“Four years ago, voters approved Proposition 30, which raised the income tax significantly on the wealthiest Californians and raised the sales tax a tiny bit on everyone,” Capital Public Radio recently recalled. “That quarter-of-a-cent increase equated to paying an additional $0.01 on a $4 coffee; $1 on a $400 television; and $100 on a $40,000 car.” But on Election Day 2016, that changed. “Voters extended Proposition 30’s income tax increases in [November’s] presidential election with Proposition 55 — but that initiative allowed the Prop. 30 sales tax hike to expire.”

The shift means California’s sales tax is the state’s only tax to be decreased this year, from 7.5 percent to 7.25 percent. As the U-T reported, “Some local jurisdictions tack on their own assessments, so residents in certain areas will still pay more than the statewide rate.” In certain parts of the state, like the San Francisco Bay Area, voters allowed substantial increases. 

From spending to taxing

Prop. 30 ushered in the so-called Schools and Local Public Safety Protection Act of 2012, as California voters threw their support behind increased spending on state education and benefits. “The act increased sales tax and income tax rates to help maintain funding levels for public schools and colleges and pay for programs for seniors and low-income families,” U-T San Diego noted. “The additional revenue also provided local governments with a constitutional guarantee of funding to comply with a new state law that shifted lower-level offenders from state prisons to county jails.”

Some municipalities, particularly in parts of the state that joined a Democrat-led initiative to hike minimum wages, opted to raise more funds. “Bay Area voters this year generously approved taxing themselves in large numbers — and they’ll feel the pinch at the cash register in 2017 as local sales taxes across Silicon Valley take effect even as a state tax expires,” according to the San Jose Mercury News. 

“As California cities struggle to fund basic city services like police, fire protection, libraries and parks, they’re increasingly turning to voters for help. And voters this year said ‘yes’ to tax hikes in at least eight Bay Area cities in exchange for fewer potholes, less traffic and more cops, including San Jose, Newark, Martinez and Pleasant Hill.”

Pension pinch

For years, public pension costs have steadily built pressure on Golden State cities. In some areas, the problem has become egregious: The city of El Monte, in Southern California, shelled out 28 percent of its general fund to pay retirement costs. “Among California’s 10 largest cities, only San Jose paid as much toward retirement costs relative to its general fund. Los Angeles spends 20 percent of its general fund on retirement costs,” the Los Angeles Times revealed. “El Monte’s outsize pension bill weighs heavily on the San Gabriel Valley city of 116,000, where half the residents were born outside the United States and a quarter live below the poverty line.” 

Meanwhile, CalPERS, the nation’s largest public pension fund, has struggled with its own imbalanced budgets. “CalPERS has 65 cents for every dollar that it needs to provide pension benefits for almost two million people,” Fox Business recently recalled. “CalPERS pension debt is roughly $164 billion and mostly likely will grow larger in coming years.” 

In an effort to come to grips with the problem, the fund reduced its forecasted return on investment from 7.5 to 7 percent. “It has been paying out $5 billion more a year in benefits than it’s receiving in contributions and investment returns, not a sustainable trend,” the Fresno Bee noted in an editorial. “With investment returns averaging 4.6 percent during the past decade, some experts urged CalPERS to reduce its forecast even more.” But that would risk pushing more California cities toward bankruptcy — or toward even higher local taxes. 

Reigniting a perpetually smoldering debate with nationwide implications, the California State Supreme Court agreed to consider whether rules cracking down on pension boosting strategies could be applied to unionized government workers. 

“A state appeals court in San Francisco ruled in a Marin County case in August that the new laws could be applied to current employees — a potentially major setback for the workers and their unions, and a victory for local governments facing mounting deficits in their pension plans,” the San Francisco Chronicle reported. “But the state’s high court voted unanimously Tuesday to put that ruling on hold while it reviews the issue for a future statewide resolution.”

“The new laws were intended to curb pension ‘spiking,’ the practice of boosting retirement benefits by increasing an employee’s pay during the final years of employment,” the paper added. “It is often done by cashing out unused vacation time, sick leave, compensation for use of one’s car and other nonmonetary benefits.” Some 2 million California public employees have retirement plans underfunded by many billions of dollars, according to the Chronicle.

Seeking momentum

As has become almost customary, labor activists and policymakers around the country have positioned themselves to act swiftly on whatever the court should decide, possibly using a ruling to press for a decisive outcome in the pension wars that have see-sawed over the course of the decade. “The ruling would apply only to California, but if the state Supreme Court decides to uphold a lower court ruling that pension benefits can be reduced in some circumstances, it would be an important signal to the many other states grappling with unsustainable pension burdens and similar rules forbidding benefit cuts,” Eric Boehm noted at Reason. “It would also signal that courts are willing to reconsider the balance between public workers and the states (and the taxpayers in those states) writing their checks.”

“According to data from Transparent California, a project of the Nevada Policy Research Group, more than 20,000 retired public workers in California pulled down more than $100,000 in retirement benefits during 2015. Meanwhile, the CalPERS pension fund is more than $139 billion in the red, an amount that would require every man, woman, and child in California to pay $11,000 if it were divided evenly.”

With over $300 billion in assets, as Andrew Andrzejewski wrote at Forbes, CalPERS has become a symbolic anchor to pension defenders and an albatross from the viewpoint of critics, “helping 1,251 local governments confer ‘highly compensated’ pensions to tens of thousands of public employees. Updated numbers displayed at OpenTheBooks.com show there is a $2.8 billion annual cost to pay out 21,862 six-figure public-sector retirees via CalPERS.”

Cautionary tales

At the same time as pension watchers have braced for the state Supreme Court’s ruling, pension hawks have urged Californians to consider cautionary tales from outside the state. “While justices will consider the case based on its legal merits, state taxpayers should hope they keep in mind what has happened in Illinois since its Supreme Court held that public employee pensions were immutable in May 2015,” the U-T San Diego Editorial Board suggested. “A state that already was in terrible shape financially now looks on the brink of disaster, unable to pay $8 billion in bills. In September, former FDIC chair William M. Isaac called for the state to declare bankruptcy.”

Even with the sense of urgency surrounding the case, observers warned that the court could take its time. “Despite the California Supreme Court’s decision to accept the Marin County pension fund case, the case may move slowly. The Supreme Court in its posting said it was waiting for another case to be resolved,” according to Pensions & Investments. “Legal observers say the state Supreme Court wants to consolidate all the outstanding cases before holding a hearing and making a final decision.”

A key moment, buried amid nearly 13 hours of recorded meetings, came when CalPERS’ Chief Investment Officer Ted Eliopoulos played a short interview video with Wall Street experts, including famed investor Warren Buffett, opining on the expected investment returns in coming years. One investment guru thought a 4 percent or 5 percent rate of return would be the objective. Buffett pointed to very slow growth in the economy.

Eliopoulos used a diagram showing a 30-year decline in interest rates, even as discount rates used by pension funds remained steady. CalPERS currently calculates its pension liabilities based on an expected return rate of 7.5 percent. Based on the data provided by CalPERS staff, it’s clear the agency would need to ramp up its risk taking to have any chance to continually meet such goals. In the past year, CalPERS’ return rate was 0.6 percent.

Longtime pension-reform advocate Daniel Pellissier, president of California Pension Reform in Sacramento, praised the CalPERS staff for its bout of truth telling, given that such predictions are not what the current system’s defenders want to hear. “I’d like to think they actually have a conscience and they understand the role they play,” he said. “What do you do when you’re facing flat returns for years ahead and liabilities are rising?”

The staff is “pushing the board to do the right thing,” Pellissier added. “Some board members are essentially saying to staff: Make me do the right thing.” The “right thing,” in Pellissier’s view, is to further reduce the expected return rates to more closely match market performance. He compares the situation to 1999, when CalPERS officials did not sound the alarm bells about the looming costs that would follow SB400, the law that led to 15 years of statewide retroactive pension increases and that still plagues the system to this day.

At least one CalPERS board member complained about the cost of reducing the discount rate. There’s no doubt that doing so means that California cities will face costly spikes in their payments. But in reality, the costs are already there. State and local governments have already made pension promises to public employees. The courts have consistently enforced the so-called “California Rule,” which stops agencies from lowering benefits for current employees, even going forward.

The question, according to reformers like Pellissier, is how forthright state officials will be in accounting for the size of the pension-related debt. Few dispute the essential point: Governments have undercharged municipalities for the cost of pension benefits, possibly for decades. They have to keep those promises. The “unfunded pension liability” is essentially the debt – the difference between what’s promised and the available funds.

In the private sector, employees typically receive defined-contribution plans, generally 401(k)-style benefits. The employee contributes a certain percentage into a fund. Sometimes the employer matches a portion of the contribution. The money is invested in mutual funds. When the market does well, the employee reaps the benefits. When it does poorly, the employee endures the downside. The employee uses whatever is in the fund for retirement. There are no “liabilities.”

The government pension plans that CalPERS manages are an entirely different animal. Agencies make benefit promises to employees based on a formula. For instance, most public-safety officials (police, fire, prison guards) in California receive “3 percent at 50.” That means they retire with 3 percent of their final years’ pay times the number of years worked, available at age 50 – plus myriad pension “enhancements” added at the end of the career. That level — 90 percent or more of final pay — is guaranteed, no matter what.

This explains the heated debate over investment-return predictions. If the market does well, there are fewer forecast debts. If it does poorly, those liabilities soar. Because taxpayers are pledged to backfill any shortfalls, it’s a highly political issue. Additionally, critics note that the CalPERS board is dominated by union officials whose members benefit from painting as rosy a scenario as possible about the future investment performance.

Union officials argue the system is fine and that, despite recent poor performance, CalPERS does well over time. Returns have been terrible since 2014, but outperformed predictions between 2009 and 2013. But even the CalPERS staff’s presentation suggests it’s unrealistic to bank on continuing 7.5 percent return rates in the current market.

As Pensions & Investments reported, “Andrew Junkin, president of Wilshire Consulting, the pension fund’s general investment consultant, told the committee its firm estimates the pension fund’s annualized investment return over the next decade will be 6.2 percent, down 90 basis points from the 10-year forecast Wilshire made a year ago of 7.1 percent.” The publication noted that CalPERS could vote on a rate reduction in February.

Pension-reform advocates aren’t the only ones raising the ghost of SB400 in the current context. “It’s time to put SB400, the 1999 California legislation that changed benefits for public workers, behind us,” argued CalPERS board members Richard Costigan, Dana Hollinger and Bill Slaton in a September column. “That bill … was a product of its time. Retirement security is too important today to get caught in a debate about the past. When SB400 became law, CalPERS was 137 percent funded.”

They vowed to examine the situation in light of the current, tougher economic climate. The staff presentation at the recent Board of Administration meetings suggest those words were more than public relations. Top CalPERS officials seem to recognize the size of the looming problem. The real test will come in December committee meetings and at the next board confab. But it’s increasingly likely that return predictions are headed downward.

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

Union battles Caltrans over costly move

Good morning! But alas, it’s only Tuesday.

CalPERS and the rising public debt continues to be scrutinized. But first, Caltrans is under fire from an employee union. 

A public employees’ union is questioning Caltrans’ pricey decision to move one of its district offices from one side of Orange County to the other, noting the high cost of new cubicle partitions and the lack of space to accommodate new staff required by two transportation proposals. 

Caltrans’ District 12 management terminated its lease two years early to move from a building it owns in Irvine to a space it’s renting in Santa Ana, to move from a space the union argues would accommodate space needs to a space that’s inadequate.

The new space saves about $1.2 million in rent annually, but it also reduces space by 50,000 sq. ft., which does not allow for the additional staff required for the traffic-relief construction called for in transportation proposals offered by both Gov. Jerry Brown and legislators.

“For state highways, this would require engineering design and construction inspection, but Caltrans is moving to a new location which would not have the space to house the staff needed to accomplish the program,” said Beth Katz, spokeswoman for Professional Engineers in California Government.

CalWatchdog has more.

In other news:

• “California’s foster-care system has long been plagued with unaddressed problems, but a recent exposé about the system’s alleged over-prescription of psychotropic drugs has propelled the Legislature into action. Gov. Jerry Brown currently has on his desk three bills that deal with some of the issues raised in a California state auditor’s report last month,” reports CalWatchdog.

• “Lawmakers agreed last month to extend a vital subsidy for [Bloom Energy], one that makes its pricey power generators more attractive to buyers such as hospitals, data centers and mega-retailers. For Bloom  and its industry cohorts, the win marked the end of a hard-fought slog against powerful adversaries including utilities and labor groups. But rival companies and some lawmakers had a different perspective… .” The Los Angeles Times has more. 

• “CalPERS pension fund defended by its most ferocious critic,” writes CalWatchdog.

• “Why the dot-com bubble is key to understanding California’s growing public employee pension debt,” reports Capital Public Radio.

Legislature:

• Gone ’til December.

Gov. Brown:

• No public events announced.

Tips: matt@calwatchdog.com

Follow us: @calwatchdog @mfleming

New follower: @cebryant

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.

The State of California has sued investment bank Morgan Stanley, filing a complaint in San Francisco Superior Court, seeking redress for what officials said was massive harm to its public-sector workers.

“Public employees in California, including peace officers, firefighters, teachers, and other public servants, suffered major losses as a result of Morgan Stanley’s residential mortgage-backed securities, in which high-risk home loans were purchased from subprime lenders, bundled together and sold for billions of dollars to investors,” the complaint alleges, according to CBS San Francisco.

Lack of disclosure

The complaint depicts Morgan Stanley as doling out bad deals out of “fear that transparency would be ‘a relationship killer,’ hampering a lucrative business with the companies taking on the risky debt,” Bloomberg noted. “Harris accuses the bank of bundling high-risk loans from subprime lenders — some directly funded by Morgan Stanley — and selling them to investors without disclosing its own concerns about the poor quality of the debt.”

In a statement, the office of California Attorney General Kamala Harris singled out the state’s large twin public pension funds as suffering particularly large losses. “The California Public Employees Retirement System (CalPERS) and the California State Teachers Retirement System (CalSTRS) — two of the nation’s largest institutional investors — lost hundred of millions of dollars on these Morgan Stanley investments,” the statement read. “CalPERS provides retirement security and health plans to more than 1.6 million California firefighters, peace officers, and other public employees. CalSTRS provides retirement, disability, and survivor benefits for over 850,000 of California’s pre-kindergarten through community college educators and their families.”

Swinging for the fences

Blaming “a culture of greed and deception,” Harris accused the bank of obscuring the investment risk posed by “toxic residential mortgage-backed securities and ‘structured investment vehicles’ it marketed from 2004 to 2007, sometimes encouraging credit rating agencies to award unjustifiably high ratings,” as Reuters reported. Seeking to maximize compensation, “California seeks to triple the damages sustained by the pension funds, plus penalties of $2,500 for each violation of the state’s business code,” according to Bloomberg, plus a court order barring similar misrepresentations in the future.

The lawsuit reflected a hope that Morgan Stanley might also be vulnerable to an approach successfully taken in the past toward ratings agencies accused of their own misdeeds. “CalPERS had previously recovered hundreds of millions of dollars in settlements with agencies such as McGraw Hill Financial Inc’s Standard & Poor’s and Moody’s Corp’s Moody’s Investors Service over alleged inflated ratings,” as the wire service noted. In previous lawsuits, officials had pegged the combined losses facing the funds at over $1 billion, according to the Sacramento Bee, with the lion’s share falling on CalPERS.

A vigorous defense

The fight came at a moment when Morgan Stanley and the state of California have been working hand in hand on another big-ticket issue of central concern to state officials: new water bonds. “California’s Infrastructure and Economic Development Bank will issue $414.2 million of clean water state revolving fund revenue bonds as green bonds through lead manager Morgan Stanley,” as Reuters observed.

The California State Teachers’ Retirement System, one of the world’s largest pension funds, has found itself in the spotlight. Recently, state Democrats ensured that CalSTRS divested from coal and guns. But diminishing returns on investment have grown the pension fund’s unfunded obligations, according to a report issued by an independent auditor. “As of June 30, 2015, the net pension liability for the State Teachers’ Retirement Plan increased by $8.9 billion to $67.3 billion due to lower investment returns during fiscal year ended June 30, 2015 as compared to last year,” the report noted.

Drawing fire

Critics pounced on the news, characterizing it as effectively an off-ballot issuance of debt equal to what’s on offer this coming November. (“On school construction, a proposed $9 billion bond issue has qualified for the November ballot,” as George Skelton observed at the Los Angeles Times.) “The $9 billion addition is as real as any other debt. Arguably it’s more real because, as the Stockton decision demonstrated, bankruptcy courts are more likely to cut bond obligations than pension obligations,” warned Govern for California co-founder David Crane, referencing the recent high-profile determination that the city of Stockton would not renegotiate pension deals in order to help it emerge from bankruptcy.

“Including interest, this $9 billion debt will devour more than $20 billion that would otherwise benefit schoolchildren. Looked at another way, just one year’s interest on this debt is almost as large as the expected growth in state support for education in the current budget year.”

An uncertain future

But the debt forecast for 2016 has been uncertain. The school construction bond measure has run up against opposition from powerful forces to the left of center. Gov. Jerry Brown, for instance, “is opposed to more bond debt,” as Skelton noted. “And teachers unions don’t want a school bond on the November ballot to compete against their anticipated tax increase proposal.” The CTA, for instance, has so far opted not to take a position on the $9 billion bond. “But the union is working on an initiative to stop the scheduled expiration of some temporary taxes that voters approved in 2012 with Proposition 30,” according to the San Jose Mercury News. “Various proposals are in the works to raise at least $5 billion a year by extending some of those taxes.”

Schools themselves have not been immune from criticism. Seeking a culprit for the derelict condition of many state schools, U-T San Diego blamed “the Legislature’s decision during the Great Recession to suspend the state mandate requiring that districts spend at least 3 percent of their budgets on maintenance.”

“Some districts essentially gave up on such maintenance and have not ramped up maintenance to old levels now that school funding has rebounded. When there is little money in the operating budget for maintenance, some districts — including San Diego Unified — have used borrowed bond money to pay for routine upkeep.”

The controversy over the responsibility of school unions and public pensions for accumulating debt has played out at a time when the costs of CTA’s political influence have increased. “The CTA has become a force in Sacramento by pouring millions into influencing ballot measures and electing lawmakers, then millions more lobbying legislators after they take office,” the Mercury News recalled. “The union’s formidable political operation — spending about $200 million on campaigns and lobbying in the last 15 years — is funded by roughly 300,000 classroom teachers who pay approximately $1,000 each in annual union dues.” In 2016, the union will face two landmark lawsuits — one that has reached the Supreme Court, and another, in California, where the Vergara lawsuit is on appeal.

CalPERS’ proposed Funding Risk Mitigation Policy would slightly lower its expected investment return, also known as the discount rate, in good investment years.

Specifically, it would reduce the discount rate by 0.05 percentage point when the investment return is at least 4 percentage points above the discount rate. Currently the discount rate is 7.5 percent, so the investment rate threshold would be 11.5 percent.

An alternative under consideration would lower the discount rate when investment returns are 2 percentage points above the discount rate.

The problem with the 11.5 percent threshold, according to critics, is that it would result in CalPERS not doing enough to lower its investment risk. In only half of the past 10 years were investment returns above 11.5 percent. Returns were just 6.5 percent last year, and they were 2.4 percent in the first half of this year.

As a result, it could take 25-plus years, perhaps never, for CalPERS to lower its discount rate to 6.5 percent, Eric Stern, a DOF budget analyst told the CalPERS board on Oct. 20. “We do feel that the strategy to lower risk only in exceptionally good years really continues to expose the fund to too much risk over the coming decades,” he said.

Taxpayer Dollars at Stake

Millions of taxpayer dollars are potentially at stake. Investment earnings account for two-thirds of CalPERS’ income. More than 3,000 government employers provide 21 percent of the system’s income. The remaining 12 percent comes from CalPERS’ 1.72 million members, nearly a million of whom are no longer active.

When the expected rate of return on investment is lowered, the difference must be made up by contributions from state and local governments, school districts and current government employees. That would likely result in less funding for other government services and/or the need for tax hikes.

Despite that, in order to be more fiscally responsible, CalPERS should reduce its discount rate to 6.5 percent, according to Stern.

“We are really looking for stability, predictability, some more certainty with our contribution rates,” he said. “Acknowledging that investment returns are likely to be lower at some point in the future and have some significant dips, means that local governments are going to need to start paying more money now to pay for those promised benefits.

“We need to implement these changes now, sooner rather than later, instead of waiting for those future investment returns that we can’t really even count on. It would create more stable rates for governments and allow governments to plan for these higher costs in the future. Instead of delaying the impact and leaving the state and other employers to even higher rate shocks in the future.”

Danger of Recession

A recession, which is due according to some economists, could hit CalPERS’ $292 billion investment portfolio hard. Sixty-three percent of its investments are in growth assets, mostly stocks. These have the potential for good returns such as CalPERS’ 16.2 percent gain in 2013, as well as bad returns like its 27.1 percent loss in 2008. Much of the rest is invested in less risky assets such as bonds and real estate.

Stern acknowledged that the CalPERS board appears set to adopt the proposed policy to reduce risk only in very good investment years. But he asked the board to reconsider and instead phase in a lowering of the discount rate to 6.5 percent over the next five years, regardless of the investment returns during that time.

Richard Costigan, who was chairing the Finance and Administration Committee meeting, acknowledged that the Department of Finance’s concerns are legitimate, given market volatility and the aging of CalPERS’ membership resulting in increased pension payouts.

“At the end of the day, where Finance would like us to go I do think is the right place to go,” he said. “I don’t think we’re going to get there. Long-term the market has done exceptionally well. But when you look at the short term snapshots … our workforce is getting older, we are getting less people.”

But the discussion indicated that it’s unlikely the board will grant Stern’s request. In fact, board member Ron Lind pointed out that the board has never set a 6.5 percent discount rate target.

Mitigating Risk Going Forward

Much of the discussion concerned board member Bill Slaton’s suggestion to lower the threshold trigger to 2 percentage points above the discount rate. That equates to investment returns of at least 9.5 percent, which have been achieved in seven of the last 10 years.

“I have been an advocate for a more, you can use the term ‘aggressive,’ but I would like to say just more structured, small increments that employers could tolerate, but at the same time moving quicker to reducing our risk,” said Slaton.

“I think we face a tremendous amount of risk going forward. We’ve spent the last year and a half talking about that risk, talking about an aging workforce, talking about the ratio difference in active [employees] versus retirees. We’ve obviously spent a lot of time on market volatility. We’ve experienced that recently.”

He continued, “I think [2 percentage points above discount] is a modest enough change. I think it’s not going to have a radical impact over time on employers. But I think it sends a message that the priority here is risk mitigation.”

He was backed by board member Richard Gillihan. “I think we are missing an opportunity in putting off the day of reckoning,” he said. “And it may come back and bite us.”

Also supportive is Dana Hollinger, who said, “I would prefer something with more certainty. Because I think going forward we’re in for some challenging times. My goal has always been to mitigate risk and make sure that these benefits are sustainable.”

Minimizing Damage to Municipalities

But other board members prefer the 4 percent threshold, worried about the financial hit to governments and their employees. “We can’t ignore the fact that over the last several years employers have noticed large rate increases they are still dealing with,” said Lind.

Theresa Taylor is also on board with the 4 percent threshold. “There are public agencies that don’t have the money to move forward on a policy to reduce our risk right now,” she said.

“I agree we need to reduce our risk,” Taylor continued. “I think it’s very important that we are working to reduce the risk. But it’s also important that we don’t hurt taxpayers and municipalities by doing it so that too much is being taken away from the municipalities that are already struggling with their rates increasing.”

J.J. Jelincic may be the hardest line supporter of the status quo, arguing for keeping the discount rate at 7.5 percent in perpetuity. “I understand that we’re under a lot of pressure to reduce our assumed rate of return because people think it’s too high,” he said. “Much of that pressure is coming from people who are opposed to defined benefit plans and people who buy Knight-Ridder newspapers.

“This may be the best idea since sliced bread, but our job is to balance risk. Over the long-term I think 7½ percent is probably doable – this year, next year probably not. But we don’t run the system for this year or next year.”

Slaton countered that it may not be doable, pointing out CalPERS’s retirement plan is only 75 percent funded. “If we had another [market crash] event similar to the event we had in 2008, then we reach a point where we can’t recover,” he said. “It is an asymmetric curve in regard to downside versus upside. The impact of the downside is much more intense and we need to be focused on it.”

Costigan agreed to place both the 2 and 4 percent threshold options on the Nov. 17 agenda when the policy comes back for a second reading. The board plans to adopt the policy by the end of the year.

Striking a deal

Losing police to other jurisdictions, Mayor Sam Liccardo faced “enormous pressure to reach a settlement,” according to Scott Herald at the San Jose Mercury News. In fact, wrote Herald, Liccardo “could legitimately argue that the city had achieved concessions in negotiations, obtaining savings he estimated at $1.7 billion over 30 years. San Jose was able to save millions by foregoing the so-called ‘bonus checks’ to employees. And the city and its public safety unions agreed on a cheaper health plan.”

In an unusual move, the City Council successfully petitioned the courts to invalidate the measure, paving the way for a renegotiated deal with law enforcement. Under the terms of the new wage agreement, the Mercury News reported, police officers will receive “8 percent in ongoing raises and 5 percent one-time bonuses.” But the fate of the deal remained in the hands of voters, who would have to approve the Measure B replacement at the ballot box in 2016.

For now, however, the city has at least managed to settle its three-year court battle with police and firefighter unions, as San Jose Inside observed. And it stanches its law enforcement losses, which were approaching crisis proportions. “Since 2012, SJPD has had 265 officers resign and 167 retire,” according to San Jose Inside. “This year alone, the department has seen 41 resignations and 54 retirements, leaving the agency with 943 sworn officers out of a budgeted 1,109 positions.”

Taking it statewide

But former Democratic Mayor Chuck Reed, along with former Republican San Diego City Councilman Carl DeMaio, continue to back a controversial ballot initiative that threatens to complicate the issue of pension costs by offering California voters a new statewide approach.

According to its authors, the matter is cut and dry: “This simple initiative gives voters the ability to stop sweetheart and unsustainable pension deals that politicians concoct behind closed doors with government union bosses,” the two said in a joint statement, according to the Sacramento Bee. “That’s why the politicians and union bosses oppose this initiative – and why they continue to try to mislead the public on what the initiative does.”

But Attorney General Kamala Harris, one of the targets of their criticism, emphasized its potentially destabilizing consequences in her office’s title and description of the initiative. According to that language, the initiative “eliminates constitutional protections” for collective bargaining, bringing “significant” savings, but also costs, for state and local government.

“In addition to allowing voters to weigh in on public employee compensation,” the Bee summarized, “the initiative would mandate that voters approve any increases in pension benefits, sign off on new state and local employees being enrolled in the ‘defined-benefit’ plans that are now commonplace, and OK governments covering more than half of retirement costs.”

Trusting the voters

For activist opponents of the Reed-DeMaio plan, however, Harris should have portrayed the measure in an even less flattering light. By any measure, the scheme raises the prospect of fewer pension programs. “Requiring a vote by each government body to continue letting new employees into pension programs could very likely fail,” Reason noted, “requiring the state and municipalities to switch to 401(k)-style defined contribution retirement funds instead (which don’t require a vote).”

“This switch is important for spending reform because it takes governments (and taxpayers) off the hook for a guaranteed return. Governments would be providing all their contributions at the front end and would not be obligated to make up for any below-expected returns from these funds like they would with a pension.”

Analysts have not yet determined how great a departure from the status quo future votes might entail. “The effects on collective bargaining could be dramatic,” wrote Orange County columnist Teri Sforza. “And due to the less-generous retirement benefits that would likely emerge, governments would face pressure to increase other elements of compensation to attract and retain workers.” Like other measures that have passed through California’s initiative process, this one would put Golden Staters’ appreciation for direct democracy to the test.

A long road

“Reformers have backed statewide initiatives before,” as U-T San Diego columnist Steven Greenhut noted. “But titles and summaries issued by the attorney general have been criticized as biased. Voters who sign petitions tend only to read those short descriptions, so biased ones can be the death knell. Reformers even attempted a county-by-county approach, but the first test case, in Ventura County, was kept off the ballot by a judge.”

As the San Jose Mercury News noted, Reed and DeMaio both “led 2012 campaigns for local measures to trim city retirement plans whose soaring costs were devouring funds for city programs and services. Voters overwhelmingly approved San Jose’s Measure B and San Diego’s Proposition B that year. But government employee unions have leveled legal challenges to overturn them.” The experience inspired the team to introduce a measure that would simply “subject many pension enhancements to a vote of the people,” according to Greenhut. “It applies mostly to new hires — and to every local, regional or state government entity.”

Dramatic changes envisioned

But the simplicity of the approach would lead to potentially dramatic changes in the way California handles the existence of pensions, not just the creeping increases that have long been associated with them. “If the proposed ‘Voter Empowerment Act’ qualifies for the ballot and voters approve it in November 2016, cities across California would need voter approval to continue offering pensions beyond 2019. Otherwise, they would have to offer new employees 401(k)-style plans like those available from private employers,” according to the Mercury News.

Dueling trend lines

Although local government employment rolls have taken a substantial dip, in the high five figures, pension agreements have ensured that the cost of those employees has continued to rise. “Today, the main pension plans for state workers and teachers in California are about $190 billion short of what workers have been promised in benefits, despite the Dow Jones Industrial Average having nearly tripled in value since its March 2009 nadir,” the Weekly Standard observed.

“The cost of government has not declined, nor have continuing budget imbalances made cities, counties, and school districts any more efficient. Rising pension expenditures have left taxpayers in the position of having to, in effect, pay more for past government services while getting less and less in the way of current services.”

Especially in recent years, the tab has grown daunting for many cities. “Pension contributions are among the heaviest costs shouldered by California municipalities,” the Wall Street Journal reported. “California cities are expected to make a total of $5.1 billion in contributions during fiscal 2015, accounting for nearly 7 percent of total revenue, according to the California Policy Center, which analyzed 459 municipalities. Higher contributions often mean cash-strapped cities are forced to cut services or raise taxes to cover the bill.”

The fiscal problems created by pensions have focused national attention around the Voter Empowerment Act, which poses a particularly sharp challenge to certain California unions. “CalPERS relies on contributions from governments to fund worker pensions, and it has argued those retirement benefits are guaranteed by California law and can’t be cut,” the Journal noted.