Unless government officials muster up the political courage to implement reforms that would make government pensions and retiree health-care benefits sustainable, the cost of government services will continue to be inflated and growing pension costs could threaten the very solvency of state and local governments.
Under the state’s “defined-benefit” pension system, workers receive a pension determined by a formula based on the number of years the employee works, a fixed multiplier, and his or her final (or highest) salary. The amount needed to pay the costs of these benefits is determined using assumptions about what the average pension fund investment return will be, how long retirees will live, how much salaries and inflation will increase, etc. These assumptions are projected out decades into the future, which creates a whole other set of problems and allows for fudging of the assumptions to determine how much must be contributed to the system. The benefits are paid for by a combination of employee contributions, employer (in this case, the government) contributions, and pension fund investment earnings.
Currently, the state owes an estimated $63 billion in unfunded pension benefits to government employees. Governor Schwarzenegger’s administration estimates that this figure could rise to as much as $300 billion if state pension funds continue to perform below their anticipated returns. Unfunded retiree health-care and dental benefits are estimated at an additional $118 billion.
The trouble has not been confined to the state level. Many local governments are being hit hard by the latest downturn in the economy—and, as a result, their pension fund investments are seeing lower returns than anticipated. When those investments return less than the rate assumed by the pension board, government employers have to contribute more to the pension fund to make up the difference. Underperforming returns may be smoothed out over a period of years, but the losses experienced over the past two years are so deep that governments across the state will need to significantly increase their contributions to pension funds at a time when their budgets are already strained.
According to a recent Press-Enterprise article, the Riverside and San Bernardino County pension funds each lost about $1.5 billion—roughly a quarter of their value—in the last fiscal year. Riverside County will have to pay an estimated $119 million a year more than its current $144 million pension contribution—about an 83% increase—starting in fiscal year 2013. Similarly, San Bernardino County will have to contribute an additional $100 million to its pension system.
The situation at the local government level is a microcosm of what is going on across the state. The state’s main pension system, the California Public Employees’ Retirement System (CalPERS) (which also administers the retirement systems of numerous local governments) lost $56.2 billion, or approximately 24% of its total holdings, last year. The California Teachers Retirement System (CalSTRS) lost $43.4 billion, about 25% of its portfolio.
Much of the pension trouble can be traced back to the late 1990s and early 2000s, when state and local governments decided to significantly increase pension benefits while contributing little to nothing to pension systems. Pension fund investments were experiencing unusually high returns due to the “dot-com” bubble. Assuming pension funds could depend on extravagant earnings indefinitely, CalPERS and labor union officials convinced lawmakers that the state could afford benefit increases. In 1999 the legislature passed SB 400, which increased state workers’ pensions by as much as 50% and made the benefit increases retroactive. This action quickly proved to be short-sighted when the dot-com bubble burst and pension investment returns plummeted.
CalPERS had encouraged local governments that participate in its plan to match the state’s benefit increases by offering to reduce their required contributions to the system in exchange for their adoption of the higher benefit levels. Thus, many local governments matched state benefit increases in the early 2000s. For example, Riverside County increased public-safety officials’ pension benefits by as much as 50%, allowing employees with 30 years of experience to retire as young as 50 years old with 90% of their working salaries.
“This situation was caused by the actions taken by the state 10 years ago and it rippled out to local governments,” said Riverside County Supervisor Marion Ashley. “We’ve created an ongoing gilt-edged system that is far beyond our wage earners in this county to support,” added fellow Supervisor Bob Buster. For an example of those “gilt-edged” pensions, consider that, according to the California Foundation for Fiscal Responsibility, there are 5,115 retired state and local government employees currently earning annual pensions of over $100,000. There are an additional 3,090 retired educators earning pensions that big.
Even governments that resisted large benefit increases have found themselves in trouble. Ventura County did not increase its benefit levels, yet its required pension contributions have more than tripled over a 10-year period. The county’s contributions, currently about $140 million, are expected to double again over the next five years.
This prompted a Ventura County Grand Jury report entitled, “Ventura County Pension: An Uncontrollable Cost,” which was released in June. The Grand Jury report included some recommendations that government officials in Ventura County and around the state should take to heart. They include:
- Locking away “excess earnings” realized during good investment years to balance out the bad years, instead of using them to pay greater benefits;
- Requiring voter approval of future government employee benefit increases, as San Francisco and, more recently, Orange County and the City of San Diego, do, and;
- Studying private-sector compensation and a switch from the current defined-benefit system to a more affordable and predictable 401(k)-style, defined-contribution retirement system, which the private sector has been doing for the last 30 years.
Unfortunately, the Grand Jury’s main recommendations have so far largely been rejected or ignored by the county. There are some signs of support, however. “When you get into defined benefit pensions, you are putting huge debt burdens on the public,” said Ventura County Supervisor Peter Foy. “We’ve seen these pensions get so far out of control and out of the realm of our ability to pay for them—the market just exaggerated the problem—what I look at is at that point we need to have the public who’s going to be paying these costs with tax increases—they should have the right to vote on any increases.” Foy also supports a lower benefit tier for new employees, and is also open to a defined-contribution plan.
At the city level, Ventura Mayor Christy Weir even went so far as to write in a recent column for the Ventura County Reporter, “[T]he statewide pension system for state, county, school district and local governments is not financially sustainable. I believe Ventura can be a leader in pension reform. That likely means moving from ‘defined benefit’ plans (which guarantee a certain retirement income and are increasingly costly to taxpayers) to ‘defined contribution’ plans (which are more fiscally feasible) for new employees.”
During the late 1990s and early 2000s, when government coffers were flush with tax revenues, it was easy to approve benefit increases that would not have to be paid for until many years later. Now that the bills are coming due, state and local officials, as well as taxpayers, are increasingly realizing that the more we spend to ensure the comfortable retirement of government employees, the less we have to spend on the programs and services citizens expect from their governments. We are finally reaching a day of fiscal reckoning. It will take some political courage to admit that current government pension and retiree health-care benefits are unsustainable–and even more to implement the significant reforms needed to restore fiscal responsibility—but this fortitude is necessary to get California state and local governments back on the right path.
Adam Summers is a policy analyst at Reason Foundation. You can read more from the Reason Foundation here.