PHOENIX – California Gov. Jerry Brown's plan to use a short-term state investment fund to make a $6 billion supplemental payment to its largest pension fund met with skepticism from some observers, who view the strategy as functionally the same as a pension obligation debt issuance.
The proposal, released in Brown’s May state budget proposal, enjoys support on both sides of the aisle. But pension liability hawks are not convinced of the plan’s wisdom, and analysts also cite risk inherent in the approach.
The payment to the California Public Employees' Retirement System would be financed with a loan from the state's Surplus Money Investment Fund. The state would repay the loan over 12 years, beginning with a $427 million payment funded from its $1.78 billion Proposition 2 liability.
Proposition 2 is a state constitutional amendment passed in 2014 requiring that from 2015-2016 fiscal year until the 2029-2030 fiscal year, 50% of revenues that would have otherwise been deposited into a rainy day fund must be used to pay down debt obligations.
Brown and other top state officials believe the move makes sense because California's annually required contribution to CalPERS is on track to rise sharply in the coming years.
An analysis by S&P Global Ratings’ Gabriel Petek from data provided by the state Department of Finance noted that California's general fund contributions to CalPERS are projected to increase to $5.3 billion in fiscal 2024 from $3.4 billion in fiscal 2018, and that under the plan the increase would be only $4.9 billion.
“Assuming CalPERS achieved its investment return target (7%), the DOF estimates that the transaction would yield savings of $11 billion, net of the interest cost on the loan, over 20 years,” Petek wrote.
Pension liabilities are becoming increasingly front and center in the minds of bond investors and analysts, who have noted that pensioners have consistently won out over bondholders in Chapter 9 bankruptcy cases such as those in Detroit and Stockton, Calif. and who say rising pension costs are likely to pressure state and local finances more and more in coming years.
Brown, a Democrat, appears to have found a reasonably bipartisan approach with the prepayment plan. Democratic leaders such as Senate President Pro Tempore Kevin de Leon and Senate Budget Committee chair Holly Mitchell released statements positive about the revision noting the savings it could net.
State Sen. John Moorlach of Orange County, a Republican and former county treasurer who has consistently argued for California to take action on its pension liabilities, also supports the plan and has urged colleagues to support it as well. Moorlach said the plan appears to be bipartisan enough to pass, though it remains a bit of a question whether it will ultimately be included in the budget that the legislature must constitutionally pass by June 15th.
“I think the outlook is reasonably bright,” Moorlach said. “I’m excited that it’s at least being discussed.”
Moorlach said that when he was Orange County treasurer, he oversaw the issuance of a successful pension obligation note issuance that saved millions of dollars for the county and sees a similar opportunity here.
“I see minimal risk in doing it other than some massive market adjustment that occurs,” Moorlach said. “It’s not as if the state is taking a real cash flow risk.”
Moorlach said one thing that is missing for him is that he wishes CalPERS would come to the table with some kind of incentive to make it more worth the state’s while, but that he nonetheless likes the concept.
CalPERS itself is also on board, urging employers to also step up their contributions to the plan.
“We are encouraged by the proposal and support employers making additional contributions toward their unfunded liabilities,” said CalPERS spokesman John Osborn.
But outside the legislature and the pension fund leadership, some observers warily view Brown’s plan as functionally identical to pension obligation bonds, which played a major role in the Stockton bankruptcy and which the Government Finance Officers Association now advises issuers to avoid.
The use of POBs, or what skeptics say is California’s structurally similar strategy, rests on the assumption that the money invested with pension assets in higher-yielding asset classes will be able to achieve a rate of return that is greater than the interest rate owed on the borrowed money.
“In the event of poor investment performance," S&P's Petek wrote, “the state could be left facing higher than projected pension contributions along with the liability related to the internal loan.”
Chuck Reed, the former San Jose mayor and an outspoken advocate for action to address unfunded pension liabilities, said that he was far from confident in the borrowing plan.
“It’s hardly ever a good idea,” Reed said of this kind of financial structure. “It’s better for the fund of course, because money is money. But they’re betting on arbitrage.
“Usually it’s a red flag for systems that are in trouble,” Reed added.
The payment to CalPERS is modest in the face of the amount of money it needs in the coming years, Reed said, adding that he believes that there is a long California tradition of “gimmicks” in which money is shifted from one place to another.
“It would be better if they used real money. What they need to do is put about $6 billion per year in for the next 20 or 30 years,” Reed said, conceding that to do that would be politically impossible.
California’s legislative leaders have said they plan to pass a budget bill by the June 15 deadline for approval by Brown by June 30. That new budget would have a July 1 effective date.