Public employee pensions are the gift that keeps on taking from the coffers of city, county and state budgets. Is there something new to say about them? Yes, there is.
“Citizens for Sustainable Pension Plans” is a highly qualified, nonpartisan group of Marin County residents. They dug deeply into public records to compile a very detailed and disheartening analysis of pension and retiree benefits in Marin County and its municipalities. Their recently published report, called “Pension Roulette,” provides “first-of-its-kind rating and assessment of the financial impacts of billions of dollars in unfunded retiree debt owed by the county of Marin and its towns and cities.” As you may expect, the situation is dire. Depending on assumptions, retiree debt in Marin County is between $1.2 billion and $2.3 billion. Even little Sausalito’s total pension debt soared from $5.2 million to $17.5 million in six short years (2005 to 2011).
The “something new” has to do with CalPERS, the giant pension trust that’s the funding mechanism for the vast majority of cities in California. I knew from prior reports that CalPERS fully embraces its role as a bully, threatening cities with endless, financially draining litigation if they seek to reduce their pension obligations through bankruptcy. But “Pension Roulette” highlights another way in which CalPERS can bully and intimidate any city that proposes to terminate its participation in the traditional (and unaffordable) pension plan: imposing termination costs that no city can afford to pay. It involves an interesting actuarial trick.
The required funding of a defined benefit pension plan depends greatly on the assumed rate of return on investments (ROI). A high assumed ROI means lower contributions. In 1999, the actuaries for CalPERS gave state legislators such a rosy assumed ROI scenario that they predicted almost no additional cost for a massive, retroactive enhancement of pension benefits for public employees. That prediction is the biggest oopsie in the financial history of California.
A lower assumed ROI produces higher required contributions. All of this may seem a bit theoretical until a pension plan terminates and the plan’s actuary has to determine how much money needs to be in the plan to pay the benefits earned through the date of termination. The official CalPERS assumed ROI was 8 percent (annually) for many years, but has now dropped to 7.5 percent. This will require cities to deposit more money in future years. But what about plan terminations? CalPERS, which is controlled top-to-bottom by organized labor, doesn’t want any city to terminate its pension plan. So CalPERS came up with a powerful anti-termination tool: Use an assumed ROI of 4.8 percent on plan termination instead of the ongoing 7.5 percent assumption. And charge an additional 7 percent, ostensibly to cover the possibility that retirees will live longer than expected and thus get more benefits than expected. This sends termination costs—technically known as the Hypothetical Termination Liability—into the stratosphere.
So let’s say you’re the city of Beneficience in Marin County. You’ve been depositing exactly what CalPERS told you to for the last 30 years. Nevertheless, enhanced pension benefits and under-performing investments have ruined your budgets. You decide to terminate your pension plan and offer employees a defined contribution plan instead—a fixed contribution cost for the city and no risk to the city for investment under-performance. But CalPERS tells you the pension plan is $23 million under-funded at termination. You can leave CalPERS behind, but not before you write it a $23 million check. You quickly realize there’s no way you can leave CalPERS. This is exactly the result CalPERS wants.
The 4.8 percent assumed ROI is approximately the actual cumulative annual rate of return experienced by CalPERS from 2001 to 2012. The fact that CalPERS uses this lower assumption to calculate termination liabilities suggests, in the words of the “Pension Roulette” report, that the 7.5 percent rate used by CalPERS for ongoing contribution calculations is “extremely risky and far beyond CalPERS’ own risk tolerance.”
Does this matter? Yes, it does. If CalPERS used a 4.8 percent assumed ROI for all purposes, the required contributions for government entities participating in CalPERS would skyrocket. Budgets and thus essential government services would be devastated. The small number of civic bankruptcy filings would become a big number. Many cities would welcome the recent ruling from Detroit that federal bankruptcy law in this area preempts state law. Why is that important? Because it potentially voids the so-called “California Rule," which effectively prevents any government entity from using bankruptcy to trim pension benefits for current employees or retirees, even on a prospective basis.
All of the entities studied by the “Pension Roulette” group—except one—demonstrated poor financial health with respect to pension funding. When the group applied CalPERS’ 4.8 percent assumed rate of return, the deficits became truly frightening. The one exception was Danville, a city in Contra Costa County. The group chose Danville to study because its demographics are very similar to cities in Marin County and because its retirement plan funding deficit is zero. That’s because Danville has a defined contribution plan with employer contributions not exceeding 15 percent of pay, with no risk with respect to investment performance. Danville contracts out for police and fire services, and it has “no difficulty recruiting and retaining good miscellaneous employees.”
There’s a crucial lesson to learn from Danville: A city can be successful without offering a defined benefit pension plan fraught with funding perils.
