The chickens have come home to roost in the California municipal pension community. The state's largest pension fund recently* gave local government officials a wake-up call about their projected pension cost increases. One city, Pasadena, has responded by laying off management workers in an effort to rein in personnel costs that are now obviously unsustainable in light of skyrocketing pension bills.
According to news reports, the Pasadena layoffs will save the city about $5 million in the context of a pension-cost increase of twice that magnitude. I've received conflicting claims that the spike in pension costs may be lower than the newspaper reported, but still larger than the $5 million in layoffs, so readers should judge for themselves the cause-and-effect in this specific city. What is evident statewide, however, is that this pension-cost epidemic is widespread. A recent survey of local governments conducted by a city finance director found that employers' pension costs for civilian workers were jumping 15 to 30 percent by 2013 and for public safety, the employer's pension costs will likely rise to levels exceeding 30 and even 40 percent of payroll. A seperate newspaper survey in northern California found that employee benefit costs have tripled, and that data did not even include the pending CalPERS costs increases.
These numbers align with what we've already seen in other states where the actuaries and pension trustees were more forthright about the financial costs of the 2008 stock market declines — which doubled the unfunded liabilities of the average public pension plan. What's disappointed California municipal employers is that CalPERS has been so dodgy about its data, and waited this long before 'fessing up to the inevitable prospect of ever-rising pension costs. Numerous employers have entered into collective bargaining sessions and even signed labor agreements with one hand tied behind their backs — while unions continued to deny that there is a pension problem given that CalPERS was withholding vital strategic information from its constituents and masking true costs.
How high will this flood crest? Local employers are now skeptical that they have been told the full truth about how high their pension costs will ultimately surge. Unlike the vast majority of public pension funds, CalPERS uses a 15-year actuarial smoothing process that camouflages the genuine economic impact of market fluctuations. I have no issue with normal industry-standard actuarial smoothing periods of 5 years, in light of the average length of a business cycle — which is 6 years based on 14 recession cycles in the past 84 years. But the CalPERS process is opaque and flunks the transparency test that taxpayers, public managers and municipal bond investors are entitled to expect. As I have explained before, such extraordinary "smoothing" practices deserve SEC investigation as an "artifice and device" to conceal relevant financial information from the investment community — as well as the employers who must now bear the financial brunt of unsustainable pension benefits.
Every public pension plan with unfunded liabilities should begin providing its sponsoring employers with multi-year projections of their full actuarial contributions. This should be based on current market values as well as their actuarially smoothed levels. Those that amortize their liabilities over periods exceeding the employees' remaining average service periods should also provide projections using intergenerationally accurate periods, such as 15 years. That's not too much to ask, and it would go a long way toward providing the transparency needed throughout the state and local government financial sector for budgeting, collective bargaining, strategic planning, debt issuance and investor-relations purposes. In addition to my GASB testimony and my prior column on this subject, I have written an article for the Government Finance Officers Associations' February issue of Government Finance Review with illustrations of the kinds of projections that are needed, and will forward a copy to inquiring readers once it is published. At least 15 years of projected costs and the resulting remaining unfunded liabilities are needed for prudent financial management.
Putting the SEC issues aside, however, Californians now face the pragmatic problem of what to do to re-balance local government budgets at the same time that newly elected Governor Jerry Brown is proposing to push state functions down to local governments without providing additional revenue sources to offset the problem. I suspect that Pasadena will not be the only city in this state that will be compelled to reduce its workforce. Of course, the pension-funding problem is only part of a mosaic of fiscal challenges facing state and local government. Rainy day reserves have been exhausted during the Great Recession, and OPEB retiree medical costs continue to mount at the same time that revenues remain stagnant.
This problem is not unique to California. We have seen huge employer cost increases in other states such as New York. In many other states, however, the employers have the option (albeit undesirable) of raising taxes to pay for rising retirement expenses, which most local governments in California lack because of constitutional tax limitations.
"Not Me"-isms. Pension advocates assert that it's not fair to now blame their function for the coming round of layoffs and personnel attrition. But that strikes me as somewhat disingenuous: If the day of reckoning has been delayed by actuarial smoothing, then the pension community should face the music and realize that there are long-term costs that have been deferred by a budgetary smoothing technique that actually raises the long-term costs eventually. If pension plans were already amortizing their unfunded liabilities over the remaining service lives of the employees and not the artificial and extended 25- and 30-year amortization periods many of them use, I might be more sympathetic. But more cost increases are coming just as the financial and investment world starts looking more closely under the covers.
Where pension advocates do have a point is in their "relative" efforts. Compared with retiree medical benefits, which remain largely unfunded nationally, the pension plans are in much better shape. Even though their unfunded liabilities doubled in the Great Recession, a 70 percent or better ratio is far better than zero. If public employers were to immediately begin paying their full actuarial costs for (OPEB) retiree medical benefits, we would likely see immediate layoffs in many states.
Total compensation: A second look is needed now. What the new numbers are showing is that the costs of public employee compensation are indeed on the rise even though salaries are flat. When public employers are ultimately forced to pay up to one-half of an employee's salary for pension and retiree medical benefits on a proper actuarial basis, it's clear that many public employees are compensated more than their private-sector counterparts on a total-cost basis. Academic research purporting to show that public employees are not overpaid has ignored true pension and retiree medical costs that have now been exposed. That's a fatal flaw I cited in my previous column on that topic.
Some public employees are underpaid relative to their private counterparts: public managers, technical professionals, teachers in some states (depending on their pension formulas), and a handful of other professions where public workers are clearly underpaid relative to their private counterparts. But the ballooning pension and yet-unpaid OPEB retiree medical costs have now bolstered the critical claims of watchdogs in a dozen states with high public-employee compensation. Very few private sector employers pay 20 to 50 percent of salaries into their retirement plans. And although I continue to oppose the movement to simply replace public pensions with 401(k)-type defined contribution plans, the facts now on the table regarding the true cost of these defined benefits are so obvious that lower-cost hybrids are clearly needed.
Attrition before layoffs. It's doubtful that hordes of local governments will lay off employees to pay for pensions. More probable is a decade of "pension attrition" accompanied by "OPEB attribution" for those employers with unsustainable retiree medical benefits. In California, raising taxes to help pay the bill is constrained constitutionally by Prop 13 and politically by already-high per-capita tax rates. That is why I expect to see 150,000 to 200,000 fewer public sector jobs (adjusted for statewide population growth) by the end of this decade. Nationwide, if taxes are not increased, more than 1 million state and local government positions will evaporate through hiring freezes, attrition and early retirement plans in the coming decade. It will be drip torture for many public managers trying to maintain service levels against a tide of retirement funding costs that just keeps rising each year until the systems regain equilibrium.
As suggested in my prior column on the capacity of financial markets to bail out the pension funds, the best we can hope for is a consistent, sustainable economic expansion in this decade, without a premature recession. That Goldilocks scenario would provide the tax revenues so desperately needed to offset some of these rising costs and enable payroll levels to stabilize enough to replace retiring Baby Boomers with lower-cost Millennial-generation employees. And if we're lucky, the financial markets could enjoy a modest expansion for an extended period beyond historical average, which would offset some of those 2008 stock market losses over the next seven years. But no rational public manager, mayor or governor can afford to gamble on that outcome as pension and OPEB bills continue to pile up on their desks.
Cali-centricism? Finally, I apologize in advance to readers in states where these issues have not festered the way they have in California: Not everybody faces these challenges and many public employers enjoy greater financial flexibility after years of sound financial planning and prudent stewardship. It would be a mistake to extrapolate this one state's malaise nationwide, although there are at least a half-dozen others in a similar quagmire — and I stand by the national projections of workforce projections I have provided above.
Outlook: More belt-tightening ahead.
[The original version of this column implied that pension cost information was delayed until after the November 2010 election for political reasons, when in fact the delays were a result of state-mandated furloughs affecting the seasonal workflow. The author regrets the misinformation and apologizes for the error.]