Rising Tide of Pension Costs Threatens Government Services: is “Underwater” Unavoidable?

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California’s finances face a giant wave in the form of employee pensions. While Redwood City has taken steps to guard against it, the breaker still threatens to dampen the city’s future.

When Gavin Newsom took over the reins of the state government from Jerry Brown in January, he expressed a sense of unlimited possibilities. The state’s finances, which had been suffering since the 2007-09 recession, recovered under the tight-fisted Brown, who left a projected budget surplus of $21.5 billion. That allowed Governor Newsom to proclaim “We will be bold” in adding money for full-day kindergarten and child-care services, free community college, and other programs.

But those promises are undermined by a much bigger number—the unfunded liabilities to pay pensions for state workers and teachers, officially estimated at $256 billion.

And even that figure could be way too low.

The Federal Reserve System last fall released its own calculations, using the same methodology it uses for its own employee pensions.

It found that California’s combined pension systems had $785 billion in assets and $1.53 trillion in liabilities, only a 51 percent funded ratio. That means there are $750 billion in benefits that must be paid without a clear way of paying for them–nearly $19,000 for each California resident.

The major difference is that the California Public Employees Retirement System assumes the investment portfolios held to pay pensions will grow at a rate of at least 7 percent a year. The Fed calculation uses a range of possible investment returns. Taxpayer advocate Jack Dean operates a Fullerton-based website called Pension Tsunami that features a picture of a big wave approaching. It warns of “multiple pension crises that are about to drown America’s taxpayers.”             “What’s unfortunate is that most people will never realize that almost all the tax increases being heaped on them will be due to escalating pension costs,” Dean said.

The pension problem affects citizens at every level of government, from the state to San Mateo County to cities and school districts.

According to the report of the 2017-18 San Mateo County Grand Jury, Redwood City pension costs are expected to almost double, from $21.2 million in 2017-18 to $40 million in 2024-25. On average, that’s an increase of $2.67 million a year, or 12.6 percent.

The grand jury report looked at the pension issue and came to a sobering conclusion.

“Rising pension costs will require cities over the next seven years to nearly double the percentage of their general fund dollars they pay to CalPERS,” the grand jury report said, quoting the League of California Cities. “[U]nder current law, cities have two choices – attempt to increase revenue or reduce services. Given that police and fire services comprise a large percentage of city general fund budgets, public safety, including response time, will likely be impacted.”

While Redwood City’s budget is balanced now, thanks in part to the recent half-cent sales tax increase, it faces unfunded pension and retiree health liabilities officially estimated at $296.4 million, or $3,419 for each of the city’s 86,685 residents.

Redwood City has 557 active employees, and even more retired members and beneficiaries—333 from public safety and 529 from other jobs as of June 2017.

The highest Redwood City pension in 2017 went to retired Fire Chief James F. Skinner, $209,619 for 34 years of service, according to Transparent California, which makes it easier to find salaries and pensions for state, county, city, and school district workers.

The grand jury report projects Redwood City will pay 42.7 percent of its regular payroll for pensions in 2025, up from 26.3 percent in 2016-17. For public safety officers, the contribution will be much higher, 65.6 percent. A portion of the increase is paid by employees through payroll deductions.

But the actual cost is likely to be higher. Currently, the cities pay in based on the CalPERS assumption they will earn a return of 7.5 percent on their investments. The factor is being reduced to 7 percent in stages until 2020-21.

Still, that’s an aggressive return target. Preliminary estimates showed CalPERS actually lost 3.9 percent on its investments in 2018, a bad year for the stock market. CalPERS’ adviser estimates the average annual return for the next 10 years will be only 6.2 percent.

With the city having to face a higher payout every year, it has been trying to get out in front of the problem. “There are numerous instances in the Grand Jury report where the city’s sound financial practices are cited as examples of how other cities can proactively address the rising pension costs that are impacting cities across the state,” Assistant City Manager Kimbra McCarthy said.

 The measures include:

Extra contributions — The city has funded a pension trust with an initial $10.5 million and plans to make additional contributions. “Those funds may be used in the future to help offset the city’s annual required pension contribution.  The city has also made payments directly to CalPERS above and beyond the required minimum annual contribution, and is budgeted to continue to do so in the long-term forecast,” McCarthy said.

Cost-sharing — Redwood City has negotiated employee cost-sharing arrangements in which current employees contribute between 8 and 18 percent of their salary towards their pension costs. Neighboring cities like Atherton, Menlo Park, and Burlingame have also negotiated cost-sharing agreements with employees.

Higher taxes and fees — Last November, Redwood City voters narrowly approved Measure RR, a half-cent sales tax. Along with a half-cent county transportation sales tax voters also approved, it brought the city’s sales tax rate to 9.75 percent. It is expected to raise $8 million a year. A cannabis tax was also approved, expected to raise at least $300,000 a year. The city has also raised development fees by approximately $2 million a year.

Budget cuts — The sales tax increase meant that the city was able to restore $2.7 million to public safety, city staff, libraries, and after-school programs that were on the chopping block. One cut that wasn’t restored was the elimination of the Community Emergency Response Team coordinator position and the consolidation of the program with that of the county. 

The city has found other internal efficiencies and changed service delivery methods, McCarthy noted.

Will all those steps be enough? “No, it is not expected that the estimated additional $8 million in new sales tax revenue will cover all future increases in operating costs and pension costs,” McCarthy said. “However, it will provide the city with relief through Fiscal Year 2021-22.”

She notes that a recommended budget for 2019-20 will be presented to the City Council in June, including the final long-term forecast.

If Measure RR hadn’t passed, forecast cuts would have included the number of on-duty firefighters, paramedics and police officers, leading to longer response times on 911 calls. As pension obligations grow, such cuts could be on the table again, since public safety expenditures make up 60 percent of the city’s budget.

Despite all the steps, the city’s plans are not fully funded. The city manager’s office says the Miscellaneous Plan budget category for non-safety employees was 67.5 percent funded as of June 2017, while the Safety Plan category was 63.1 percent, for an average of 65.1 percent funded.

That’s toward the bottom of San Mateo County cities. Funded percentages range from Portola Valley at 91.8 percent to San Carlos at 63.3 percent. In the middle are Menlo Park (74.4 percent) and Woodside (72.3 percent).

For private-sector plans, the federal government considers a funding percentage below 80 percent as at-risk.

Pension payments in San Mateo County are relatively moderate in comparison to what other cities and agencies face. According to the Los Angeles Times, Los Angeles pays dozens of retired employees, mostly police and firefighters, more than the $220,000 limit on pensions imposed by the Internal Revenue Service. That has forced the city to set up a separate fund that has cost $14.6 million for 110 employees since 2010.

The highest pensions paid by CalPERS in 2017 were $378,118 to former Solano County Administrator Michael D. Johnson and $349,194 to UCLA psychology professor Joaquin Fuster.

The pension wave has taken 87 years to become a monster. CalPERS was established in 1932 and has grown to encompass 1.9 million members in its retirement system.

Much of the problem dates to 1999, when the state was flush with cash from taxes paid on stock option gains during the dot-com boom. The Legislature and Governor Gray Davis sweetened the formula for pensions. Highway patrol officers—and later, police, firefighters, and prison guards—got a new formula called “3 percent at 50,” meaning a cop who started at age 25 could retire at age 50 with 25 years of service at 75 percent of pay.

The new formula led to a class of retired workers, now over 40,000, who receive $100,000 pensions or more. The checks are further bolstered by pension “spiking,” for example, by working massive overtime in the last years of service or getting a promotion a year or two ahead of retirement.

The system sailed along until 2008, when the bottom fell out of the stock market, and it became obvious that there wouldn’t be enough money.

In 2011, the state’s Little Hoover Commission found that “pensions will crush government” unless the formulas were altered. Its biggest recommendation was to reduce future pension accrual rates for current employees, especially police and fire.

Governor Brown responded with a reform package. After extensive negotiations, the Legislature passed the Public Employees Pension Reform Act of 2013. Among other changes, it reduces pension formulas and caps the salary that can be used to compute pensions. But there was one big part of the Little Hoover Commission’s plan that was missing—most of the limits only applied to workers hired after January 1, 2013.

“That helps a little bit,” said Robert Fellner, executive director of Transparent California. “The really big weakness is it’s only for future hires, and even then it’s only trimming around the edges.”

By law, employees earn pension credits at the rate that was in effect when they were hired. A 1955 California Supreme Court statement known as the California Rule means that once an employee is hired, the formulas can’t be reduced even for years they haven’t worked yet.

“If we don’t change the California Rule, we will bankrupt the state,” said Wayne Weingarten, senior fellow in business and economics at the Pacific Research Institute. “We’ll either have massive tax increases, or massive expenditure cuts. Either way, it’s economically devastating.”

A case involving the California Rule is currently before the California Supreme Court. A 2004 state law let public employees buy up to five extra years of pension credits—known as “air time”—before they retired. The Legislature took that right away in 2013, but Los Angeles firefighters challenged it, saying the change was unfair since air time was part of what they had been promised.

“The greed and disregard of the public unions is incredible,” Fellner said. “Jerry Brown’s reform was very, very minor and government unions are suing because they want provisions to spike their pensions.”

If the court rules against the firefighters, depending on the language, it could open the way for state and local government to negotiate with unions for reductions in benefits for future service.

But Steve Smith, communications director of the California Labor Federation, an umbrella organization representing most of the state’s unions, says workers are already giving back.

“Coming out of the Great Recession, it’s taken time for pension funds to recover, but we’ve seen steady returns since we got out of recession and continue to see pension funds get stronger and will remain solvent. Our unions have recognized that some cities are in a bit of a fiscal crisis and we’ve negotiated. Workers are paying more of their paychecks for pensions.”

“Workers entered into an agreement with local cities to have a fair retirement. It makes it difficult to plan if pensions are cut or switched to a 401(k), as a certain faction wants to do,” he said.

Smith said that while attention is focused on a relatively small subset of public safety workers, “You have to understand that job is dangerous, it’s taxing on the body, that’s what factored into those initial calculations.”

The average retired state employee gets a pension of around $25,000, he noted. Some also receive Social Security, others (like teachers) don’t, depending on the plan they’re in.

More comprehensive solutions appear to be off the table. The League of California Cities would like cities to be able to negotiate new formulas for the future service of pre-2013 employees, but that can’t be done under the California Rule.

What about adopting a defined contribution plan to replace the defined benefit plan, as many private employers have done? At this point, CalPERS doesn’t even offer one, and a bill that would have allowed new state workers to choose a defined contribution plan failed in the Legislature.

A few localities have made drastic cuts in pensions for new employees. In San Diego County, employees hired after July 1, 2018, get only 1.62 percent of their salary for each year worked, and not until age 65.

Some pension reform advocates would like to see cities get out of CalPERS entirely, but the system is as hard to leave as Hotel California. CalPERS charges districts that want to leave a large sum to make sure it can pay benefits already earned. It does this by reducing the assumed rate of return on investments down to 3 percent.

When Stockton filed for bankruptcy in 2012, it tried to reduce its $375 billion in unfunded pension obligations by buying its way out of CalPERS and switching to a different system. The agency threatened to sock it with a termination bill of $1.6 billion, effectively killing the plan. Bankruptcy judge Christopher Klein called it a “poison pill.”

A bill in the Legislature last year that would have allowed local governments to opt out of CalPERS without paying huge termination fees did not pass. 

“We have a very large fiscal hole that has to be filled,” said Weingarten. “We’ll either have massive tax increases to fund it, or massive expenditure cuts. Either way, it’s economically devastating.”

He noted that with people living longer, an employee who works 30 years and is eligible to retire at 55 likely will be getting a pension for as long as they worked, or longer.

Several other states are in even worse shape. At the bottom is Illinois, where the funded ratio is only 25 percent by the Fed’s calculations.

“In Illinois, there’s no doubt people 70, 80, 90 years old are going to see their pensions cut—that’s the ultimate way this will be paid after the taxpayers flee the state,” Fellner said.

While California’s situation isn’t that dire, the possibility exists that some workers won’t get their full pensions. For example, after the tiny mountain town of Loyalton, north of Truckee, pulled out of CalPERS because it couldn’t afford the premiums, its four retired employees found their benefits slashed. They have sued to recover them. 

School districts are also affected. Ed-Data is a partnership of the California Department of Education, EdSource, and the Fiscal Crisis and Management Assistance Team/California School Information Services (FCMAT/CSIS) designed to offer educators, policy makers, the legislature, parents, and the public quick access to timely and comprehensive data about K-12 education in California.

This site shows that employee retirement costs for the Redwood City School District went from $4.4 million in 2012-13 to $9.2 million in 2016-17. The figures combine the State Teachers Retirement System and the Public Employees Retirement System figures.

San Mateo County’s pension system appears to be in better shape than most systems.

The county has its own plan, outside CalPERS, called the San Mateo County Employees Retirement Association (SamCERA), with about 5,000 members.

Its highest-paid pensioners in 2017 were retired county counsel Thomas F. Casey, $229,341; retired public works director Neil Cullen, $228,524; retired district attorney James Fox, $228,295; and current District Three Supervisor Don Horsley, who received $228,161 as retired sheriff; according to Transparent California data. 

According to a grand jury report, the county in 2013 agreed to start making supplemental contributions to its pension plan. It put a big down payment of $50 million into the fund in 2013-14, when its capital budget was swelled by the profitable sale of the county-owned Circle Star Plaza in San Carlos. A half-cent county sales tax, first approved by voters in 2013 and since extended until 2043, has also helped pay for extra contributions. So far, extra contributions have totaled $139 million, with more planned.

The county also has a less generous formula than other jurisdictions, ranging from 2 percent a year with retirement at 55.5 for members hired before 2011 to 2 percent at age 62 for those hired after 2013. As with the state, newer members also have restrictions on income enhancements used to boost pension payments. 

The grand jury report notes “it will take many years before the reduction in benefit formulas will be fully realized in pension payments.” Still, already, about 30 percent of current employees are in the lower-pension tier. The grand jury estimated that an employee in the new tier who retired at age 55 after 30 years’ service will receive a benefit 33 percent lower than one hired under the pre-2011 plan.

The result? SamCERA has a funded ratio of 84.3 percent, considerably better than the state average. The county expects to eliminate its unfunded liability by 2023, saving over $300 million in interest charges that would have occurred otherwise.

The county also makes more conservative assumptions on investment returns, assuming a 6.75 percent return compared to 7.5 percent for CalPERS plans in 2016-17.

And it continues to hold the line in labor negotiations. A new three-year contract with Service Employees International Union Local 521 was expected to raise pension costs only 0.04 percent, despite raises of 3 percent to 4 percent a year. Terms of a tentative settlement reached in February were not available at Climate’s press time.

The grand jury commended county supervisors and the SamCERA board “for their foresight and decisive actions. SamCERA is now rated as one of the top pension plans in the state, based on their conservative assumptions.”

This story originally appeared in the March 2019 issue of Climate Magazine.