Pensions Seen Squeezing California Local Government

Bond Buyer, 6/12/14.

LOS ANGELES — The fate and status of public pensions have been among the debates that emerged during California’s two ongoing municipal bankruptcies.

But whatever the outcome in the San Bernardino and Stockton cases, the pressure of meeting retirement obligations is likely to remain a major policy problem for many California cities, some experts say.

Stockton and San Bernardino filed for Chapter 9 within weeks of each other in the summer of 2012.

Now bankruptcy attorneys, bond holders and policy wonks across the country are following each move made by participants in those bankruptcy cases as they move through the process.

Among their questions: whether pension reforms could arise as part of the bankruptcy outcomes.

About 450 cities are members of the California Public Employees’ Retirement System, and there’s no data about how many of the 450 CalPERS member cities could be on the brink of insolvency.

“It is a ‘you will know it, when you see it’ situation,” said Chris McKenzie, executive director of the League of California Cities.

One thing is clear, he said: many cities in the CalPERS retirement system are facing significant rate increases over the next five years, starting in fiscal 2014-15.

Many cities have already cut other services that are maintaining police and fire services, McKenzie said.

To recognize investment losses that occurred in 2008, CalPERS has estimated the pension fund may need to raise rates by 50% over the next five years on its member cities, McKenzie said.

“We recognize that the fiscal environment at the local level is still tight but not taking action will only put costs off to a future day at a greater expense,” Priya Mathur, vice president of the CalPERS board, said in a statement after new demographic assumptions were adopted in February.

The way local government works – and the state government budget works the same – there are certain priority payments, everything else is not a priority, said David Crane, a lecturer in public policy at Stanford University who was a policy advisor for former Gov. Arnold Schwarzenegger in ultimately unsuccessful efforts to reshape California’s public employee retirement system.

“Among the priorities are debt service payments and payments for pensions and retiree healthcare,” Crane said.

As those obligations grow, there is less money available for services for citizens, said Crane.

“As a consequence, you get fewer and fewer services for citizens as more and more dollars go to pay past promises,” he said. “Well before bankruptcy, you get to service level insolvency – where cities exist to pay off past obligations, rather than to provide services.”

Crane pointed to two non-CalPERS cities with pension pressure nonetheless: San Jose where the city pays more for police services, but fields fewer officers; and Los Angeles where the sidewalks have not been repaired in years, trees go untrimmed and a number of the city’s streets have been deemed failing.

Crane said the city’s projections estimate that Los Angeles’ pension costs, currently 5% of the budget, will rise to more than 20% in years to come.

The reason rates are going up is not because of outlandish pension promises, according to Crane.

“It wouldn’t be a problem if cities and states had funded the promises when they made them originally,” Crane said. “But they played games with the accounting; aided and abetted by the actuaries.”

As a result, they under-reported the size of the promises and underpaid the size of the promises by overinflating projected returns, he said. Pension funds traditionally do well achieving compounded 7% returns by annum, historically. But the rates are going to go up because the assumed returns were higher than that, he said.

“It is like the frog being boiled to death,” Crane said. “If done slowly enough the frog doesn’t notice – citizens get less and less without an outcry even though their costs go up.”

Battles have emerged in both the Stockton and San Bernardino bankruptcies pitting bond payments against pension obligations.

Speculation about how Bankruptcy Judge Christopher Klein will handle the treatment of Stockton’s pension obligations has become central to the bankruptcy case.

Stockton has stayed current on its CalPERS payments throughout its bankruptcy but that has not been the situation in San Bernardino. The Inland Empire city broke new ground by impairing the pension giant when it missed a year of payments to the pension fund after it declared bankruptcy in July 2012.

Although CalPERS is not a creditor in the Stockton bankruptcy, it was the major focus last week during a hearing on the city’s proposed bankruptcy exit plan.

The attorney for Franklin Advisors Inc., the last creditor needed to sign off on Stockton’s plan of adjustment, said during the hearing that the plan unfairly discriminates against Franklin because the city is treating other creditors — notably the pension system, which would be untouched — more favorably than Franklin, which would get next to nothing for its bonds.

Franklin’s attorney, James Johnston of Jones Day, argued that if Stockton can continue meeting its pension obligations then it should be able to pay Franklin more than a penny on the dollar.

Stockton owes Franklin $33 million. Johnston contends that CalPERS should be impaired.

Johnson said the city’s pension liability is disproportionate to its workforce, and that if the city does not impair its pension contributions, it will continue to pay for its mistakes.

“Stockton has a problem no matter how you slice it,” Johnson told the judge. “By 2018-19, its pension expenses will be 18.5% of its general fund and its contribution rates, as a percentage of payroll, will be 57.1%”
He said there won’t be a “pension Armageddon” in which all city employees flee the city. He pointed to Detroit, where employees have not fled in response to the pension impairment there.

Mark Levinson, a partner with Orrick, Herrington & Sutcliffe, representing Stockton, however, said he was “incredulous” at Johnston’s assertion that employees wouldn’t leave the city if pensions are impaired.

If Stockton defaulted on its agreement with CalPERS, it also would have to pay a $1.6 billion termination liability fee, according to Kim Nicholl, senior vice president and National Public Sector Retirement Practice Leader for Segal Consulting, Stockton’s pension funding expert.

Michael Gearin, an attorney for CalPERS, said a city of Stockton’s size has never ended a contract with the pension fund.

“There is a very low default rate in the system,” Gearin said. “Only one city is delinquent with CalPERS of more than $150,000 – and that is San Bernardino.”

As for comparisons to Detroit, Gearin said Detroit’s system is much smaller and run by the city, while CalPERS is much larger with millions of members and is run by the state.

San Bernardino has been in confidential mediation on its case since November 2013. Statements that have come out of that process indicate that the main thrust in the mediation appears to be on negotiations between CalPERS and the city.

The larger question remains about whether cities that exit bankruptcy without impairing pensions will be hobbled by those obligations in the future.

A tenet of approving a bankruptcy adjustment plan is that the judge must find the plan is feasible; and that the city will not have to return to bankruptcy for some time.

Klein can confirm Stockton’s plan, or deny it. But he can’t tell the city how to run its finances, according to Robert Christmas, a partner in Nixon Peabody’s New York City office.

“The federal government can’t interfere with local finances under the U.S. constitution,” Christmas said.

Municipal bankruptcy statutes initially passed in the 1930s, were shot down, and then re-written to preserve states’ rights, Christmas said.

Those tenants both prevent federal bankruptcy judges from instructing cities how to resolve the problems that led to bankruptcy, but also act as a protection for CalPERS. Gearin has argued in both San Bernardino and Stockton that the pension fund is an “arm of the state.”

Christmas added that the notional value of pension liability in cities across the country represents trillions of dollars.

“It is not just a local problem, but a national one,” Christmas said.

In his experience in bankruptcy cases where the stakes are high, “creativity becomes paramount and a settlement is entered into.”

That fact could mean that the California cities reach an agreement with CalPERS that relieves pressure for the cities without the pension fund being impaired on the same level as other creditors.

He doubts there will be a rush to bankruptcy for other struggling California cities.

“It is not easy to get into Chapter 9,” Christmas said.

Tonya Chin contributed to this article.

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