From Wisconsin to California, budget hawks fear out-of-control unfunded pension promises. Employees fear they are being forced to pay for profligate legislators’ mistakes. What should policy be for employees looking to devote their careers to public service? Excerpted from “The True Cost of Public Pensions: Reform or Bust?,” January 25, 2011.

JON COUPAL, President, Howard Jarvis Taxpayers Association
JOE NATION, Lecturer, Stanford Institute for Economic Policy Research
ROXANNE SANCHEZ, President, Service Employees International Union Local 1021

DANIEL BORENSTEIN, Columnist and Editorial Writer, Contra Costa Times and Oakland Tribune – Moderator

 

BORENSTEIN: Were going to be talking about pensions given to employees of state and local government in California. Under these pensions programs, when a worker retires, she receives a set amount each year for the rest of her life; the amount is usually adjusted annually for inflation. The amount the worker originally receives is based on her final salary, the number of years she worked and her age at retirement. Starting back in 1999, the formulas were changed to increase the benefits. The increased costs of those benefits are a contributing factor to the current strain on the pension system.

Let’s look at the other side: To pay for the those benefits, public employers – the government, or more accurately, the taxpayers – make payments to the pension system. In many cases, the employees also make a contribution; in other cases, however, they do not. The idea is that the contributions each year from the employer, in some cases the employee as well, will earn enough interest through investments so there will be enough money in the system to pay the pensions when those workers retire. This, of course, assumes that those investments make money rather than lose money, as they did in a big way in 2008. That market downturn is another big contributing factor to the strain on the current pension system.

How bad is our problem today? Cal

PERS [The California Public Employees’ Retirement System], the state’s largest pension system, had about $227 billion in assets as of yesterday. The problem is that only about 65 to 70 percent of the amount they should have is covered with that money. Put another way, the system is about $115 billion short. CalPERS is but one of many public employee pension systems across the state, most of which face similar huge deficits. What does all this mean? In the future, state and local taxpayers and probably public employees will have to pay more and more into the pension system to make up for that shortfall. That will mean less money to hire public employees, and that will mean less money available for public services. From social services to road maintenance to public libraries to, well, just about any public service you can think of. The question is how we get out of this mess. 

Roxanne, can you tell us how workers see this problem?

SANCHEZ: So first of all, though I hold a title in my union, I would like the audience to know I’ve been a worker all my life and I’m now on full release for the next 9 to 10 months as a representative of the union. So I’m right from the ranks. In 2009 my co-workers in the City and County of San Francisco reduced their earning and wages through concessions by $150 million, that’s several hundred dollars per month, to deal with the economic meltdown of 2008. In the spring of 2010, workers again agreed to lower their earnings by $24 million over two years. So San Francisco city and county workers have lost earnings of close to half a billion dollars over the next three years.

On top of that, we’ve had severe job cuts. The job cuts now put the city of San Francisco at the lowest level ever, at 49.7 percent of the total expenditures going to labor. So you can see the burden on the working class during this economic downturn has been severe, and remember this came off of another downturn in 2001. So workers are anxious; we’re concerned. The pensions that he spoke about from workers that have already retired are modest, about $2,100 a month. Children are moving back into our houses, we’re taking care of our parents, our costs are going up, everything is more expensive. That’s sort of the backdrop; on top of that, millions  have lost their retirement because of the meltdown of the economy, their life savings and 401(k)s. Workers are panicked. What I’m looking for and what will hopefully happen in this discussion is that we all come together and rebuild our country from where it has been taken.

BORENSTEIN: Anxious, concerned, panicked workers. Tell us a little about how taxpayers are seeing this picture.

COUPAL: Those adjectives apply to taxpayers as well. I think the difference is that there is a perception that the public sector – people can agree with it or not – is more protected from the economic vagaries than are taxpayers. Just one example: State employment actually has gone up in the last couple of years. At the same time, California’s unemployment [rate] is 12.5 percent. There is a perception on the part of the taxpaying community that the public sector has not borne its fair share of the pain. We can argue whether or not that’s a fair assessment. I will say right off the bat that my organization, which got its start with Proposition 13, that many of our members are either retired or active government employees, and they want to keep their homes.

So there is this tension, and I think everybody wants the same thing. We want good public services and we want fair compensation. But there is a perception right now that in California the compensation levels are way out of whack both in respect to other public sector groups across the country and certainly in the private sector here in California. That is the problem we are facing; that is the perception that we believe is grounded in large part in reality, that there is a disparity in how much of a haircut the public has taken relative to the private sector.

Another problem we see is some of the abuses in the pension system; the pension spiking, we all know about the city of Bell situation and certainly the city of Bell was a bit of an outlier. But some of those same problems are endemic across California and they need to be addressed in a major way.

BORENSTEIN: Joe, you’re the academic here, a former politian. Which side has the right reality?

NATION: As a politian I’ll say they’re both right. The question both sides have to ask and answer is: Is the system healthy? Is the system sustainable? Is the pension system something we can count on 5, 10, 20 years down the road?  There is a growing recognition on both sides of the discussion that the system is in trouble. Then I think you have to get to that second layer of questions where you start talking about benefits, you talk about portfolios, investments, governance and so forth.

But the first question has to be: Will the system survive? The work that we’ve done at Stanford suggests that the shortfall at the state level and municipal level combined could be as much as about $700 billion statewide. To put that into perspecttive, the general fund budget request from Governor Brown is $84 billion. So, $84 billion, a potential shortfall of $700 billion, Houston, we have a problem.

BORENSTEIN: What happens when you go back to your members? Do they understand this? How do they see it, and how do you see it?

SANCHEZ: One of the reasons that we ran a group of working people to these positions in our union is to get involved in the discussion and debate from our experience. Because the perceptions just aren’t our reality. 

But I want to look at historically what impact pensions and pension funds have had on the economy. If we look at the period between 1990 and 2002, pension funds supplied about 44 percent of the new venture capital, endowments and foundations were the second largest with about 17 percent, and then insurance companies and financial companies at about 16 percent. So if you look at that investment in venture capital, you have to look at the fact that pension funds fueled the growth and development of small companies and new products and technologies for over a decade. That’s the contribution that these pension funds have done for our economy.

Now the economy is a mess. Pension funds are part of the economy, and obviously they are affected. But that doesn’t mean that the pension funds are the problem. The reform [we need] is broader than pensions; it has to be a broader financial reform.

BORENSTEIN: Jon, how do you see that?

COUPAL: As it relates to the pension funds, you know the major pension funds have invested a lot – PERS [Public Employees’ Retirement System], STRS [State Teachers Retirement System] and the counties – but the question is: Have they invested wisely? Have they made the decisions based on the interests of their members? Oftentimes some of these investments are made with political motivations, and some of the investments of STRS have been horrible. Part of the problem that taxpayers see is that when bad decisions are made, the pension system knows that the taxpayers are there to make up the shortfall.

You always have the taxpayers in a defined benefit program, constitutionally mandated to make up the difference if PERS and STRS goes belly-up. And that’s what were seeing right now. By the way, we’re all for public employees getting a really good pension, but we believe that the ultimate answer is to have those pension benefits granted in the form of defined contribution like 401(k)s and not in these defined benefits. Now, people say 401(k)s are risky. If each individual employee owns their own 401(k), they could accept whatever investments and accept whatever risk tolerance they wanted. For example, you could have a 401(k) that invested in nothing but Treasury bills, that would be absolutely guaranteed not to lose money. Would you get the 12 percent return? No, but perhaps you shouldn’t. Here’s the question: Why have taxpayers assumed the risk of not only the losses of their own retirement funds but also the potential losses of the public employees that are guaranteed a rate of return? That is the disparity, and we believe that the ultimate answer is the shift to very generous defined-contribution plans that would take away some of the political master machinations of these public employee pension funds that oftentimes have not acted in the best interest of either their members or the taxpaying public.   

BORENSTEIN: What are some of the options to fix this system in California?

NATION: The first thing that is really critical is the pension fund managers and actuaries need to change the assumptions they employ. Currently, according to [Governmental Accounting Standards Board] rules, pension fund managers say, “If we’re going to earn 7.75 percent, then we’re going to discount our liability at 7.75 percent.” The math works out really nicely if they do that. But the problem is that, because these are guaranteed payments, you really have to value these liabilities at something other than 7.75 percent. You have to value them at something probably much higher. It’s a somewhat esoteric argument among economists and actuaries, but if you were to do that and change the way they account for this – truly value those liabilities at what you should value them – then pension funds would be horribly underfunded. The work that we’ve done suggested that they are not 70 or 80 percent funded but closer to 40 or 50 percent funded. They’ve got a dollar for every two dollars they owe.

BORENSTEIN: People should know that the work that Joe has done on this is somewhat controversial. There is a debate as to what the proper rate of return is.

NATION: Not among economists; among economists and actuaries there is. So that’s one thing.

BORENSTEIN: Let’s take that option before we confuse people with other things. If you reduce the assumed rate of returns, that would mean that both the employee and employer would have to kick in more going into this system. Roxanne, how are your members going to react if they’re asked to kick in more if the assumed rate of returns is reduced?

SANCHEZ: Like all working people that are strapped for money. Let’s look at the San Leandro school workers who get between $11.55 and $29 an hour and contribute about 7 percent of their total wages to their pension. Let’s look at the jurisdictions where they’re already paying $800 a month for their pensions. Look at how we’re talking about significant problems and significant issues, but the most significant problem is the drop in investment return, which means our most significant problem is that our economy, our economic system, is in shambles. It’s in total disarray.

The real reform has to be much broader. You can tweak reform and take more out of our pockets and we’ll buy less and will suffer more, but that’s not fixing our economy. Millions of Americans have already lost their retirements, but has that fixed our economy and society?

This is not the way to look at fixing a problem that’s facing all Americans. We need to look at a retirement system, whether our system or Social Security, that gives us what we require and have worked for all our lives, which is financial protection.   

BORENSTEIN: I want to let Jon respond to that and address the rate of return issue.

COUPAL: I’ll just talk about the rate of return issue; it’s a huge problem. There are a number of bright economists and investors that think we’ll experience a huge double-dip recession and plunge right back into another depression. They’re looking at all the debt load. We’ve got other economists that think we’re on the verge of another recovery. They’re all brilliant people, but the thing is, we just don’t know. That is why, when you try to determine rate of returns, it’s so difficult.

The problem is when we’re in a boom cycle, you have a horrible situation, that is, a public employee fund that is a ton of cash within arm’s reach of politians. What happens is the public employee labor unions figure out a way to say, “It’s so overfunded right now, we can bump up benefits.” There were people back when Senate Bill 400 came up that said we couldn’t do this; it’s one-time money. But a lot of them voted [for it], including Republicans, and they shouldn’t have. Everyone thought it was a free lunch. That’s the problem with trying to determine rates of return.

NATION: Should funds assume that they’d get a 7.75 rate of return? They do that because they say from 1982 to up until recently that’s what we got. Well, 1982 until 1999 was the biggest market run-up in the history of the planet.

If you look at the time between 1900 to 1999, the beginning and the end of the century, the return is about 6.15 percent. So if a fund [expects] a return of 6.15 percent from the capital market, that’s probably a reasonable number to use.

Another issue has to do with the type of investments. There is probably tension growing between pension fund managers to reach a little more, to be a little riskier. People need to understand that if you chase a rate of return of 10 or 12 percent, you may get a return that may get you 10 or 12 percent one year but may also get you a negative 20 percent the next year.

SANCHEZ: Yeah, I think there is truth in what all three of us are saying.

BORNSTEIN: OK, but I want to stay with the specifics here. Jon, should the rate of returns be more conservative?

COUPAL: I agree with Joe they need to lower their sights. That also cuts to the issue of governance, who’s on the board of directors of PERS and STRS? Again, no slam on labor, but if it’s labor dominated they have a certain agenda in respect to their investment choices and it may not be in the best interests of their members if the taxpayers weren’t backing it up. But because taxpayers are always backing it up, these pension board members can pursue a political agenda without fear of retribution from their members, because taxpayers are always able to back them up. 

BORENSTEIN: Joe, what’s the next possible solution?

NATION: The next issue is governance and transparency. If you are on a board of supervisors in California and you come up with a pension benefits program for your rank and file workers, you get the same plan. So you get a member on the board of supervisors who thinks, “Wow, this plan is kind of generous,” but then says, “That’s ok, because I get the same plan.”

It’s outrageous that we have a system that has that sort of conflict of interest. I think that there are some issues with these boards of pension funds. I think there needs to be minimum requirements for financial investment experience and so forth, which just doesn’t exist today.

The other issue is transparency. Pension fund managers ... ought to just say, “This is what we invested, this is what we owe; if you need some information I’ll provide it to you.” I think there is a lack of transparency because there have been some allegations – in fact, there have been some indictments in some parts of the country about kickbacks to board members and so forth. So I think they are trying to hide some of those transactions.

BORENSTEIN: Joe, talk about increased contributions.

NATION: I don’t think there is any doubt that there will need to be increased contributions from both workers and employers. Some jurisdictions are asking workers to contribute more, but the contributions are so slight. In Marin, where I live, workers are contributing not 1 percent but 2 percent to their pension, the city is contributing about 20-25 percent. So clearly there will have to be some sort of increase in contributions from employers and employees.

SANCHEZ: That’s something employees are doing. You have to understand that the shift of cost is always on the workers, so we’ve taken concessions consistently over the last decade. The concessions we’re taking are in pay, benefits, pension, furloughs; we’re working with far less people so our workload is far greater. So we are paying for it.

BORENSTEIN: Joe, real quick explain another solution, the two-tier solution?

NATION: The two-tier system is one were the employee continues to receive the same benefits, salary, pension, etcetera, and a new employee will receive a lower salary, pension, etc.

BORENSTEIN: If we went to a two-tier system everywhere, would we solve the problem?     

NATION: No, the numbers are so large and even if you hired someone today with a reduced benefit, they wouldn’t retire for another 30 years, so you really don’t get a decrease until that person retires.    

BORENSTEIN: Jon, two-tier?

COUPAL: I think two-tier has to be a big part of it. Theoretically, if the fund performance just went bonkers coupled with substantial economic growth in California, we could get out of it. But it’s a real longshot, so second-tier is definitely needed.