Friday, February 25, 2011

Day of Reckoning on California Pensions?

The LA Times posted an editorial, Day of reckoning on pensions:
The housing bubble and subsequent Wall Street collapse wreaked havoc on the nation's retirement savings, as many pension funds and 401(k) plans suffered losses of 30% or more. State and local governments are now facing huge unfunded pension liabilities, prompting policymakers to scramble for ways to close the gap without slashing payrolls and services. But a new report from the Little Hoover Commission in Sacramento makes a more troubling point: Many state and local government employees have been promised pensions that the public couldn't have afforded even had there been no crash.

The commission's analysis of the problem is hotly disputed by union leaders, who contend that the financial woes of pension funds have been overblown. The commission's recommendations are equally controversial: Among other things, it urges state lawmakers to roll back the future benefits that current public employees can accrue, raise the retirement age and require employees to cover more pension costs. Given that state courts have rejected previous attempts to alter the pensions already promised to current workers, the commission's recommendation amounts to a Hail Mary pass. Yet it's one worth throwing.

A bipartisan, independent agency that promotes efficiency in government, the Little Hoover Commission studied the public pension issue for 10 months before issuing its findings Thursday. Much of the 90-page report is devoted to making the case that, to use the commission's blunt words, "pension costs will crush government." Without a "miraculous" improvement in the funds' investments, the commission states, "few government entities — especially at the local level — will be able to absorb the blow without severe cuts to services."

The problem is partly demographic. The number of people retiring from government jobs is growing rapidly, and longer life expectancies mean that a growing number of retirees will collect benefits for more years than they worked. But the report argues that political factors have been at least as important in driving up costs, starting with the Legislature's move in 1999 to reduce the retirement age for public workers, base pensions on a higher percentage of a worker's salary and increase benefits retroactively. The increases authorized by Sacramento soon spread across the 85 public pension plans in California.

Compounding the problem, the state has increased its workforce almost 40% since the pension formula was changed and boosted the average state worker's wages by 50%. Local governments, meanwhile, raised their average salaries by 60%. Much of the growth came in the ranks of police and firefighters, who increased significantly in number and in pay.

There's nothing inherently wrong with generous pension plans. Pensions, after all, are just a form of compensation that's paid after retirement, not before. The problem, particularly for local governments, is that the plans are proving to be far costlier than officials anticipated or prepared for. By their own reckoning, the 10 largest public pension systems in California had a $240-billion shortfall in 2010.

When the funds don't have enough money to cover their long-term liabilities, state and local governments are compelled to increase their contributions. In Los Angeles, the report says, the city's retirement contributions are projected to double by 2015, taking up a third of the city's operating budget. It projects that governments throughout the state will have to raise their contributions by 40% to 80% over the next few years, then maintain that higher rate for three decades.

The more tax dollars governments have to devote to pensions, the more they'll have to take from other programs or from taxpayers. That means more layoffs or pay cuts for public employees, higher taxes, fewer services, or all of the above.
The situation won't be so dire if the plans earn more on their investments than expected. But with the plans typically counting on annual returns near 8%, or twice the "risk-free" level suggested by some analysts, it seems just as likely that they'll earn less than that, forcing local governments to contribute even more.

The Legislature and some local governments have sought to ameliorate the situation by reducing benefits for new hires and persuading current workers to contribute more to their pension funds. The commission's report, however, argues that these moves aren't sufficient. The savings from the lower pensions for new employees won't be realized for many years, and the increased contributions aren't nearly enough to close the funding gap.

The only real solution, the report contends, is to reduce the benefits that current employees are slated to earn in the coming years. That's hard to do. California courts have held that pensions for current employees can be increased without their approval, but not decreased unless they're given a comparable benefit in exchange. Nevertheless, the commission calls on the Legislature to give itself and local governments explicit authority to trim the benefits that current employees have not yet accrued, without touching the amounts they have already earned. It also calls for a hybrid retirement plan that combines a smaller pension with a 401(k) plan and Social Security benefits, as well as the elimination of a variety of loopholes used to inflate pensions.

The commission is right about the importance of reducing the liabilities posed by current employees. And though picking a fight with unions over unilateral reductions in pensions probably isn't the solution, the report should persuade both sides to do more at the negotiating table to prevent pension costs from swamping state and local budgets. As the commission notes, public employees in California enjoy some of the most generous pension plans in the country. Those plans won't do them much good, however, if their employer can't afford to keep them on the payroll.
You can read the Little Hoover Commission's report for details. It basically sounds the alarm on pensions and states outright: "pension costs will crush government". From the report:
The problem, however, cannot be solved without addressing the pension liabilities of current employees. The state and local governments need the authority to restructure future, unearned retirement benefits for their employees. The Legislature should pass legislation giving this explicit authority to state and local government agencies. While this legislation may entail the courts having to revisit prior court decisions, failure to seek this authority will prevent the Legislature from having the tools it needs to address the magnitude of the pension shortfall facing state and local governments.

The situation is dire, and the menu of proposed changes that include increasing contributions and introducing a second tier of benefits for new employees will not be enough to reduce unfunded liabilities to manageable levels, particularly for county and city pension plans. The only way to manage the growing size of California governments’ growing liabilities is to address the cost of future, unearned benefits to current employees, which at current levels is unsustainable. Employers in the private sector have the ability and the authority to change future, unaccrued benefits for current employees. California public employers require the ability to do the same, to both protect the integrity of California’s public pension systems as well as the broader public good.

Freezing earned pension benefits and re-setting pension formulas at a more realistic level going forward for current employees would allow governments to reduce their overall liabilities – particularly in public safety budgets. Police officers, firefighters and corrections officers have to be involved in the discussion because they, as a group, are younger, retire earlier and often comprise a larger share of personnel costs at both the state and local level. Public safety pensions cannot be exempted from the discussion because of political inconvenience.
There is no doubt that pension reforms are needed in California and elsewhere in the US. But all stakeholders need to do their part. It's not just about cutting benefits. How about amalgamating all these dinky underfunded city plans into one large defined-benefit plan and introducing better governance on existing large plans, including better compensation for pension fund managers.

Finally, I invite readers to carefully go through a recent presentation by Jean-Claude Ménard, Chief Actuary of Canada, to the Board of Directors of the Canada Pension Plan Investment Board. I quote Mr. Ménard: "Overall, the results confirm that the current legislated rate of 9.9% is sufficient to sustain the Plan over the long term, with assets projected to accumulate to $275 billion by the year 2020."

If US states want to bolster their public pension plans, I urge them to contact the Office of the Chief Actuary of Canada. I consider this to be one of the best departments in the federal government of Canada made up of truly top-notch professionals who take great care in researching their findings. Moreover, they are transparent and welcome exchanges with actuaries from around the world. There is no reason why US public pensions can't be fixed. All the doomsayers who want to scrap public pension plans are just peddling fear and nonsense.

***Update and clarification***

Bill Tufts who maintains the blog, Fair Pensions for All, shared these thoughts with me:
I think you are a little off in trying to compare the CPP with public sector pensions in California.

I had a chance to go to the conference that Jack Dean (of sponsored last week. There is a big difference between a 70% of final salary pay for the California system and the 25% that the CPP tries to replace. If we assume that the CPP costs 9.9% of pay for 25% replacement income the California plans replacing 70% would require close to 30% contributions. This is close to the 34% cost that the CD Howe estimates and this number is backed up by
Keith Ambachtsheer.

The CPP assumes that workers will be paying CPP until age 65 or even 75, with the new late retirement rules. The public security workers in Canada and the US can retire with as little as 25 years of service or age 50. The CPP expects workers to draw pensions for about 14 years currently and the California pensions will have to support pensioners for almost 30 years. This is a big difference.

A big problem in the US is that many workers pay nothing into the pension plans so the total cost is on counties and cities to fund the pensions. Also with the severe financial challenges that the state of California is facing, they are expecting that the state will be reducing its public workforce by about 150,000 in the next several years. This means no new employees coming on board to fund the ponzi style pension schemes. This contrasts with Canada for example, where we are bringing in 300,000 foreign workers a year. The foreign workers are paying into the CPP and have no expectation of getting any pension benefits from it. The CPP is based on all future workers in Canada paying into the fund.

The CPP is based on a constantly growing workforce contributing into the plan the California system will probably have a shrinking system paying into the plan.

The average CPP payout is a little over $6,000 per year and this is funded by workers paying in 9.9%.

The CPP report shows that by 2019 the actuarial liability on the CPP plan will have grown to $1.3 Trillion and have accumulated assets of $ 258 Billion. That is a long ways out there and a lot has to go awfully smooth for us to get there. There has not been any contingency plans built into it. I am no actuary but most tell me the CPP seems secure based on current funding formulas:

There are a whole lot of assumptions on the CPP plan for it's continued success.
  • Fertility rates
  • Migration and immigration
  • Mortality rates
  • Working age population
  • Labour participation rates
  • Unemployment and job creation
  • Inflation/CPI (flat inflation at 2% forever)
  • Earnings assumptions
  • Investment returns
    • Bonds
    • Equities
    • Private equity
  • Asset mix assumptions
  • Contribution rates
In other words if all these conditions match the assumptions that are made in the pension plan the CPP will be solvent forever. If we truly thought that this wold be the case over the next 40 years we are not very good students of history!

One other big challenge coming to the state that the LA times article did not address is the cost of future other post-employment benefits (OPEBs). Many of the experts at Jack's conference are expecting the shortfalls in OPEBs to be even bigger than the pension shortfalls.
I thank Bill for sharing these comments with me. First, let me clarify, I'm not making a direct comparison between CPP, a partially funded plan, and state pension plans that are fully funded plans suffering severe deficits. There are obvious differences, many of which Bill outlines above. What I was trying to convey is that pension reforms are not just about cutting benefits to existing and retired workers. There are ways to bolster pension plans and it requires concessions from all stakeholders, including taxpayers. I know this will not please people but states have to assume their responsibility in this pensions mess because they too went years without topping up their pension plans.

Second, I have confidence in the assumptions the Office of Chief Actuary of Canada (OCA) uses for the CPP over the long-term fully recognizing that things can drastically change here in Canada and around the world in the near term. The Canadian economy is highly leveraged to global growth and it's vulnerable if things go awry again. But the OCA knows this and they have models which project outcomes for various possible scenarios, including dire economic and financial scenarios.

Final point I really want to make here. There is a concerted effort going on right now to weaken public pension plans or abolish them altogether. I'm of the school of thought that this is pure fear mongering and totally ridiculous. Yes, we have to reform public pension plans in the US and across the world, to bolster them, not to weaken or abolish them. I understand the frustration of taxpayers who saw their private retirement savings get hammered after the 2008 crisis. But why take it out on public sector workers who accepted lower paying jobs for the security of a stable retirement income? (There are abuses but they're not the norm).

In the meantime, Wall Street continues to enjoy record bonuses. They couldn't care less about what is going on with private and public retirement systems. In my opinion, they should care and they should be very concerned about what is going on right now. But in their myopic world, all that counts is the last trade. That shortsighted mentality is going to end up costing them trillions down the road.

***Additional comments by Bernard Dussault***

Bernard Dussault, the former Chief Actuary of Canada, provided these additional comments, which I share with you:
Any social insurance program like the CPP is not basically different from any public program such as the California system. They are both defined benefit pension plans providing retirement benefits. The main two not basic areas of differences are generally benefit design and financing. The following analysis pertains exclusively to defined benefit (as opposed to contribution) pension plans.

Benefit design

Social programs (covering essentially all workers of a country) generally include anti poverty-related measures, such as the CPP drop-out provisions, i.e, a few (about 8 out of 47) years of lowest employment earnings being disregarded for the determination of the retirement pension benefit rate. Surprisingly, public pension plans (covering goverment employees), like most private plans, generally drop out an even larger number of years of lowest pensionable earnings by considering only the last five years or so of earnings for the determination of the retirement benefit rate. This looks as if private plans had more anti poverty measures than social programs, which is true to a certain extent but the irony is that these measures are in some cases more beneficial to richer participants.


Ideally, any pension plan, be it private, public or social, should be fully funded.
  • Private and public pension plans are generally designed and meant to be fully funded, as their contributions rates are required by local government to be determined in such fashion. Therefore, their funding ratio should theoretically be at any time at least 100%. However, funding ratios can hardly not avoid getting under 100% at times due mainly to the normal statistical fluctuations in market values of investments. It happens that most private and public plans' funding ratios get too often and too much under 100% because of contribution holidays beign inappropriately taken by the plan sponsors as soon and any time the funding ratio exceeds 100%.
  • Social pension plans are rarely, if never, fully funded or even designed to be so. However, following the CPP 1998 reform, any amendment to the CPP shall now be financed in a fully funded basis. The CPP was implemented on a partial funding basis and, despite the 1998 reform, does and will remain a partially funded scheme. Before 1998, the CPP funding ratio was about 7%. With the reform, it is projected to increase gradually to no more than 20% and to stay so for ever. If the CPP had been implemented on a fully funded basis in the first instance in 1966, its contribution rate would now need to be only about 6% rather than 9.9%. In other words, all current and future contributors now have to compensate for the insufficient amount of contributions made by cohorts of contributors from 1966 to about 1996.
Clarifications of certain points raised by Bill Tufts
  • "This is close to the 34% cost that the CD Howe estimates and this number is backed up by Keith Ambachtsheer." If the CPP were fully funded, increasing its benefit rate from 25% to 70% would require a contribution rate of about 16.8% (rather than 30% or 34%), i.e. the above-mentioned CPP full-cost rate of 6% times the ratio of 70% over 25%. The CD Howe 34% rate rather pertains to its estimated cost of the Canadian fedeal public service pension plan (PSPP). This CD Howe's 34% estimate of the PSPP is grossly overestimated because it assumes that all PSPP assets would be invested in bonds, while a large portion of PSPP assets are actually invested in the private markets (equities, real estate, etc.). The PSPP cost is more appropriately and realistically estimated at about 19% rather than 34% in the triennial statutory actuarial reports prepared by the Office of the Chief Actuary.
  • "The CPP assumes that workers will be paying CPP until age 65 or even 75, with the new late retirement rules". CPP contributions are required only until age 65. Contributions may be made from age 65 to 70 (not 75), in which case the CPP retirement benefit rate is thereby increased two-fold, fristly to account for the shorter period over which benefits are paid and secondly to account for any CPP contributions made over age 65.
  • "The public security workers in Canada and the US can retire with as little as 25 years of service or age 50. " Under the Canadian PSPP, any plan member is entitled to an unreduced pension only if the plan participant is either:
    • at least 60 years of age and has at least two years of pensionable service
    • at least 55 years of age and has at least 30 years of pensionable service
  • "The CPP expects workers to draw pensions for about 14 years currently and the California pensions will have to support pensioners for almost 30 years." As shown on page 17 of the latest (25th) actuarial report onf the CPP (, the average life expectancy at age 65 combined for men and women is about 21 years rather than 14 years.
  • "This contrasts with Canada for example, where we are bringing in 300,000 foreign workers a year. The foreign workers are paying into the CPP and have no expectation of getting any pension benefits from it. The CPP is based on all future workers in Canada paying into the fund. " Net immigration to Canada is less than 300,000 and does not include exlusively workers. Moreover, not all immigrating workers do find a job in Canada. The CPP partial financing approach relies on all Canadian workers contributing 4.95% of salary up to YMPE, minus the YBE, and the employer contributing the same amount. Like any other CPP contributors, foreign workers paying into the CPP will receive CPP retirement benefits consistent with contributions made to the CPP as for any other CPP contributors.
  • "The CPP is based on a constantly growing workforce contributing into the plan. The California system will probably have a shrinking system paying into the plan." If a plan is financed on a fully funded basis, as should be the case for the California plan, a gradually shrinking proportion (as opposed to number) of participating contributors to the plan has essentially no effect on the funding ratio and solvency of the plan. As the CPP is not fully funded, a growing workforce should help improving its funding ratio or reduce its required constant contribution rate of 9.9%. However, as shown in Table of page 19 of the 25th CPP actuarial report, the ratio of population in age group 20-64 to that in age group 65+ is projected to decrease gradually from 4.6 in 2010 to 2.1 in 2075. If it were projected to remain at 4.6 or to increase, the estimated required constant contribution rate of 9.9% would be lower.
  • "The average CPP payout is a little over $6,000 per year and this is funded by workers paying in 9.9%." The CPP 9.9% contribution rate is shared equally by workers and employers (i.e. 4.95% each).
  • "I am no actuary but most tell me the CPP seems secure based on current funding formulas." The CPP is secure to the extent that:
    • the long-term economic and demographic assumptions upon which rests the contribution 9.9% contribution rate will be realized
    • future employers and contributors will remain willing to pay the required contribution rates
    • provisions of the existing plans remain unaltered
In this vein, the Chief Actuary claims on page 6 (under the heading Open Group) in his Actuarial Study number 8 on the CPP ( that the CPP is fully funded if the actuarial projections are made on an "open group" basis because under such projection basis the present value of projected benefits is equal to the projected value of projected contributions. I already indicated to the Chief Actuary that this is a seriously inappropriate actuarial statement because it infers that the CPP could also be claimed to be fully funded if it were financed on a pay-as-you-go basis (i.e. if if where not funded at all), as under pure paygo financing contributions are equal to benefits in any year.
As always, I thank Mr. Dussault for providing me with his excellent comments.

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