Pension Reform Newsletter – June 2015

This newsletter highlights articles, research, opinion, and other information related to public pension problems and reform efforts across the nation. To find previous editions, please visit https://reason.org/newsletters/pension-newsletter/.

Articles, Research & Spotlights

• New California Pension Initiative Announced: Voter Empowerment Act of 2016
• Privatization Can Help Cover Costa Mesa’s Rising Pension Costs
• Should Public Workers Get Special Treatment?
• How Will State Courts Rule on Pension Reforms? Pension Law Map Gives Guidance
• Public Pension Plans: A False Recovery
• Dubious Practices in Public Pensions
• California Hides Most of Its Unfunded Retirement Debt
• S&P State Pension Review

Quotable Quotes on Pension Reform

Pension Reform Handbook

Contact the Pension Reform Help Desk

 

Articles, Research & Spotlights

New California Pension Initiative Announced: Voter Empowerment Act of 2016
By Pete Constant, Reason Foundation

On June 4, a bipartisan coalition of politicians and business people, led by former San Jose Mayor Chuck Reed and former San Diego Councilmember Carl DeMaio, filed a pension reform ballot initiative with the California Secretary of State.

Unlike many other efforts targeting pension reform, this initiative does not dictate how various government agencies approach their own, unique circumstances, instead requiring that local voters approve of the pension benefits being promised to any new employees.

While not impacting current employees or retirees, the Voter Empowerment Act of 2016 would give voters the right to approve, or reject, the compensation and retirement benefit promises made to new employees, as well as requiring voter approval before pension benefits are enhanced for any current or future employee. The proposed state constitutional amendment covers the retirement benefits offered by all state and local government agencies, including the state itself, cities, counties, school districts, the University of California and California State University systems, and special districts.

If an agency finds that their voting residents don’t approve of a defined benefit plan for new employees, the act allows those agencies to use the collective bargaining process to agree on other types of retirement benefits, potentially including the 401(k)-style defined contribution plans already being offered by CalPERS, CalSTRS and other pension plan providers, without voter approval.

To read more about the initiative, go here and here.

Privatization Can Help Cover Costa Mesa’s Rising Pension Costs
By Leonard Gilroy, Reason Foundation

As the Register’s Editorial Board recently noted, Costa Mesa’s Pension Oversight Committee presented data to the City Council showing that the city’s total annual payments to the pension system are going to skyrocket, rising from approximately $25 million this year to almost $40 million a year by 2030. Even scarier, the analysis showed that pension costs are increasing at roughly twice the rate of overall city revenue (approximately 6.5 percent versus 3 percent, respectively).

The rising cost of government employee pensions in Costa Mesa has long been recognized as a major fiscal problem. In fact, the pension costs were a motivating factor behind the large-scale – and ultimately failed – attempts to privatize city services in recent years because pensions have been swallowing a growing share of the city budget. This trend will only continue to worsen for Costa Mesa residents, which is why privatization should remain a serious pursuit.

In 2012 courts blocked a sweeping privatization initiative that would have contracted out 18 services performed by over 100 city employees. Ironically, by blocking privatization and fighting the city charter movement to protect current workers, unions are basically guaranteeing a long-term decline in the city workforce, since pension costs will increasingly squeeze out spending on the future workforce.

To read more about the issue, go here.

Should Public Workers Get Special Treatment?
By Pete Constant, Reason Foundation

A few years ago, it was easy to blame the state’s growing public pension crisis on the recession and sluggish economic recovery. But today, the Dow Jones Industrial Average is regularly above 18,000, the national unemployment rate is 5.5 percent, California’s unemployment rate is 6.5 percent and the state’s General Fund tax receipts are even higher than expected for the fiscal year.

And yet, California’s unfunded pension and health-care liabilities continue to grow. Last year, Mac Taylor of the nonpartisan Legislative Analyst’s Office reported that the California State Teachers Retirement System “has not been appropriately funded for most of its 101-year history.” He noted CalSTRS’ unfunded liabilities rose from $23 billion in 2003 to over $73 billion in 2013.

A number of elected leaders who have been working to reform the system are being frustrated by adverse rulings by the Public Employment Relations Board and the courts. These rulings have exposed the astounding differences in the way we treat government pension systems compared to the pension systems of private companies.

To read more about the issue, go here.

How Will State Courts Rule on Pension Reforms? Pension Law Map Gives Guidance
By Adam Crepelle, Reason Foundation

The New Jersey Supreme Court recently upheld payment reductions to the state’s pension fund. A month before, the Illinois Supreme Court rejected the state’s pension reform efforts. Both states have among the worst pension funding levels in the country, and Illinois is sinking faster than New Jersey. So what explains the different court rulings?

The answer in part is the states offer their public pensions different levels of protection. In states that view public pensions as contracts, The United States Constitution forbids states from making laws impairing contractual obligations, and many state constitutions have a similar prohibition. Determining whether modifications to contractually protected pensions are constitutional requires a three step inquiry:

1. Is there a contractual relationship?
2. Has the contractual relationship been substantially impaired?
3. Was the change reasonable and necessary to serve an important public purpose?

On the other hand, states that treat pensions as a property interest have a better chance at reforming pensions. Property rights apply to what one already has, not prospective gains. Thus, states can modify future benefits but not previously accrued benefits. Altering future benefits under the property approach requires:

1. No individual be deprived of a fundamental right.
2. The state not act in a manner so “arbitrary and outrageous” that the conduct “shocks the conscience.”

Accordingly, states that treat pensions as a property interest have a better chance at bringing pension benefits to a sustainable level than states where pensions are considered contracts.

To read more about the issue, go here.

Public Pension Plans: A False Recovery
By Truong Bui, Reason Foundation

Rising stock markets have improved the funding levels of many public pension plans, prompting some to claim that the national pension crisis is overblown. Pension expert Andrew Biggs in a recent op-ed on the WSJ shows how misleading this claim is.

While public plans’ overall funded status rose from 72 percent to 76 percent in 2014, it was a far cry from a real recovery. Less than half of state and local plans (41 percent) paid their annual required contributions in full last year, down from 65 percent in 2008. Even plans that did pay the full contributions relied on overly high discount rates that undervalue liabilities, and consequently underestimate required contributions. If the US public plans followed the same accounting rules as their private counterparts, annual required contributions would about double. This means most public plans are not meeting a very low bar in the first place.

High discount rates and low contributions encourage US public plans to take excessive investment risks to earn higher returns. In fact, the average plan invests 72 percent of its fund in stocks and other risky assets. This high level of risk taking however does not guarantee the returns those plans expect. While the expected rate of return of most plans ranges from 7 percent to 8 percent, the median projected return over the next decade for a portfolio of 70 percent stocks and 30 percent bonds is only 5.9 percent.

To read the full article, go here.

Dubious Practices in Public Pensions
By Truong Bui, Reason Foundation

A recent article by Joe Luppino-Esposito and Bob Williams describes popular practices by public pension plans to obscure the true costs of pension funding and to push those costs far into the future. Those practices include:

• Outdated life expectancy assumptions: longer life expectancy increases pension costs. Outdated assumptions that underestimate life expectancy, therefore, cause plans to set aside inadequate resources for future benefit payouts.
• Inflated discount rates: by using the higher expected investment rate of return rather than the lower market-valued discount rate to value pension liabilities, public plans artificially reduce required contributions while increasing contingent liabilities on future taxpayers.
• Underfunding required contributions: not paying the required contributions creates unfunded liabilities that are compounded at the discount rate.
• Pension obligation bonds (POBs): POBs allow state and local governments to cover unfunded liabilities while taking advantage of low interest rates. This practice however encourages underfunding annual required contributions and risks plunging those governments into more debt when actual returns fall short of the interest rate on the bonds.
• Rolling amortization and smoothing: rolling amortization potentially increases the unfunded liability to infinity and never truly pays off the debt.

To read the full article, go here.

California Hides Most of Its Unfunded Retirement Debt
By Truong Bui, Reason Foundation

A recent report by Truth in Accounting reveals that California hides 74 percent of its unfunded retirement debt from its balance sheet. According to the report, the state owes $150 billion in unfunded retirement benefits, but discloses only $39 billion of these liabilities. Including the hidden debt means that the state owes $328 billion in total, but only has $94 billion available to pay the bills, leaving a shortfall of $235 billion, which is equivalent to $20,900 per taxpayer.

To read the full report, go here.

S&P State Pension Review
By Truong Bui, Reason Foundation

S&P in a recent review of state pension plans provides some key insights into the state of pension reform and pension funding in the US. The rating agency affirms the important role pension funding status plays in a state’s creditworthiness. While pension liabilities are not an immediate threat to most state’s finances, S&P believes that these obligations when mismanaged do adversely affect a state’s credit profile.

State pension funded levels improved slightly in 2013, but the gap between well-funded and poorly funded plans remains substantial. Despite strong market returns, funding ratios of 24 states declined compared to the previous year.

S&P stresses the significance of fully funding the annual required contribution (ARC). It also notes the incentive of many state governments to defer full ARC payments for short-term budgetary needs, eventually creating distressed situations in the long term. Underfunding ARCs, therefore, has a potential of negatively affecting credit ratings.

The report identifies a number of factors that have slowed down pension reform efforts. One possible factor is “reform fatigue”: as it takes so much political capital to effect measures that produce small short-term benefits, legislators with limited terms have few incentives to continuously push for reform. Another factor is recent court rulings that challenge past reforms on constitutional grounds. Combined with recent strong market returns and competing priorities, these factors seem to have discouraged the need for reform.

To read the full report, go here.

Quotable Quotes on Pension Reform

“Let me describe this more clearly. If the state has promised a worker certain payments in the future for having worked at least up to this date-so-called accrued benefits-and it is certain that those payments are going to be made, anybody, any economist, and probably most of you in this room would ask, how do you value that? It’s simple. You find US Treasury securities that would provide cash flows to match those payments. That is how you should value the liability.”
– William F. Sharpe, Nobel Laureate

“U.S. state and local governments are required to contribute half as much to their pensions as are private employers, and six-in-10 public plans fail to receive even that low required contribution. If public pensions are indeed back on track, that track may simply be leading the country to more trouble down the road.”
– Andrew Biggs, resident scholar at the American Enterprise Institute

“Borrowing money is not a fix. It kicks the can down the road and steals from our children and grandchildren.”
– Barry Shutt, retired state worker

“The deals are generally pitched to state and local officials as an arbitrage play: The government will issue the bonds; the pension system will invest the proceeds; and the investments will earn more, on average, than the interest rate on the bonds. The projected spread between the two rates makes it look as if the government has refinanced its pension shortfall at a lower interest rate, saving vast sums of money.

But that’s just on paper. In reality, the investment-return assumption is just that – an assumption, and a deceptive one at that because it does not take risk into account.”
– Mary Williams Walsh, American investigative journalist

“It boils down to this: Decision-makers with the short-term incentive to make outlandish promises were able to ignore long-term costs.”
– Keith Naughton, public affairs consultant

 

Pension Reform Handbook

For those interested in the process and mechanics of pension reform, Lance Christensen and Adrian Moore published a comprehensive starter guide for state and local reformers. This handbook aims to capture the experience of policymakers in those jurisdictions that have paved the way for substantive reform, and bring together the best practices that have emerged from their reform efforts, as well as the important lessons learned.

To access the handbook, go here.

 

Contact the Pension Reform Help Desk

Reason Foundation set up a Pension Reform Help Desk to provide information on Reason’s work on pension reform and resources for those wishing to pursue pension reform in their states, counties, and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.

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Adrian Moore
Vice President, Policy
Reason Foundation