Cal­i­for­nia's new taxes are paying for pen­sions

The Pak Banker - - OPINION - David Crane

WHAT if a cor­po­ra­tion raised $500 mil­lion in a se­cu­ri­ties of­fer­ing on the premise that the pro­ceeds would go for op­er­at­ing ex­penses, then dis­closed a few months later that $300 mil­lion of this amount would in­stead be used to ser­vice a debt that wasn't dis­closed in the of­fer­ing doc­u­ment? This would be false ad­ver­tis­ing, sub­ject to sanc­tion by the Se­cu­ri­ties and Ex­change Com­mis­sion. Un­for­tu­nately, the SEC doesn't have ju­ris­dic­tion over state politi­cians en­gag­ing in the same be­hav­ior, and, in the case of Cal­i­for­nia, in­volv­ing sums that are 100 times big­ger.

Last Novem­ber, Cal­i­for­nia politi­cians per­suaded vot­ers to sup­port a pro­posed seven-year, $50 bil­lion tax in­crease, largely on the vow that the money would go to pub­lic ed­u­ca­tion. The first five words of the ini­tia­tive's ti­tle were "Tem­po­rary Taxes to Fund Ed­u­ca­tion."

Now, just four months af­ter the elec­tion, the state's Leg­isla­tive An­a­lyst's Of­fice has an­nounced that the Cal­i­for­nia State Teach­ers' Re­tire­ment Sys­tem re­quires an ex­tra $4.5 bil­lion a year for 30 years -- $135 bil­lion -- to cover its un­funded li­a­bil­ity for teacher pen­sions and that the money will have to come from some com­bi­na­tion of school dis­tricts and the state. To the ex­tent that it comes from the school dis­tricts, $4.5 bil­lion a year is 167 per­cent of the an­nual amount those dis­tricts ex­pected from the tax in­crease. To the ex­tent that it comes from the state, $4.5 bil­lion is more than 100 per­cent of the an­nual amount it ex­pected in new rev- enue. Ei­ther way, more than $30 bil­lion over the next seven years will go to the ser­vice of a debt that wasn't dis­closed be­fore the vot­ers were asked to ap­prove the tax in­crease.

None of this is a sur­prise to long­time ob­servers of many teacher pen­sion funds and of Cal­strs specif­i­cally. It's just as I pre­dicted a year ago on Bloomberg View, as the Vol­cker-Rav­itch report on Cal­i­for­nia's bud­get out­lined last year, and as Bill Gates ex­plained in a 2011 TED talk. It's also no sur­prise to state of­fi­cials. On the day the pro­posed tax in­crease was an­nounced in early 2012, I raised the is­sue with the lead­ers of Cal­i­for­nia's State As­sem­bly and State Se­nate and later with Gov­er­nor Jerry Brown, and surely all were aware of the Vol­cker-Rav­itch report.

Worse, the $4.5 bil­lion-a-year re­quire­ment is based on the teach­ers re­tire­ment fund's self-re­ported un­funded li­a­bil­ity, which in turn is based on Cal­strs's self­cho­sen and un­re­al­is­ti­cally high in­vest­ment-re­turn as­sump­tion that im­plic­itly fore­casts the stock mar­ket to dou­ble ev­ery 10 years. Any­thing less than that and the cost to ser­vice the un­funded li­a­bil­ity will be higher (even that frothy as­sump­tion pre­sumes bond yields will rise to lev­els ex­ceed­ing their cur­rent lev­els and will do so with­out crush­ing the prin­ci­pal value of Cal­strs's ex­ist­ing bond port­fo­lio).

To put the far-fetched na­ture of this an­nual in­vest­ment- re­turn as­sump­tion in per­spec­tive, it's al­most 15 per­cent higher than the in­vest­ment re­turn that War­ren Buf­fett as­sumes for his pen­sion funds, which not only are in­vested un­der Buf­fett's di­rec­tion but also are, in size, a tiny frac­tion of Cal­strs's port­fo­lio and there­fore much eas­ier to com­pound at higher rates of re­turn.

That's why fi­nan­cial econ­o­mists work­ing for the Vol­cker- Rav­itch report said last year that, un­der a more rea­son­able earn­ings as­sump­tion, the cost to meet the re­tire­ment fund's un­funded li­a­bil­ity is closer to $7 bil­lion a year. Nondis­clo­sure of Cal­strs's li­a­bil­ity be­fore the tax vote con­tin­ues a pat­tern of de­cep­tion about Cal­i­for­nia's pen­sion obli­ga­tions.

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