To pension reformers, California's only hope is a friendly Supreme Court ruling

By Taryn Phaneuf | Jan 26, 2017

SAN FRANCISCO — California has a pension-debt problem, with a combined unfunded liability sitting close to $1 trillion, according to estimates.

Advocates of reform believe a lawsuit pending before the California Supreme Court could open the door for real change. But it’s a crisis that’s going to require parties on both sides of the issue to pitch in, one expert said.

Joe Nation, a public policy professor at Stanford University, told the Northern California Record that aside from legislation in 2012 that made small changes to benefits for future public employees, the state’s response to crushing pension debt is limited. But it’s felt most acutely in local governments.

“They’re under tremendous financial pressures, I think, in large part because of these pension costs,” Nation said. “An economic downturn — even a mild one — could be enough to sink many. You could see a lot of governments who simply say, ‘You know what, we don’t want to do this. but we’re going to file for bankruptcy.’”

He said public-employee union leaders aren’t willing to make concessions. But that could change if the state Supreme Court upholds a ruling that pensions are not “immutable.” According to court documents, a three-judge panel in the Court of Appeals in the 1st Appellate District concluded that while a public employee has a constitutionally protected right to a pension, that right extends only to a “'reasonable' pension.” And the legislature is permitted to alter benefits for existing employees — not just future employees.

Gaining the ability to modify benefits for current employees is crucial, Nation said.

“If that happens, in my opinion, it’s the only way to save the system,” he said.

Naturally, not all lawmakers agree. State Rep. Freddie Rodriguez (D-Pomona), chairman of the General Assembly’s Public Employees, Retirement and Social Security Committee, told the Northern California Record he sees the California Public Employees Retirement System — or CalPERS, the state's largest pension fund — making “tremendous progress” in reducing its debt since the recession.

“CalPERS alone saw its funded status drop 40 percent during a two-year period,” he said. “It will take time to recover fully from those sorts of losses, but I’m confident in the management of CalPERS and believe that they will continue to work to reduce their unfunded obligations.”

Meanwhile, Sen. Mike Morrell (R-Rancho Cucamonga), vice chair of the Senate Public Employment and Retirement Committee, took on a tone of alarm.

“We are at great risk of passing on debt to future generations that may never be fully payable. It is a burden that our children and grandchildren should not have to bear,” Morrell told the Northern California Record.

But it’s not just taxpayers who will be affected.

“Without overhauling the system, individuals who worked hard for years and played by the rules to save for their futures will also have their financial security jeopardized,” Morrell said.

How it got this far

Nation said there are several factors that, put together, explain the situation in which California has placed itself.

First, systems like CalPERS dole out pension benefits based, in part, on what rate of return they assume they’ll get on the invested money. In December, the CalPERS Board of Administration voted to lower its assumption from a 7.5 percent rate of return to 7 percent over the next three years. In the event that the fund performs poorly, the state, schools and public agencies have to make up the difference. The burden shifts to taxpayers.

Nation said that, while this is a good step at setting a realistic expectation of how much the fund will grow — which, in turn, gives a fuller picture to the public about how much benefits will cost — activity over the last 10 years shows that the actual rate of return is much lower.

“They’ve been assuming 7.5 percent, but only earned about 3.3 percent. So their financial hole got deeper and deeper,” he said. “So, one thing they’ve done wrong, I think, and they continue to do, is they continue to assume that they’ll earn more than what’s realistic. And the big problem is all these future benefits are based on the assumption that you’ll earn 7.5 percent. It’s not as though they’ve earned 7.5 percent and set aside the money.”

He likened it to a gambler guaranteeing he’ll win the round of roulette.

Second, CalPERS’ methods tend to kick the can down the road. The fund’s policy calls for amortizing — or paying back the unfunded liability — over 30 years.

“The method they use is all about delaying costs and heightening costs, frankly,” Nation said.

Ken Churchill, a contributor who tackles pension policy at the California Policy Institute, compared the 30-year amortization to taking 30 years to pay off a credit-card debt. In November 2015, he wrote that CalPERS previously amortized the debt over nine years. Like with a mortgage, paying back the unfunded liability over nine years would require higher regular payments, but result in less interest, meaning a lower cost overall.

Like Nation, Churchill wrote that this simply pushes the problem on without solving it.

“Worst of all, by doing this CalPERS is passing a mountain of debt, higher taxes and fewer services onto our children and grandchildren,” he wrote.

Third, Nation sees it as problematic that pension systems in the United States are overseen by boards controlled by public employee unions and politicians who are their friends.

“So they don’t make tough decisions,” he said.

Lastly, he pointed to legislation that passed in California in 1999, known as Senate Bill 400. The bill increased benefits to public employees and even applied the improvements retroactively. For example, he said, a safety employee, such as a firefighter or police officer, can retire after 30 years and receive 90 percent of their base pay for the rest of their lives.

“It really gave away the store,” Nation said. “No one really understood the math — no one paid attention to it.”

In a Los Angeles Times report on pensions published in September, SB 400 was sold as a measure that wouldn’t increase costs for state taxpayers because the fund would grow enough to cover the difference.

“They were off — by billions of dollars — and taxpayers will bear the consequences for decades to come,” the Times reported.

What to do

What happens next depends greatly on the Supreme Court.

Rodriguez said he was surprised by the appellate court’s departure from case law, “which have been clear that benefits for existing state employees cannot be reduced without giving a corresponding offsetting benefit increase.”  

He said he hopes the Supreme Court’s conclusion will align with this historical perspective.

“I think it is too early to speculate what actions might take place if the Supreme Court rules otherwise,” he said.

If it upholds the appellate court’s ruling, it could spur on more productive negotiations with unions, Nation said.

“I think the most important thing that will happen is employee union groups are going to say, ‘OK, this is not a sure bet any more. Pensions actually can be reduced. We need to sit down and talk.’ That’s what I hope happens,” he said. “If the court does end up there, it will change the dynamics of that process. And help save the system.

“There’s simply no way to climb out of this financial hole that we’re in without some sort of reduction in pension benefits accrued in the future.”

To tackle the mounting debt, Morrell said the problem needs to be examined from every angle, including through the courts. He added that experts have recommended increasing employee contributions. He criticized Democrats who want to raise taxes to pay for pension obligations because he thinks higher taxes mean more people will leave the state.

In the state senate, he expects to see greater scrutiny of CalPERS’ “flawed” assumptions about its rate of return.

“Since I have been watching CalPERS, it seems they have missed their economic forecast on returns almost every year. I have rarely, if ever, seen CalPERS meet its previous target return of 7.5 percent.  It has been a known problem for years, yet they repeated the same forecast again and again, missing their targets by a wide range,” he said. “We need better people to manage the money of those who have worked to save for retirement.”

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