Trouble Brewing…The Disaster of California State Pensions

Trouble Brewing…

The Disaster of California State Pensions
By Stuart Buck, Distinguished Doctoral Fellow, Department of Education Reform, University of Arkansas, (abridged)\

California has promised its public employees lavish pensions and retiree health benefits without setting aside nearly enough money to pay for those benefits. As a result, California already admits to a $75.5 billion shortfall in paying for those promises to public employees—$40.5 billion for the teachers’ retirement plan (California State Teachers’ Retirement System, or CalSTRS) and $35 billion for the California Public Employee Retirement System (CalPERS).

The history of state pensions over the past decade is one of hubris, irresponsible behavior and lack of foresight. The booming stock market of the 1990s resulted in stronger-than-expected asset performance in pension plans, leading to funding surpluses. As a result, state governments started making “commitment(s) to significantly increase benefits, particularly in the 1990s and in the early part of this decade,” as one state pension director said. “A lot of people were riding that wave of euphoria from investment returns.”

California, in particular, gave in to union pressure to increase pensions based on the promise that the stock market would keep rising forever, eliminating the need to actually come up with the money. As a recent Reason Foundation report points out, a 1999 California bill increased public pension benefits to staggeringly high levels, allowing many public safety employees to retire with up to 90% of their final year’s salary as a guaranteed pension, and moreover made those increases retroactive and thus applicable to workers who had not paid nearly enough into the pension system.

As is the case in almost all states, (two exceptions are Michigan and Alaska), California’s pension plans are defined-benefit plans. That is, employees are promised a specific amount of money regardless of how well or poorly the plan’s investments have done or any budgetary problems the plan or the state might be experiencing.

Under California law, pension plans are akin to contracts, which means that “amending state pension plans may violate the contract clauses of both the federal and state constitutions.” While such plans can theoretically be changed, the California Supreme Court has held that “changes in a pension plan which result in disadvantages to employees should be accompanied by comparable new advantages.”

Unfortunately, the situation is far more dire than is currently admitted. The actuarial valuations mentioned above took place as of June 30, 2008 and both pension systems have had substantial losses in their investments since that date. As of the most recent information available, (December 2010) CalPERS’ assets had dropped to a reported $200 billion, and the teachers’ retirement system’s assets had dropped to $134 billion; these losses would add another $44 billion in unfunded liabilities.

But it gets even worse. When the California pension systems set aside money for future pension payments, they rosily assumed that their investments were going to earn a steady 7.75 percent or 8 percent return year-after-year. California politicians can either continue hiding their heads in the sand, or else face up to these looming obligations by ceasing to promise overly lavish benefits and by increasing the required contributions from salaried employees. In addition, California may consider changing the structure of its pension system so that it depends more on employee savings, rather than promising a guaranteed financial payment regardless of how much a given employee saved.

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As a first step, California must account for the existing liability and fund it appropriately. Unfunded pension liabilities have ballooned in part because politicians preferred to incur hidden pension costs instead of visible wage costs; it is easier to hand out more generous retirement benefits to be funded later than give pay raises that cost money now.

This first step will not be easy. But under California constitutional law, California does not have the option of defaulting on existing pension liabilities. Thus, the $326.6 billion in unfunded pension liabilities will simply have to be paid off over time through higher taxes and/or cost savings in other areas of government.

As a second step, California should take measures to reduce pension promises for the future. One option is to shift away from defined-benefit pension schemes to defined contribution options such as 401(k) plans. In lieu of contributions to a pension plan, governments can make deposits into individual employees’ accounts, into which employees may also deposit their own funds. Defined-contribution plans cannot, by definition, have funding deficits; the employer only makes initial deposits into the retirement account and does not guarantee returns. The state employee makes decisions about investing the asset balance.