The official, Brad Hudson, is right that public pension costs are growing, but not that investment losses are to blame. To the contrary, these expenses are rising despite gains in pension-fund investments.

If not because of investment losses, what’s the reason?

Let’s start by assuming you left the Earth on Dec. 31, 2007, returned June 3, 2013, and had no news in the interim five-plus years.

When you left, the Dow Jones Industrial Average stood at 13,264. On your return it was 15,252, up 15 percent. Dividends provided an additional 2 percent each year. Fixed-income investments did even better because interest rates declined while you were away, with AA corporate bonds producing returns bettering 8 percent per annum.

From your perspective, it looks as if investments did just fine during your trip. And for long-term investors, you would be right. For example, the assets reported by the largest U.S. public pension fund, the California Public Employees’ Retirement System, are greater today than in 2007. So to whom is Sacramento County’s executive referring?

He’s referring to short-term investors who were forced to sell at the wrong time. Handed a newspaper from 2009, you learn that the country suffered a recession while you were away and that at one point the stock market dropped below 7,000. When that happened, short-term or leveraged investors who had borrowed money to buy stocks suffered investment losses when they were forced to sell equities at low prices.

Long-Term Investors

That category of investor doesn’t include public pension funds. They don’t have short-term liabilities and aren’t forced to sell at the wrong time. Instead, they are invested for the very long term — decades — and are run by professional investors with the expertise to take advantage of market volatility. They are more like Warren Buffett’s Berkshire Hathaway Inc., another long-term investor that isn’t forced to sell when prices decline and has the resources to take advantage when prices fall.

The reason for rising pension costs has nothing to do with the recession or short-term declines on Wall Street. Public pension costs are increasing simply because liabilities are growing faster than assets.

Calpers is a good example. As an intermediary that administers pension promises made by the state of California and other public-sector employers to their employees, it collects contributions from employers and employees, invests those funds to generate earnings, and uses the proceeds to pay benefits to retired employees.

In 2007, Calpers reported that the pension liabilities of its largest pool of employers totaled $248 billion. By 2011, just four years later, those liabilities had grown 32 percent, to $328 billion. That rapid growth happens because pension liabilities grow (“accrete”) at the rate used to discount those obligations to present value, which at Calpers is a very high 7.5 percent per year. Pension assets must grow at that “hurdle” rate or pension costs rise. For example, to meet the rate at which pension liabilities were increasing in 2007, Calpers needed the Dow to reach 20,000 by now. Because it is at 75 percent of that level, pension costs must rise to make up the difference.

This isn’t a new phenomenon. To meet the rate at which pension liabilities were growing in 1999, Calpers needed the Dow to reach 30,000 by now. Because it is half that level, California has spent $20 billion more on public pensions than would have been the case had pension assets grown at the hurdle rate.

Hurdle Rates

It’s very hard for Calpers, or any other professional investor, to grow at such a high rate, which is almost double the rate at which Buffett’s pension liabilities accrete. Looked at another way, the Calpers hurdle rate is almost 15 percent greater than that at which the typical portfolio of pension investments grew in the 20th century. Calpers is a good investor, but the odds are against outperforming markets for decades, especially for very large investors.

Because public pension liabilities continue to grow faster than assets, Calpers recently announced a 50 percent increase in pension costs for governments, starting in 2015. For the same reason, Sacramento County needs to spend more on pensions to keep up with the growth of its liabilities.

Public officials need to be clear with their constituents that pension costs rise whenever pension funds fail to earn their hurdle rates. They should also acknowledge that total costs would be lower if the funds reduced their hurdle rates and required larger upfront contributions when pension promises are made.

That way, more money would be invested earlier, reducing the need to outperform markets. That shift would also be fairer to future taxpayers, who get no benefit from the services provided by past employees but have to cover pension deficiencies when hurdle rates aren’t met.

(David Crane, a former financial-services executive, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011.)

Link to full article: http://www.bloomberg.com/news/2013-06-16/california-s-misleading-pension-losses-.html

The California Teachers’ Retirement System, CalSTRS, administers pension promises made to teachers by their employers, which are school districts. CalSTRS is an intermediary that collects contributions from districts, teachers and the state, invests those contributions to generate earnings, and uses the proceeds to pay out benefits to retired teachers.

Everything works fine when contributions + earnings = benefits. But when earnings fall short, a deficiency is created that, because defined benefit pensions are owed regardless of investment performance, must be paid off. To do that, CalSTRS is seeking a cash infusion from its contributors of $4.5 billion per year for 30 years, or $135 billion. That’s on top of the $5.7 billion it already receives in contributions each year from those contributors.

Not meeting the request is the equivalent of borrowing money from a loan shark because, according to CalSTRS, the deficiency grows by $6.2 billion every year the $4.5 billion isn’t contributed. It’s also fatal, because without the infusion, CalSTRS says it will run out of money by 2044. Some observers believe that CalSTRS will run out of money in the 2020s and needs more than $135 billion but, either way, everyone agrees CalSTRS needs a lot of money and the sooner that money is contributed, the lower the cost.

When CalSTRS runs out of money, a huge wave will hit school districts. That’s because districts will then be responsible for 100 percent of pension payments, which are owed in amounts far greater than contributions and for many decades after 2020 and 2044. Those pension payments will swamp district budgets, leaving less for the classroom. School districts will exist largely to pay retirement costs, not to teach children.

Unlike the California Public Employees’ Retirement System, CalPERS, which administers retirement benefits for the state and other governments, CalSTRS can’t just send a bill for the deficiency. Instead, CalSTRS’ funding is set by state statute. The governor and Legislature haven’t updated the statute to reflect the shortfall, so contributions have failed to keep up. As a result, the deficiency keeps growing – as does the height of the wave that will hit the districts.

Brown has been silent on teacher pension funding. The cynic’s view would be that’s because he knows that the wave won’t hit during his tenure. But that’s terrible financial management since every $4.5 billion not contributed in cash means an additional $6.2 billion of debt and increases the height of the wave. If Brown doesn’t act on CalSTRS’ request before he likely leaves office, the wall of teacher pension debt will grow by $43 billion.

As with climate change, pension problems grow invisibly and then become unsolvable when they manifest. If CalSTRS’ debt is allowed to keep growing, funding for classroom instruction will be destroyed. To restore that funding, citizens at that time will likely seek cuts in pension payments to retired teachers who rightfully expect to receive what they were promised. The only way to prevent these consequences is to fund in advance, and the further in advance, the smaller the payments.

That solution takes a courageous leader, one who acts before problems are visible and tells truths citizens don’t want to hear. That’s why the state should use its unexpected revenue this year to kick-start a global agreement on CalSTRS, which must include reforms and increased contributions from the state, school districts and employees.

Another reason to act now is that time is not on the state’s fiscal side. It has extra revenue this year, but its own pension bills from CalPERS are going up by 50 percent in 2015, the state expects higher Medi-Cal costs, the Proposition 30 tax increase expires in 2019, and stock and real estate prices won’t go up forever.

In 2002, Warren Buffett warned that derivatives were financial weapons of mass destruction. When later they exploded, we wondered why authorities did not act earlier. In 2008, the same Buffett warned about public pension-cost surprises. When that happens and wipes out K-12 education, people will ask why authorities did not act earlier. After all, they were warned.

Brown should use the new revenue to address the teacher pension shortfall. If not now, when?

David Crane is a former CalSTRS board member. He is a lecturer at Stanford University and president of Govern for California.

Link to full article: http://www.sacbee.com/2013/05/30/5457102/unexpected-state-revenue-should.html

It has been 35 years since California voters overwhelmingly approved Proposition 13, a measure that, as Governor Jerry Brown put it in 2011, “started the centralization of power” in the state. He should know because he was also governor in 1978 and helped oversee that shift.

At the time, Californians were enraged that their inflation-fueled home values were accompanied by rising local property taxes. The referendum limited those taxes to 1 percent of their property’s value.

At the time, advocates of Proposition 13 claimed it would limit government spending. They were wrong. Proposition 13 simply shifted revenue collection from localities — which rely on property taxes — to Sacramento, the state capital. Taxation moved from relatively stable property taxes to erratic income taxes and regressive sales levies. By moving to income taxes that treat capital gains as ordinary income, California raises much of its revenue from a boom-or-bust system.

That’s why state revenue is rising today as the stock market reaches new highs, just as state revenue rose alongside robust markets in 1999 and 2007, allowing Governors Gray Davis and Arnold Schwarzenegger to temporarily proclaim the budget balanced, just as Brown can do now.

When stocks fell, however, revenue tanked. As an example, when California’s economy shrank by 2.8 percent in 2009, state revenue contracted by 10 times as much because of the larger decline in stock markets.

Uncertain Revenue

Those temporarily balanced budgets were followed by years of deficits and tax increases. In the absence of reform, that will inevitably happen time and time again.

The state also moved to rely more on sales taxes on goods, raising the rate by more than 60 percent since 1970. In parts of California, the sales-tax rate on goods exceeds 9 percent. This system is inherently regressive, because low-income people spend a much larger share of their incomes than wealthy people do on the consumption of taxable goods.

There is a solution.

The California Legislature and Brown could adopt a sweeping tax-reform measure combined with a request to voters to repeal Proposition 13 (only the electorate has that power). Legislators already have two tax-reform models in front of them, one from the Commission on the 21st Century Economy, and the other by the Think Long Committee for California. To varying degrees, they reduce sales- and income-tax rates, and they impose sales taxes on services and severance levies on oil and gas.

Yet neither of those proposals would do anything about repealing Proposition 13. That leaves untouched a significant source of stable revenue and fails to tax real estate, California’s biggest industry, which, because of the state’s climate and other advantages, would still attract capital, even with higher property taxes.

It’s crazy to tax incomes and goods that can move to other states but be barred from raising levies on real estate and resources such as oil that can’t be moved. Accordingly, no California reform would be complete without enacting a severance tax and getting rid of Proposition 13.

Repealing it might seem politically impossible. Homeowners who are worried about higher property taxes would have to be guaranteed a long phase-in period, low increases and meaningful cuts in sales- and income-tax rates.

Governments would first need to reduce pension and health-care liabilities because, if not, most of the new revenue raised from lifting Proposition 13 would go to retired employees, instead of to current services. Of course, there would be opposition from oil and gas companies, commercial-property owners and government employees.

Overcoming Opposition

Overcoming their opposition would require a great politician. No one would play that role better than Jerry Brown. He has high approval ratings, and he knows he won’t solve the state’s core budget issues — or fulfill his dreams for high-speed rail and other legacy-building projects — unless he addresses the tax system, pensions and health care. If he seeks and wins re-election in 2014, what else could be more important?

To his credit, Brown has started to move government closer to the people by devolving some functions from the state to local governments. Now he needs to devolve revenue generation, as well. Doing so would move more power to local governments and school districts.

He will have allies: environmentalists who favor taxes on fossil fuels, local governments and school districts desperate for more control over their affairs, education reformers who support decentralization, anti-poverty advocates keen to shield welfare and other government aid from being siphoned off for pensions and health-care costs, businesses and taxpayers attracted by lower sales- and income-tax rates, and good-government groups in favor of more local control. Even conservatives are beginning to understand that Proposition 13 moved power to Sacramento and, if anything, boosted spending.

I worry that Brown wants to run for president before the next California budget crisis rears its ugly head. Yet who else can take responsibility for creating a sustainable revenue system and establishing effective government in California?

(David Crane, a former financial-services executive, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011. The opinions expressed are his own.)

To contact the writer of this article: David Crane in San Francisco at davidgcrane@gmail.com.

To contact the editor responsible for this article: Katy Roberts at kroberts29@bloomberg.net.

Link to full article: http://www.bloomberg.com/news/2013-05-19/jerry-brown-s-last-chance-to-save-california.html ]]> http://davidgcrane.org/?feed=rss2&p=1167 0 http://davidgcrane.org/?p=1126 http://davidgcrane.org/?p=1126#comments Thu, 28 Mar 2013 01:14:44 +0000 David Crane http://davidgcrane.org/?p=1126 What if a corporation raised $500 million in a securities offering on the premise that the proceeds would go for operating expenses, then disclosed a few months later that $300 million of this amount would instead be used to service a debt that wasn’t disclosed in the offering document?

This would be false advertising, subject to sanction by the Securities and Exchange Commission. Unfortunately, the SEC doesn’t have jurisdiction over state politicians engaging in the same behavior, and, in the case of California, involving sums that are 100 times bigger.

Last November, California politicians persuaded voters to support a proposed seven-year, $50 billion tax increase, largely on the vow that the money would go to public education. The first five words of the initiative’s title were “Temporary Taxes to Fund Education.”

Now, just four months after the election, the state’s Legislative Analyst’s Office has announced that the California State Teachers’ Retirement System requires an extra $4.5 billion a year for 30 years — $135 billion — to cover its unfunded liability for teacher pensions and that the money will have to come from some combination of school districts and the state. To the extent that it comes from the school districts, $4.5 billion a year is 167 percent of the annual amount those districts expected from the tax increase. To the extent that it comes from the state, $4.5 billion is more than 100 percent of the annual amount it expected in new revenue.

Inflated Investments

Either way, more than $30 billion over the next seven years will go to the service of a debt that wasn’t disclosed before the voters were asked to approve the tax increase.

None of this is a surprise to longtime observers of many teacher pension funds and of Calstrs specifically. It’s just as I predicted a year ago on Bloomberg View, as the Volcker-Ravitch report on California’s budget outlined last year, and as Bill Gates explained in a 2011 TED talk.

It’s also no surprise to state officials. On the day the proposed tax increase was announced in early 2012, I raised the issue with the leaders of California’s State Assembly and State Senate and later with Governor Jerry Brown, and surely all were aware of the Volcker-Ravitch report.

Worse, the $4.5 billion-a-year requirement is based on the teachers retirement fund’s self-reported unfunded liability, which in turn is based on Calstrs’s self-chosen and unrealistically high investment-return assumption that implicitly forecasts the stock market to double every 10 years. Anything less than that and the cost to service the unfunded liability will be higher (even that frothy assumption presumes bond yields will rise to levels exceeding their current levels and will do so without crushing the principal value of Calstrs’s existing bond portfolio).

To put the far-fetched nature of this annual investment-return assumption in perspective, it’s almost 15 percent higher than the investment return that Warren Buffett assumes for his pension funds, which not only are invested under Buffett’s
direction but also are, in size, a tiny fraction of Calstrs’s portfolio and therefore much easier to compound at higher rates of return.

That’s why financial economists working for the Volcker-Ravitch report said last year that, under a more reasonable earnings assumption, the cost to meet the retirement fund’s unfunded liability is closer to $7 billion a year.

Nondisclosure of Calstrs’s liability before the tax vote continues a pattern of deception about California’s pension obligations.

In 1999, California legislators enacted a huge retroactive increase in pensions without voter approval and based upon an assertion by the California Public Employees’ Retirement System that there would be no cost from the increase.

Hiding Risks

Not surprisingly, that prediction — which implicitly forecast the Dow Jones Industrial Average to reach 30,000 by now — didn’t come true, with the result that the pension increase has already cost the state more than $20 billion, with tens of billions more to come. Recently, internal documents exposed that Calpers knew of this risk but chose not to disclose it to the public.

Teachers, who don’t receive outlandish wages or pensions, didn’t cause this problem, and the good news for them is that they will get their pensions because the state is legally required to back up school districts if they can’t meet their commitments.

Likewise, this problem wasn’t caused by defined-benefit pension systems, which can work perfectly fine so long as promises are funded properly when they are made.

But many politicians don’t want to fund pension promises properly. Most want to keep doing the opposite so they can keep making promises that can’t be kept, except at great expense to innocent people down the road. (Some of these politicians voted to remove me from the Calstrs board seven years ago after I
repeatedly said investment-return assumptions must be reasonable and contributions must be raised.)

There’s no free lunch here. To the extent that school districts pick up the cost, kids in school today will be hurt because more dollars will go to pension costs and fewer dollars will go to classrooms. To the extent that the state picks up the cost, residents will receive fewer services. Either way, voters will get little for the tax increase they approved in November.

(David Crane, a former financial-services executive, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger
from 2004 to 2011. The opinions expressed are his own.)

To contact the writer of this article: David Crane in San Francisco at davidgcrane@gmail.com.

To contact the editor responsible for this article: Katy Roberts at kroberts29@bloomberg.net.

Link to full article: http://www.bloomberg.com/news/2013-03-27/california-s-new-taxes-are-paying-for-pensions.html

A recent report by California Common Sense, a nonprofit research group, describes how state finances changed over that period. (Disclosure: I am on the organization’s board.)

State revenue is expected to be $139 billion in 2013-14, a gain of $11 billion from 2007-08. This isn’t surprising, given that California raised the top income-tax rate to 13.3 percent from 10.3 percent, increased the sales-tax rate to 7.5 percent from 7.25 percent and boosted regulatory and other fee collections by 36 percent.

In light of the growth in revenue, one might expect spending on public services to be back at the levels of six years ago, if not higher. Recovery in this spending is important because in the U.S. federal system, it is the states that do the blocking and tackling. They “have the principal responsibility for most domestic governmental functions including education, safety, health, infrastructure, administration of justice and implementation of the social safety net,” as Paul Volcker, the former Federal Reserve chairman, and Richard Ravitch, the former lieutenant governor of New York, put it in their 2012 report on state budget crises.

Yet in California, spending on many of those services will be lower than six years ago. Social services, including welfare, will receive $1.3 billion less. The state will contribute almost $900 million less to the University of California and California State University. Even K-12 education will receive no more than it did six years ago.

Tuition Doubles

To make up the difference, citizens are paying more. Tuition doubled at California State University and more than doubled at the University of California. State park fees and court-filing fees cost 56 percent and 36 percent more, respectively.

Where did the revenue increase go? In short, to health care, employee compensation, retirement benefits and debt service. State spending on health care, almost $28 billion, will be 62 percent higher than in 2007-08. (Including federal funds, the state will spend more than $60 billion on health care.) Spending on salaries and retirement costs has been boosted by 18
percent to $23 billion a year (or more if university salaries are included). Debt service is up by 23 percent to $5.8 billion a year.

Spending on those categories is destined to keep growing for five reasons:

First, California has opted to expand Medicaid eligibility under the federal Patient Protection and Affordable Care Act, a step that, according to the RAND Corp., will increase state spending by as much as $4 billion a year starting in 2016, on top of normal growth in health-care costs.

Second, even after the recovery of investment markets, unfunded pension liabilities officially grew by $80 billion over the six years because pension liabilities increased faster than pension assets. (As measured by financial economists, pension liabilities rose even more.) Public-pension funds must not only make up for lost ground but also grow at a high rate or fall
even further behind. As a result, pension costs for governments will keep rising.

Third, the California State Teachers’ Retirement System is seeking a source for an extra $4.5 billion a year in pension contributions (and more if it doesn’t achieve its unlikely earnings target). To meet that need, the state faces a dilemma. If school districts put up the money, $4.5 billion is more than those districts will receive in total each year from the tax increase passed by California voters in November, which means that new tax revenue won’t make it to the classroom. If the state puts up the money, $4.5 billion is more than the state’s share of that tax increase, which means more crowding-out of state services.

Unfunded Promises

Fourth, because the state doesn’t pre-fund health care for retired government employees, it has officially built up an additional $80 billion in unfunded promises. As more of the aging workforce retires, pay-as-you-go health costs for retired employees, which rose more than 60 percent over the six-year period, will keep growing rapidly.

Fifth, the state has issued $28 billion of general-obligation bonds since 2007, a 56 percent increase, and Governor Brown has ambitious plans for California’s transportation and water systems, subject to voter approval. (Unlike spending on health care, employee salaries and retirement benefits, voter approval is required for the issuance of bonded debt.)

California proves what Volcker and Ravitch concluded in their report, which is that state revenue simply cannot keep up with the rates at which health-care and employment costs are growing. Failure to address those problems portends even more tax and fee increases and the loss of public services.

To his credit, Brown has called for a special session on state health-care spending. He knows those expenditures must be addressed if other services are to be maintained. It remains to be seen what he intends to do about compensation and benefits.

California’s 2007-08 balanced budget was followed by five years of deficits, four tax increases and several fee boosts, proving yet another point made by Volcker and Ravitch: State and local governments must go beyond deceptive cash-basis budgeting to provide open, detailed and honest accounting. Then, to truly balance their books for the long haul, they must address root causes of deficits.

(David Crane, a former financial-services executive and a Democrat, is a lecturer at Stanford University and president of
Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011. The opinions expressed are his own.)

Link to full article: http://www.bloomberg.com/news/print/2013-02-20/california-a-high-revenue-low-services-state.html

For Californians, rapid growth in retirement costs has meant less money for universities, parks, courts and other services as well as a temporary tax increase in 2009 and another being proposed currently (one of three proposed tax increases on the November ballot – Propositions 30, 38 & 39). In the absence of reform, that share will grow, which means even more taxes and fewer services.

California’s general and special fund spending for 2012-13 is budgeted at $131 billion and effectively fits into three categories: Non-discretionary, Fiscally-protected and Discretionary.

Allow me to explain all three in layman’s terms:

• Non-discretionary spending consists of constitutionally-protected spending for K-12 education, community colleges and voter-approved general obligation bonds; special fund spending dedicated to specific purposes, such as for parks, environmental protection and motor vehicles; and court-ordered spending, such as on prison healthcare.  Legislators have little control over Non-discretionary spending, which this year amounts to more than $80 billion. One exception is for the state employees’ salaries that make up a portion of that spending.  Over the past ten years, legislators allowed salaries to grow 46% – more than the 36% growth in overall spending, but less than the 54% growth in revenue over that period.
• Fiscally-protected spending consists of state spending on Medicaid (known as “Medi-Cal” in California). Reductions in state spending on that service would result in reductions in federal support and thus produce no net budget savings.
• Discretionary spending, which for Fiscal Year 2012-13 amounts to $28 billion, or 22% of general and special fund spending, consists of everything else, including but not limited to pensions and other retirement costs; support for the University of California and California State University systems; prison spending not required by courts; spending on K-12 and community colleges in excess of amounts constitutionally required; discretionary health and human services spending; and non-special-fund spending for parks, courts and other services.  It is with respect to Discretionary spending that elected representatives make all the decisions.

Based on enacted budgets, here’s how legislators chose among major categories making up more than 80% of Discretionary spending in FY 13:

As the chart makes clear, over the past decade legislators chose in favor of retirement benefits, prisons, K-12 and colleges – and against universities and taxpayers (the 2009 tax increase).   Presumably citizens would be pleased that legislators chose in favor of schools and colleges and perhaps public safety (though more than 50% of prison costs go to salaries, which grew rapidly), but not so that legislators chose in favor of retirement benefits, and to the point that more discretionary money is going to retirement costs than to schools and colleges.

Because Discretionary spending is just 22% of total spending, the growth of a relatively small portion of the total state budget can have a big impact on other programs.   In FY 03, retirement costs consumed 2.84% percent of total spending, which at that time translated into 7.86% percent of discretionary spending.  Ten years later, their share of the total budget had less than doubled, to 5.06%, but nearly tripled as a share of discretionary spending, to 23%.   Not surprisingly, university tuition more than tripled and class sizes grew larger.

It doesn’t have to be this way.  Legislators can reduce retirement costs.  To do that materially, they must reduce un-accrued benefits for current employees. But to date, they have only reduced benefits for future employees, which has little budgetary impact and even then not for decades.  Worse, in 2011 the state walked back from a 2010 agreement requiring employees to contribute to their healthcare.  Worse yet, legislators now claiming to be interested in reform are talking only about so-called “abuses” such as “spiking” and “airtime,” which make for great headlines but have nothing to do with the retirement cost explosion.

Retirement costs are exploding because politicians made promises – even retroactively – to state employees totaling hundreds of billions of dollars without voter approval and without setting aside enough money to meet those promises.  Big bills are now coming due and they’re going to be much bigger.

It would be wonderful to collect from those politicians – there are some very familiar names in that mix — but they have immunity. Everyone else, including the public employees receiving those benefits, is innocent, but the burden has fallen only on citizens, taxpayers and future employees.  It’s not fair to any of them, but it’s time for current employees and retirees to share in the sacrifice.

Alicia Munnell, director of the Boston College Center for Retirement Security and formerly a member of President Clinton’s Council of Economic Advisors, recently reported on steps taken by other states to reduce benefits for current employees (the Center’s also looked at the funding status of states’ public plans). Those are the types of steps that must be taken in California if the burden of unfunded retirement promises is to be shared by all.

Some current employees claim that California law won’t allow changes to un-accrued benefits. But as Munnell explained and Amy Monahan of the University of Minnesota recently outlined, pensions are not constitutionally protected and current case law hangs on a thin and flawed thread.  California’s Legislature should make it clear that the state has the power to adjust un-accrued benefits – and then act to do exactly that.

With the promise of action by month’s end, California’s lawmakers have an opportunity to do something of enormous benefit for their citizens by enacting real retirement benefit reform.

They should seize the moment.

David Crane is a lecturer in the Public Policy Program at the Stanford Institute for Economic Policy Research (SIEPR) and president of Govern for California.

Link to full article: http://www.advancingafreesociety.org/eureka/with-retirement-costs-consuming-one-fifth-of-discretionary-spending-california-must-reduce-un-accrued-pension-benefits/

Read more: August 2012 SIEPR Policy Brief

Solving California’s budget woes requires addressing five root causes: unfunded health-care promises to retired employees, excessive incarceration rates, a boom-and-bust revenue system, underfunded pension commitments and fast-growing spending on Medicaid.

Except for alterations to Medicaid (which requires agreement from the federal government for material changes), the Legislature and governor have all the power they need to address these causes. They just need to use it.

This article looks at the role of retiree health care, technically known as “other post-employment benefits.” Visible state spending on these benefits grew at a 12 percent annual rate from fiscal year 2001-02 to 2011-12, but there is even greater invisible spending.

The state promises post-retirement health and dental coverage to its employees as part of an exchange for employee services rendered. Accounting standards suggest that these benefits be financed when the exchange occurs (known as “pre- funding”) rather than after the employee has left active service (this is called “pay as you go” or “pay-go”).

Double Whammy

If the cost isn’t pre-funded, then the cash has to come out of later budgets that get hit with a double whammy: The state gets no benefit from the services it is paying for and has to cut other programs or employees and/or increase taxes to make room for the payment. That is what is happening now.

California isn’t alone in facing this challenge. According to the Pew Center on the States, states owe more than $600 billion of unfunded liabilities for retiree health-care benefits. A few states, such as West Virginia, have taken meaningful steps to pre-fund them, but California is one of 17 that set aside no money. In 2011, it even abandoned a commitment made in 2010 to do so.

The pay-go system used by California means state budgets don’t report the financial effects of the benefits until they are actually paid. According to the Governmental Accounting Standards Board, which sets standards of accounting and financial reporting for U.S. state and local governments, that means those budgets don’t reflect full costs as they are incurred, liabilities for promised benefits for past services or — of particular relevance to California’s proposed tax increase — growing demands on future cash flows to meet those promises.

California’s budget for the last fiscal year (ended June 30, 2012) illustrates this misleading practice. The budget reports that $1.5 billion was spent on retiree health care, but the full cost — $4.74 billion — is found in a report issued by the state controller. The difference — $3.2 billion — is just as much of a cost as the reported expense. But since it wasn’t paid in cash, it becomes an unfinanced liability that will demand payment from future budgets.

These retiree health-care promises at the state level, which aren’t approved by voters, now amount to more than $60 billion in California, almost half of the general-obligation bond liabilities approved by voters. Deliberately or otherwise, the health-care obligations aren’t well publicized by the state, showing up on the controller’s obscure report but not on a report issued by thestate treasurer that claims to measure the state’s debts. Like off-balance-sheet debt in the corporate world, these liabilities are findable only by those who know where to look.

Eliminated Benefits

They are a big drain on budget cash, as has been made painfully clear in cities such as Stockton — which also financed the retiree health care of its public employees on a pay-go basis and recently entered bankruptcy partly because of these obligations. Starting in 2013, retiree health benefits in Stockton are set to be eliminated, according to the terms of the city’s bankruptcy budget.

At the state level in California, these liabilities have big implications for the proposed tax increase. Proponents claim more tax revenue will help services. But this seems unlikely, given the increasing amounts of cash needed to meet existing liabilities and new unfinanced benefit costs that will add up to more than 40 percent of the revenue from the seven-year tax increase.

Worse, the structure of California’s budget, which pays for K-14 education and debt service ahead of everything else, means that increases in health-benefit spending have an outsized impact elsewhere. Areas such as parks, courts, child care, welfare, the University of California and California State University are the first crowded out by higher spending on post- employment benefits.

As one example, even though state revenue grew more than 50 percent over the past 10 fiscal years and taxes were raised in 2009, state spending on the University of California declined 20 percent over that period partly because outlays for retiree health benefits more than tripled and consumed more than $11 billion.

Solving this problem will require more short-term budget pain because one way to lower total costs is to finance the promises upfront, as they are made. As State Controller John Chiang points out, “even slight amounts set aside will help lessen the impact on future generations.” But that solution is only partial and puts the entire burden on taxpayers and programs. A full solution would also require substantial contributions by employees during their working years, changes to benefits, and reforms to reduce health-care costs.

Raising taxes in November without first fixing the retiree health-care benefits system is akin to providing capital to the pre-financial-crisis Lehman Brothers Holdings Inc. without first demanding that it address its off-balance-sheet debt.

This would continue a callous pattern by California legislators of raising taxes and slashing programs but not addressing root causes. And that means even greater cuts and tax increases down the road.

(David Crane, a former financial-services executive and a Democrat, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011. The opinions expressed are his own.)

To contact the writer of this article: David Crane in San Francisco at davidgcrane@gmail.com

To contact the editor responsible for this article: Katy Roberts at kroberts29@bloomberg.net.

Link to full article: http://www.bloomberg.com/news/2012-07-09/rein-in-benefits-now-and-tax-californians-later.html