The truth about public pensions in California

When it comes to meeting California’s state pension obligations, everyone agrees that paying the bills is a challenge. But exactly how big is the “unfunded liability”? Pessimists and optimists throw out wildly different totals for the state’s 80 retirement systems, making for confusion at best and stalemate at worst when it comes to honest policymaking.

The truth is, pension systems have to involve assumptions. Workers and employers pay in at a certain rate, the money is invested, and if it all goes according to plan, there is enough to cover the promises made to the workers when they retire. The health of each plan depends on many variables, such as how much is paid in how fast, the size of the promises made, the number of retirees and how long they live, and the rate of return on the invested money.

That last variable, known as the discount rate, is at the heart of the arguments over the state’s current liabilities.

Pension pessimists say California is short by about $500 billion. That’s such a big liability, they say, that it may require a massive taxpayer-funded bailout, or reneging on promises to retirees, or doing away with pensions altogether. This group figures the state’s liability using a discount rate of about 6%, a guess just higher than the very conservative 5% municipal bond rate of return.

Pension optimists, on the other hand, use a rate of nearly 8%, a guess based on making riskier investments (stock market, hedge funds, real estate) that have the potential to make higher returns. Their liability figure is about $170 billion, and they suggest modest cures: somewhat lower benefits for incoming employees, slightly increased employee contributions, and eliminating abuses such as spiking, in which a worker gets a big raise right before retirement, upping his or her pension allotment.

Even though the two rates are off by only a few percentage points, they obviously make a big difference. Now, the Government Accounting Standards Board is stepping in to referee. GASB (pronounced like “Gatsby,” without the “t”) is an independent national board that sets the rules of financial reporting for state and local governments. It can’t tell Sacramento or Los Angeles exactly how to set up their pension plans or exactly what discount rate to use, but it can tighten the standards for how those variables will work together in measuring the unfunded liability.

GASB’s new standards, which have to be met by June 2015, won’t stop all arguments, but they will make measurements more realistic. And they may even change the behavior of many of California’s pension plans for the better.

Under the new rules, if a pension plan is on track to be “fully funded” sooner — that is, set up to ensure that what is owed to current workers is available before the date current workers retire — then the plan may value its liabilities using a liberal rate, one based on its best guess about future market returns. In other words, taking a conservative approach on the front end allows a pension plan to take a greater risk in the way it calculates future returns. If its investment predictions falter, it will be forced to take other actions, like increasing payments from workers, to meet its “fully funded” requirements.

On the other hand, GASB rules will constrain the discount rate for pension plans that adopt what might be called the “easy payment plan,” in which pension payouts aren’t covered before workers retire but instead are dependent on future contributions and future investment returns. Such plans will have to use the conservative municipal bond rate in figuring the return on what will have to paid by the next generation.

So what would happen to California’s pension liability if the new rules were applied today? Is the sky falling or not? Using a liberal 8% applied to the liability expected to be funded before current workers retire, and the current 5% bond rate applied to the liability expected to be funded after current workers retire, you’ll get a liability figure somewhere between sunshine and gloom: $300 billion.

And GASB adds one more new rule to the process: Pension liabilities must be included on the balance sheets of the agencies responsible for funding their employees’ pensions. Until now liabilities have been buried in arcane footnotes that few read and even fewer understood.

Taken together, these standards may accomplish what argument and hysteria has not: better, more sound pension plans.

For example, after being warned by actuaries for years that the California teachers pension system — CalSTRS, an easy pay plan — is going broke, state officials are finally starting to tackle the shortfalls. (Nothing is currently being paid toward the system’s unfunded liability.) Unless a more prudent payment plan is in place before June 2015, the looming liability will be entirely valued using a pessimistic discount rate. And the results will have to be reported school district by school district. Suddenly and publicly, most of California’s school systems will come up looking worse than Greece.

That potential kick in the pants ought to help push realistic pension reform forward. The political arguments about liability can be tamed, to some degree, by GASB’s new reporting rules. The new system should mean less posturing, clearer accounting for you and me, and a big incentive to finally fix the pensions that need it most.

Marcia Fritz is the president of the California Foundation for Fiscal Responsibility. She served on the GASB committee that revised the board’s reporting rules for 2015.