Thanks to upcoming changes in accounting and budgeting standards, along with a push for a thorough audit of state and local public finances, California’s long history of fuzzy-math pension budgeting may be coming to an end. Two rules changes—by Moody’s Investor Services and the Government Accounting Standards Board (GASB)—set to take effect this year and next, will require that pension funds make more conservative investment projections and disclose liabilities more clearly. Meanwhile, an audit of California’s finances last year cast a harsh light on the state’s fiscal structure and is prompting calls for a more comprehensive look at how both Sacramento and city governments handle their finances.
At issue is the state’s long-term pension liability. Thanks to a combination of excessively generous contracts, unrealistically rosy investment projections, and lowballing of future costs, the state’s government-employee retirement and health plans are chronically underfunded. Unlike many states, where pension and health-care shortfalls loom in the future, California is seeing shortfalls in current budgets.
“Although politicians have been crowing about balanced budgets,” says Dan Pellissier, president of the advocacy group California Pension Reform, “the budget only balances if you ignore about $9 billion a year in unfunded pension liabilities. CalSTRS (California State Teachers’ Retirement System) is underfunded by about $4 billion a year; CalPERS (California Public Employees’ Retirement System) is underfunded by about $2 billion. And retiree health care systems need about $4.7 billion a year to fully fund them, of which we’re only paying $1.7 billion because we’re doing it on a pay/go basis—only paying the bills as they come up.” The problem is equally acute in municipal governments. Los Angeles, for example, is engaged in a long debate over how to fix unrealistic funding and liability projections.
The movement to reform government-employee pensions first attracted widespread public attention in California, but the state has seen formidable resistance to pension fixes during both the Schwarzenegger and Brown administrations. Pension-reform ballot initiatives passed by wide margins last year in San Diego and San Jose, but an inadequate statewide reform measure adopted late last year took some of the urgency out of the issue. Union-backed Democrats in September countered with a nebulous new law that would put the state in charge of creating pensions for private-sector employees—despite the financial straits of public-employee benefit programs. And in the November general election, Governor Jerry Brown won voter approval for new tax hikes through Proposition 30. In late November, former Los Angeles mayor Richard Riordan abandoned a ballot initiative that would have converted most government-employee guaranteed pensions to 401(k)-style defined contribution plans and changed some benefits for existing workers.
This lost momentum has discouraged reformers and given pro-union zealots renewed confidence that they have vanquished what they regard as a right-wing attack on public-employee benefits. That assumption overlooks two crucial facts. First, California’s most prominent reform advocates haven’t been conservatives, but centrist or progressive Democrats such as San Francisco public defender Jeff Adachi, former Schwarzenegger advisor David Crane, and San Jose mayor Chuck Reed. Second, though the reform push has stalled for the moment, the unsustainable numbers remain—as will become clear all over again later this year, when Moody’s is expected to institute substantial changes to the way it measures fund investments.
The changes will allocate more accurately the liabilities in multiple-employer cost-sharing plans to specific government employers, based on their shares of total plan contributions; reduce the amount pension funds can estimate for future returns to a more conservative 5.5 percent annually (as opposed to the current projected returns of 7.5 percent per year for CalSTRS and 7.75 percent for CalPERS); replace “asset smoothing” with reported current market or fair value; and adjust annual pension contributions to reflect these changes.
The change at Moody’s isn’t the only big shift in store for pension-fund budgeting. The GASB last year approved Statement 68, an amendment to its rules that will require governments to recognize their long-term obligation for defined-benefit pension plans as a liability and to measure the annual costs of pension benefits. Statement 68 will also require plans to move some information from the fine print to the main sections of reports and include more supplementary information. These changes will take effect in June 2014.
“Those two things—lowering the rate of return and requiring it to be put on the balance sheet—are going to make this issue more urgent,” says California Foundation for Fiscal Responsibility board member Jack Dean, who runs PensionTsunami.com. “This will require governments to show on their balance sheets any unfunded commitment—not just current payments. It also applies to healthcare costs. So most citizens will see how these numbers are shaping up. There’s going to be panic in some city halls.”
As an example, Dean points to a report by John Dickerson for the California Public Policy Center (which publishes Pension Tsunami) assessing the effect of the new Moody’s standards on the pension funds of six counties in the Bay Area and North Coast. Dickerson concludes that “the rate of investment profits assumed by practically all local and state government pension funds is significantly too optimistic” and “should be more consistent with those used for private sector pension funds.” Ominously, his findings indicate that if local governments made the necessary changes to projections, they would “be paying all their property tax income” just to fund public-worker benefits packages. “[I]f Moody’s is correct,” Dickerson writes, “the only reason these counties are retaining any of their property tax income for other purposes is they are pushing hundreds of billions of unfair debt onto the backs of the next generation.”
Recent popular victories for pension-reform measures suggest that voters are becoming aware of the crisis, but state and local politicians apparently lack the political will to do anything about it. For this reason, many reformers want a more comprehensive audit of state finances along the lines of last year’s Paul Volcker/Richard Ravitch State Budget Crisis Task Force report on California. That report found the state to have one of the highest per-capita unfunded pension liabilities in the country.
Dean likens that report to the ill-fated “California Performance Review,” a 2004 study conducted with great fanfare that wound up having no impact on the state’s fiscal crisis—the Schwarzenegger administration quietly filed it away. Nevertheless, Dean sees the advantage in raising public awareness of the state’s dire numbers. Pellissier agrees. “If we had a comprehensive look at our budgets, these things would be exposed,” he says. “The public would understand the cost of kicking the can down the road, and there would be more pressure to pay for all of the government we’re providing.”
Joe Nation, a Stanford-based public-policy consultant and former Democratic state assemblyman, says that several policy foundations have expressed interest in having his team conduct such a survey for California as a whole and a “more narrowly focused” study specifically for Los Angeles, where, despite chronic shortfalls, the will for change remains weak. Nation notes that establishing solid numerical arguments will be crucial for changing the political stagnation in L.A. Mayor Antonio Villaraigosa makes sporadic attempts to stanch the bleeding of the city’s public finances, but highly regarded City Administrative Officer Miguel Santana has had little luck getting the city council to consider comprehensive reform.
“L.A.’s a very blue city,” Nation says. “It’s not easy to do any meaningful reform. But the numbers are going to slap them in the face.”