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California Pensions May Face $200B Hole

SAN FRANCISCO — Nestled in the Redwood-studded hills north of San Francisco, Marin County has been home to the likes of Brad Pitt and Jerry Garcia.

And with its per-capita income of around $90,000 — one of the highest in California — you would not at first think that it would be facing $700 million in unfunded pension liabilities.

But the county may be facing more like $1 billion to $2 billion in unfunded pension obligations, according to Joe Nation, a professor of public policy at Stanford University and a former assemblyman who represented Marin.

In a report last month for the Stanford Institute for Economic Policy Research, Nation said independent public employee pension systems in California may have unfunded actuarial accrued liabilities of roughly $200 billion.

One of the key differences between Nation’s calculations and those of Marin officials and other municipalities across the state is that he uses a “risk-free” 4% discount rate. That rate is used to determine the anticipated rate of return on a pension fund’s assets and is used to calculate how much cities and counties must pay into funds. And that rate is lower than many funds use to estimate returns. If they used the lower rate they would have to make higher annual payments in order to meet their pension benefits.

Marin County investment officials have questioned Nation’s methodology and told the local Marin Independent Journal that it has been estimated that roughly $1 billion would pay off all of the county’s debt if the pension system went belly-up.

Another report issued by SIEPR earlier in the year found that the unfunded liabilities of the California Public ­Employees’ Retirement System, California ­Teaches’ Retirement System and University of California Retirement ­System hit $425 billion in June 2008, using the risk-free rate.

Nation said most pension funds use a much higher discount rate, usually around 8%, based on riskier investment assumptions. “That is the dirty little secret of this whole game,” he said in an interview.

“What these municipal governments and pension funds are doing is they are saying, 'we cannot put away more, we can’t get more from employees, we can’t contribute more — let’s just role the dice and hope it works.’ ”

The average funded level for all systems in California at a 4% discount rate is 45%, while at a 6% discount rate it’s 63% based on 2008 numbers, which were the most recent available.

Many think the risk-free discount rate is an unrealistic measure and puts an unnecessary burden on a municipality’s pension obligations.

“I don’t subscribe to that [discount-rate] philosophy,” said Jay Goldstone, San Diego’s chief operating officer. “I think there has got to be some relationship to reality if you have a historical database.”

The discount rate should have some resemblance to the historical rate of return based on an average over a period of 10 years or longer, reflecting the highs and lows, he said.

Goldstone admitted he has a vested ­interest in a higher discount rate from a budgetary standpoint because the higher the rate, the lower the city’s annual ­payment.

“Whatever dollar you don’t earn is a ­dollar the taxpayers have to pay, then it becomes a trade-off for services,” he said. 

Adding to the trade-offs for future ­services are the rising costs of other post-employment benefits, or OPEBs, which are typically dominated by health care costs.

In his report, Nation noted that local governments reported substantial underfunding for OPEBs. For instance, Los Angeles County reports unfunded other post-employment benefits at about half its unfunded pension liabilities.

Municipal governments appear likely to devote about half of covered payroll over the next 18 years to meet unfunded pension obligations and OPEBS, the report said. The figure climbs to nearly two-thirds of covered payroll when added to ongoing costs for pensions and other benefits.

Unfunded pension liabilities share of covered payroll ranges from 4% in Tulare County to 12% in San Diego. The highest combined ratio of unfunded pension plus other benefit liabilities is 14% in San Diego, while the lowest is Tulare County at 4%, according to the report.

“What happens in the end, everything else gets squeezed out,” Nation said. “The only thing left is to have devastating cuts in services.”

In Vallejo, which declared Chapter 9 in May 2008, most discretionary spending has been cut and the city has gone on to slash police and fire jobs, its largest expenditure, by more than 40% since 2003. Employee salaries and benefits account for 80% of gross general fund spending.

Nation, whose five family members work in the public sector, said political reform is needed to help fix the problem, as voters have shown little stomach to take on new taxes to pay for benefits that are likely better than their own.

On the state level, Gov. Arnold ­Schwarzenegger recently signed two measures that increased state pension system transparency and decreased state employee benefits.

The measures require pension benefits for new hires to be based on the average salary in the final three years of employment, compared to only one year today. It also requires some new state workers, who were able to retire under a formula of 2% of salary times years worked at age 55, to now retire under a formula of 2% of salary times years worked at age 60.

According to the formula used by many pension systems, an employee gets 2% of their salary at a specified age, multiplied by their years of services, to come up with their annual retirement earnings.

Local governments have started to follow suit with similar reforms that will likely include reductions in benefits, increased employee contributions, and further restrictions on pension “spiking,” which is when an employee retires at an income based on their final year.

“The benefits that were negotiated or agreed to in the past are really unsustainable benefits,” Goldstone said. “We are stuck with the bad decisions that previous administrations and councils made but we can at least stop the bleeding, or slow it down a bit.”

In San Diego, which faces unfunded ­liabilities of $2.1 billion, the ­administration has closed the old pension system for new hires for everyone but firefighters, who are in negotiations. The city has also ­reduced the benefit formula within the defined plan.

San Diego Mayor Jerry Sanders has proposed to close the defined-benefit plan altogether for new hires and make it more like a corporate 401K program. The plan needs voter approval and will likely be on the ballot in the next city-wide election.

San Diego is also working to make modifications to it retiree health plan to make it more affordable.

“I do not think [health care] is a vested benefit for those who are still working, unlike what a pension plan may be,” Goldstone said.

However, those reforms may only have a small impact on the fiscal pain left by current employee pension obligations.

Municipalities are locked into current worker pension benefits by law, which would take a major legal challenge to change.

“Can you change the pension benefits for current employees? I think that is going to be tested more and more,” said Howard Cure, director of municipal research at Evercore Wealth Management. “That is a very key question that may work its way” through the courts.

He added that there is also the concern about whether municipalities will get so frustrated from difficult negotiations that their only resort is bankruptcy.

However, he noted that the possibility of bankruptcies, and potential defaults, really needed to be evaluated on a case-by-case basis. 

But Cure also noted that Vallejo’s more than two and a half years of bankruptcy proceedings, the largest in California since Orange County in 1994, has been a warning. The bankruptcy has been expensive and extremely time-consuming.

When asked whether the pension obligations could lead to more bankruptcies, Nation said yes. “I think there will be intense pressure” to declare bankruptcy, he said. “But I hope that is not the case.”

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