California's unfunded public pension liability, when measured correctly, is two to four times larger than official government estimates. The failure to fully fund the pension promises has allowed the current generation to receive public services that they are not fully paying for, pushing the pension problem onto future generations. California Dreaming explains how six reforms would solve the state's pension problem in an equitable, responsible, and moral way: preserving pension benefits already earned, providing competitive pensions going forward, and granting the flexibility needed so that future generations are not paying for deals they did not make.
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About the Author
Lawrence J. McQuillan is a Senior Fellow and Director of the Center on Entrepreneurial Innovation at the Independent Institute. He has served as Chief Economist at the Illinois Policy Institute, Director of Business and Economic Studies at the Pacific Research Institute, Research Fellow at the Hoover Institution, and Founding Publisher and Contributing Editor of Economic Issues. Dr. McQuillan’s books include A Brighter Future: Solutions to Policy Issues Affecting America’s Children and California Prosperity: Roadmap to Recovery 2011. He is the author of more than 350 articles in the Wall Street Journal, New York Times, Chicago Tribune, the Los Angeles Times and other publications.
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Lessons on How to Resolve America's Public Pension Crisis
By Lawrence J. McQuillan
The Independent InstituteCopyright © 2015 Independent Institute
All rights reserved.
How Are Defined-Benefit Pensions Calculated?
THE VAST MAJORITY of California's public pension systems operate as defined-benefit (DB) plans, meaning that these plans pay a specific pension amount to their retirees each month for life. In total, about 4 million Californians — 11 percent of the population — are members of one or more of the state's 86 defined-benefit public pension systems: 6 state plans, 21 county plans, 32 city plans, and 27 special district and other plans.
Some plans are small and run by a single city or county. Other plans are huge statewide systems. The "Big Three" are the California Public Employees' Retirement System (CalPERS), the California State Teachers' Retirement System (CalSTRS), and the University of California Retirement Plan (UCRP). CalPERS and CalSTRS are the largest and second-largest public pension systems in the country, respectively.
CalPERS is a pension system for 1.68 million current and former state and local government employees and their families (see Figure 1.1). More than 3,000 public-sector employers participate in CalPERS (1,581 public agencies at the city, county, or state level and 1,508 school districts covering the nonteaching employees, such as janitors and office workers). Employees with the twenty-three campus California State University system are members of CalPERS.
CalSTRS serves 868,000 current and retired K–12 and community college public school teachers and their families. About 1,600 employers (school districts, community college districts, and county offices of education) participate.
UCRP serves 253,000 active, inactive, and retired employees of the University of California system and their families. Participating employers include the university's ten campuses, five medical centers, Lawrence Berkeley National Laboratory, and Hastings College of the Law.
Cities and counties have the option of participating in CalPERS and/or CalSTRS, or they can create their own independent pension system.
DB payments for retirees are calculated based on (1) the number of years of service; (2) age at retirement; and (3) final compensation, which is typically the highest annual pay plus special compensation averaged over a 3-year period. There are variations, however, in the number of years used to calculate "final compensation." Some California teachers with 25 years or more of service, for example, can use their highest consecutive 12-month period of pay to calculate final compensation. Making the pension calculations more complicated, a variety of formulas are applied depending on the employer (state, school, or local government agency), occupation (general office, safety, industrial, or police/fire), and the specific terms in the contract between the employer (government agency) and the pension fund.
To illustrate how a pension benefit is calculated, a state employee hired under CalPERS's "2 percent at 55" can retire at age 55 with 2 percent of their final compensation for every year they have worked. If an employee with 30 years on the job, having earned a final compensation of $100,000 a year, chooses to retire at age 55, then that employee will receive 60 percent (30 × 2 percent) of his or her compensation, or $60,000 annually for life.
If this same employee retires at age 63 or older, the "benefit factor" rises from 2 percent to 2.5 percent, meaning that after 30 years on the job, he or she would receive 75 percent (30 × 2.5 percent) of compensation, or $75,000 annually for life. Note that DB "benefit factors" are back loaded, meaning they increase with age and, therefore, reward additional service years at an increasing rate.
Pension calculation formulas can also vary with occupation. For example, some local police officers and firefighters can retire through CalPERS at age 50 with 3 percent of final compensation for every year served. And pension calculation formulas can vary by jurisdiction. For example, Orange County's pension system permits a 2.7 percent benefit factor at age 55 for some non-public-safety workers. The largest group of state workers is under a "2 at 55" formula with CalPERS.
Most public-sector collective bargaining agreements include automatic annual cost-of-living adjustments (COLAs) or automatic "step increases" for length of time on the job, or both. These features automatically increase base pay used to ultimately calculate pension benefits, and neither is typically available in the private sector. Pension payments to retirees are often increased annually through automatic COLAs as well.
The "special compensation" used to calculate pensions includes overtime pay, unused vacation pay, allowances, and bonuses. To the extent possible, each employee has a strong incentive to bump these up in the last few years of service since these are the years used to calculate pension benefits. This practice is called pension spiking. The fewer the number of years that are used to calculate final compensation the more attractive pension spiking becomes to workers.
Under current federal law, a private-sector pension cannot be based on an average compensation using fewer than 5 years. State and local pensions are exempt from this law; thus, public pensions in California typically use 3 years or less of earnings to calculate pension benefits, making spiking very attractive and beneficial. Very few state workers have yet to retire under an "average-of-three-years" formula — most are less than three years.
Through spiking, lifetime annual pensions for some retired government workers exceed their final year's pay. For example, retired Ventura County Sheriff Bob Brooks receives an annual pension of $283,000. His final salary was $227,600. Former Merced County Sheriff Mark Pazin receives a higher annual pension than he received in pay when working — nearly $200,000 a year. Former San Francisco Police Chief Heather Fong was paid more than $528,000 in her last year as chief, but more than $303,000 of that were payouts for unused sick, vacation, and comp time before retirement. Fong, who left office at age 53, receives a public pension of $277,656 a year for life, a lot more money than she received when working ($187,875).
The California Rule
California's defined-benefit public pensions pay a specified amount to each retiree for life. In what has come to be called the California Rule, public-pension benefits earned by past work performed and future pension benefits are contractually protected in California.
A series of cases decided by state court judges, culminating in the 1955 California Supreme Court ruling in Allen v. City of Long Beach, established California's "vested rights doctrine" regarding pension benefits.
Alexander Volokh, a professor at the Emory University School of Law, defines the California Rule as thus:
[I]n California (and some other states), the courts give constitutional protection not only to the amount of public employees' pensions that has been earned by past service, but also to employees' right to keep earning a pension based on rules that are at least as generous for as long as they stay employed. (Emphasis in original.)
Pensions once promised are a "vested contractual right" that cannot be diminished, not even for work not yet performed, without equal alternative compensation. In Allen, the state Supreme Court found that any "changes in a pension plan which result in disadvantage to employees should be accompanied by comparable new advantages."
A public-sector employee has, according to the California Supreme Court, "the primary right to receive any vested pension benefits upon retirement, as well as the collateral right to earn future pension benefits through continued service, on terms substantially equivalent to those then offered" when he or she was hired.
Jack Beermann, professor of law at Boston University School of Law, has emphasized that some California court decisions have held it permissible to eliminate future pension accruals in the interest of government financial flexibility and control. Though not completely settled, it is safe to say, however, that California courts generally hold to a relatively strict application of the California Rule.
With few exceptions, the pension formula in effect on the date of hire becomes a contract between the government agency and the employee for all service the worker will provide and the contract cannot be impaired unless offset by a new benefit of comparable value.
There is considerable controversy regarding whether California courts ruled properly when they established the California Rule and, if not, what the best rule should be. But the rule has generally been the legal basis for pension protections in California since the 1950s. There have been recent court challenges to the vested rights doctrine (more on this later).
The next chapter examines how funds are amassed to pay pension benefits.CHAPTER 2
How Are Pension Funds Amassed?
LIKE ALL DEFINED-BENEFIT (DB) pension systems, California's DB plans receive their funding from payroll contributions from the employee and from the employer (the government agency). It is important to note, however, that all contributions — employee and employer — originate from taxpayers. Pension systems are intermediaries that collect contributions, invest the contributions to generate earnings, and use the proceeds to pay benefits to retirees. It's that simple — in theory.
The contributions are invested in various instruments such as stocks, bonds, and real estate, under the supervision of board members. For example, a thirteen-member Board of Administration runs CalPERS, which had assets worth $295 billion as of September 2014. CalSTRS has a twelve-member board and its assets totaled $181 billion as of February 2014. The 26-member U.C. Board of Regents governs the UCRP, which had assets worth $53 billion as of June 2014. Board members oversee management of the funds and decide where funds are invested.
Board members are either political appointees, elected by plan members, or ex-officio members (the State Treasurer and State Controller are ex-officio members of both the CalPERS and CalSTRS boards).
Defined-benefit pension systems work as intended when employer and employee contributions plus investment earnings equal promised benefits (and administrative expenses). This is the defined-benefit pension equation:
Employer & Employee Contributions + Investment Earnings = Promised Benefits
During the past 20 years, for example, 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.
When total proceeds fall short of promised benefits, a pension fund deficit is created. A pension deficit is also called an unfunded liability: defined as the difference between what a pension plan promises to pay (its estimated liabilities) and the money accumulated to fulfill those promises (its estimated assets). In other words, an unfunded liability is an estimate of the amount, in excess of assets, needed to pay pension benefits earned up to that time, but not yet paid.
Of course, assets will change based on many factors including contribution levels and investment performance. Contributions are adjusted based on a variety of factors including salary raises, total payroll increases, and cost-of-living increases. And liabilities will change based on many factors including benefit levels and increasing lifespans. So an unfunded liability is a moving target and it is unrealistic to think there will never be times with unfunded liabilities.
The relevant question, therefore, is whether an unfunded liability is manageable long-term or whether it has grown to dangerous and unsustainable levels.
The next chapter looks at the health of California's public pension plans. The numbers speak for themselves and reveal dangerous underfunding and unsustainable pension debts.CHAPTER 3
California's Massive Public Pension Unfunded Liabilities
California's Statewide Public Employee Pension Systems
CALIFORNIA HAS SIX statewide defined-benefit public pension systems: Judges' Retirement System I, Judges' Retirement System II, Legislators' Retirement System, CalPERS, CalSTRS, and UCRP. The latter three are the biggest systems.
The pension obligations of these six systems are massive: $613 billion in fiscal year 2013, according to the U.S. Census Bureau. Pension obligations increased $21 billion in one year alone, from 2012 to 2013. The assets of these pension systems totaled $473 billion, or only 77 percent of obligations.
The role of California officials is to make sure that obligations and assets keep pace such that no dangerous unfunded liabilities emerge. As Governor Jerry Brown has said: "There is no doubt that we are going to have to adjust our pensions so that money coming in is going to be equal to what we can expect what the money going out will be. It's not even a matter of higher math. It's fifth-grade arithmetic."
The numbers presented in this section show that state officials have flunked arithmetic when it comes to managing the pension funds, and this exposes California residents to extreme risk.
Figure 3.1 shows the unfunded liabilities of California's three largest pension systems — CalPERS, CalSTRS, and UCRP — at a point in time that permits comparisons across multiple assessments. The solid black bars are the unfunded liabilities as calculated by each pension plan itself — these are the government's own numbers.
All three systems self-reported massive unfunded liabilities — UCRP $6.5 billion, CalSTRS $50.6 billion, and CalPERS $85.5 billion. According to the Big Three's own calculations, the state should have had $143 billion more in the bank in 2011 just to pay benefits that have already been earned. And despite several years of strong stock-market performance since 2011, the self-reported unfunded liability has fallen only $7 billion to $136 billion today ($57 billion for CalPERS, $71 billion for CalSTRS, and $8 billion for UCRP). This represents catastrophic mismanagement by California officials. And more significantly, the Big Three's funding ratios are dangerously low.
When a pension system has an unfunded liability, one measure of health is its funding ratio (available assets divided by liabilities). A ratio of 100 percent means that the pension system has sufficient assets to pay all of the accrued benefits owed. Some argue that a funding ratio of 80 percent or more is adequate, but the American Academy of Actuaries calls this a "myth": "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." The reason for this strongly worded admonition is that investment markets fluctuate wildly over time and commitment by government officials to full contributions often weaken over time, making anything less than an explicit goal of 100 percent funding a dangerous path. A lower funding ratio implies that a pension system has a greater potential not to pay its promised benefits. Moody's Investors Service considers funding ratios a good tool for determining whether a pension system is at risk of running out of money.
Using each fund's own numbers, every system's funding ratio was dangerously low (see solid black bars in Figure 3.2). CalSTRS's assets, for example, equaled only 70 percent of benefits accrued in 2011. Today, the self-reported funded status of CalSTRS (67 percent) and UCRP (80 percent) each deteriorated from 2011, whereas CalPERS improved (77 percent). In the private sector, pension plans are labeled "at risk" if their funded status falls below 80 percent. Even plans funded above 80 percent can be in danger.
The American Academy of Actuaries warns: "A plan with a funded ratio above 80 percent (or any specific level) might not be sustainable if the obligation is excessive relative to the financial resources of the sponsor, if the plan investments involve excessive risk, or if the sponsor fails to make the planned contributions." The goal should always be 100-percent funded. By this measure, California's Big Three public pensions are dangerously underfunded, putting current and future taxpayers at risk.
In 2008, the Employee Retirement Income Security Act (ERISA) — the federal law that sets minimum standards for private-sector pension plans — was amended to add restrictions on private pensions with funding ratios below specified levels. For example, if the funding ratio falls below 60 percent, private pensions must freeze plan benefits regardless of collective-bargaining agreements. And as Stanford University Professor Joe Nation notes: "A funded status of less than 80 percent precludes systems [in the private sector] from improving benefits or making payments in accelerated forms (such as the lump-sum option within UCRP) that are otherwise available. None of these restrictions applies to public-sector pension systems."
Excerpted from California Dreaming by Lawrence J. McQuillan. Copyright © 2015 Independent Institute. Excerpted by permission of The Independent Institute.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
ContentsTables and Figures,
SECTION I The Problems,
1 How Are Defined-Benefit Pensions Calculated?,
2 How Are Pension Funds Amassed?,
3 California's Massive Public Pension Unfunded Liabilities,
4 What Are the Major Drivers of the Pension Problem?,
5 Why Did Lawmakers Allow This Problem to Worsen and Why Have They Not Solved It?,
6 The Immorality of California's Public Pension Crisis,
SECTION II The Solutions,
7 Why Offer Pensions at All?,
8 The Critical Elements of a Comprehensive Solution,
SECTION III How a Comprehensive Public Pension Solution Benefits You,
9 The Fiscal Advantages,
10 The Moral Advantages,
About the Author,