In last month’s column, I wrote that the most crucial “Open Trench” topic during the last two years was the financial crisis of public employee pension obligations. I noted two dangerous misconceptions: First, that there isn’t really a crisis; and second, that our elected officials have actually done something significant to address the crisis. In this column, I’ll look at: “Is there a crisis?”
I hope everyone understands this whole issue is intensely political. Only a minor percentage of private sector employees are unionized, but the vast majority of public employees are unionized. Public employee unions exist to obtain better pay, benefits and working conditions for members. Many politicians hugely depend on union support. Therefore, unions exert big influence on elected officials at every level.
The most important benefit for public employees is the lifetime defined benefit pension plan, something that’s becoming almost nonexistent in the private sector due to unpredictably high costs. There are three principal worries about the status of any particular defined benefit pension plan: First, how much does the plan’s actuary say should be contributed to the plan this year; second, what is the gap—the “unfunded liability”—between the amount of money actually in the plan and how much has already been promised to employees and retirees; and, third, what rate of return does the actuary assume for the plan’s existing assets. If the plan’s assets don’t meet the assumed rate of return, both the current year’s contribution and the unfunded liability will go up. A fourth concern is: How much did the plan sponsor borrow—pension obligation bonds—to make the unfunded liability look smaller than it actually is. Any calculation of true annual cost needs to include money that was borrowed to deposit into the plan.
Now let’s look at the perfect storm for public employee pension plans in California. The disaster began in 1999, when state legislators approved massive retroactive pension enhancements for state employees. Unions pushed hard for the state-level enhancements, convincing legislators that the cost would be negligible. Instead, the annual cost for California has mushroomed to almost $4 billion.
Over the next few years, the enhancements spread through every level of government. In almost every case, the better pension benefits were calculated retroactive to date of hire, with a painful effect on plan funding levels. Even if a particular plan was fully funded the day before retroactive enhancements were granted, it would have a big unfunded liability the day after. And the stock market took a dive in 2000, decreasing the value of defined benefit plan assets and thus increasing required annual contributions and the overall unfunded liabilities.
The city of Santa Rosa and county of Sonoma approved retroactive pension enhancements about 10 years ago. Both floated pension obligation bonds to reduce their sharply higher unfunded liabilities. In 2003, the county borrowed $210 million and the city about $50 million. Later (2010), the county borrowed another $290 million. The theory was that the interest rate on the bonds was lower than the rate the plans would charge (7.5 percent to 8 percent) if money was put in the plans over time. But this is just the equivalent of taking a loan against your house to pay down your credit card balance. The interest rate is lower, but you still owe the money. There’s a further risk if the borrowed money doesn’t produce expected investment returns. For instance, almost all public employee pension plans in California had big investment losses in 2008. More recently, Sonoma County’s plan and CalPERS both had annual earnings less than 1.5 percent. This has a big effect on the size of unfunded liabilities and the actuary’s determination of annual contributions.
Using a possibly over-optimistic earnings assumption of 7.5 percent, Sonoma County has a combined unfunded liability and pension obligation bond debt between $800 million and $1 billion. Santa Rosa’s similar hole is about $150 million. A more conservative earnings projection could more than double the numbers for the county and the city. Is it different elsewhere? No. A recent audit in Marin County showed the unfunded liability for San Rafael’s pension plan went from $89 million in 2007 to $154 million a year ago (to, perhaps, $178 million currently). Using a more conservative earnings projection, the unfunded liability for San Rafael might be $500 million.
Why don’t actuaries simply tell the various government sponsors every year how much to contribute to fully fund their pension plans? Because it would wreak havoc on budgets. If Sonoma County had been ordered to deposit an additional $500 million into the pension plan after investment losses in 2008, county services would have been thrown into chaos. So actuaries find ways to spread the financial pain over a period of years. Some people might call this gifting a fiscal lump of coal to our children and grandchildren.
So the perfect storm included retroactive benefit increases throughout the state, two periods of big investment losses, other years of investment under-performance, steadily rising public employee salaries and steadily more creative ways of spiking pensions.
What about salaries? Of the majority of California counties operating under the County Employees Retirement Law of 1937, Sonoma County has the highest average pensionable payroll—about $85,000 per employee. This is substantially higher than the average for other counties. And Sonoma County is tied with three other counties offering the best pension formula. What trend does this produce? Regular contributions and debt payments averaged $10 million per year in the 1990s. When you add higher unfunded liabilities, the annual cost from 2001 to 2010 went up to about $100 million per year. This number could be $200 million per year by the end of the current decade, when you include interest payable on the debt and on the unfunded liability.
The crisis is real. The next question: Have our elected officials done anything significant about it? Stay tuned next month for a non-surprising answer.
