A risk worth taking to cut CalPERS' pension liabilities

One of the major challenges facing the California Public Employees Retirement System, which handles retirement benefits for the state and more than 3,000 local agencies, is that its $324-billion pension fund is about 35% short of the amount needed to cover current and future pension obligations — and that’s using CalPERS’ own assumptions, which critics say are too optimistic. Gov. Jerry Brown and Treasurer John Chiang have suggested a way to chip away at the shortfall, and although it’s no substitute for real pension reform, it’s a step worth taking.

The shortfall happened because CalPERS’ fund hasn’t grown fast enough to keep up with the cost increases caused by the growing number of public employees, higher salaries and the more generous pension benefits the state Legislature and Gov. Gray Davis approved in 1999. Although CalPERS has three sources of income — contributions by workers, contributions by employers and returns on investments — the system counts on investment returns to cover the lion’s share of the costs. But two recessions helped drag returns well below what CalPERS had expected, digging a deep hole of “unfunded liability.”

Because California’s courts consider pension promises to be well nigh unbreakable, state and local agencies can’t reduce CalPERS’ unfunded liability by slashing retirement benefits for their current workforce. So they’ve tried instead not to add to the shortfall, taking such steps as reducing benefits for newly hired workers, negotiating larger contributions from current employees and kicking in more money themselves. CalPERS’ board also agreed in December to gradually lower the amount it expects the fund to earn from 7.5% to 7%, starting next year — a more realistic target, but one that will drive up the pension contributions that workers, local governments and the state have to make.

In the meantime, there’s still the shortfall to deal with. CalPERS duns state and local agencies an extra amount every year in the hope of filling the hole bit by bit, and that extra amount comes straight out of taxpayers’ pockets. But it’s a tough slog: Even as CalPERS pays down its unfunded liability each year, the leftover shortfall grows a bit to reflect the returns CalPERS would have earned on that money if it hadn’t been lost.

Brown and Chiang are proposing to narrow the shortfall by pre-paying $6 billion in pension debt, or about 10% of the unfunded liability on state worker pensions. The state would borrow the money from the pool of cash it uses for day-to-day operations, then repay the in-house loan by 2030 with interest, leaving its coffers a little better off than they would be if the cash had been left unused. That interest rate would be pegged to two-year Treasury bills, which currently earn about 1.3% annually.

The idea is to substitute a low-interest loan for higher-interest debt, much like one might refinance a mortgage. This bit of arbitrage would save the state an estimated $11 billion over time, reducing the amount the state contributes to CalPERS by hundreds of millions of dollars annually. Of course, the savings will shrink if Treasury interest rates rise faster than Brown and Chiang have factored into their proposal, increasing the cost of borrowing the initial $6 billion.

Some critics of the proposal say it’s a bailout for public employee unions, but the money won’t reduce workers’ contributions to the fund. Instead, it will cut the amount that the state and its taxpayers owe CalPERS for its unfunded liability by hundreds of millions of dollars per year.

Others argue that it’s risky to pour all that money into CalPERS at one time. What if the markets tank and CalPERS loses $6 billion or more? Like any investor, CalPERS always runs the risk of an ill-timed bet on the market. That’s a reason to diversify one’s holdings, however, not to keep one’s money in a mattress. Short of an across-the-board collapse, the fund will be better off with a smaller shortfall than the one it has today. The extra $6 billion will give the fund a larger base from which to grow.

Again, the cash infusion would be no substitute for structural pension reforms that put CalPERS and other retirement systems on a sounder footing. Lawmakers shouldn’t convince themselves otherwise. All this step would do is trim the amount that taxpayers ultimately will have to pony up for public-employee retirement benefits already accrued. The savings are likely to be considerable, however, which is why it’s worth taking the risk.

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