The bankruptcy of Detroit in 2013 shocked the country due to its sheer size, but was also fairly expected given the decline of the American automotive industry in the 2000’s. Less commonly known is that in just a four year period from 2008 to 2012, three cities in California–San Bernardino, Stockton, and Vallejo–also filed for bankruptcy, with Stockton having held the record for the biggest city to file for bankruptcy prior to Detroit. While California was hit hard by the 2008 financial crisis, the three California cities that declared bankruptcy did so mainly because they found themselves unable to fund the pensions of their retired public sector workers. In fact, although California as a whole has not gone bankrupt like these cities, it is facing the same problem of pension payments. Every year, the State of California collects money for pensions from current employees and employers, but this amount is less than the amount they pay in pensions, thus are running a deficit. This has lead to CalPERS, the California Public Employees’ Retirement System, despite being one of the biggest investors in the world with over $300 billion in assets, being worth less than 68% of what it owes in pensions. California’s other main pension system, the California State Teachers’ Retirement System (CalSTRS), also has the same issue with unfunded liabilities of $97 billion, being worth only 64% of what it owes. These deficits are expected to continue growing if kept untouched, with spending on pensions rising each year as more public sector workers retire. This brings California in a very difficult spot of having to make several major decisions and having to do so quickly before these deficits snowball.

Source : CalPERS

Explanation of the Issue:

While there are many reasons as to why California is in a pension crisis, it can be simplified into several key causes. The first cause is that California offered a far too generous pension plan to public sector workers around the Dot Com boom in the late 1990’s. One particular unsustainable pensions bill that was passed was the SB 400 in 1999. The bill offered most workers to have a higher percentage compensation at a lower retiring age. For example, highway patrol officers’ pension benefit formula changed from 2% at 50 to 3% at 50, which means that if they work for at least 30 years, they are able to retire as young as 50 years old and get the full yearly benefit of 3% multiplied by the number of years worked of their final salary. This is a significant change, with police officers who start working at age 20 retiring at age 65 with  a pension worth 135% of his salary at retirement. Another important factor is that this bill was retroactive, meaning it applies to all workers and not just workers who were hired after this bill, thus the increase in pensions immediately started taking effect.

Such a generous pension plan was set based on several incorrect assumptions. During the Dot Com boom the economy was in a strong bull market, leading CalPERS to expect a very high rate of return of 8.25% per year on average over the next 11 years. This assumption turned out to be wrong very quickly, with the return going negative in just one year as the Dot Com bubble burst in 2000. Even after recovering from this poor start, investment returns struggled yet again with the 2008 financial crisis. CalPERS has since then gradually lowered their expected investment return rate, the most recent decrease coming in 2016 to 7% by 2020 after not being able to meet their 7.5% target for 2 years consecutively.

Another factor CalPERS failed to assume was that life expectancy would increase by approximately 2 years from 76.6 in 1999 to 78.6 in 2017. Although this may seem like a small change, if the current 600,000 retirees live another 2 years than what was predicted, that means 1,200,000 more pension payments of approximately $35,000 per year, or $42 billion in total. With there being more state employees who retire each year than retirees who pass away, the number of people who get pension benefits keeps increasing every year. The number of retirees with pensions will also not decrease in the future because California is still increasing public employment despite these issues.

In addition to this, public sector wages have also been rising. With state worker labor unions becoming more organized and stronger, new wage increases have been negotiated every few years. These increases have been significant and persistent in recent years, and the total wages for California state workers excluding college, university or court employees has risen from around $15 billion in 2015 to $17.7 billion by the end of 2017. Due to the pension payments being a percentage of an employee’s wage, these raises also cause an increase in total payments.

For the aforementioned reasons, California now finds itself in a situation where it lacks funds in their investments and face increasing pension payments every year. While CalPERS spent $23 billion and CalSTRS spent over $14.5 billion in fiscal year ended June 2018, this spending is set to keep increasing. By 2023-2024, CalPERS is expected to have to pay approximately $34 billion annually, while only collecting $28 billion. The gap between the payments and contributions can be shown by this graph published by CalSTRS, in their 2017 auditors report. For more than a decade, benefits have exceeded contributions, with the 2016-2017’s contributions being almost $4 billion in deficit to benefits.

Source: CalSTRS

The only difference between what goes into CalPERS and CalSTRS is that CalSTRS is funded through 3 sources–state contributions, employer contributions, and employee payments–while CalPERS uses investment earnings in place of employers contributions. For CalPERS, every dollar spent on pensions, 59 cents come from investment earnings, 28 cents from employer contributions, and 13 cents from employee payments. Keeping these factors into consideration, there are only two real solutions to this problem. Either to raise contributions or to lower benefits. There are approximately four options available in raising contributions: increasing investment earnings, state contributions, employer contributions, or employee contributions.

1. Investment earnings :

Increasing investment earnings if possible would be very convenient as it does not adversely affect other stakeholders, but it is not realistic for CalPERS. As discussed in previous paragraphs, California previously failed to meet its 8.25% target in 2015 and 2016, so it has lowered the target all the way to 7% for 2020. Attempting to readjust the target rate higher will result in having to invest in more risky investments, making the fund more susceptible to market fluctuations. Historical data shows that while 2016-17 did have a great return of 11.2%, which boosts the last 5 years’ average return to 8.8%, the investment return during this period was very volatile with 7.3% deviation. If we move track back further, investment return was 4.3% in the past 10 years, much lower than the current revised 7% target. Considering this past data, it is very unlikely that CalPERS will make riskier investments, since any further losses could jeopardize the pension fund.

CalPERS Historical Investment Returns and Volatility

Source: CalPERS

2. State Contributions :

State contributions are also difficult for California to increase, as state law prevents state contribution rates from rising more than 0.5% per year. With the current contribution rate of 9.828 %, CalSTRS can only rely on state contributions to a limited extent. There is also the option of directing more bills like SB 84, which made the state pay an extra $6 billion to CalPERS in 2017, but these bills are more of a special case. Raising state contributions leads to a further problem of the state having to use funds originally allocated to other purposes to pension payments, or raise the total fund size by taking measures such as increasing taxes. With California already having such a high tax rate, such a decision will be very difficult to push through.

3. Employer Contributions :

Employer contribution rates vary according to which sector the employer is in. For all sectors however, rates have been on the rise, the reason being from an increase in normal costs – costs theoretically required to pay pensions the current active employees, and not to pay the unfunded liabilities. Rates rose by about 1% in each sector from 2017-18 to 2018-19, and this trend is expected to continue in the near future.

Source: CalPERS

While school employers have lower contributions rates to payrolls, they are also subject to increases, rates going up from 13.88% in 2016-2017 to 15.531% in 2017-18 and 18.062% in 2018-19. While raising these rates may seem to only hurt employers, all of these increases in employer contribution will in the long term spill over to users and employees of these services. State safety employees may face lower wages in order for the employers to cut costs and maintain profits, or prices could rise for state industrial related goods. Another example being potential decreases in salaries for professors at University of California schools and increases in tuition for students.

4. Employee Contributions :

Employee contributions vary similarly to employer contributions, with employee separated into 5 different groups, Miscellaneous tier 1 or 2 – state employees in administrative positions, industrial tier 1 or 2 – employees in California Department of Corrections and Rehabilitation or state hospitals, state safety – employees in correctional or forensic facilities at state hospitals or developmental centers with state safety named positions, peace officer/firefighter, and California highway patrols. These employees have contribution rates that correspond with their future pension benefits.

Contribution rates by Sector  

Source : Human Resources Manual

Provisions have been made to raise contribution rates, but have been difficult as it must be met with a corresponding increase in pension rates for it to be fair. Despite this, California did create a plan in 2013 called The Public Employees’ Pension Reform Act of 2013 (PEPRA) which has dramatically changed situations for employees hired after 2013. The act requires these employees to contribute 50 percent of the total annual normal cost of their pension benefit as determined by the actuary. Therefore, they have to contribute half of the normal cost of 12.91 %, 6.5%. This rate will continue to rise automatically as normal costs rise, the PEPRA members facing an contribution rate increase to 7% in 2018-19.

Provisions like these will increase employee payments into the pension funding system and will help reduce the unfunded liability. However will need to be carefully implemented as state workers may feel discouraged from a deduction in real wage, causing risks such as more workers choosing the private sector over the public. In fact, labor unions hold a lot of power in California, just recently, the United Teachers Los Angeles, a labor union for public school teachers in LA, had a week long strike which lead to a 6% increase in wages and additional staffing. Due to the immense costs of public worker strikes, states are forced to negotiate.

Reducing Pensions:

While the CalPERS Actuarial Office has been using a 3% per year payroll increase rate, this number seems to be outdated, with the payroll growth being 3.7% in 2017.  In order to maintain the rate at 3%, the formula calculating pensions need to be updated. There are several methods, such as raising the retirement age by a few years, changing the wage from which a worker’s pension is calculated from, or reducing the cost of living escalators. However any change will have to be non-retroactive – it cannot affect any workers that have already been employed. This is because of the “California Rule” which states that workers are presented a pension benefit plan when they are employed, and that this pension can only be replaced by one that is equal to or increases benefits. This protection means that any change made now will take many years to actually cause any large change in the growing pension payrolls.

PERPA was an attempt to reduce pensions, along with getting more contributions from members, with it changing the benefit formula to 2% at 62, a lower percentage and a higher retirement age.  Former Governor Jerry Brown, who made this plan, also attempted to change the plan into a 401k style one, which is not defined benefit but rather defined contribution. However, this was rejected with huge opposition from labour unions, and Brown left office while still arguing with the state Supreme Court on changing the California Rule. Realistically, PERPA is a step forwards, but not significant enough to solve the problem. As long as the California Rule stands, solving the problem by reducing pensions will be a very long term plan.

Conclusion:

Analysis of the various methods of reducing CalPERS’ unfunded liabilities shows that most realistic methods will result in employees suffering. An increase in contributions by the state or employers will have spillover effects to all employees, and a plan like PEPRA will result in direct costs to future employees. Increase in contributions could also mean effects on unrelated California citizens who will have to face the decisions the state and employers make in order to maintain profits during rising costs.

The 401(k) style plan that Jerry Brown pushed for does seem reasonable when looking at how the burden of pensions is divided. A 401(k) plan would share the burden between the employees and employers, and could do so in a way in which benefits can automatically balance out employees’ own contributions. The current defined benefit system, on the other hand, puts too much burden on the employers, and the employees’ contributions are not what determine their pensions. However, it has been very difficult to implement this, as shown by the rejection of Senate Bill 1149 last year by labor unions. The biggest opponents of this bill, which simply offered an alternate 401(k)-style plan to new state workers, were K-12 teachers. This is because the current plan gives a higher benefit in comparison to the 401(k) alternative after one teaches for around 20 years, and 75% of current California teachers will serve 20 or more years before they retire. The biggest advantage of the 401(k) that makes it popular in the private sector is that there is no vesting period, one does not have to work in the same company for years to be allowed pensions, but this is not very attractive for California teachers. It can also be understood from the teacher union’s perspective that allowing an alternate plan could lead to the state attempting to make it the only available plan in the future, therefore wanting to reject it at all costs.

We can also learn several key lessons from the pension problem. We can see that when making decisions that will have a huge effect in the long run, it must be made with a lot of care for any risks. It must not be overly optimistic like SB 400, which was issued with an expectation for the economy to continue growing at a high speed and failed to consider economic fluctuations. We can also analyse that caution is especially necessary when the market is in a long bull market, like the years leading up to 1999 when SB 400 was issued, which coincidentally is very similar to what the stock market looks like right now. There is no such thing as a never-ending bull market, a recession no matter the size being inevitable. The fact that the US economy has looked so good in recent years, yet California has failed to meet investment return targets, also exemplifies just how poorly the funds have been managed.

This crisis is also an example of decisions that were made primarily for political gain, and without knowledge of long term economics. SB 400 was made partially because of the strong support and voting power of the public sector employees – short term gains being a factor that still affects many decisions in the government and state. The bill is especially bad because of the rigid nature of pensions, and the California rule which cements past plans through law. This California rule makes sense if the past benefits were reasonable, as it protects the state employees, but in a situation like this where it is causing a crisis, it is up to debate. As Governor Brown ended his term mid-negotiation, it will be up to the new governor, Gavin Newsom, to take his predecessor’s plans and set them into action without succumbing to the pressure of the labor unions.

Kengo Miyakoshi

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USC Economics 2021