Last week California Governor Jerry Brown criticized as “irresponsible” the decision of his state’s largest public pension fund, CalPERS, to continue using unreasonably high investment return assumptions when setting pension contributions. CalPERS’s president Rob Feckner, a retired public employee, disagreed. Why the fuss? In large part, it’s about financial manipulation of an asymmetry.
When local and state governments make pension promises, both taxpayers and public employees are required to make upfront contributions to pension funds, which invest the proceeds in the hope that contributions plus investment earnings will be sufficient to make the future pension payments. The size of the upfront contribution is a function of the investment return assumption. The higher the assumption, the smaller the contribution. If it turns out that the assumption was too high and therefore the contribution too small, the pension fund won’t have enough money to pay the pensions as they fall due. When that happens, only taxpayers are forced to make up the difference. Because of compound interest, the deficiencies caused by inadequate upfront contributions are enormous. E.g., for a difference of just 1 percentage point in annual investment return, a reduction of $300 million in upfront contributions can translate into an extra $2 billion of taxpayer cost.
Because of that asymmetry — i.e., because employees contribute only to upfront costs while taxpayers are on the hook for both upfront and backend costs — employee representatives such as Feckner are biased in favor of the highest possible investment return assumptions*. Since Feckner and government employee representatives control CalPERS’s board, they get their way, even when the governor disagrees. Past manipulation by government employees and their acolytes has already cost taxpayers tens of billions of dollars. CalPERS’s decision last week will cost them more.
None of this should come as a surprise to anyone who understands that state and local government employees are a business interest, just like pharmaceutical companies and military contractors. No other special interest extracts so much money from state and local governments, who across the country pay them the lion’s share of more than $3 trillion of state and local spending every year. That’s why state and local government employees are the biggest political spenders in California.
Allowing Rob Feckner to determine pension fund investment return assumptions is akin to allowing the president of Boeing to determine federal military spending. California’s legislature should end the asymmetry or ask voters to change pension fund board governance in favor of citizens. In the meantime, Feckner and his board should accede to Brown‘s request.
*Manipulation by Feckner and his allies is also encouraged by government accounting. Because state and local governments budget on a cash basis, high investment return assumptions also understate the cost of pensions until deficiencies are actually funded, hiding the true cost of the promises.