CalSTRS’s Extra Hurdle

Fox & Hounds Daily, 8/23/10.

By David Crane, Special Advisor to Governor Schwarzenegger for Jobs & Economic Growth

In May 2008, Federal Reserve Vice Chairman Donald Kohn delivered important remarks about an obscure but consequential issue:

“Public pension benefits are essentially bulletproof promises to pay. The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.  However, most public pension funds calculate the present value of their liabilities using the projected rate of return on the portfolio of assets as the discount rate. This practice makes little sense from an economic perspective [and] pushes the burden of financing today’s pension benefits onto future taxpayers, who will be called upon to fund the true cost of existing pension promises.”

To the vast majority of Americans those remarks were hardly understandable, much less relevant.  But not to some public pension fund officials.  Later, the CEO of the California State Teachers Retirement System (CalSTRS) labeled as deserving of a “letter grade of F” a study from Stanford University that adopted the Kohn methodology for measuring California’s pension liabilities.

Why such a petulant reaction from CalSTRS? Presumably fear, because under that study CalSTRS’s unfunded liability rises by more than $100 billion. But perhaps it’s because CalSTRS has a unique concern when it comes to financing that liability.   Unlike its sister pension fund, CalPERS (the California Public Employees Retirement System), CalSTRS cannot automatically draw on the state treasury to make up for a failure to achieve its expected investment return.  When CalPERS needs extra cash from the state, it just sends a bill. (That’s how it was able to draw $25 billion from the state over the last ten years as it fell 60% short of its investment return assumption.)  But when CalSTRS needs more money, it must get approval from the legislature and governor.  As a result, CalSTRS (which fell even shorter of its investment return assumption) is readying a request for what is reported to be a 150% increase above the $1.2 billion per year already being provided by the state’s general fund.

However, with the state budget already crushed by fast-rising retirement costs that are doubling in size every five years, the outlook for legislative success is uncertain. Also, with more than 50 cents of every dollar of new revenue already going to cover increases in employee costs rather than to needy programs, politicians aren’t likely to embrace tax increases to meet even more such costs.  With such obstacles, CalSTRS is no doubt concerned about reports that it needs even more capital. But as the financial crisis demonstrated, financial enterprises cannot forever hide the truth. Lehman, Merrill and Fannie Mae also failed to face up to the true sizes of their problems and as a result initially sought too little capital.  And when attacked by financial analysts for under-stating their shortfalls, they too defended their accounting as consistent with generally accepted accounting principles.  But those principles failed in their cases and as Dr. Kohn, Stanford, the University of Chicago, Northwestern and other observers agree, they fail to account for public pension liabilities.

Since the public is on the hook for CalSTRS’s pensions, the public is entitled to know the real size of the pension debt that has been issued in their names. Moreover, it’s in their interest to gain a full understanding of CalSTRS’s needs sooner rather than later, both to avoid extra costs (the longer you wait to address pension shortfalls, the more expensive it gets) and to protect innocent future generations who, as Dr. Kohn noted, otherwise “will be called upon to fund the true cost of existing pension promises.” CalSTRS is slowly starting to communicate this reality, recently reassuring its members that their pensions are safe because of state backing, explicitly confirming the Kohn view.  The next step is to report liabilities in the same way and then to sit down with political leaders to map out a long-term survival strategy. Part of that strategy must include a reorganization of CalSTRS’s board so that it represents the real parties at risk; i.e., taxpayers, including future taxpayers in the form of young people now being set up by CalSTRS’s misleading accounting to face budget-busting burdens that will destroy their ability to fund their own services.

Also, using a risk-free rate for liability-reporting purposes doesn’t mean CalSTRS must or should use a risk-free rate for investment return assumption purposes.  Just as the size of your mortgage is the same regardless of how much you expect to earn in the future, the size of pension liabilities is the same regardless of how much a pension fund expects to earn in the future.  New York City discloses pension liabilities using a risk-free rate while employing a different rate for investment return assumption purposes.

CalSTRS can and should do the same.

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