Pension Prop 13

Last week I discussed the primary features of California Gov. Jerry Brown’s thoughtful 12-point plan to reform the state’s unsustainable pension mess. The night before my column published, a group called California Pension Reform (or CPR, an artfully chosen name) filed two ballot proposals that called the governor’s bid and raised him two. Their plan is to test the waters with two proposals and pick one to begin collecting petition signatures. This is the long-awaited “Pension Prop 13” -- the pension-reform descendent of the legendary grassroots tax-limitation measure that swept through California and several other states three decades ago. It is the most comprehensive pension reform language ever filed in any state in the country, yet less severe than Rhode Island’s recent narrower, sharper proposals to actually freeze, modify and cut incumbents’ benefits.

In this column, I will explain the key features of these two proposals, how they differ and how they compare with the governor’s plan. Then I’ll try to analyze what may happen next, as these two announcements are just the opening act of what will be a year of political theatre in the Golden State.

To set the stage, the Democrat-controlled Legislature adopted a law in October that essentially forces all ballot proposals in 2012 onto next November’s ballot, where they feel that voter turnout on their side will be stronger with President Obama running for re-election and a higher turnout favoring a vastly larger statewide number of registered Democrats. There will likely be other issues on the ballot, such as a measure to reduce union and corporate contributions that the unions see as a direct threat, thus bringing out that voting bloc. Pundits believe the governor is likely to put a tax increase measure on the ballot, especially if he can link it to pension reform to appease voters. So it will be a crowded, complicated “bedsheet ballot” with well over $100 million expected to be spent on TV and radio ads bewildering an electorate that otherwise would prefer to think about anything but politics and pensions if the state were not in such a mess.

Now enter the CPR group on stage right, led by former Schwarzenegger administration fiscal experts and a former GOP leader who called the various reform factions together to assemble a “best of breed” proposal that has been vetted through constitutional attorneys and a host of pension specialists. (Full disclosure: As with any such pension proposal, I have made myself available for expert commentary on technical matters, and the CPR leaders ran some of the specific provisions by me, including their hybrid plan language, remedies for severely underfunded plans, anti-abuse provisions, and definitions. They used some of my suggestions, and rejected others, so I’m not a partisan here. Any other group, including the state Legislature, the governor’s office or any ballot petitioner -- on the left, the center or the right -- is welcome to likewise seek my independent, uncompensated, critical reviews of their state-level retirement reform proposal at any time).

The two CPR proposals contain many common features, so let’s start with those first. As with last week’s analysis of Brown’s proposal, I will present them in two categories: anti-abuse provisions and fundamental fiscal reforms.

Anti-abuse provisions. Brown’s announcement was incredibly timely, as it gave the CPR folks a template for their own proposals. They worked diligently in the week before they filed their initiatives to incorporate several of the governor’s specific anti-abuse proposals. Great minds think alike, so there really isn’t too much difference on many of these key concepts. Thus, what you find in these two new proposals are many elements shared with the governor’s proposal, but now expressed in constitutional terms to assure they endure beyond one legislative session. The anti-abuse provisions that are comparable to Brown's plan are:

• Anti-spiking provisions, including a tighter definition of “base pay” to eliminate all the abusive overtime and non-recurring and special pay features that bloat pensions, plus a three-year averaging process which is conventional in many other states.
• No more retroactive benefits increases -- a hot button for pension reformers, because such ‘retros’ never actually “attract and retain employees” which has been the traditional baloney we’ve been fed for years about those giveaways. SB 400 in California was the millennial poster child for the failure of this selfish gambit which has since been discredited by the professional associations. That landmark bill’s 50 percent retroactive increase in pension benefits was based on a projection of stock market gains equivalent to DJIA 25,000 today and we all know how that worked out. Nationwide, many of today’s unfunded pension liabilities are directly attributable to these retros. Anybody who opposes this reform is either greedy or unteachable.
• No more employer pension-contribution holidays. Just look at Illinois for proof positive on this one. When politicians cut corners in pension funding, the results are predictably disastrous. Californians need only look at CalSTRS, the state teacher’s system, for a classic example of the systematic failure of legislative underfunding.
• Felons would be ineligible for public pensions related to their government employment. This feature will win votes every time after Bell, Calif.’s compensation scandals.
• No more “air time," or purchasing service credits for time never worked in the first place. Military and qualified prior public service credit purchases are still permitted. Experience has taught us that taxpayers lose every time an employee makes this selection because they know their personal life better than the government actuaries.
• Governance reforms are included to assure that a majority of pension board members are actually qualified for the job by virtue of professional expertise and are independent of the benefits. CPR also provides for the state director of finance (presumably through a designate, as the treasurer and the controller do now) to serve on all the large pension boards in the state.

Before I go on to the other provisions, let me now say, Hurrah! Each feature here deserves the support of everybody serious about preserving retirement security for public employees. These anti-abuse measures simply convert the rhetoric and the essence of the governor’s proposals into clear constitutional language, and there should be no quibbling about the details. If the Legislature needs a template for the work they need to do, they should start here. CPR’s language is cleaner, clearer and more concrete than similar provisions I have seen in any other state’s laws or legislative proposals.

The notable shortcoming in these measures is that they really don’t fix the underlying financial problem. As strong as the anti-abuse proposals presented by the governor and CPR are, the fact is that by themselves they do not come anywhere close to fixing the underlying fiscal problem any more than a band-aid will fix intestinal bleeding. We have to stop thinking in terms of solutions that save millions of dollars and confront the reality that California alone faces a problem with a price tag in the hundreds of billions.

Fundamental fiscal reforms. In terms of fundamental financial reforms affecting new employees, CPR goes beyond the governor’s proposals in several key areas:

• Most importantly, both CPR proposals empower public employers to change benefits plans for new hires without limitation. This puts an end to California’s crazy judicial concept of “vested” benefits that cannot ever be reduced prospectively after an employee walks in the door. This is a fundamental constitutional difference in their plans, and a major deficiency in the governor’s proposal, in my opinion.
• CPR follows the governor’s lead with age 67 as the new retirement age for general employees, and then goes on to define a full-service career for them as 35 years. For public safety workers, the CPR selects age 58 (accepted by unions in the San Francisco mayor’s 2011 “consensus” ballot proposal) with 30 years of service, whereas the governor’s proposal left those details unspecified. CPR also allows earlier retirements with an actuarial reduction.
• Both CPR proposals require new employees to share at least half of the total cost of their benefits. The governor’s proposal stops at half the normal service cost, and leaves employers and taxpayers on the hook for the rest. Thus, employees under the governor’s proposal bear only one-third of the total market risk of the state system (the defined-contribution component) since federal and state taxpayers remain on the hook for all unfunded liabilities of the defined benefit and Social Security systems.
• CPR would move disability benefits outside of the pension system, where it’s widely abused because of privileged federal tax treatment. In some cities, the disability claims are totally out of control. CPR’s provisions would remove the HR staff and pension board co-workers who are susceptible to peer pressure from the process and require intergovernmental self-insurance agencies, insurance companies or impartial arbitrators to make these decisions when taxpayer money is involved.
• CPR would outlaw supplemental defined-benefits plans that could circumvent the limitations of their proposals. No more “top hat plans” and special deals for management employees, for example.
• The governor’s proposal has wisely and skillfully addressed retiree medical benefits for new hires, which could be addressed by statute in a package of bills. The CPR folks avoided this subject because of legal limitations on what can be included in a single ballot proposal. They had also watched a pension-reform proposal in San Francisco fail last year, partly because it also dared to address skyrocketing health benefits costs. Thus, CPR decided to focus only on pensions and similar defined benefits in their constitutional amendment.

If there is one feature I’d urge the governor and allied reformers to push through the Legislature independent of all these pension issues, it would be his sensible proposal for retiree health-care benefits reform, plus a statutory requirement for all public employees to eventually pay one-half of the normal costs of their retiree medical (part of OPEB, which stands for “other post-employment benefits”) plans as with their pensions. Just like the governor’s basic cost-sharing plan, these could be phased-in, perhaps over 3 or 4 years. These two related reforms would likely require a separate statute and probably cannot be placed in the same constitutional amendment with pension reform. Even if enacted by statute, they would virtually double the overall savings from public-sector retirement reform. State law must require all public employers to begin incrementally to fund their OPEB plans actuarially and stop this neglectful nonsense of paying only the retirees’ benefits costs, which will snowball in the coming decade and guarantee the next crisis. Because the stakes are so huge here, OPEB reform is one area where some hard-nosed horse-trading between the two political parties could still result in a Grand Compromise, as I will discuss later.

Comparing basic benefits: The Hybrid. With these basic reforms discussed, the next logical place for explanation and comparison is the CPR proposals for basic benefits for new employees. Here, they have filed two versions. I will begin with the one closest to the governor’s proposal: the CPR hybrid plan.

The CPR hybrid puts constitutional structure and teeth into the governor’s general outline for pension reform for employees hired after June 30, 2013 (seven months after the election). For those employees, the Legislature would be instructed to implement a statewide system that provides for “hybrid” plans that provide retirement benefits not exceeding 75 percent of an employee’s eligible pre-retirement income. Benefits would include a combination of a defined-benefit and a defined-contribution plan. As with the governor’s proposal, defined benefits would be integrated with Social Security: those in that system would get a smaller pension, and those outside the federal system would get a larger pension to compensate. Employees can then supplement their employer benefits with voluntary deferred compensation as many governmental-sector financial planners already recommend. Those who save 5 percent of pay as normally recommended should ultimately exceed the common industry benchmarks for retirement replacement income -- and they will clearly receive much richer retirement benefits than the average private-sector employee.

The CPR proposal then mirrors the governor’s proposal to require that employees pay one-half of the cost of this plan. Using the industry-classic analogy of a “three-legged stool,” the hybrid plan must include a defined-contribution plan for one-third of the total benefit structure, again consistent with the governor’s plan. To again be comparable, the CPR proposal also provides that employees with Social Security would receive a defined-benefit pension plan that provides about 1/3 or less of the total benefit. (Social Security typically provides 25 to 40 percent of most employees’ replacement income with participating lower-paid workers receiving a higher percentage which would be offset by a lower pension ratio under both the governor’s and the CPR hybrid’s integrated benefit structure.) Those outside Social Security would receive a pension paying about one-half of their pensionable pay. CPR also addresses the “$100,000 pension club” issue by restricting the pension component of this overall package to that level, adjusted for future inflation. That will forever control outrageous pensions such as those in the notorious cities of Vernon and Bell, and high-end pensions for all highly paid public employees earning more than $250,000 elsewhere, whatever their profession may be. Overall, the plan design is structured to require employees to bear one-half of the plan costs and to bear roughly half of the investment risks for those in Social Security. (Miller’s sidebar opinion: Ultimately, future public employees will most likely be required to participate in Social Security as Congress realistically confronts the subsidy they now receive, so all these proposals should be viewed in the light of a universal Social Security system in the future.)

The CPR hybrid plan also requires all public employers to offer retirees an option to convert their defined-contribution account into a life annuity (including a spousal-survivor option), and also permits the use of a collective defined-contribution trust, which I have described in a prior column, to assure that employees do not outlive their money. When the Legislature considers the governor’s hybrid proposal, I would urge them to include these protective retirement-security features as well.

• Administrative notes: To forestall a state monopoly, CPR wisely allows every public employer to select its own defined-contribution administrator, which will encourage competition that can still include an efficient state-run plan. Also, their hybrid plan would allow supplemental defined-contribution benefits for the upper-income employees subject to pension caps, as long as the plan remains faithful to the overall 75 percent retirement benefits cap.

The 6 percent/9 percent plan: CPR’s other plan design presents a clear philosophical alternative to the governor’s hybrid proposal for new employees. Appealing more to staunch conservatives and libertarians, it would:

• Limit the government employer’s annual contributions to 6 percent of base income for general employees and 9 percent for public safety. Employees pay all remaining costs including amortization of unfunded liabilities in a defined-benefit plan, and no less than the employer’s share. This provision shifts all investment risk to the employees and away from employers.
• Provide an additional Social Security equivalent replacement income plan for those outside that system. To put this in perspective, public employees in the Social Security system would see combined employer/employee contributions of at least 24 percent of their base pay, and public safety professionals would see combined contributions of 30 percent or more. That’s still a lot of money going for retirement: few private employers provide retirement benefits at such a level. Those outside the Social Security system would receive equivalent benefits at lower cost because pension plans can deliver the same benefits for less without contributing to national income redistribution like the rest of us taxpayers.
• Prohibit any defined-benefit plan for new employees from burdening a government employer with liabilities beyond its annual contributions. Some reporters have assumed that this requires 401(k)-style, defined-contribution plans, but that oversimplification is erroneous. This version of the CPR proposal simply requires that somebody other than the taxpayers must hereafter bear the risks. If employees want a guaranteed benefit, they can (1) demand a union-run, Taft-Hartley-like plan in which the workers run the system and collectively bear the investment risks, or (2) the pension trustees can buy institutional group annuities underwritten by third parties or (3) existing pension funds can offer a qualifying defined-benefit plan in which future employees and not the employers are responsible for all unfunded liabilities. This version simply says that employees can’t have their cake and eat it too. Government employees can no longer expect taxpayers to guarantee benefits on the basis of the unpredictable and variable stock market returns now used to calculate advantageously low contribution rates, while they tell the world that they themselves should not be subjected to market risk.The price tag of that privilege nationwide now exceeds $400 billion as I see it. This proposal recognizes that investment risk has a cost as well as a benefit, and freedom from investment risk has a price. So it requires those who want freedom from risk to pay the price of that freedom in a risky world -- and not the taxpayer who has never had a voice in the matter. Here, the “6 percent/9 percent” proposal differs significantly from the governor’s and the CPR hybrid, which would share market and actuarial risks more equally. I personally prefer the hybrid design for new hires, as my prior columns have explained, but this version has its rationale and a legion of strong advocates.
• In both plans, CPR will require three-year averaging to control pension spiking by current employees after a three-year transition period. Those who want to game the system had better hustle and get out by then, or try to tell the judge later why they are so special.

The Hammer. Finally, we come to the most interesting and thoughtful part of the CPR proposal -- its remedy for severely underfunded pension plans. Governors, mayors, school boards and underwater pension boards nationwide will be watching this one. Going well beyond anything Brown has proposed, the CPR folks figured out a way to begin fixing the broken pension systems’ massive unfunded liabilities. They have looked at federal case law regarding the revision of pension benefits, and established what I would call an “emergency remedial provision” that empowers employers to require higher contributions for current employees if their budgets cannot tolerate proper funding of a distressed plan without impairing essential public services.

First the pension plans must evaluate and begin to shore up their funding status using standards similar to those required of private companies under federal pension laws. What’s good for the goose is good for the gander, CPR proponents would say: A severely underfunded governmental pension plan requires just as much public intervention as a corporate plan. Thus, the same rules that protect private-sector workers would be used to protect California taxpayers. These standards require the plan to attain the 80 percent funding level that is often cited as prudent, using a more-conservative valuation based on federal rules for the private sector.

Thus, most major pension plans in the state are presently “at risk” under this definition. Until their funding improves, that status triggers a requirement for the public employer to properly fund its required contributions to relieve the plan of its “at risk” status. If the employer cannot afford to make those contributions without impairing essential services, then it can impose a similar 6 percent/9 percent limitation on its contributions towards the plan’s normal cost, and compel current employees to pay the difference. The employer’s savings must still be contributed toward the unfunded liabilities in most cases, so the pension plan receives more money each year as a result.

Balancing the impact on current employees. These employers may also require current employees to contribute toward the unfunded liabilities if “necessary and equitable.” That will require due process and findings of fact. Employees are protected by a 3-percent-of-pay comprehensive annual cap on such contribution increases, to phase-in the remedial funding. Employees also would be allowed to suspend their participation in the plan and opt instead into the plan offered to new hires, if they don’t want to pay the higher costs of continuing to receive more service credits in their current, richer plan. It should go without saying, but employers are still free to raise non-recurring pay under this system to equitably mitigate part of the contribution increases, if such can be done without impairing public services or the plan’s actuarial status.

This provision might have been simpler in design, but its structure and logic flow from the new hire provisions explained earlier. More importantly, it takes into account the time-tested pension funding standards used by the federal government for private-sector plans in a way that provides a rational basis for determining which pension plans really require a remedy and which employers need to raise employee contributions from incumbent workers. If the employer’s budget can bear the costs of fixing its pension problems, then current employees can continue with the status quo. But if the public would be required to suffer a loss of essential services in order to properly fund the pension plan, then it’s time for the employees to step up and pay more -- or opt into a lower-cost benefit plan.

Unlike pension reforms and benefits modifications in other states that have been upheld by federal courts, this arrangement is legally even softer for employees: it requires only that their future contributions increase, not that their benefits must change. These modifications cannot be invoked unilaterally without cause, using the federal government’s own standards for evaluating pension plan funding. There must be a finding of compelling necessity and equitable treatment of the employees by the employers. In my lay opinion, this legal structure should stand up well against the “minimum change necessary” and “reasonable remaining benefit” tests that federal courts have applied historically when upholding public pension plan changes for vested government employees.

The one missing piece. If I have any criticism of this arrangement, it would be the same one I expressed previously: it would be better if it included OPEB retiree benefits plans as well. Almost all OPEB plans in the state flunk this 80 percent test, and they should be addressed in a similar fashion by legislators when they start deliberating over the governor’s proposal. It’s too bad that CPR couldn’t also apply this remedy to OPEB, for legal reasons explained above.

Credit where credit is due. What I haven’t said thus far, and must say here, is that regardless of how this all plays out in the California political theatre, the CPR folks have done the state, its citizens, its local governments and the pension community a great service by putting their ideas out there for everybody to consider and evaluate. They have crafted a carefully constructed proposal with plenty of legal advice that is invisible to the naked eye but obvious to those who follow these issues closely. They address three of the four major weaknesses I identified in the governor’s proposal last week, and for that alone they deserve credit. The Legislature now faces earnest competition for thought leadership and the voters’ support. Pension reform is not pleasant work; sacrifices are inevitable all-around. There are hundreds of billions of dollars of pension and OPEB debt in California alone. A sustainable remedy is urgently needed, which these alternative measures can provide. As with the governor’s proposal last week, CPR‘s initiative will be a game-changer. Californians can finally hope to see light at the end of the dark tunnel of pension abuses and pension deficits entrapping the state and its municipalities.

What’s next? The CPR folks will select a single proposal for signature-gathering after they hear from the attorney general and the legislative analyst, who review ballot proposals. Unions have opposed these measures and spokesmen have labeled them “extremist” or “illegal.” (I’m always amazed that a constitutional amendment that clears the attorney general’s office, seeking to cure judicial interpretations and defects in current laws, could be called “illegal” on its face. I would like to think that in a democracy, voters can trump lawyers and spin-doctors, but I’m not qualified to argue that one before the bar. With respect to federal law issues: The CPR remedies for current employees appear to be tame, disciplined and informed by standards upheld in federal courts in other states, so it’s hard to see an obvious federal issue here.) What’s more important now is the manner in which the Legislature takes up the governor’s proposal, as I suggested they ought, in my column last week.

Labor lobbyists now have to decide where and when to pick their fight. Journalists have already reminded everybody of the consequences of legislative dithering in 1978 when tax-limitation-fever swept the original Prop 13 into law. (Historical note: Jerry Brown was a first-term governor in 1978 and will surely remind the Legislature and labor lobbyists of the lessons he learned.) So I’d be willing to bet we’ll see something noteworthy come out of Sacramento that includes most of the seasoned, wiser governor’s proposals.

Thus the wild card now is whether the Legislature can include enough of the fundamental CPR reform proposals to swing a Grand Compromise that would call off the dogs who will be circulating their competing petition. Unless union-friendly legislators agree to install the governor’s hybrid, enable prospective changes in benefits for new hires, craft a comparable remedial process for the severe under-funding problems of today’s system, and clear a viable path for current employees to share more of those fix-it costs, I seriously doubt that the pension hawks will withdraw once they raise the money to fight this battle.

That said however, a genuine long-term compromise solution might still be possible if it includes most of CPR’s fundamental fiscal reform provisions and a companion bill in the legislative package to enact similar reforms of the equally large OPEB mess that CPR can’t fix on its own. If they could also secure statewide OPEB reform in the final Sacramento package, GOP legislators and the CPR leaders should consider settling for a little less on the pension side. That would provide a loaf-and-a-half for everybody who’s serious and pragmatic about fixing California’s retirement plan finances, and not just the half-a-loaf-plus-margarine in the governor’s proposal. At least, that’s what I’d encourage.

(Theatre program): Following these proposals and the ensuing media response, the curtain has now dropped on Pension Prop 13, Act One, Scene One: The Gauntlets. Without intermission, the cast will next present Scene Two: The Petitioners and The Horse-Traders. After a full intermission, Act Two will feature the Midsummer Nights’ Campaigns which will be followed by a second, brief intermission and then the closing Act Three: The Fall Election. In the next twelve months, we can all look forward to some great political theatre featuring high drama, pageantry and a cast of thousands.