Next fiscal year, Newsom wants to give $3 billion to the California Public Employees’ Retirement System. He also proposes giving up to $5.9 billion over four years to the California State Teachers’ Retirement System.

Both funds have less than 70 percent of the assets they will need to pay off promised pensions. Last year, CalSTRS’ unfunded liability was estimated to be $107.3 billion and CalPERS’ was put at $136 billion. Some see Newsom’s proposal as a confirmation of the failure of ballyhooed efforts by Gov. Jerry Brown and the Legislature to reform pensions and shore up the pension giants.

In 2012, they enacted the California Public Employees’ Pension Reform Act (PEPRA). It changed retirement terms for state employees hired after Jan. 1, 2013, by limiting what types of pay would apply toward pensions and by making small reductions to benefit calculation formulas and pushing back when employees could retire.

Brown hailed the law’s passage as a significant first step toward Sacramento bringing pension costs under control.

The next significant step came in 2014, when the Legislature and Brown approved a bailout of CalSTRS. It gradually raised the $5.7 billion that school districts, the state and teachers contributed to CalSTRS in 2013-14 to $11 billion in 2020-21, when the phased-in increases were complete. Districts have to pay for 70 percent of the new contributions, with the state picking up 20 percent and teachers 10 percent.

‘Significant’ CalSTRS changes didn’t stabilize fund

The nonpartisan state Legislative Analyst’s Office described the funding law as a “significant” accomplishment with promise to keep CalSTRS on firm ground for decades to come.

But as Brown’s second term wore on, with CalPERS alternating between poor and relatively successful years with its investments, it became clear that the 2012 pension reform measure hadn’t changed the grim long-term picture for CalPERS’ finances. A 2017 Pensions & Investment report detailed how CalPERS’ 10-year record of 4.4 percent average returns wasn’t keeping up with its obligations and noted that in one poor investment year alone, CalPERS saw its unfunded liabilities soar by $27.3 billion.

And the LAO soon changed its tone on the CalSTRS bailout. In 2016, its analysts warned that liabilities continued to increase. And in November, as CalWatchdog reported, an internal CalSTRS analysis concluded there was a 50 percent chance that CalSTRS’ funding would drop to less than 50 percent over the next 30 years. Pension analysts note that few pension systems ever recover from dropping below the 50 percent level.

Perhaps the most significant hope for pension reform from the Brown era came as the surprise result of a legal challenge to some of the limits on pensions for new hires in the 2012 law. A public safety union argued that this was a violation of the “California rule,” the long-standing court precedent that held pension benefits could not be reduced for public employees without comparable additional benefits being provided.

But two appellate courts not only disagreed with the lawsuit’s premise, they held the “California rule” of inviolate pensions didn’t apply to years not yet worked by public employees, and that cheaper benefits could be collectively bargained.

The California Supreme Court held a hearing on the lawsuit last month and a decision is expected in coming weeks.

Legislators have largely avoided the pension issue since passage of a reform law that went into effect in 2013, and reformers have struggled to settle on an initiative strategy to take to voters. That’s unlikely to change. But last week the high court agreed to review a union appeal of a decision involving an obscure concept known as the California Rule. The decision could change everything.

The California Rule is not actually a rule, but a legal doctrine that emanated from a 1955 court case. Essentially, it states that no vested public-employee benefit such as a pension can be reduced unless public employees are granted another benefit of equal or greater value. Unions claim that a 2013 state law unfairly deprives them of vested benefits.

The rule remains the stumbling block for most efforts to reduce pension costs, given that it severely limits public agencies’ efforts to slice current pension costs. Hence, pension reformers and unions alike are eager to get a final verdict on the matter.

In the private sector, companies that offer defined-benefit pension plans – those plans that guarantee a pension payout based on a formula, as opposed to 401(k)s – are free to reduce the benefits going forward. In other words, employees must be made whole through today, but may start receiving lower benefits tomorrow. By contrast, in California and other states that follow this rule, government workers must be paid the full amount of the promised benefits until they (and their spouses) pass away.

The accepted interpretation has been that a benefit hike, once approved by a government agency, is permanent. It can never be rolled back. As a result, most pension reform proposals deal only with shaving benefits for new hires, who won’t start retiring for 25 or 30 years. That leaves service cuts and tax hikes as the only way to deal with increasing pension debt.

Some localities have tried to take on the rule. In 2012, for instance, San Jose officials put a pension-reform measure on the ballot that required current city employees to choose between new pension plans that offered fewer benefits than current plans. It passed with 70 percent of the vote, but the courts later gutted that measure. They relied on the California Rule.

But now the California Supreme Court is ready to address the issue, at least around the margins. Last week, the court, without comment, agreed to a union challenge of a San Francisco appeals court that put limits on the application of the rule. Last summer, unions appealed a similar Marin County case, in which an appeals court also put some limits on the rule’s application.

At issue is the California Public Employees’ Pension Reform Act, which went into effect in January 2013. Most analysts viewed the law as a modest attempt to get control of the state’s growing unfunded pension liabilities, or debt. Most of it applied only to newly hired state workers. But it did include a handful of provisions that affect current workers.

On Dec. 30, the First District Court of Appeal in San Francisco rejected a challenge by a state firefighters’ union claiming that PEPRA’s elimination of a 2003 benefit that let firefighters purchase up to five years of additional credits (airtime) before retiring was in violation of the rule.

“The unions argued that their members had a legal right to the pension benefits that were in effect when they were hired and that the state broke its contractual promise to them by eliminating those benefits,” according to a San Francisco Chronicle analysis. The 3-0 written opinion found that public employees have a right to a “reasonable pension” but they aren’t guaranteed “fixed or definite benefits immune from modification or elimination.”

“(P)laintiffs assert a vested contractual right to purchase up to five years of airtime service credit that is not subject to elimination or destruction by legislative amendment or repeal ‘even before the benefit has been accessed or the time for retirement has arrived.’” The court said plaintiffs “disregard the fact that, when amending the statutory scheme governing pension rights, the Legislature in fact provided (eligible public employees) … a several-month window in which to purchase the airtime service credit before the option terminated.”

The high court could uphold the rule or overturn it, or put certain limits on its application and deal narrowly with the “airtime” issue. In that separate Marin County case, five unions challenged PEPRA’s limitation of various ways that public employees enhance, or spike, their end-of-career salaries (bonuses, unused leave, etc.) to boost their lifetime retirement pay.

Unions argue that the reform reduced their vested pension benefits and was therefore in violation of their constitutional rights, as upheld by – you guessed it – the California Rule. “(W)hile a public employee does have a ‘vested right’ to a pension, that right is only to a ‘reasonable’ pension – not an immutable entitlement to the most optimal formula of calculating that pension,” ruled Justice James Richman, in language similar to the San Francisco ruling. He wrote that the Legislature may “prior to the employee’s retirement, alter the formula, thereby reducing the anticipated pension.”

As reporter Ed Mendel has explained in Calpensions, “The high court will wait until an appeals court rules on three similar spiking ban suits consolidated from Alameda, Contra Costa and Merced counties.” That might take some time, but this issue is definitely coming to the state’s high court in one form or another, sooner or later.

Battle lines are drawn. The unions claim that state and local agencies may not reduce any pension benefits. Pension reformers – and the courts, in recent decisions – say that while a reasonable pension remains a right, that doesn’t stop localities from reducing some things. These cases deal with pension-spiking enhancements and the purchase of airtime – controversial and somewhat limited practices. But the future of pension reform is on the line.

Steven Greenhut is Western region director for the R Street Institute. Write to him at sgreenhut@rstreet.org.

This end-of-year board vote to reduce expected investment returns from 7.5 percent to 7 percent portends difficulties for local agencies that provide pensions to their public employees through the CalPERS system. Lowered earnings estimates mean these agencies will have to contribute significantly higher payments to the pension fund to defray the costs of these benefit packages. In 2012, CalPERS dropped its expectations from 7.75 percent to 7.5 percent.

“The three-year reduction of the discount rate will result in average employer rate increases of about 1 percent to 3 percent of normal cost as a percent of payroll for most miscellaneous retirement plans, and a 2 percent to 5 percent increase for most safety plans,” according to a CalPERS statement following the vote. The “normal” cost doesn’t address the growing size of the fund’s unfunded liabilities (i.e., debt), so local governments will also have to boost their “unfunded accrued liability payments” by as much as 30 percent to 40 percent.

California local governments already have faced 50-percent hikes in their CalPERS payments over the past several years, which has led local officials and pension reformers to increasingly fear a continuing cycle of service cut-backs and tax increases. Indeed, there was some pressure at CalPERS to push the expected return rates down to the 6 percent range, but some officials expressed concern about what this would mean, cost wise, for member agencies.

“The reduction in the rate of return is not as big as was discussed last month,” according to a Dec. 21 report in Pensions & Investments. “Chief Investment Officer Theodore Eliopoulos said at last month’s finance and administration committee meeting that given diminished investment return assumptions over the next decade, 6 percent was a more realistic return for the coming 10 years. Andrew Junkin, president of Wilshire Consulting, which serves as CalPERS’ general consultant, said at the November meeting that Wilshire was predicting an annual return of 6.21 percent for the next decade, down from its estimates of 7.1 percent a year earlier.”

Even a 6 percent expected rate of return would be overly aggressive, according to many pension-reform advocates who note that CalPERS received a 0.6 percent return last fiscal year – and 2.75 percent in the previous fiscal year. Furthermore, beginning in 1999, the state and most local agencies began a spree of retroactive pension increases.

These massive benefit hikes – oftentimes 50 percent or more – put additional strain on the system. Critics call for CalPERS to embrace rate returns that are considered risk free – i.e., tied to the Treasury bond rate. That would mean an expectation of about 3 percent a year for the coming decade.

The burden falls mainly on local governments, but public employees hired after a 2013 pension-reform measure (the Public Employees’ Pension Reform Act, or PEPRA) will face higher personal contributions to their pension plan. Because of something known as the “California Rule,” the state’s public employees cannot be forced to increase their contributions or receive fewer benefits than promised – but that doesn’t apply to those hired under a new set of rules. (A court decision last year opened the door to reduce benefits for current workers, but that case has yet to be resolved.)

Few California cities will face what is taking place in Loyalton, a tiny Sierra County town west of Reno, Nevada. The town could no longer afford to pay its fees to CalPERS, and the fund has threatened to cut off its four retirees’ pensions. As Calpensions explained, “According to a state controller’s report for 2015, Loyalton had revenues of $1.17 million, expenditures $1.68 million, liabilities $6.16 million, assets $11.1 million, fund equity $4.8 million, and population 733.”

This is an extreme version of the stress faced statewide, a problem exacerbated by the fact that the pension fund will soon have more retirees collecting pensions than active workers paying into the system. That situation wouldn’t be a problem if the system were entirely sustainable – i.e., if it weren’t amassing unfunded liabilities.

Gov. Jerry Brown applauded CalPERS’ decision to reduce its assumptions. “Today’s action by the CalPERS Board is more reflective of the financial returns they can expect in the future. This will make for a more sustainable system,” the governor said in a Dec. 21 statement.

These debates over the “rates of return” are so significant because of the way CalPERS and other defined-benefit systems operate. In defined-contribution systems (401/k-style systems, for instance) typical in the private sector, employees contribute a portion of their income into their retirement fund. Employers often match a certain percentage of these contributions. The money is invested in, say, a mutual fund. If the returns are high, the employee gains more retirement income. If they are low, the employee receives less. There are no future liabilities.

By contrast, public employees receive a promised benefit level determined by a formula based on years worked and a percentage of salary. Pension funds invest the money and their investment returns help assure the system has enough cash to meet all the current and future promises. If investment returns sag (or benefits are increased), the funds incur large unfunded liabilities or debts. Ultimately, the state’s taxpayers are responsible for any shortfalls. So the expected rate of return carries enormous public-policy implications for the state and municipalities.

Critics complain that the CalPERS board is comprised largely of public employees, retirees and elected officials with close ties to public-employee unions, which provides a strong incentive to push funding problems further into the future. But even with that dynamic there’s only so much that can be done in a world of weak investment returns and stepped up accounting standards. Efforts by CalPERS’ investment staff and board members – and by the Brown administration – to deal more realistically with the issue is viewed by most Sacramento observers as an encouraging sign.

Steven Greenhut is Western region director for the R Street Institute. Write to him at sgreenhut@rstreet.org.

That decision was good news not just for pension-reform activists, but for the Jerry Brown administration and legislators from both parties who had supported a 2012 reform law meant to shave the state’s pension obligations. As Justice James Richman noted in his ruling, spiking “has long drawn public ire and legislative chagrin.”

But pension reformers got even better news, given the nature of the judge’s reasoning. The court ruled that employees have a right to a “reasonable pension – not an immutable entitlement to the most optimal formula of calculating the pension.” That simple logic undermines the core obstacle to far-reaching pension reform in California, and which has been adopted in several other states. It involves something known as the “California Rule.”

It’s not actually a rule, but a precedent derived from a variety of rulings that date back to 1955. Ultimately, it says that once a legislative body (city council, board of supervisors, the state Legislature) grants a pension-benefit increase, that increase is indeed immutable; it can never be rolled back. Employees can never be forced to contribute more to their pension plan unless they get something of equal or greater value in return.

By contrast, the courts allow private-sector employers to roll back pension benefits on a forward-going basis. In other words, an employer can’t reduce pension benefits that have already vested, but it can cut back future benefits that have yet to be earned.

Four years ago, California politicians from both parties acknowledged the depth of the state’s public-employee pension crisis. Unfunded liabilities – i.e., the taxpayer-backed debt to pay for the state’s pension promises – were rising. Localities were struggling to make ends meet as their pension obligations rose, with a handful heading into bankruptcy and others struggling with service cutbacks to afford their pension bills.

The resulting pension-reform law, called the Public Employees’ Pension Reform Act (PEPRA) of 2013, has been criticized for not going far enough in its reforms. Some Republicans even alleged it was more about public relations than reform. Its passage in 2012, for instance, was used by supporters of the Proposition 30 tax increase measure to convince voters the state was serious enough about governmental reform that they should vote yes. But the Brown administration and legislators argue it was a serious step toward reining in pension problems.

Whatever their motives, legislators and the governor have dealt with the same problem faced by other local governments that have tried to reform pensions: the courts use the California Rule to stop most proposals that reduce benefits for current employees. PEPRA mostly made changes for future employees. The pension-spiking restrictions at issue in this ruling, Marin Association of Public Employees v. Marin County Employees’ Retirement Association and the State of California, were found in a trailer bill that was passed after it became clear that PEPRA actually would “increase pension-spiking opportunities,” as the East Bay Times’ Dan Borenstein reported.

Despite the reform, however, massive pension problems remain. The Stanford Institute for Economic Policy Research produces a pension tracker that calculates the size of the pension debt for all of the state’s employee-retirement systems. Depending on assumptions about rates of return, the debt ranges from $281 billion to $946 billion, or a range from $22,000 per California household to $75,000. In the ensuing four years, the debt problems have intensified, especially following the California Public Employees’ Retirement System’s recent returns, which were below 1 percent for the past year.

Unlike a 401(k) system, where the ups and downs of the market raise or lower the returns that an employee will receive, these governmental defined-benefit systems guarantee a payout to employees based on a formula. If the market goes down, then the taxpayer-backed unfunded liability, or debt, goes up. There’s variation in the size of the debt based on how well the pension funds do. The main pension fund assumes their investments will earn an aggressive 7.5 percent. If it’s wrong, agencies will need either to come up with more money or cut back public services.

Hence, the significance of the California Rule. The state and local agencies have cut back pension benefits for new and future employees. That’s allowed. But most of those employees won’t start retiring for 30 years. Many analysts believe the only way to get these debt numbers under control is to reduce benefits of current employees going forward. The courts have so far stopped that approach. A federal court in the Stockton bankruptcy case ruled that benefits can be cut for current employees, but cities have to go belly-up to take advantage of that process.

The latest ruling offers a possible way out of this conundrum. “(T)he Legislature may, prior to the employee’s retirement, alter the formula, thereby reducing the anticipated pension,” the judge ruled. “So long as the Legislature’s modifications do not deprive the employee of a ‘reasonable’ pension, there is no constitutional violation. Here the Legislature did not forbid the employer from providing the specified items to an employee as compensation, only the purely prospective inclusion of those items in the computation of the employee’s pension.”

The judge pointed to a report from California’s watchdog agency, the Little Hoover Commission, noting the size of the pension problem: “The money coming in is nowhere near enough to keep up with the money that will need to go out. The state must exercise its authority – and establish the legal authority – to reset overly generous and unsustainable pension formulas for both current and future workers.” In other words, the promised benefits cannot be considered outside of the overall health of these public retirement systems.

The ruling will almost certainly be reviewed by the state Supreme Court. Pension-reform advocates have made progress in the past in addressing this rule (e.g., the 2012 passage of a San Jose reform that rolls back benefits for current employees) only to be rebuked in court. And even if it stands, the decision will leave no clear roadmap. How much can future pension benefits be cut or how much more can employees be expected to contribute before it becomes “unreasonable”?

It’s unclear, but as a Santa Rosa Press-Democrat editorial from last week opined, the “court ruling opens a path for pension reform.” That’s not a freeway, but it’s a way forward that reformers didn’t have before the 1st District Court of Appeal’s decision.

Steven Greenhut is Western region director for the R Street Institute. He is based in Sacramento. Write to him at sgreenhut@rstreet.org.