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Study: California Faces $379 Billion Retirement Liability

Adam Summers
October 6, 2010, 11:06pm

A new study released by the Foundation for Educational Choice and the Pacific Research Institute estimates California's unfunded liability for state (CalPERS and CalSTRS) pensions and retiree health care at $379 billion.  This includes $327 billion in unfunded pension obligations—more than four times the $75.5 billion obligation the state publicly admits to—and $52 billion in retiree health-care liabilities.  The total shortfall is more than five times the amount of existing state debt outstanding.

The difference in the study's estimate and those of the state have to do with the discount rate used to determine the present value of future liabilities.  CalPERS and CalSTRS, like many other government pension plans, utilize overly optimistic discount rates (7.75% and 8%, respectively) to calculate these obligations.  By contrast, study author Stuart Buck used the corporate bond index rate, which is the standard for private-sector pension plans.  As Buck explains,

Pension payments scheduled to be made in the future are given a current valuation using a 7.75 percent or 8 percent discount rate.

While this assumption is allowed by the Government Accounting Standards Board (GASB), it is too optimistic to be an accurate way to estimate future pension liabilities. This is because defined-benefit pension plans offer a guaranteed benefit, not a benefit that swings up and down along with high-risk investments. If investment returns are below expectations, as is often the case with the stock market, the government is responsible to cover the shortfall. The pension plan does not have the option of shortchanging current pension recipients just because the stock market hasn’t performed as expected.

For this reason, private-sector pensions are required to use discount rates equal to the interest paid on high-quality corporate bonds. This is true even if the private pension invests in stocks or other investments that supposedly have a higher rate of return in the long run. Bonds represent a guaranteed stream of payments year after year, just as the pension plan’s obligation to pay out pensions is a guaranteed stream of payments. Currently, the rate paid by corporate bonds is about 5.2 percent, the lowest in nearly a decade.

Using the same standards that govern private sector pension plans and taking into account the declines in stock market values, actual financial liabilities for California pension plans are more properly estimated at over $326 billion.

Even this may be a bit conservative, for, as the author elucidates, the use of the corporate bond index rate "reflects the fact that pension obligations are essentially a high-quality debt obligation but nonetheless could be defaulted under certain narrow circumstances (such as corporate bankruptcy)."  "But," as he later notes, "under California constitutional law, California does not have the option of defaulting on existing pension liabilities."  For this reason, other recent analyses (see here and here, for example) have used an even more conservative discount rate, such as the U.S. Treasury bonds rate.  This method leads to estimated unfunded state pension liabilities of roughly $500 billion.

Another interesting finding is that stock market declines over the past couple of years have little to do with the state's mounting pension obligations:

This actuarial deficit is not primarily a result of the recent stock market decline. As of June 30, 2007, before the stock market crash, CalSTRS already had an admitted unfunded liability of $18.7 billion and CalPERS had an unfunded liability of $44.5 billion, for a total of $63.2 billion. Out of the total $326.6 billion figure that I estimate here, only around $44.4 billion of the increase in unfunded liabilities stems from declines in the market value of the plans’ investments, while $206.6 billion is due to the funds’ use of excessively aggressive discount rates for future liabilities in addition to the choice to balance budgets by delaying or reducing pension contributions.

And here is another nugget of interest:

In an alarming report filed with the Teachers’ Retirement Board on February 5, 2010, the head of CalSTRS noted that given substantial stock market losses in 2008-2009, the unfunded actuarial obligation “would increase to about $78 billion and the funded ratio would decline to about 58 percent. Moreover, given existing assumptions around investment returns and contributions, the funded ratio will decline to 13 percent over the next 30 years.” The report went on to observe that even if the stock market recovers, it is extremely implausible that it could ever make up for the losses to date: “In order to fully fund the [defined-benefit] program in 30 years, investment returns for the next five years would have to exceed 20 percent per year, a rate of return that is 2 ½ times the assumed investment return.” The report also noted that the Teachers’ Retirement Board had recommended increased contributions from employers, members, and the state back in 2006, but “unfortunately, many felt that CalSTRS could ‘invest its way’ out of the problem.”

Finally, the FEC/PRI study correctly chastises state elected officials for knowingly increasing pension costs, and then not setting aside the money needed to pay them: "Unfunded pension liabilities have ballooned in part because politicians preferred to incur hidden pension costs instead of visible wage costs: it is easier to hand out more generous retirement benefits to be funded later than give pay raises that cost money now."  It concludes that "The unfunded status of California state pensions is massive and unsustainable. California must stop hiding its head in the sand about the overly optimistic promises made to state employees." The study, furthermore, notes the sobering reality that "there is not much to be done about the accrued liability: it represents income already earned by public employees but not yet paid," and recommends that to avoid digging an even deeper fiscal hole the state shift new employees to 401(k)-style defined-contribution plans or, if that is not politically feasible, at least to hybrid plans such as cash-balance plans or a TIAA-CREF-style hybrid plan.

» See also my California public pension reform study, released in June 2010, How California's Public Pension System Broke (and How to Fix It)


Adam Summers is Senior Policy Analyst


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