Monday, September 10, 2012

California's Public Sector Unfunded Pension Liabilities and Proposed Tax Increases

Today we're reporting extensively and attempting to explain the future impact on We the People of our trillions of dollars in unfunded public sector pension liabilities and the co-conspirator relationship between Democratic Party leadership and public sector union officials.

Understanding this stuff is a little like speaking a foreign language for the first time. It's indecipherable initially but becomes easy once we get the hang of it. Besides, We the People need to know what's going on and what our government leaders and public sector union officials are doing for, or perhaps better said, to, us.

Although most of the current news is centering around the deplorable Chicago teachers strike, there's also lots of excitement for California's taxpayers as reported in California's Pension Dodge:

"California Governor Jerry Brown and union representatives, er, Democratic legislative leaders last week agreed to pension reforms that could help save the state's municipalities from a Category 5 fiscal storm—three decades from now. Unfortunately, the reforms won't prevent the fast-growing tempest from knocking out Left Coast cities and soaking taxpayers.

The Golden State is spending $6.6 billion this year on retirement benefits, up from $2.7 billion a decade ago. The tab will continue to increase as the state amortizes its $225 billion unfunded liability (and that's a low-ball). Meanwhile, pension and retiree health benefits are consuming more than a third of many local government budgets, forcing cuts in services and public safety, and in some cases bankruptcy.
Stockton's bankruptcy earlier this summer should have served as a red alert. But the only thing that got Democrats moving was the Governor's warning that their lethargy on pension reform could sink his tax-increase initiative this November. Lawmakers have finally leapt into action, but their emergency response is much too small.

On the plus side, the reforms raise the retirement age to 57 from 55 for public safety officers and cap the salary that's used to calculate their pensions at $132,000. The latter will trim costs at the margins, but as a California Public Employees Retirement System analysis notes, this "change will not impact the pension benefits of the majority of CalPERS members." Meaning it won't significantly reduce the state's pension bill either.

Lawmakers deserve some credit for taking on local government pensions, which are often more generous than the state's. The reforms reduce benefit formulas for new workers and require employees to pay half of the "normal cost" of their pensions. However, that doesn't include the cost of paying down unfunded liabilities, which is what's really sending local pension bills through the roof.

Municipalities also won't realize material savings until new employees retire in another two to three decades, so retirement costs will continue to batter cities. Case in point is Los Angeles, which last year pared benefits for new public safety officers. A budget analysis last month warns that the city's pension bill for officers will still increase by 56% over the next four years. Ouch.

To achieve significant savings sooner and slash unfunded liabilities, lawmakers need to freeze the pensions of current workers and reduce their benefits going forward, as San Jose voters did earlier this summer via referendum. Democrats in Rhode Island also shifted current workers to hybrid plans that include a defined-contribution component.

Barring such reforms, the state and local pension tab will continue to balloon, which is the real reason Democrats want voters to approve a tax hike. Retirement costs will soon consume all $8 billion that politicians hope the ballot measure will raise. Rather than saving taxpayers and schools, the tax increase will merely give political shelter to Sacramento's free-spending politicians.

Raising taxes may be Mr. Brown's idea of disaster relief, but the only ones who will be protected are politicians."

Summing Up

With respect to pension funding, it's important to distinguish between funding "normal costs" and funding to amortize or pay off "unfunded past service liabilities."

Normal costs are the costs incurred for any current year. Thus, if we obligate taxpayers to pay $100 in the future, taxpayers incur a normal funding cost of $100 in the year in which the promise is made. (For the sake of simplicity, we're ignoring herein the difference between the present value and future value of money.)

However, if we don't make cash contributions to the pension fund to pay for that cost in the year the promise was made, that incurred liability becomes an unfunded past service obligation. If we habitually don't fund promises to make future benefit payments, we rack up additional unfunded past service liabilities each year, with the accumulated total then being compounded annually.

{NOTE: If we diligently fund the normal cost of the promises we've made each year, we incur no such past service costs and are fully funded as we go along, assuming our various rate of return, mortality, inflation, salary increase and other actuarial assumptions are close enough for horseshoes over a long period of time. And they will be.

Accordingly, we'll leave out of the discussion herein the assumption on investment returns that we make for funds contributed to the pension fund and their impact on our ability to pay future promised benefits. 

As an example, however, if we contribute $100 and expect that money to earn 3% annually in REAL INFLATION ADJUSTED RETURNS (remember the rule of 72 says that a 3% annualized rate of investment return over 24 years will double the original $100 -- 3 x 24 = 72}, in REAL MONEY our initial contribution of $100 will grow to $200 in 24 years. Got it?  Good for you.}

That brings us back to the cash method of government accounting and its tendency to blindside both taxpayers and teachers. The ones doing the blindsiding, of course, are the union officials and government negotiators. They're willful blindsiders unless, of course, they're innocent of willful wrongdoing and just plain ignorant, incompetent or both, which is not an acceptable excuse either.

Thus, California wants to increase taxes to pay for the pension underfunding of the past. Its "normalized" public sector pension funding obligations were consistently ignored, probably because the government didn't want to fight with the unions or ask the voters to approve huge tax increases to pay for the promised benefits. So they punted. Got it?

Now the elephant in the room has grown to a size where it can no longer be ignored. Or perhaps more accurately, at least a big part of it can't be ignored. 

Thus, the state's political strategy is to raise taxes somewhat and then let future taxpayers decide how to pay for the bulk of the still outstanding and unpaid for promises at a later time. A much later time.

Or at least until such time as the current crop of "public servants," like Elvis, have safely left the building.

Thanks. Bob.

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