It seems that scarcely a day passes when our politicians aren't exhorted to run government like a business, or like a couple pondering household finances over the kitchen table.
Usually this advice is misguided, since government has vastly different concerns and responsibilities from business or the typical household. But California Gov. Jerry Brown and Treasurer
Their idea is to borrow $6 billion from the state’s Pooled Money Investment Account and spend it on an extra payment to the California Public Employees’ Retirement System — that is, make an advance payment to
The money would be repaid over eight to 12 years from the rainy day fund established by Proposition 2 of 2014. Chiang and Brown figure that the one-time payment will save the state and its localities $11 billion during the next 30 years via reduced CalPERS contributions. They say the idea isn't much different from borrowing in the debt markets to make the payment, except in this case the state is effectively borrowing from and paying interest to itself.
The Pooled Money account's investments currently yield about 0.88% a year. The borrowed funds would be paid back with interest pegged to the two-year U.S. Treasury rate, which has been running modestly higher than that (currently about 1.3%). So the Pooled Money account would do a little better and the state, by paying down a rapidly-expanding obligation, would do a lot better.
Thus far, the plan has elicited a fair amount of questions and doubts. The doubts are natural, since any plan based on assumptions about interest rates and investment returns in the future is bound to be packed with imponderables. For the most part, however, the state would be doing what couples do when they judge whether to make an extra mortgage payment on a home loan costing 4.5% a year, or let the money sit in a bank account, which pays a fraction of a percentage point in interest, but at least is there if the money is needed right away.
Indeed, one of the issues recently raised by the state Legislative Analyst's Office is whether it would leave the Pooled Money account too dry if the money was needed in the near term. On the whole, however, the LAO gave the proposal its conditional blessing, finding "budget savings likely, but hard to predict." The LAO recommended that the Legislature take its time appraising the idea: Though the budget deadline is June 15, "there is no reason why this proposal needs to be approved by that time."
The plan resembles a step being taken by the city of Newport Beach, which is boosting its contribution to CalPERS by $9 million in the coming year, raising it to about $43 million, in order to save an estimated $15 million over the following two decades, a period in which its pension obligations are expected to rise by about 7% a year.
"It's like we have a 7% debt out there that we want to pay down as much as we can," City Manager Dave Kiff told me. He recognizes that Newport has financial advantages not shared by many other municipalities, including sales tax income from the upscale retailers at Fashion Island and Newport Center, and the Fletcher Jones Mercedes dealership. "Most of my colleagues are just struggling along," Kiff says of other cities. Still, sales growth at Newport's big retail centers shows signs of flattening out, so the city may have thought it should make the extra payment while it still has the money.
The state has considerably more fiscal flexibility than any city. So let's take a closer look at how this maneuver would work.
First, the hard realities. The state's unfunded pension liabilities are currently estimated at nearly $60 billion. Its annual contributions to the pension fund under current assumptions are expected to nearly double from about $5.8 billion now to $11.2 billion in 2031-32.
The sources of the shortfall are etched into history; they include a period during the late 1990s when CalPERS felt so flush from market gains that it gave the state a contribution "holiday," cutting required annual contributions by more than 80% even as it endorsed increases in pension benefits. When the markets crashed in 2000 and again in 2008, a yawning gap opened in the pension fund. The options for filling it today are to raise taxes, cut services, or deny workers promised benefits, none of which is palatable.
That's the liability side of the ledger. On the asset side, there's the Pooled Money Investment Account, which is currently brimming with $50 billion in state funds, invested in safe, short-term paper yielding a measly 0.88% a year. The account typically is used to help state and local agencies manage their seasonal cash flows, since bills don't always sync up with tax revenues. But its balance is unusually high just now, thanks in part to recent budget surpluses.
Chiang contends that the balance helps make this the perfect moment to exploit the account to help close the pension gap. "Rates are low and we have this incredible surplus," he says. He doesn't think the further study advocated by the legislative analyst is warranted: "I understand that they want more information. But this makes sense now."
What could go wrong? The most outspoken critic of the plan is David Crane, a former investment professional who has served as a University of California regent and (from 2004 to 2010) as a financial advisor to Gov. Arnold Schwarzenegger.
Crane argues that increasing pension contributions is good, but borrowing to do so is bad, especially now. "This is just a leveraged bet on the markets," he argues, when interest rates are near a historic low and the stock market is at a record high. Those conditions increase the risk that the cost of the borrowing will outstrip any gains from paying down the debt, especially since the state will be paying a floating rate on the borrowing. He says the process Brown and Chiang have in mind is akin to borrowing from a child's college savings to fund a parent's bank account.
Crane is speaking from experience: He helped Schwarzenegger craft his "deficit reduction bonds" in 2004 to kick the state's deficit down the road, but acknowledges now that that was a mistake. "Those borrowings … just covered up the problem, with interest to boot," he recently wrote on his blog. He argues that the only proper way to fund the pension red ink is by raising taxes, cutting spending and paring back pension benefits so employees share the costs.
It's certainly true that no one knows for sure what the future holds for interest rates and stock markets. As the legislative analyst observes, over the last 30 years, the annual return of the Standard & Poor's stock market index has ranged from negative 37.22% (in 2008) to plus 32.43% (2013), though its average annual return over that period has been an inflation-adjusted 7.36%. In the same period, the two-year Treasury rate has ranged from above 14%, to almost as low as zero.
So it's possible that the cost-benefit calculation could turn upside down in the time that the loan from the pool is outstanding; as Crane observes, almost no one expected the practice of refinancing one's home to take out cash while housing values were on a permanent curve upward to be a bad bet — until the housing market crashed in 2007.
Chiang may be a bit too unnervingly sanguine about something like that happening again — he says the return from CalPERS investments might fall below the two-year Treasury rate "if the U.S. collapsed, but then we'd have larger problems." So it would be wise to follow the legislative analyst's advice and subject this plan to further actuarial scrutiny. But in a world where nothing is certain, its risk-reward ratio looks like a good bet.