California’s unfunded pension liabilities are out of control
As California struggles to address its alarming budget deficit, big bills are coming due for retirement past benefits promised city, county and state workers.
Choking on unfunded pension and health care liabilities, cities like Carmel-by-the-Sea pay their pensioners more than active employees. While the average annual earnings of Carmel’s 99 workers are around $85,000, its 108 pensioners collect nearly $95,000 per year. Carmel’s combined pension and health care promises add up to nearly $100 million. This includes over $30 million in unfunded liabilities. Though this looks good in comparison to the nearby Monterey County city of Pacific Grove’s $66 million in unfunded liabilities, it still demands attention.
Sadly, San Jose faces $4 billion in unfunded pension and health care liabilities. San Francisco faces a staggering $7 billion. California’s total unfunded pension liabilities are an eye-watering $250 billion. At the heart of California’s pension crisis are “defined benefit” retirement programs.
To fix its pension problems California should follow the lead of the federal government and private sector and shift from defined benefit programs to defined contribution, or 401(k)-type plans. Under defined benefit programs, cities and unions negotiate future pension and health care promises and then set aside funds to cover those liabilities. Much like Social Security, employees contribute a fraction of their paychecks to the retirement system. Unlike Social Security, where employers contribute 6.2% of wages, cities deposit an average of over 25% of their payrolls into California’s public pension funds.
The nation’s largest pension fund, the California Public Employee Retirement System, known as CalPERS, manages pooled assets of roughly 75% of California municipalities. San Jose has two similar retirement funds, the Police and Fire Department Retirement Plan and the Federated City Employees’ Retirement System. San Francisco relies on its San Francisco Employees’ Retirement System. Regrettably, the CalPERS fund is bleeding red ink. Its pension debt of nearly half a trillion dollars is only 72% funded. More than $150 billion of CalPERS over $600 billion in pension promises remain unfunded.
Historically, a major risk for retirement funds is investment returns fail to meet pension and health care obligations. Budget holes faced by Carmel, Pacific Grove, San Jose, San Francisco and other cities, counties and special districts are partly the result of overoptimistic pension fund forecasts and overly generous taxpayer-guaranteed pension promises.
Remarkably, the average retirement benefit distributed by California’s public pension funds is nearly five times greater than comparable Social Security benefits. Furthermore, the California Rule gives retirees a legal right to public pension benefits even if a city can no longer afford them. Exploding pension costs are priority obligations, forcing municipalities strapped for cash to boost taxes or sacrifice funding for infrastructure, maintenance and public safety, or they have to dip into their financial reserves. City services suffer and future taxpayers are left on the hook. Unfunded liabilities compound a city’s problems by sinking its credit worthiness. This can raise borrowing costs at precisely the time a city needs to issue bonds to meet pension obligations.
The pension crisis is not the fault of California’s public employees. Voters, taxpayers and state and local officials all failed to notice the revolution taking place in retirement benefits. The federal government and most private companies determined decades ago that defined benefit programs were unsustainable. They depend on complex and easily manipulated economic, demographic and actuarial variables. Consequently, a complete picture of pension and health care promises is often hidden until it’s too late. The result is unfunded liabilities.
Today, the federal government and most major companies have largely transitioned away from defined benefit programs to defined contribution plans. These plans clearly define periodic pension contributions that are deposited in their employee’s individual retirement accounts, typically matching a fraction of their savings. The cumulative value of an employee’s pension upon retirement is simply a function of their saving decisions, employer contributions and investment returns. This eliminates the risk of unfunded pension liabilities.
To avoid insolvency and turn unfunded liabilities into a historical footnote, municipalities must gradually shift from defined benefit programs to defined contribution plans. But because these 401(k)-type plans transfer investment risks from employers to employees, public unions are likely to resist. Fortunately, these objections can be overcome (and cities assured of retaining valued employees) by offering higher wages, and/or more generous matching. The major benefit is revealing the true cost of public services.
Although adjustments to employee benefits are politically sensitive and can provoke labor disputes, cities are at a breaking point. The remaining challenge is the near impossibility of a city escaping its liability without making large payments to CalPERS, the Police and Fire Department Retirement Plan, the Federated City Employees’ Retirement System and the San Francisco Employees’ Retirement System. This suggests the only way to implement the transition may be through a state referendum that requires Sacramento to secure all municipal pension obligations. The dual benefit would be to encourage state officials to modify future benefits to better align with Social Security and to facilitate the transition from defined benefit programs to defined contribution plans.