California's Little Hoover Commission (officially, the Milton Marks "Little Hoover" Commission on California State Government Organization and Economy), an independent oversight agency, added to the growing California public pension literature when it issued a report on the condition of the state's public pension systems recently. As with other reports published over the past few years from academics (see, for example, here, here, and here—see pp. 197-199) and think tanks, including ours (see here and here), the Little Hoover Commission's report concluded that the state's public pension situation is grim and requires substantial reform in order to avoid a fiscal catastrophe, if it is not already too late.
The report found that local governments "face the prospect of increasing required contributions into their pension funds by 40 to 80 percent of their payroll costs for decades to come." This, the report continued, "is practically enough money to fund a second government, and it will – a retired government workforce." In addition, cities such as Los Angeles, San Diego, San Francisco, and San Jose are preparing to "spend one third of their operating budgets on retirement costs in coming years."
One would think that the recession that began December 2007 as a result of the financial and housing meltdown would have served as a wake-up call to state and local governments to get their own fiscal houses in order. Sadly, governments were slow to respond, and oftentimes, rather than restrain their spending and employee benefits commitments, they continued to add to them. As the Little Hoover Commission report notes, incredibly, since 2008, just after the onset of the recession, only 27 local government agencies out of the 1,500 that comprise the California Public Employees' Retirement System (CalPERS) network adopted less generous pension benefits for new hires, while 193 agencies actually increased benefits during the recession.
One important argument the report makes is that merely reducing benefits to more reasonable levels for future employees will not be enough. The magnitude of the obligations is such that it will also be necessary to revise the future, unearned benefits of current employees (i.e., all benefits accrued in the past would be honored, but benefits going forward from this point could be reduced). This is a bit of a murky legal question, and would surely draw lengthy litigation from the public labor unions, which is why all other pension proposals to date have focused only on future hires. My own reading and interpretation of prior case law leads me to believe that this is a viable option, though (and it makes sense purely from a fairness standpoint, considering that private firms have the ability to adjust future, unaccrued employee benefits, so governments should be able to as well), but you never know what a judge might rule, so the report recommends that the Legislature "pass legislation giving this explicit authority to state and local government agencies."
The Little Hoover Commission report also suggests shifting to a hybrid pension system that would consist of a reduced defined-benefit (DB) portion plus a 401(k)-style defined-contribution (DC) portion for future employees. This recommendation seems to be en vogue, and I have heard it discussed elsewhere, but I have serious reservations about such a system. In another section of the report, it astutely asserts, "A lesson from history would suggest that, when the market eventually recovers, the pressure from employees will return to ramp up pension formulas and undo any reforms being made today. The ability or willingness of elected officials to hold the line on their own is in serious doubt." This is why I think nothing less than a complete overhaul of the system and shift to a pure DC system, which relies on predictable contributions to be made by the government each year instead of overly-optimistic actuarial assumptions, will ultimately fail. I see it being all too easy to keep bumping up the DB portion of the hybrid plan as the economy improves (like we've seen over and over again—the same thing happened in California during the 1990s) so that eventually governments will be saddled with hybrid plans made up of overly generous DB plans—plus a DC plan on top of that! In fact, that's exactly what happened in San Diego, which has had a "supplementary" DC option for a while now.
The Little Hoover Commission report contained a number of other recommendations as well, many of which were the same as those I made in my California pension study from last year, How California's Public Pension System Broke (and How to Fix It):
- To restore public confidence in the public pension system, the state must impose a cap in the $80,000 to $90,000 range on the salary used to determine pension benefits, or alternatively, a cap on pensionable income.
- The Legislature should give state and local governments the authority to alter the future, unaccrued retirement benefits for current public employees.
- Set appropriate pension eligibility ages to discourage early retirement of productive and valuable employees.
- Set a tight definition of final compensation, computed on base pay only, over a five-year average to prevent and discourage pension "spiking."
- Set uniform standards for the maximum hours that retirees can return to work and continue to receive public-sector pensions.
- Set uniform standards and definitions for disability benefits.
- Restrict pension allowances to exclude service in an elected office.
- Eliminate the purchase of "air time."
- Strengthen standards for revoking or reducing pensions of public employees and elected officials convicted of certain crimes involving the public trust.
- The Legislature must prohibit employees and employers from taking contribution "holidays," except under rare circumstances.
- The Legislature must prohibit retroactive pension increases.
- The Legislature must require employees and employers to annually adjust pension contributions based on an equal sharing of the normal costs of the plan.
- State and local governments must explore options for coordinating pension benefits with Social Security.
- The Legislature must require government retirement boards to restructure their boards to add a majority or a substantial minority of independent, public members to ensure greater representation of taxpayer interests.
- All proposed pension increases must be submitted to voters in their respective jurisdictions.
- The Legislature must require all public pension systems to include in their annual financial reports:
— The present value of liabilities of individual pension funds, using a sensitivity analysis of high, medium and low discount rates.
— The government entity’s pension contributions as a portion of the general operating budget and as a portion of personnel costs, trended from the past and projected into the future.
Finally, here are some additional findings and nuggets from the report:
- In another five years, when pension contributions from government are expected to jump and remain at higher levels for decades in order to keep retirement systems solvent, there will be no debate about the magnitude of the problem. Even with the introduction of two-tiered pension plans, barring a miraculous market advance, few government entities – especially at the local level – will be able to absorb the blow without severe cuts to services.
- Payroll growth – in terms of both compensation for public employees and the number of employees – has ballooned pension liabilities. The minimum retirement age has dropped to 55 – earlier for public safety employees – as people live longer, creating an upside-down scenario where governments potentially will send retirement checks to an employee for more years than they earned paychecks. At the same time, state and local governments have increased what used to be considered a good pension into pensions that are the most generous in the country. Banking on high fund returns and an aggressive investment strategy, employers and employees also have failed to contribute sufficiently – and on occasion, stopped paying into the system at all. Today, the state’s largest pension systems are dangerously underfunded. [Emphasis added]
- The situation is dire, and the menu of proposed changes that include increasing contributions and introducing a second tier of benefits for new employees will not be enough to reduce unfunded liabilities to manageable levels, particularly for county and city pension plans. The only way to manage the growing size of California governments’ growing liabilities is to address the cost of future, unearned benefits to current employees, which at current levels is unsustainable. Employers in the private sector have the ability and the authority to change future, unaccrued benefits for current employees. California public employers require the ability to do the same, to both protect the integrity of California’s public pension systems as well as the broader public good.
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