., wealthy financial interests – the only solution left is privatization. Isn’t that anathema to the agenda of public sector unions?

California’s total state and local government debt is approaching a trillion dollars. But nobody, not the State Controller, the State Treasurer, the California Dept. of Finance, or the Office of Legislative Analyst, knows exactly how much is owed. Yet as long as borrowing can cover deficits, spending cuts can be deferred. This is a powerful incentive indeed to anyone who works for the government or contracts with the government to remain optimistic, and back up their optimism with misleading, incomplete financial disclosures.

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