Fixing California’s Pension Problem

State must rein in unaffordable increases in employee benefits

Pension reform might not be the sexiest of political issues, but it may well be one of the most important. California state and local governments continue to struggle with the high cost of employee retirement benefits. While some officials have tried to blame the problem on such things as poor stock market (and thus pension fund) performance, the real cause is simply the unaffordable increase in employee benefits.

The argument of generations past that government must offer greater benefits than the private sector to offset smaller salaries clearly no longer applies. Today, government employees receive significantly higher benefits and salaries than their private-sector counterparts. According to a 2005 study by the Employee Benefit Research Institute, public-sector employees earn 40 percent higher salaries and 60 percent greater benefits than private-sector employees.

Despite strong pension fund investment performance in recent years, the California Public Employees’ Retirement System (CalPERS) currently has a long-term unfunded liability of $26 billion, and the state teachers’ retirement system has a deficit of nearly $20 billion. In addition, Controller John Chiang estimates the shortfall for the state’s retiree health benefits at $48 billion, which, according to the Legislative Analyst’s Office, may be overly optimistic.

To address the state’s public pension problem, former Assemblyman Keith Richman has formed the California Foundation for Fiscal Responsibility (CFFR), which is trying to place a pension reform initiative on the ballot in 2008.

The CFFR’s initiative focuses on bringing the state’s traditional defined-benefit (DB) system more in line with private-sector compensation. It would amend the state constitution to limit pension and retiree benefit levels and would cover local government agencies as well as the state’s. Among the initiative’s provisions:

  • Retirement age for new, nonsafety employees would be aligned with Social Security requirements (65-67 years for most; public safety workers such as police and firefighters would be eligible to retire at age 55).
  • Pensions (including any Social Security payments) would be capped at between 60 to 67 percent of an employee’s final compensation.
  • Pension calculations would be made based on the average salary of the five highest earning years (California is the only state in the nation that bases its pensions on just the single highest earning year, which encourages “pension spiking”).
  • Pension calculations would only include base salaries (no adding in accrued vacation time or overtime to boost pension payments).
  • Retroactive benefit increases and “contribution holidays,” where the state does not make any contributions to the pension system in a given year because pension fund returns have been particularly good (thus forcing the state to make large payments to compensate when returns are low or negative), would be prohibited.
  • Local governments could still increase benefits with a two-thirds vote, and the state by a three-fourths vote.

The proposal is expected to produce savings of $500 billion over 30 years. The savings come largely from encouraging employees to work longer, which affords them greater income in the long run and reduces the amount of time (and costs) the government must pay for their post-retirement health benefits.

The CFFR’s plan would be a huge improvement over the current system, although I believe that nothing short of switching to a 401(k)-style defined-contribution (DC) plan for new government employees will really solve things in the long run.

The private sector has recognized that DB systems are unpredictable and, ultimately, unsustainable, which is why private companies have been switching from DB plans to DC plans for the past 30 years. Under a DC plan, the government’s contribution would be a fixed percentage of payroll, so it would be predictable and the state would have to come up with the money to pay its share immediately. By contrast, the current DB system relies on all sorts of actuarial assumptions that can be fudged or erroneous. The fact that the state must try to guess what its costs and investment returns will be up to several decades in the future means that it can make dumb decisions (such as taking contribution holidays or issuing a “13th check” when pension fund returns are “excessively high”) and pass along the costs of these decisions to the next generation.

Nevertheless, the CFFR initiative would be a big step in the right direction. There are many things the government should not be wasting our tax money on. But if those tax dollars must be taken from us, they should be used to provide actual services to the taxpayers, not line the pockets of overcompensated government employees.