California's Pension Contribution Shortfall At Least $15 Billion per Year

“Pension-change advocates failed to find funding for a measure during the depths of the 2008 recession and the havoc it wreaked on government budgets, so they won’t pass (a measure) when the economy is doing well.”
–  Steve Maviglio, political consultant and union coalition spokesperson, Sacramento Bee, January 18, 2016

It’s hard to argue with Mr. Maviglio’s logic. If the economy is healthy and the stock market is roaring, fixing the long-term financial challenges facing California’s state/local government employee pensions systems will not be a top political priority. But that doesn’t mean those challenges have gone away.

One of the biggest problems pension reformers face is communicating just how serious the problem is getting, and one of the biggest reasons for that is the lack of good financial information about California’s government worker pension systems.

The California State Controller used to release a “Public Retirement Systems Annual Report,” that consolidated all of California’s 80 independent state and local public employee pension systems into one set of financials, but they discontinued the practice in 2013. The most recent one issued, released in May, 2013, was itself almost two years behind with financial data – using FYE 6-30-2011 financial statements, and it was almost three years behind with actuarial data – used to report funding ratios – using FYE 6-30-2010 actuarial analysis. Now the state controller has created a “By the Numbers” website, but it’s hard to use and does not provide summaries.

No wonder it’s so easy to assert that nothing is wrong with California’s pension systems!

The best source of raw data on California’s pensions comes from the U.S. Census Bureau. Since that data is better than nothing, here are some critical areas where roughly accurate numbers can be reported.

(1)  The Cash Flow, Money In vs. Money Out

What is the net cash flow of these pensions funds? How much are they collecting in contributions and how much are they distributing in pension benefits? This information, especially if it can be compiled over a period of years, determines whether or not pension funds are net buyers or sellers in the markets. The reason this matters is because if America’s pension funds, with over $4.0 trillion in assets, are net sellers, they put downward pressure on stock prices. They’re that big.

California State/Local Pension Funds Consolidated
2014 – Cash Flow


This cash flow (above) shows that during 2014, California’s state/local pension funds, combined, collected 30.1 billion from state and local agencies, and paid out $46.1 billion to pensioners. They are paying out 50% more than they’re taking in, and this is a relatively recent phenomenon. Historically, pension funds have been net buyers in the market. Now, pension funds across the U.S., along with retiring baby boomers, are sellers in the market. This is one reason it is difficult to be optimistic about securing a 7.5% average annual return in the future, despite historical results. And as for that healthy 15.4% return on investments in 2014? That was offset in 2015, when the markets were flat. It is also noteworthy that employee contributions of $8.9 billion are greatly exceeded by the $21.2 billion in employer (taxpayer) contributions. How many 401K recipients get a 2.5 to 1.0 matching from their employer?

(2) The Asset Distribution and Portfolio Risk

What is the asset distribution of these pension funds? How much have they invested in relatively risk free, fixed income bonds, vs. their investments in stocks and other variable return assets?

California State/Local Pension Funds Consolidated
2014 – Asset Distribution


This asset distribution table (above) indicates that the ratio of riskier, variable return investments to fixed return investments is nearly four-to-one. What if stocks fail to appreciate for a few years? What if real estate values don’t continue to soar? What if there simply aren’t enough high-yield investments out there to allow these assets, valued at a staggering $751 billion in 2014, to throw off a 7.5% annual return? This is a precarious situation. If these projected 7.5% returns were truly “risk free,” the ratios on this table would be reversed, with most of the money in fixed return investments.

(3) The Unfunded Liability and the “Catch-up” Payments

What is the amount of the unfunded liability for these pension funds? And of the total amount collected and invested each year in these funds, how much is the “unfunded contribution” – the amount allocated to pay down the unfunded liability and eventually restore the systems to 100% funding – and how much is the “normal contribution” – the amount required to fund future pension benefits just earned in that particular year by active workers?

This question, for which neither the State Controller, nor the U.S. Census Bureau, can provide timely and accurate answers, is the most complex and also the most important. While consolidated data is not readily obtainable for these variables, by assuming these pension systems, in aggregate, are officially recognized as 75% funded, we can compile useful data:

California State/Local Pension Funds Consolidated
2014 – Est. Required Unfunded Contribution


The above table estimates that at a 75% funded ratio, at the end of 2014 the total pension fund liabilities for all of California’s state and local government pension funds was just over $1.0 trillion, with unfunded liabilities at $250 billion. The middle portion of the table shows, using conventional formulas adopted by Moody’s investor services for analyzing public pensions, that if the annual rate-of-return projection is lowered to a slightly more realistic 6.5% (already being phased in by CalPERS), the unfunded liability jumps to $380.1 billion, and the funded ratio drops to 66%. For a detailed discussion of these formulas, refer to the California Policy Center study “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County.”

The lower portion of the table spells out just how deep a hole California’s state and local public employee pension systems have dug for themselves. Using standard amortization formulas, and a quite lengthy 30 year payback term, at a 6.5% rate-of-return assumption, it would take a payment of $29.1 billion per year to return California’s pension funds to 100% funded status by 2046. Since the total payments into California’s pension funds – refer back to table 1 – were only 30.1 billion in 2014, it is pertinent to wonder just how much the normal contribution was, in aggregate, in 2014, vs. the unfunded contribution.

One promising pension transparency project is being directed by professors Joshua Rauh and Joe Nation via Stanford University’s Institute for Economic Policy Research. Their “Pension Tracker” website has already compiled an impressive body of data, especially useful at the local level. Hopefully they, or someone, will get eventually compile and present accurate data, both locally and statewide, not only showing cash flows, but differentiating between the normal contributions and the unfunded contributions.

In the absence of data, here’s a rough guess: Approximately 1.5 million active state and local government workers in California probably earned pension eligible income of at least $100 billion in 2014. If the “normal contribution” is 16% of payroll, that equates to $16 billion per year. This is a very conservative estimate.

Mr. Maviglio, and all of his colleagues who wish, like many of us, to save the defined benefit pension, are invited to explain how California’s pension systems will ever become healthy, if, best case, their required unfunded contribution is $29.1 billion per year, their required normal contribution is $16 billion per year, and the total payments actually being made per year are only $30.1 billion. That’s a shortfall of $15 billion per year.

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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.

Orange County Pensions At Risk – Unions Just Call Critics “Extremists”

“Just as the overseer of Detroit lied to the public about Detroit’s unfunded pension liability, these extremists are likewise lying to the taxpayers of Orange County, and they’re following his playbook.”
–  Jennifer Muir, Communications Director, Orange County Employees Association

We’re not lying, Jennifer. We’re not even stretching the truth.

What government union spokesperson Muir is referring to is an analysis released last week by the California Public Policy Center entitled “Are Annual Contributions Into Orange County’s Employee Pension Plan Adequate?

They aren’t adequate. They aren’t even close to adequate. No lie.

The problem with pensions, unfortunately, as Teri Sforza aptly put it in her coverage of the CPPC study on September 10th in the Orange County Register, is “the nature of America’s public pension systems is to peer 20 to 30 years into the future – and the crystal ball can get a bit murky.”

And hiding behind this convenient murkiness, defenders of the system – inadequate payments included – can call anyone concerned about the long-term solvency of the system “liars,” and “extremists.”

It’s much easier, and certainly much more effective, to disparage the critics than grapple with facts. But anyone familiar with the real estate and credit crash of 2008 should understand that ignoring financial fundamentals is a dangerous game. Here are the financial facts:

As of 12-31-2012 the Orange County Employee Retirement System had invested assets of $9.47 billion. For the plan to be fully funded, those assets needed to be equal to the liabilities; defined as the present value of the system’s financial obligation to pay all active participants – working and retired – retirement pensions. Here’s where the crystal ball gets murky – because how big that liability is today depends on what rate of interest the assets will earn each year, for the next 20-30 years. At a projected rate of return of 7.25%, those liabilities are valued at $15.14 billion. Underfunding = Assets – Liabilities.

OCERS is officially underfunded – according to their own annual report, by $5.67 billion. No lie. Fact.

Now it is fair to argue over what rate of return is truly realistic. But even if we use a higher rate, say, 7.5%, that liability only shrinks to $14.69 billion. Put another way, if you increase the projected rate of return by one-quarter of a percent, your unfunded liability will go from $5.67 billion down to $5.22 billion.

To verify these numbers, download the spreadsheet created by CPPC analysts and see for yourself. Go to table 1 “unfunded liability” and enter .075 in the yellow highlighted cell D23, and look at the result in the green highlighted cell D26. To construct this spreadsheet, the CPPC relied on those extremists at Moody’s Investor Services, whose formulas are meant to provide credit analysts with accurate tools to perform what-if analysis.

The point of all this?

In order to pay down their unfunded liability of $5.67 billion – or $5.22 billion if you want to use something approximating the union’s number – during 2012 OCERS contributed $218 million. Was that enough?

If there were no interest at all on this unfunded liability, at a rate of $218 million per year, it would take OCERS 26 years to pay off $5.67 billion; 24 years to pay off $5.22 billion. But it isn’t that simple.

Pension plans like OCERS rely on investment returns for most of their annual contributions. The assets they’ve got invested are supposed to earn – presumably – 7.25% per year. Investment returns, not contributions, are the intended source for most of the money OCERS needs to fund current and future pension payments. And if OCERS were fully funded, their investments would be earning $1.1 billion each year, that’s $15.14 billion times 7.25%. But because OCERS was only 63% funded in 2012, because they only had $9.14 billion of invested assets, at their projected rate of return of 7.25% they would only have earned $687 million. To earn the required $1.1 billion, at a 63% level of funding OCERS would have to have earned 11.6% – and they would have to do that every year just to avoid going further in the hole.

Does anyone really think OCERS is going to average a return of 11.6% per year for the next 25 years? Should only “liars” and “extremists” be concerned?

The reason OCERS got away with contributing a mere $218 million during 2012 towards a liability of $5.67 billion is because they intend to eventually increase these annual payments. Meanwhile, OCERS CEO Steve Delaney acknowledged that during 2012 the OCERS unfunded liability experienced “negative amortization,” despite better than normal investment returns. How much do these payments need to increase?

If OCERS were serious about restoring adequate funding, they would adopt the recommendations of Moody’s Investor Services – those extremists with the green eye shades – who in April 2013 called for a “20 year level payment” plan for reducing the unfunded liabilities of pension plans. At 7.25%, that would equate to $546 million per year. And if reality reveals over time that OCERS can only earn 6.2% per year on average, that payment would increase to $685 million per year. By this reasoning, the OCERS unfunded contribution was well over $300 million short in 2012, and the longer they wait to increase their annual unfunded contribution, the greater – above and beyond $300 million – the required increase.

By adopting graduated repayment schedules instead of telling the truth about just how perilous the situation is for OCERS, defenders of the status quo are putting the entire system at risk of a complete collapse. They are committing precisely the same unsustainable excess as the issuers of subprime mortgages ten years ago – financial instruments with graduated payment plans that mislead borrowers into thinking they could buy things that they couldn’t possibly afford.

Jennifer Muir, Nick Berardino, and others who have been outspoken critics of pension reformers, are invited to download the spreadsheet the CPPC has produced to evaluate the financial health of OCERS. Before trotting out the insults, perhaps they might first familiarize themselves with the liberating reality of algebra, a discipline that is indifferent to lies, extremism, and all other flights of wishful fancy.

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Ed Ring is the executive director of the California Public Policy Center, and the editor of UnionWatch.