Skimming ‘Excess’ Pension Investment Earnings

Originally posted at CalPensions.
By Ed Mendel.

An issue in the San Jose pension reform trial, a “13th check” bonus for retirees when investment earnings exceed the annual forecast, reflects a widespread attitude that added to public pension debt.

In its starkest outline: When pension fund earnings are above the target, it’s a surplus or windfall that can be distributed to employees and employers. When earnings are below the target, it’s a shortfall that must be paid by taxpayers.

The notion that pension fund investment earnings, now often expected to cover about two-thirds of pension costs in the future, could be regarded as “excess” or “surplus” can seem out of step with the times.

Growing costs of under-funded pensions are taking money from other programs. Optimistic earnings forecasts are said to hide crushing debt. And the long-term viability of public pensions is questioned as similar private-sector benefits disappear.

A belief that pensions have excess or surplus earnings might have been a step in the evolution of actuarial practice, still struggling with volatile stock-market risk after a shift from predictable bonds authorized by voters with Proposition 21 in 1984.

Or declaring earnings excess or surplus might have been a backdoor way to give employees more money and employers short-term budget relief, knowing from the outset future generations were likely to get a larger pension bill.

But whatever the cause, treating investment earnings as an excess or surplus, in ways large and small, has skimmed off money that could have been invested, adding to pension debt rather than lowering it.

The Economist magazine cover, July 27-August 2 2013 issue

In lawsuits to overturn a San Jose pension reform, unions and retirees argue that the “13th check” bonus, totaling about $13.4 million this year, is one of the vested rights, protected by contract law, that are violated by the voter-approved measure.

The city argues that the bonus has been suspended during the last several years, that unions have proposed eliminating the bonus in bargaining, and that the city charter reserved the right to change pension benefits.

An attorney for the city, Arthur Hartinger, described the Supplemental Retiree Benefit Reserve during a five-day superior court trial last month merging several union and retiree lawsuits.

“What it would do is if, for example, in a given year, the fund performance measured in a given year showed that it exceeded the actuarial assumption, you’d take that money, and then subject to the discretion, you could give it away, even though you’re facing a multi-billion-dollar unfunded liability,” Hartinger said.

San Jose’s actuaries assumed investments would earn 7.75 percent a year, regarded as too optimistic by critics but similar to the earnings forecast used by other California pension funds.

The long-term debt or “unfunded liability” of the two city-run pension systems is nearly $3 billion. The annual city pension costs soared from $73 million to more than $245 million during the last decade, eating up about 20 percent of the general fund.

In a memo to the city council two years ago, Deborah Figone, the San Jose city manager, said the retiree bonus “was patterned on state legislation that been adopted in 1983 to permit certain counties to do the same.”

The 20 county retirement systems operating under a 1937 act, ranging from Los Angeles to Mendocino, can use “excess” earnings, amounts exceeding 1 percent of total assets, for retiree bonuses, retiree health care or lowering employer contributions.

The option is said to be seldom used now because reserves are depleted. The county option to divert “excess” earnings apparently was not changed by the pension reform, AB 340, pushed through the Legislature by Gov. Brown last year.

In the past, the giant California Public Employees Retirement System had two programs that used excess earnings. Retiree pensions were brought up to 80 percent of original purchasing power with excess earnings on employee contributions.

The Extraordinary Performance Dividend Account (EPDA) and the Investment Dividend Disbursement Account (IDDA), whose names refer to the diversion of earnings, were replaced in 1991 by the Purchasing Power Protection Act.

Former Gov. Pete Wilson used EPDA and IDDA “surplus” reserves, $1.6 billion, to help close a huge state budget gap. Unions got the “raid” overturned in court and countered with an initiative, Proposition 162 in 1992, strengthening pension boards.

As a booming stock market in the late 1990s gave CalPERS a temporary surplus, with more than 100 percent of the projected funding needed for future obligations, there were two major changes.

CalPERS dropped employer contributions to near zero in some cases. The state contribution fell from $1.2 billion in 1997 to about $60 million in 2000. It’s about $3.9 billion this year.

In addition, CalPERS sponsored a major retroactive pension increase for state workers, SB 400 in 1999. Legislators were erroneously told surplus funds and “superior” investment returns would cover the cost.

The bill increased Highway Patrol pensions by 50 percent, setting a benchmark later matched in local police and firefighter negotiations. Now SB 400 is often cited by critics who say “unsustainable” pension costs are devouring local government budgets.

CalPERS apparently has not calculated the impact of the huge contribution “holiday” given employers in the late 1990s. The other two state pension funds, who also cut contributions and raised benefits, have made estimates of the impact.

The UC Retirement Plan dropped employer and employee contribution rates to zero in 1990, when it was 137 percent funded. After a remarkable two-decade holiday, which included some benefit increases, contributions restarted in 2010.

UCLA Chancellor Gene Block warned that a plan to push employer contributions to 20 percent of pay by 2018 could cause cuts. Late last month UC imposed a contract on one of three unions refusing to agree to another round of pension contribution increases.

“Hypothetically, had contributions been made to UCRP during each of the prior 20 years at the Normal Cost level, UCRP would be approximately 120 percent funded today,” a UC staff report said in September 2010.

The California State Teachers Retirement System would be 88 percent funded, instead of 67 percent, if benefits had remained at the 1990 level, Milliman actuaries told the CalSTRS board last April.

As CalSTRS had a brief surplus in 2000, one of a half dozen pension increases, AB 1509, diverted a quarter of the teacher pension contribution into a new individual-investment fund with a guaranteed minimum return based on the 30-year Treasury bond.

The full teacher contribution to the pension fund, 8 percent of pay, had been going into the pension fund. For 10 years, a quarter of the teacher contribution, 2 percent of pay, was diverted to the Defined Benefit Supplement, a new “cash balance” fund.

As with the CalPERS claim for SB 400, the Legislature was erroneously told that a decade-long diversion of a quarter of the teacher contribution would have “no effect to the solvency of STRS; the STRS surplus will absorb the cost of DBSP.”

Most California public pension systems set an annual contribution rate that employers must pay. But CalSTRS, which lacks that power, has been trying for a half dozen years to get the Legislature to raise contributions.

CalSTRS has an “unfunded liability” of $71 billion and needs an additional contribution of more than $4.5 billion a year to project a full funding level of 100 percent in 30 years.

When the Legislature held a joint hearing on CalSTRS funding in March, some were optimistic about getting a phased-in rate increase. But that seems unlikely now as the Legislature moves toward adjournment for the year on Sept. 13.

A New York Times story Saturday about Gov. Brown’s successes so far said one of the notable exceptions is his pension reform. In the view of most analysts, said the story, the reform does not “come close” to addressing long-term pension liabilities.

“I’ve said there needs to be more pension reform,” Brown told the Times. “Well, when to do that is a matter of my prudential judgment. People who want to do everything all at once generally don’t get anything done.”

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