“Smoothing” Today Makes For Bumpy Road Tomorrow

Fox & Hounds Daily, 6/16/09.

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

This week, the board of the California Public Employee Retirement System (CalPERS), the largest pension fund in the country, will be asked to approve a “smoothing” proposal designed to provide short- term cash flow relief to local and state governments by deferring pension contributions. If that sounds to you like a free lunch, you’re right. Such an offer is tempting to governments facing harsh budget troubles, but CalPERS should reject the proposal as at best imprudent and at worst dangerous to future generations.

From Enron to AIG, we have seen the consequences when complex financial engineering and mystifying terminology is employed to obscure simple truths. In AIG’s case, “credit default swaps” masked transactions that in reality were unregulated insurance contracts. In CalPERS’s case, what is unthreateningly framed as “smoothing” is in reality a negative amortization borrowing of the type that recently led so many homeowners down the garden path to foreclosure.

Under such “name your payment” or “pay option” loan programs, borrowers were allowed to defer mortgage payments in the hope that future appreciation on their house would more than cover the amount by which the loan balance grew as a result of the payment being deferred. If the house appreciated more than the loan balance grew, all was well. If not, all the homeowner got was a larger loan balance.

Likewise, CalPERS proposes to name their payment and reduce pension contributions in the hope that investment earnings on its assets will grow faster than its liabilities accrue. But if the hoped-for investment earnings don’t materialize, all that will be left is a larger balance due. The only difference is in who picks up the check: in the case of the house, the homeowner who agreed to the loan suffers all the consequences. But in the case of deferred contributions for pension promises, it is future general funds that pay the tab.

Unfortunately we have been here before. In 1999, CalPERS told California governments at that time that they could not only defer contributions but also even boost pension promises retroactively by tens of billions of dollars because future investment earnings would cover the cost. As things turned out, not only did CalPERS not earn what was projected, but proposed contributions from governments today are nearly 5 times greater than what CalPERS projected would be the case. As a result, general funds in California today are facing an unanticipated $3 billion of contributions for past promises underfunded on faulty assumptions.

Worse, even those higher contributions understate the amounts required to put CalPERS on financially sound footing and to protect future general funds. This is because CalPERS continues to employ a high-yield earnings assumption ungrounded in reality (particularly for such a large fund), lulling employers into complacency about the real size of contributions needed to meet pension promises. To put this matter in perspective, to meet its earnings assumptions CalPERS needs the Dow Jones Industrial Average to grow even faster in the 21st century than it grew in the 20th century and to yield more than the legendary investor Warren Buffett assumes his defined benefit plan assets will earn.

The difference between a reasonable and unreasonable assumption means life or death for government programs. Because of the long-term nature of these liabilities, a tiny difference in earnings assumption can mean billions of dollars of shortfall and, as a result, understaffed and undercompensated police, parks, fire, education and other departments for decades to come.

Yet, CalPERS proposes to defer even these late and inadequate levels of contributions and once again promises to earn its way out of the deficit. We have seen the consequences of such “kick-the-can” actions in the form of businesses such as General Motors that assumed unrealistic investment earnings rather than face up to reality, which is that promises had been made and sufficient money must be set aside on a timely basis to meet them.

To compound the matter, governments have yet to start funding another promise they’ve made to employees in the form of retiree health care. Already-existing retirement health care promises in California already amount to nearly $50 billion, growing at 4.5% per year plus the cost of new promises.

Instead of deferring contributions, CalPERS should focus on meeting its obligations without resorting to risky assumptions and shifting costs to future generations. This means not only reviewing the assumptions upon which it now bases contributions but also evaluating the opportunity to reduce the cost of new promises to future employees. Absent such meaningful and sustainable pension reforms, the State of California should decline to participate in any effort to shift more costs to our children.

Link to full article: http://www.foxandhoundsdaily.com/blog/david-crane/smoothing%E2%80%9D-today-makes-for-bumpy-road-tomorrow