Insufficient Rate Hikes Will Put Davis in Peril

At the same time, as a new piece from Ed Mendel at Calpensions makes clear, CalPERS policies are contributing to future problems by making rate hikes too small in an effort “to avoid hitting state and local governments with a big rate increase after heavy losses in the stock market crash.”

This is crucial because, by deferring the costs of pensions, local governments get a misleading perception about the true costs of their policies.

“A consultant, Girard Miller, who said he wants to save CalPERS from itself,” writes Mr. Mendel, “told a pension “boot camp” sponsored by a reform group last week that paying off unfunded pension debt over 30 years is “kicking the can to our children and to our grandchildren.””

Argues Mr. Mendel, much of the concern has been that the rising costs of pensions funds remain unsustainable, which has resulted in proposals that range from increased employee contributions to two-tiered plans with lower pensions for new hires.

However, he argues that the new criticism, which I am not sure is all that new, recasts the problem as a much broader dilemma.

He writes “Make much bigger pension contributions now that could increase pressure for tax increases and crowd out funding for education, health and other programs — or require future generations to pay for government services they did not receive.”

This is precisely the problem that Davis faces.  We are going to have to cut city services in huge ways.  The public will be paying the same amount and getting less.  The alternative would be to compete with the local schools for tax increases.

Mr. Mendel argues that this may finally focus the public on the power of CalPERS and other pension funds, which have the ability to set annual pension contributions that government employers must pay.

He writes, “The powerful pension boards that control one of the few costs that can’t be cut by state and local government elected officials are, like CalPERS, usually dominated by labor representatives and their allies.”

Ed Mendel argues that in most cases, “Pension boards set employer rates by using actuaries, who make estimates of future costs and revenue decades into the future. Actuarial methods can vary, apparently allowing a wide range of flexibility in the high-stakes work.”

However, in the early 1990s, control of these actuaries was shifted from CalPERS “to the governor and Legislator when former Gov. Pete Wilson sought $1.6 billion in CalPERS “surplus” funds to help balance the state budget.”

In response, “To prevent future “raids,” labor groups got voter approval of an initiative, Proposition 162 in 1992, that greatly strengthened CalPERS and other public pension boards, giving them control of all pension funds and, crucially, the actuaries.”

CalPERS has chosen to deal with shortfalls by rate-smoothing mechanisms, changes that were aimed at spreading costs over a number of years, which would avoid the shock of a sudden major rate increase for employers.

CalPERS adopted a policy in March 2005 of spreading investment gains and losses over 15 years, up from the previous three years and more than double the industry standard for actuarial “smoothing” of three to seven years.

“This plan will help end the whiplash employers experience when contribution rates dramatically increase and decrease year to year,” the CalPERS board president, Rob Feckner, said in a news release.

On the other hand, Ed Mendel, I think, underestimates the potential for managing a large fund in this way.  If one can show a rough annual rate of return over a long period, and there is any intermediate shock to the system, such as occurred in 2008 during the stock market crash, then rate smoothing makes sense.  The key is to accurately estimate the annual rate of return over a given period.

CalPERS’ strategy is to allow a three-year phase-in of a rate increase to cover the losses, which will be paid off over 30 years.

The problem with that plan is that increases risks, since the plan becomes underfunded.

Writes Mr. Mendel, ” In February of last year CalPERS adopted a policy that requires a rate increase for state and school plans if cash flows hamper hitting either of two funding levels by 2042 — an increase of 15 percent or a level of 75 percent.”

He continues, “It’s the failure to push for full funding, the contributions needed to cover 100 percent of future obligations, that is criticized by the head of the group working on a pension reform initiative.”

“In setting its state contribution rates, CalPERS brazenly assumes that it does not need to eliminate the pension fund deficits, intentionally leaving unconscionable deficits that range from 13 percent to 25 percent … in 2042,” Pellisier said in a newspaper article.

It’s a violation of the “fiduciary” duty of the CalPERS board to protect pensions promised workers, Pellisier said, comparing it to an “extremely easy payment plan” that only pays off half of a 30-year home mortgage.

A study issued  last year by the Pew Center, which found that state pension funds had a “$1 trillion gap” before the full impact of the market crash, said part of the problem is that states “shortchanged their pension plans in both good times and bad.”

A rule of thumb is that pension funding should not drop below 80 percent. A complication is that CalPERS uses the market value of assets, an offset for the radical 15-year smoothing, which tends to be lower than the actuarial value used by most funds.

“Based on our current market value of assets, $231 billion, our funded status is approaching 70 percent,” said Brad Pacheco, a CalPERS spokesman. The CalPERS fund dropped to $160 billion in March 2009 after peaking at $260 billion in the fall of 2007.

However, defenders of this policy will argue that if the fund gets back to the 30-year average of 7.75% in annual rate of return, then there will be few problems.

The problem comes when they expect it not to reach that level.  The fund can make up shortfalls in investment incrementally, but not if it falls short of the 7.75%.  Even a small adjustment of .25% means several million to the City of Davis.  A fall to 7.25% for example, will result in millions of dollars that the city will have to pay back into the fund in order to fully fund our liabilities.

However, all that may change, as it appears they will be adjusting their horizon from 30 years down to 15.

Writes Mr. Mendel,  “At the pension “boot camp” for local government officials, the pension consultant, Miller, said the Governmental Accounting Standards Board is expected to recommend that pension “unfunded liabilities” be paid off in 15 years, not the current 30 years.”

“We will be converting a 30-year mortgage into a 15-year mortgage when we finally step up to the realization that we have to pay for these pension promises during the lifetime of those employees before they retire,” said Mr. Miller. “Otherwise, they are truly kicking the can to our children and to our grandchildren.”

This does not even cover the failure to predict other key assumptions.  Factors such as salary increases and lower retirement ages coupled with longer life expectancy, among others, have taxed the pension fund.

The proposals put on the table this week are a good start.  As we reported yesterday, the Hoover Groups’ recommendations are strong ones that we have recommended for some time.

The group presents four basic recommendations.

First, “To reduce growing pension liabilities of current public workers, state and local governments must pursue aggressive strategies on multiple fronts.”  These include giving state and local governments more authority, and slowing down costs by controlling payroll growth and staffing levels.

Second, they argue the need for a hybrid model.  “To restore the financial health and security in California’s public pension systems, California should move to a ‘hybrid’ retirement model.”  They continue, “The Legislature must create pension options for state and local governments that would retain the defined-benefit formula – but at a lower level – combined with an employer-matched 401(k)-style defined-contribution plan.”  They argue that the defined contribution component “must be risk-managed to provide retirement security and minimize investment volatility.”

Third, “To build a sustainable pension model that the public can support, the state must take immediate action to realign pension benefits and expectations.”

These include caps on salary that can be used to determine pension allowances or capping the pension itself to a level that is fair and reasonable, setting more appropriate eligibility agencies, and tightening the definition of final compensation to include a five-year average to prevent and discourage pension spiking, among others.

These include prohibiting “pension holidays” that allow government employers and workers to skip contributions when pension funds are flush, and ending retroactive benefit hikes – increases should only apply to the future, splitting the employer and employee shares of contributions equally and limiting pension increases to those that are passed by a public vote.

Fourth, “To improve transparency and accountability, more information about pension costs must be provided regularly to the public.”

The problem that Davis faces is the exact problem laid out in this report – we face increased burden of paying for pensions based on salary increases and rate hikes, a second tier will not get us out of the problem and we need a way to freeze if not reduce costs for current employees.

And if the annual rate of investment return continues to decline, Davis will face an almost unimaginable crisis.

The sad thing is that most people in our community do not understand what is about to hit us and they will never see it coming and will wonder what our leaders did not know to prepare us for such a hit.

—David M. Greenwald reporting