SAN FRANCISCO — California’s new pension reform legislation is a significant step forward for state and local government finances in the Golden State, though the changes will take a long time to have a significant impact and many unknowns remain, rating analysts say.
“Overall, the pension reform legislation appears to contain material changes to the state’s pension benefit regime, but with incremental or limited budgetary or fiscal implications in the near term,” said Standard & Poor’s analyst Gabriel Petek. “In the bigger picture, it is one more example of the state’s credit quality taking a step in a stronger direction.”
In February, S&P raised its outlook for California’s A-minus credit rating to positive from stable. The other raters have held steady, with Moody’s Investors Service assigning California an A1 and Fitch Ratings an A-minus, both with stable outlooks.
“Pension reform like this is unlikely to cause a sharp dip in pension funding costs in the near term, but can have a significant longer-term impact,” said Moody’s analyst Emily Raimes. “This continues the trend we are seeing of states and local governments enacting pension reform to try to bring down significant and rising fixed costs.”
On Aug. 31, the last day of the legislative session, lawmakers passed AB 340, implementing the pension reform agreement announced earlier in the week between Democratic lawmakers, who have majorities in both chambers, and Democratic Gov. Jerry Brown.
For future hires, the reforms cap benefits, increase retirement ages, roll back formulas used to calculate pensions, and require employees to pay at least half of the normal cost of the pension.
Additionally, current employees would also have to pay at least half of the costs, which will be negotiated through collective bargaining or be imposed after five years.
The legislation also tackles issues making recent headlines such as “pension spiking,” which are salary increases near the retirement date that artificially bump up pension calculations, and it prevents convicted felons from collecting a pension from the time of their offense forward.
Significantly, the reforms will also apply to general law local governments. They exclude the University of California System, charter cities and governments that are chartered and have retirement systems outside of the state programs.
Since most of the changes only apply to new hires, most savings will be realized as the state’s workforce changes over time; pension liabilities for current workers are still overhanging.
The bill has been sent to the governor’s desk and he has until Sept. 30 to act. Brown is expected to sign it after appearing at the news conference announcing the deal.
“We think the most powerful changes in the reform will be those raising the retirement age along with an adjusted benefit formula and — not insignificantly — the increase to the employee contributions,” Petek said.
“We expect the potential incremental cost savings from the law will be greater among local governments than for the state government itself,” he said.
Local governments appeared to support the major changes in the reform act.
The League of California Cities said in a statement that the legislation is a “substantial” step forward, but added that “there are numerous questions of implementation and interpretation that will need to be resolved in the days and months ahead.”
The California Public Employees’ Retirement System, the state’s and the country’s largest pension system, said the reforms would save between $42 billion and $55 billion over 30 years, according to a quick analysis it released last week.
The California State Teachers’ Retirement System, the next-largest system in the state, said the overall impact of the pension reform act may take decades to be fully realized.
However, CalSTRS said it estimates changes to the benefit formula would save $22.7 billion over 30 years.
“It is too soon to know what the immediate and long term impact will be but it is certainly a step toward a more sustainable path on pension obligations for the state and for locals,” said Fitch analyst Douglas Offerman. “The benefits of the legislation will take some time to become clear.”
Republicans argued that the bill moved too quickly through the Legislature without enough time for analysis — it was introduced on a Tuesday and passed on a Friday. They also argued the bill doesn’t go far enough.
Even though most Republicans supported the legislation, they still said it diverged too far from Brown’s original pension-reform plan introduced earlier in the year, which would have moved employees away from the defined benefit plan and into a “hybrid” plan. The bill passed the Senate in a 38-1 vote and the Assembly in a 48-8 vote.
“Today’s so-called fix addresses only $15 to $60 billion over the next 20 to 30 years, yet the current pension liability is $240 billion to $500 billion. We still have a lot of work to do,” Senate Republican leader Bob Huff, R-Diamond Bar, said in a statement Friday.
Some have pegged the state’s unfunded liabilities at around $80 billion. Academic studies have put the total pension-funding gap for all public workers in California as high as $500 billion.
Petek noted that the pension reform does not shrink the state’s existing unfunded liability that S&P pegs at $89 billion, when measured actuarially.
The state has not traditionally had a major pension-funding problem, according to Offerman, because employers must make annual actuarial contributions to CalPERS.
However, this does not apply to CalSTRS, which noted that the pension bill doesn’t address its $64.5 billion funding shortfall.
“We have been working for some time to raise awareness of our funding shortfall, the cost of waiting to address it and the ultimate risk of failing to do so presents to the state general fund,” CalSTRS chief executive officer Jack Ehnes said in a statement Wednesday.
Since the governor announced the pension reform deal on Aug. 28 the state’s yield spreads versus the MMD index of triple A-rated municipal bonds tightened a tad in the out years — moving from 93 basis points to 91 basis points in the 20-year maturities and from 90 basis points to 86 basis points for 30-year bonds, according to Thomson Reuters.
The short-term spreads remained unchanged.
“We now have a state that is adding jobs at an accelerating pace, two consecutive on-time budgets, a materially smaller structural budget deficit, and now pension reform,” Petek said. “These improvements have to be placed in context, with recognition of the compromised place in which the state began this process.”
California is still struggling, like much of the country, in a slow economic recovery, with its jobless rate at 10.7%.
That number is especially important for the state government because it is highly dependent on personal income taxes for its revenue.
The state has also been able to mitigate its cash problems by improving its available tools for moving money around various funds, and a recent voter initiative has limited the ability of lawmakers to delay budgets.
“As far as California’s credit goes, the pension systems have not been at the top of the list of concerns,” Offerman said. “The state’s fiscal and cash situation has been a far more urgent credit challenge for the state since the downturn began four years ago.”