The California Pension Crisis

 

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.

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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.

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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

Years 2016-17 2012-2017 2007-2017 1997-2017 1987-2017
Investment Return (%) 11.2 8.8 4.3 6.6 8.2
Volatility (%) 7.3 13.4 11.5 10.1

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.

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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  

Misc. Tier 1 Misc. Tier 2 Industrial Tier 1 State Safety Peace Officer/Fire-fighter Patrol
8-10% 3.75 % 8-9 % 11 % 13 % 11.5 %

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.

 

The Economics of Esports

esportsimage

Ten years ago, few people believed that playing video games as a competitive professional sport could become a billion dollar industry. Yet this is precisely what has happened. Within just one decade, the esports industry has grown tremendously and is expected to make more than a billion dollars in revenue in 2019. Many investors are looking at the industry as a new investment opportunity and are establishing new esport teams to compete in official tournaments. To understand how these esport teams have achieved such financial success, this article will analyze the competitive online video game, League of Legends (LOL). This game’s success is remarkable–viewers recently spent a total of 10.65 million hours watching the games in just a span of 8 days during LOL’s biggest international tournament, the League of Legends World Championship. This is a result of both the game’s international popularity and an organized league structure that has made esports teams willing to compete.

The Revenue Side

Sponsorships

Many esports teams make a majority of their revenue, approximately 90%, from sponsorships and advertising. These revenue streams include sponsorships in exchange for advertisement on the player’s jerseys, similar to those of traditional sports. For example, the energy drink brand Red Bull and the smartphone company HTC have jersey sponsorships for Cloud 9, a legacy esports team. These sponsorships allow companies to gain nationwide recognition, and potentially international recognition as well if the esports team qualifies for international tournaments. While jersey sponsorships are not as effective as they would be in traditional sports since the camera is not centered around the players, the main reason why they still sponsor esports teams is due to the teams’ strong social media presence. In the digital age, esport teams allow sponsors to target demographics that have been traditionally difficult to reach through standard marketing tactics. Millennials typically watch less television and listen to the radio less often than older demographics, increasing the importance of social media marketing. Players and sponsors will typically collaborate on advertising campaigns; Grubhub, for example, recently posted several videos on their Youtube channel featuring Cloud9 players. Research has found that the average age of esports viewers is 29, with 39% of the total audience in the 25-34 age range, thus illustrating the effectiveness of marketing towards a young audience through esports.   

Prize Money

Prize money in esports is increasing at an incredible rate. While prize pools amounted to a mere couple thousand dollars at most in the past, they now reach several million dollars for large competitions. League of Legends for example distributed a total of $4.9 million for their World Championships last year to teams according to their final standings. This money does not go directly to the players, and most of it is absorbed by the organization as revenue. The esports team in this sense acts like a company, with the players as employees on yearly contracts. This meaning that the liability/ownership of any team related events are all held by the team owners. Domestically, teams in the North American League Championship Series (NALCS), after the franchising starting from 2018, are entitled to 32.5 percent of the league’s revenues. Half of this is evenly distributed, while the other half is allocated according to each team’s standings and viewer/fan engagement contribution. The way in which the last component is measured is not explicitly stated, but is predicted to be mainly related with the peak and average viewership of the team’s games throughout the season. The fan base growth incentive is a big priority for the League’s organizers, with several the questions they ask new teams being: How does the team plan to engage with and acquire fans? What’s their strategy for providing value to fans through merchandise, content and other opportunities? Why should fans support them? The league only allowing teams who plan to work on fan engagement to compete.

Merchandise Sales

Each esports team similar to traditional sports offers apparel and other related merchandise. These include jerseys to t-shirts, and also other gaming related goods such as mouse pads which target their unique audience. Teams take various approaches such as the 100 Thieves, a new team formed in 2018, which uses a “hypebeast” style of merchandising, with high prices and limited quantity. This has been very successful for them with apparel selling out within 20 minutes of release. This is not surprising considering the low elasticity of demand that a lot of these core fans have. By setting price high and quantity low, 100 Thieves also attempts to make team merchandise into a Veblen good, a good that is demanded more when prices are high, as the good has value as a status symbol. One issue stopping many teams from getting larger income from this sector is that esports stadiums are still very small compared to traditional professional sports. Since less fans can attend the actual games in person, it lacks incentive for fans to support teams at the stadium by wearing merchandise. A research paper,  “Comparison of eSports and Traditional Sports Consumption Motives” by Donghun Lee, Ball State University and Linda J. Schoenstedt, Xavier University, addresses this difference in esports and traditional sport fan behaviors . In their analysis, it is shown that compared to traditional sports, esport consumers spend relatively little on sport merchandise and attendance. Therefore it may be fair to assume that this is not an area of priority from the esports team’s perspective. Merchandise will most likely stay a smaller portion of the team’s revenue in the long run, even as the industry continues to mature, due to the fundamental differences in consumption and fan support as discussed. This fact further justifies 100 Thieves’ stance on team merchandise as a component that improves their team value rather than one that significant profits can be made through.

Content Creation

Although very small compared to the other sectors, esports teams also make money through content creation on platforms such as Youtube and Twitch. Popular teams like Team Solo Mid have regular videos on how the teams are doing, and these videos rack up above 100,000 views each. With advertisement revenues on each view, the teams can keep funding high quality videos. Teams like Team Liquid take this onto a higher level by partnering with 1 Up Studios, an esports production company, showing just how much care they put into this sector. The income from this sector is very small and for some teams is a loss, but its spillover effects are huge in terms of reaching new audiences and expanding their fan base. The fan base, as we can see, being the number one priority in attracting sponsors.

The Cost Side

Initial Investments

Many new Esport teams require significant investments on top of sponsorships in order to pay for the costs listed below. While raising cash for esport teams was very difficult in the past, this is becoming much easier with esports becoming more recognized. Cloud 9, recently raised $50 million through their series B funding round, led by Valor Equity Partners. They intend to use this money in constructing their training facility which they will also use as an office. Individuals are also investing large amounts of money into teams through these equity investments. Entrepreneur Scooter Braun and artist Drake recent became co-owners of the 100 Thieves through it’s Series A funding round. With this addition, this new team has had a total investments of more than $25 million in just one year.

Player and Staff Salaries

As esports becomes more major and accepted worldwide, player wages have increased significantly. While in the past, there were even cases where players were not paid any money other than prize money distributed, nowadays taking the example of LOL, players are paid more than an average first year undergraduate. The current minimum salary of players in the NA LCS is $75,000. Many of the more established players have higher wages, some rumored to go up to a million. This is very similar to traditional sports, where the high competition rewards “superstar” players, giving them significant negotiating power to demand high wages. Another factor for the bidding up of wages is the high labor mobility of esports players internationally, with many teams in the US having players from Europe or Korea. These players are attracted to the high wages and better job security North American teams offer, and are physically able to do so. On the other hand, there are also other costs related with labor, such as coaches and other staff. While these are smaller costs individually, they are larger in number. The number of non-technical staff is starting to increase in supply with the recognition of esports teams as a fairly stable company, so wage growth for these non-player employees is unlikely to match the pace of superstar player salaries.

Capital Costs

In order to increase productivity of the players, many of these teams have chosen to take a “gaming house” system, where players live in the same house and train up to 12 hours a day while other living issues are all sorted out by staff including chefs and cleaners. In order to reduce costs in this section, teams like 100 thieves have signed partnerships with housing related companies like Rocket Mortgage by Quicken Loans. On top of gaming houses, other teams have purchased training facilities such as Team Liquid’s Alienware training facility so that they can train in a setting specifically made for esports. This is another example of just how close esports is coming to traditional sports.

Advisement/Content Creation

As mentioned in the revenue section, while content creation is a source of revenue, it is also an area where teams invest a significant amount of capital and man power. Many teams have marketing teams working with the social media accounts of the team, and graphic design teams to make content such as posters of their players to advertise. The importance of content creation is almost equal to team performance as it is how the team can attempt to gain fan bases. For example, teams like Flyquest while lacking recent success, have managed to maintain popularity by producing content around their veteran players. Though players are the ones operating in the public spotlight, esports teams typically have dedicated teams operating behind-the-scenes to cultivate larger fan bases.

Franchising Costs

A recent big cost for NA LCS teams was franchising costs. The NA LCS changed the structure of the league by setting the team limit to 10 permanent teams, who will not face risks of relegation as they would have in the past. The cost in exchange for this right was $10 million, a sizable price tag for the organization. This cost is a fixed cost which could be amortized along the many years that the team competes in the league. The benefits of this $10 million is that they can expect to make long term projects around their esports teams, improving them from a mere short term investment. While there are concerns on the league’s level without relegation, it is a format that many major teams in the US use such as the MLB or NBA.

Outlook

Analysis of the revenue and costs of esports teams we can see that things are moving towards traditional sports with a lot of the costs becoming long term investments into the teams. It can also be seen that with 90% of revenues coming from sponsors, a lot of these costs go into the final goal of making the teams more popular. There are two main ways by which teams can do this, through better content creation and marketing, or by competitive success. The positives are that teams can meet these demands with long term planning now that traditional league structures such as franchising have been implemented. The franchising also incentivises teams to improve their competitiveness and viewership numbers through prize money distribution. The enthusiasm of new investors and the fact that is it in a small bubble phase right now will also contribute to making esports into a sustainable industry in the future.

A different concern is the demand side of esport, especially whether or not esports consumption will continue growing. Looking at the general trend, viewership seems like it will continue increasing exponentially as shown in the data provided by Newzoo. However it is necessary to understand the reasons for why these people view esports and if it will continue.

esportsgraph

Source: Statista 

An interesting study shows the differences in esports and traditional sports’ consumption. The report “What is eSports and why do people watch it?” by Juho Hamari, Max Sjöblom, attempts to explain the reasons for viewing esports through the Motivational Scale for Sport Consumption (MSSC). They found that from the components of MSSC, watching sports as a means to escape everyday life, knowledge acquisition related to the sport, novelty of new players and teams, enjoyment of aggression and the aggressive behaviors the athletes exhibit, were the four highest positively and statistically significantly associated factors with the frequency of watching eSports. What is particularly interesting is that this last factor, the aggression enjoyed by viewers is something that become less visible in traditional sports as they become modernised. For example, Major League Baseball has taken major steps to reduce injuries at the plate, with them implementing the collision rule in 2014 which penalises physical contacts on purpose at home base. Many sports are also implementing video replay systems in order to accurately penalize rough plays, this being emphasised most recently in the Soccer World Cup. This aggression on the other hand is automatically implemented in most video games in the form of kills or attacks. Famous esport games that build around aggression include shooting games like Counterstrike or more mild games like Fortnite. What this means in economics is that esports and traditional sports are not substitutes to each other from a consumption perspective. Therefore there will be no need for esports to steal consumers from traditional sports, reducing one of the huge potential obstacles to esports expansion. However this also means that esports will need to make conscious efforts to amass their own consumer base as it will not simply be able to attract the same consumers as traditional sports, one of the major issues the franchising of League of Legends is attempting to tackle.

In conclusion, the demand (viewers) and supply (esport teams) for esports seem to be moving towards a more sustainable growth model with the supply side understanding what their priorities should be – competitiveness and popularity, and incentivising it through methods such as franchising and prize money distribution. It should also be noted that while using the word “sports”, there are key differences in consumer behavior that push it into prioritising sectors such as content creation over merchandise. Performance may catapult esports players to initial fame, but it is personality that keeps viewers coming.