The Tragedy of California Public Pensions

aaeaaqaaaaaaaatiaaaajgm4nzmzotlilwyyzmutnddiys05ntg1lwu1ymm4odg2mgu0za

It is well known that California has a pension problem that offers a challenge for public officials and current and future retirees alike. Even if people aren’t aware of the details, it has been talked about for quite some time that there are underlying aspects of the public retirement system that need to be addressed, sooner or later. The fact of the matter is that such problems can’t be ignored by the State forever; and what is perhaps more important to me, as one who professionally helps people secure their financial futures, is that the beneficiaries of these public pensions need to understand what is going on and work to prepare themselves for what is ahead.

Thus, the purpose of this short overview of the problem is to help awaken people to their own unique scenarios, to inspire them to make the proper moves before it is too late.  Everyone is in a different situation and there is no one-size-fits-all approach to figuring out what one should do personally; but hopefully after considering the following, the reader will be encouraged to reflect deeper on how the pension crisis may affect their futures.

The first thing to understand is that California’s public pension system is made up of a conglomeration of “6 state plans, 21 county plans, 32 city plans, and 27 special district and other plans” according to the Independent Institute Senior Fellow Lawrence J. McQuillan (McQuillan, page 3). The majority of these operate on a “defined benefit” model, which means that, upon retirement, these plans pay a specific amount per month for the rest of the retiree’s life. By far, the three largest of these 86 CA pension systems are CalPERS (1.68 million retirees), CalSTRS (868k retirees), and UCRP (253k retirees). For the remainder of this article, we will refer to these as the Big Three.

The “defined benefit” for these retirees rests on a relatively complicated formula which includes the number of years employed with the employer, one’s age at retirement, and one’s “final compensation.” There are fluctuations and other variables within this formula as well and factors can also include the specific employer, the occupation, and even variations of contract specifics. However, as Jon Ortiz reports in the Merced Sun-Star:“the largest group of state workers is under a “2 at 55” formula. To give an example here, assume an employee has worked for 30 years before retiring at age 55, her final compensation being $100,000. The “2 at 55” formula would indicate that she gets 2% of her salary (100k) multiplied by the 30 years she worked. 2% of her salary is $2k, which multiplied by 30 giving her a total of $60k per year for the rest of her life.

As McQuillan explains (page 6), however, there are also a variety of COLAs (cost of living adjustments) and automatic “step increases” that can substantially effect the annual increase in pension benefits. These are a result of a variety of collective bargaining aspects that are part and parcel of the California pension system. Essentially, what these features allow is for the “final compensation” levels to be boosted above their actual levels so that “lifetime annual pensions for some retired government workers exceed their final year’s pay.” In other words, due to this practice of “pension spiking,” future state obligations can in many cases exceed the levels that existed while the retiree was still employed. This has a significant “snowball effect” on the obligations faced by the state (and future taxpayers).

There are two sources of funding for these pensions that are to be paid out to millions of California retirees: taxpayers and investment market returns. The taxpayer originated funds flow through both employer (the government agency) and employee payroll contributions. These contributions are invested and, at least in theory, both the contributions plus investment earnings are paid out as the defined benefits to retirees. In other words, the employer/employee contributions (originated as taxes) plus the investments gains needs to be at least equal to the pension obligation levels in order to be sustainable. Where things start to get interesting, and overwhelming, is that, according to McQuillan (page 12), over the last 20 years, “for every dollar paid in CalPERS pension benefits, CalPERS’s employer members contributed 21 cents, employees contributed 15 cents, and the remaining 64 cents came from investment earnings.” In other words, historically, 64 percent of the funds paid out needed to rely on the performance of capital markets.

Now, what happens when the total assets (contributions + investment earnings) are less than the pension promise? The answer is that a deficit is created and these deficits are referred to as an unfunded liability. This unfunded liability is the total amount between the assets of the pension and the liabilities of the pension. Whenever the liabilities (what are owed) are greater than the assets (the contributions + investment earnings), there is an unfunded obligation. It is the sheer level of CA’s unfunded obligation that is the primary face of the California Pension Crisis.

According to the U.S. Census Bureau, the pension obligations for the largest six pension systems in CA came to a stunning $613 billion in 2013. Of this, only a portion is covered by the pension’s current assets, resulting in a sizable unfunded obligation level. The specific dollar amount of these unfunded obligations depends upon which calculations are being used. According to the calculations of the Big Three pension systems themselves, the unfunded portions are as follows: CaPERS $85.5 billion, CalSTRS $50.6 billion, and UCRP $6.5 billion. These represent the amounts, calculated by the agencies themselves, that the pension plans are short what is needed in order to meet what they owe to retirees. Collectively, this number is $143 billion short of what retirees are expecting to live off of for the rest of their lives. To give the reader a sense of the absurdity of these numbers, these were calculated in 2011 and since that time the US stock market has experienced large multi-year rally; however, in that time, the assets have only gained $7 billion in investment earnings so that today the unfunded liability still sits at the impossible goal of $136 billion.  That’s $136 billion in the hole.

This, after a massive stock market rally!

This means that the “funding ratio” of assets and liabilities is such that CalPERS is only 77% funded, CalSTRS is only 67% funded, and UCRP is only 80% funded. McQuillan quotes the American Academy of Actuaries on the issue of funding ratios to say: “Pension plans should have a strategy in place to attain or maintain a funded status of 100 percent or greater over a reasonable period of time.”  McQuillian comments on this quotation by noting that “a lower funding ratio implies that a pension system has a greater potential not to pay its promised benefits.” And yet, as can be seen according to the pension’s own numbers, the funding ratio is troubling.

Unfortunately, the bad news does not stop here. As emphasized above, the numbers thus far have all been merely reflective of the pension fund’s own estimates. According to a 2011 study conducted by the Stanford Institute for Economic Policy Research (SIEPR), the unfunded obligation levels for the Big Three pensions in CA were as follows: $169.8 billion for CalPERS, $104 billion for CalSTRS, and $16.8 billion for UCRP. This means that the funding ratios too are in a much worse condition, according to the SIEPR calculations.

The chart shows the unfunded obligation levels and the funding ratios (in parentheses) for each pension according to both the agency and SIEPR estimates (remember, the greater the unfunded liability, the lower the funding ratio):

Needless to say, in the words of McQuillan, “by [the above] measure, California’s Big Three public pensions are dangerously underfunded, putting current and future taxpayers at risk.”

Without getting into too much detail, the reasons that there is such a severe discrepancy between the third party calculations and the agency’s estimates of itself have to do with the various assumptions that the agencies are making. Specifically, these agencies, in order to make their numbers look better (and, sadly, negative $136 billion is “better”) misrepresent the actual reality by massaging factors in the following ways:

  1. Overestimating investment return potential (they are assuming between a 7.75 and 8% average annual return— compare this to private pension assumptions between 3 and 4%).
  2. Implementing an abnormally large “smoothing recognition period,” which basically allows the potential market losses to be hidden in an average of many years (15 yrs, compared to the private sector smoothing period of 2 yrs).
  3. Refusing to include the reality of increasing life expectancy into their models, so that their numbers assume they will have to pay for a shorter “lifespan” than what the recent mortality data reflects. Even Governor Brown’s office calculated that “CalPERS needs an additional $1.2 billion a year to pay for added pension expenses due to longer life expectancy.”
  4. Overestimating the length to which public employees will keep working (therein overestimating how many years of contributions will be made and underestimating how many years these employees will be recipients of the pension system).

McQuillan quotes Stanford Professor Joe Nation to say: “In short, public pension systems utilize assumptions and methods supporting a consistent theme of understating liabilities, overstating assets, and pushing costs into the future.”McQuillan himself goes so far as to say: “The bottom line is that officials at California’s public pensions are permitted to engage in behavior that would be considered criminal under ERISA [Employee Retirement Income Security Act—CJE]if done by officials overseeing private-sector pensions.”

To bring things here to a close, let it be said that the systemic problems underlying the numbers themselves are such that there is no easy way to fix this. Even on their face, the numbers summarized above tell a frightening tale of severely underfunded pension obligations, problem which is growing worse and worse.

What needs to be remembered too, and this is the thing that far fewer people talk about, is that we are on top of a major bull market that has only since January threatened to come back down. The chart below is of the “S&P 500” which is an index of stock market price levels.

As can be seen, we are at much higher levels than we were before both the 2000 “dot com” crash and the 2008 financial crisis. In other words, all these pensions that are relying on years of 7% returns in order to be, well, hundreds of billions of dollars in the hole, may in fact be facing an era of negative returns if we are confronted with the likely situation of a stock market correction.

Needless to say, far from having “their future taken care of,” those relying on public pensions for their retirement are not only going to be requesting funds that simply aren’t there, they are going to be requesting funds from pension systems who have yet to face the third recession in 15 years. A recent report from Casey Research wrote that:

“Public pensions are a slow motion train wreck that can’t be stopped. Millions of workers who expect a steady stream of income when they retire will get nothing. The U.S. public pension system is mathematically guaranteed to crash.

According to the National Association of State Retirement Administrators (NASRA), U.S. public pensions expect to earn 8% per year on average.

That’s a wildly optimistic number. They’re extremely unlikely to earn anything close to 8% per year.

Earning 8% per year in normal times is difficult enough. And as Casey readers know, we’re not in normal times.

Returns on both bonds and stocks will likely be low or negative for the next many years. With interest rates at historic lows, bonds barely pay anything. And U.S. stocks have very little upside because they’re so expensive today.

Expecting returns to average 8% per year going forward is foolish. And we’re not the only ones who think so. BlackRock (BLK), the world’s largest asset manager, says state and local pensions should expect to earn 4% per year or less going forward.

The average public pension earned just 3.4% last year. And Bloomberg Business reports that the California Public Employees’ Retirement System (CalPERS), the largest pension fund in the U.S., earned just 2.4% last year.”

Moreover, while many assume these pensions can “just go to the taxpayers” to fulfill their obligations, the fact of the matter is that this is politically and financially impossible in the context of a recession, especially when the taxpayers themselves are facing the reality of this very same market downturn. It is one thing to attempt to siphon off a little bit from taxpayers during a  7 year bull market, but it is an entirely other thing to do the same during a painful downturn. The long and short of the situation is this: those relying on public pensions for their retirement are quite possibly not going to receive the full extent of what they are expecting.

Practically speaking, therefore, any attempt to protect one’s non-pension assets, retirement accounts, and cash flows, is to be well heeded. This means that it is time to face the reality of the situation before retirement and before it becomes publicly obvious that there is a massive problem. There are many who are putting things off and looking to figure things out down the road. Unfortunately, I am not convinced that the prudent individual can afford this luxury. Some readers may need some creative strategies, capital preservation efforts, and an honest assessment of just how, exactly, one should minimize their dependency on public pensions. This is the key: separating one’s dependency on the pension system for retirement is the only way to avoid pain later on down the road.

Planning today will put you in a much better position to face whatever may come tomorrow. And this is precisely what we at The Sullivan Group aim to do on a daily basis with our clients. We are especially in tune with the the systematic problems with the California public pensions, and we want to help figure out where, exactly, the right solutions can be found to minimize personal dependency on a struggling retirement system.