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Pension liabilities are one of the most important, and most poorly understood, fiscal challenges facing California. Unfunded pension liabilities are a large and growing fiscal burden for the state government and for local governments as well. For the state government, the share of pension contributions in the budget has increased by 350 percent since 2002. For large cities, including Los Angeles and San Jose, pension contributions are now about 10 percent of their budgets. Pension contributions are around 15 percent for some smaller California cities. These pension contribution increases arise because the pension system is not fully funded by accumulated pension assets and the shortfall is made up by taxpayers. However, even these very burdensome contribution rates—which translate directly into higher taxes, worse public services, and higher debt burdens—have not succeeded in preventing the unfunded pension debts from spiraling upward.
As currently measured, unfunded pension liabilities are underreported through the use of a particular accounting procedure. This underreporting masks the importance and urgency of this problem. Pension fund agencies, such as CalPERS, the California Public Employee Retirement System, measure these liabilities based on assumptions about the future returns on the pension fund investments. The higher the assumed return, the smaller the unfunded liability. Using a projected 7 percent return, the state’s unfunded liability was $22 billion in 2002 and has been growing since then to about $110 billion in early 2018. Earlier this year, the Pew Charitable Trust found that California was the sixth worst state in the country in terms of the relative adequacy of government pension contributions.
The inadequacy of California pension funding is even worse, however. Assumptions about future pension returns, which are highly uncertain, are used in making calculations of unfunded pension liabilities as if they are certain returns. This practice is inappropriate based on the standard principles of finance, which instead call for using the returns on safe assets, such as US Treasury securities, when making calculations that require a high degree of certainty. The key point is that making a certain calculation of future liabilities can only be done using an asset that provides an extremely safe return. Treasury securities are considered by finance professionals as the asset with the safest return. Because of this safety, US Treasury securities deliver a much lower return than the assumed returns that traditionally have been used by pension fund agencies.
The size of the state’s unfunded pension liability is much larger when calculated using the returns on Treasury securities, with maturities matched to the timing of pension payouts. The state’s unfunded pension liability is about $769 billion when valued according to the appropriate Treasury returns. This works out to a liability of more than $60,000 per state household.
Outgoing Governor Jerry Brown understands the unsustainability of the state’s pensions. He and the Legislature implemented some productive pension changes. These changes primarily affect new hires and involve a later retirement age and higher pension contributions. But some of the other changes, including limitations on “pension spiking,” are being litigated. Pension spiking is the process of artificially inflating employee compensation prior to retirement in order to increase the lifetime pension. While pension spiking is explicitly prevented under CalPERS, there are many different ways to enhance salary within the CalPERS rules that are effectively similar to salary spiking, such as paying bonuses for performing job responsibilities adequately and for maintaining job certifications.
The pension spiking lawsuit is now being reviewed by the California Supreme Court. The court’s decision will bear more broadly on what is known as the California Rule, which treats a pension as a contractual obligation that cannot be reduced.
Growing pension obligations are even more problematic because California’s tax revenue is extremely volatile—more volatile than any other state. This is because the top 1 percent of earners account for 50 percent of income tax revenue. These incomes, particularly income from capital gains and stock options, tend to drop substantially during economic downturns. During the last recession, gross state product fell around 4 percent but tax revenue fell around 20 percent. This led the state government to drastically cut basic services and issue IOUs. This suggests that large tax increases will become increasingly necessary during future downturns to pay pension promises. These tax increases would further damage the state economy.
Brown has warned about the state’s revenue vulnerability during the next downturn. This requires tax reform that reduces revenue streams from the most volatile sources. In 2009, Michael Boskin and John Cogan wrote a paper on this topic, the same year that the state issued the “Final Report of the Commission on the 21st Century Economy.” They described reforms that include reducing the number of income tax brackets, eliminating the state corporate income tax, and instituting a small, value-added tax on business transactions.
Current pension promises are unsustainable. Both state and local governments must address this issue immediately and significantly. We recommend transitioning state and local government employees into a defined contribution program, which has the added benefit of portability in the event that an employee moves to another sector of the economy.
Our preferred approach is to transition employees to a 401(k)-type plan. To encourage employee participation, the initial employer contributions could be around 10 percent, which is a relatively generous level of contributions compared to private sector plans. The federal Thrift Savings Plan, a 401(k)-like defined contribution plan with very low management costs and sensible investment options offered to federal employees, provides a very sound governance model for both state and local governments.
References
Boskin, Michael, and John Cogan. 2009. “Reforming California’s Outdated Tax System.” Hoover Institution, Stanford University.
Parsky, Gerald, et al. 2009. “Final Report of the Commission on the 21st Century Economy.” See www.cotce.ca.gov, accessed October 21, 2018.
Joshua Rauh, “Can California Save Itself from a Pension Disaster?” Eureka, January 25, 2018, accessed October 21, 2018, https://www.hoover.org/research/californias-pension-indigestion-appetite-fine-dining-while-stuck-fast-food-budget.
Novy-Marx, Robert, and Joshua Rauh. 2014. “Revenue Demands of Public Employee Pension Promises.” American Economic Journal: Economic Policy 6, no. 1: 193–229.
Joshua D. Rauh is a senior fellow and director of research at the Hoover Institution and the Ormond Family Professor of Finance at Stanford’s Graduate School of Business. He formerly taught at the University of Chicago’s Booth School of Business (2004–09) and the Kellogg School of Management (2009–12). Rauh studies corporate investment, business taxation, government pension liabilities, and investment management. He has published numerous journal articles and received awards for his research, which has appeared in the Journal of Finance, Quarterly Journal of Economics, Review of Financial Studies, Journal of Financial Economics, and the Journal of Political Economy. Rauh’s research on state and local pension systems in the United States has received national media coverage in outlets such as the Wall Street Journal, the New York Times, the Financial Times, and The Economist. Rauh received a bachelor's degree in economics, magna cum laude with distinction, from Yale University and a PhD in economics from the Massachusetts Institute of Technology.
