Public Pension and Retiree Health Benefits: An Initial Response to the Governor's Proposal

Public Pension and Retiree Health Benefi ts: An Initial Response To the Governor’s Proposal M AC TAY LO R • L E G I S L A T I V E A N A L Y S T • N OV E M B E R 8, 2011 AN LAO REPORT 2 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT EXECUTIVE SUMMARY Th e Governor presented a 12-point plan to change pension and retiree health benefi ts for California’s state and local government workers on October 27, 2011. Th is report provides background on the state’s retirement policy issues and our initial response to the Governor’s proposals. Our Offi ce’s Key Principles on Public Retirement Benefi ts. As we have noted in the past, we do not view the current system of defi ned benefi t pensions for California’s public employees as an intrinsically bad thing at all. Rather, we view pensions and retiree health benefi ts as just one part of overall public employee compensation—in many cases, as benefi ts off ered in lieu of what otherwise might be higher salaries over the course of a public-service career. Moreover, we believe that encouraging public or private workers to defer a portion of their compensation to retirement represents sound public policy. Well-managed and properly funded retirement systems, therefore, are meritorious. What Is the Problem With Public Retirement Benefi ts? California’s current structure of public employee pension and retiree health benefi ts has some substantial problems. Th ere is a notable tendency in the current system for public employers and employees to defer retirement benefi t costs—which should be paid for entirely during the careers of retirement system members—to future generations. Th is leads to unfunded liabilities that have spiraled higher in recent years and are producing cost pressures for the state and many local governments that will persist for years to come. Under the current system, governments have very little fl exibility under case law to alter benefi t and funding arrangements for current employees—even when public budgets are stretched, as they are today. Finally, there is a substantial disparity between retirement benefi ts that are off ered to public workers and those off ered to other workers in the economy. Sustaining a fi nancially manageable system of public employee retirement benefi ts—one that is more closely aligned with the benefi ts off ered private-sector workers—will require substantial, complex, and diffi cult changes by the Legislature, the Governor, local governments, and voters. Governor’s Proposal Is a Bold, Excellent Starting Point Would Help Increase Public Confi dence in California’s Retirement Systems. We view the Governor’s proposal as a bold starting point for legislative deliberations—a proposal that would implement substantial changes to retirement benefi ts, particularly for future public workers. His proposals would shift more of the fi nancial risk for public pensions—now borne largely by public employers—to employees and retirees. In so doing, these proposals would substantially ameliorate this key area of long-term fi nancial risk for California’s governments. At the same time, the Governor’s proposals aim for a future in which career public workers receive a package of retirement benefi ts that would be (1) suffi cient to sustain employees’ standards of living during their retirement years and (2) more closely aligned with benefi t packages off ered to private-sector workers. For all of these reasons, we believe that the Governor’s proposals could increase public confi dence in the state’s retirement benefi t systems. Many Details Left Unaddressed in Governor’s October 27 Presentation. Despite the strengths of the Governor’s pension and retiree health proposal, it leaves many questions unanswered. In particular, we do not understand key details of how his hybrid benefi t and retirement age proposals would work. Moreover, www.lao.ca.gov Legislative Analyst’s Offi ce 3 AN LAO REPORT the Governor’s plan leaves unaddressed many important pension and retiree health issues, including how to address the huge funding problems facing the state’s teachers’ retirement fund, the University of California’s (UC’s) signifi cant pension funding problem, retiree health benefi t liabilities, and other issues. In making signifi cant changes to pension and retiree health benefi ts, we would urge the Legislature also to tackle these very diffi cult issues concerning the funding of benefi ts. Raising Current Workers’ Contributions Is a Legal and Collective Bargaining Minefi eld. Th e Governor proposes that many current public employees be required to contribute more to their pension benefi ts. Others have proposed reducing the rate at which current employees accrue pension benefi ts during their remaining working years. Our reading of California’s pension case law is that it will be very diffi cult—perhaps impossible—for the Legislature, local governments, or voters to mandate such changes for many current public workers and retirees. Moreover, employer savings from these changes likely will be off set to some extent by higher salaries or other benefi ts for aff ected workers. Given all of these challenges, we advise the Legislature to focus primarily on changes to future workers’ benefi ts. Such changes should produce net taxpayer savings only over the long run but are certain to be legally viable. A Golden Opportunity to Make These Benefi ts More Sustainable Clearly, there is signifi cant public concern about public pension and retiree health benefi ts. In our view, the current structure of these benefi ts—wherein state and local governments provide compensation in forms that are very diff erent from that off ered in the private sector—impairs the public’s ability to assess whether government is carefully managing its funds and can aff ect the public’s trust in government itself. We believe that the Legislature, the Governor, and voters should change these benefi ts—as well as the way in which governments and workers fund the benefi ts—in order to address these problems. Th ese changes will involve diffi cult, complex choices. In the end, however, we believe that such changes can result in the public becoming more comfortable with public retirement benefi ts. Th is, in turn, will help ensure that the state and local governments can continue off ering such benefi ts in the future. 4 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT BACKGROUND: PUBLIC PENSION AND RETIREMENT BENEFITS TODAY A Complex System of Public Pensions people who now receive benefi t payments and around 700,000 “inactive” members—that is, Not Just One Pension System…But Many. individuals who were once, but are not currently, During the fi rst half of the 20th Century, California public employees and who do not yet receive began to implement a public policy to provide pension benefi ts. a comprehensive set of retirement benefi ts to Th e two largest entities managing state and its retired public employees. Public employees local pension systems in the state are the California typically begin to accumulate rights to receive Public Employees’ Retirement System (CalPERS) future benefi ts the moment that they are hired, and the California State Teachers’ Retirement and the longer that they work in the state or local System (CalSTRS). Combined, these two statewide government sector in the state, the more pension systems serve 3.1 million active and inactive and other retirement benefi ts they accumulate. Th is members, including around 750,000 members policy continues today. and benefi ciaries now receiving benefi t payments. Today, pension and retiree health benefi ts for While both CalPERS and CalSTRS operate California’s public employees are determined in pursuant to state law, they are very diff erent. a largely decentralized fashion. Th is means that Members of CalPERS include current and employees of the state, the public universities, past employees of state government and California school districts, community college districts, cities, State University (CSU), as well as judges and counties, special districts, and other local govern- classifi ed (nonteacher) public school employees. In ments earn a variety of diff erent pension and retiree addition, hundreds of local governmental entities health benefi ts during their careers. As such, any (including some cities, counties, special districts, eff ort to modify pension and retiree health benefi ts and county offi ces of education) choose to contract for public employees will prove complex, dealing with CalPERS to provide pension benefi ts for their as it may with a variety of diff erent governments, employees. Local governments can choose from benefi t plans, and pension systems. a variety of plan options in CalPERS, as allowed A Variety of “Defi ned Benefi t” Pension Plans. in the state’s Public Employees’ Retirement Law. California has both statewide and local public Governmental employers make contributions to pension plans that off er defi ned benefi ts. Defi ned their current and past employees’ pension benefi ts, benefi t pensions provide a specifi c amount aft er as in most cases, do public employees themselves. retirement that is generally based on an employee’s Each employer generally is responsible for its age at retirement, years of service, salary at or own employees’ costs in CalPERS, meaning that near the end of his or her career, and type of the state does not directly contribute to CalPERS work assignment (for instance, public safety or to cover pension costs for local government non-public safety work assignment). In total, employees. (Local governments, however, oft en about four million Californians—11 percent of the do use a portion of various funding streams they population—are members of one or more of the receive from the state government to pay a part of state’s 85 defi ned benefi t public pension systems. their own pension costs.) Th is four million fi gure includes about one million www.lao.ca.gov Legislative Analyst’s Offi ce 5 AN LAO REPORT Diff erent governmental entities in CalPERS contribution plans, which are intended to have a variety of pension contribution arrange- supplement their defi ned benefi t pensions aft er they ments with their employee groups, meaning that retire. Defi ned contribution plans include 401(k), some employees pay more or less than other, 403(b), and 457 plans in which the rate of contri- similarly situated employees of other governmental bution by the employer is fi xed, sometimes serving entities. In practice, various elements of CalPERS in practice as a “match” to amounts deposited benefi ts—benefi t amounts and employee contribu- to those funds by employees. Accordingly, an tions—now are determined in collective bargaining employee’s defi ned contribution plan benefi ts with unions that represent rank-and-fi le state and equal what amount the accumulated employee and local government employees. employer contributions can provide at retirement, Compared to CalPERS, CalSTRS off ers plus investment earnings. Unlike defi ned benefi t an entirely diff erent—oft en less generous—set plans, therefore, defi ned contribution plans do not of benefi ts to teachers and administrators of promise a specifi c amount to be paid to the retiree California’s public school and community college each month or each year. Some governmental districts. Benefi ts off ered by CalSTRS, as well as entities manage defi ned contribution plans, oft en required payments by employees, districts, and the in conjunction with private-sector investment state, are specifi ed on a statewide basis in the state’s managers. For example, state employees can Education Code—that is, they apply on a generally enroll in defi ned contributions plans managed by equal basis to all districts. As such, CalSTRS the Savings Plus Program of the Department of benefi ts generally are not determined through Personnel Administration (DPA). Some teachers collective bargaining. Unlike many CalPERS also enroll in CalSTRS’ Pension2 supplemental members, CalSTRS members generally do not savings plan. A variety of other public and private participate in Social Security. defi ned contribution plans serve California’s local In addition to CalPERS and CalSTRS, about governments and school districts. 80 other defi ned benefi t state and local pension Social Security. Social Security—established systems (such as the University of California in the 1930s—initially did not provide benefi ts Retirement Plan [UCRP], the Los Angeles County to public employees, but in the 1950s, the federal Employees Retirement Association, and the Los government approved amendments to the Social Angeles City Employees’ Retirement System) Security Act to allow states to enter into agree- serve about one million other Californians, ments with the Social Security Administration to including about 300,000 who currently receive provide such benefi ts to their public employees. benefi t payments. County pension plans generally Over time, Congress has added to these require- are governed by the state’s County Employees ments, essentially mandating Social Security Retirement Law of 1937 (known as the “1937 for specifi ed public employees not covered by a Act”). Benefi ts and employee and employer qualifi ed public pension plan. contributions in these various other plans can It has been estimated that only about one-half vary widely—typically, subject to negotiation with of California’s public employees participate in the rank-and-fi le employee unions. federal Social Security program. Teachers and most “Defi ned Contribution” Plans Also Now in public safety offi cers, including corrections offi cers, Place for Some Public Employees. Many public police, and fi refi ghters, generally are not enrolled employees currently are enrolled in defi ned in Social Security. Th ere are a variety of reasons 6 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT why this is so. Public safety offi cers generally age 66 and 67, as specifi ed in law. For individuals are eligible for retirements at earlier ages than born in 1960 and aft er, the Social Security normal envisioned under Social Security’s benefi t formulas. retirement age is 67. (Individuals generally can receive Moreover, it is expensive for a government to reduced benefi ts if they retire earlier than the normal initiate enrollment of its employees into Social retirement age, provided that they are at least 62.) Security without, at the same time, enacting reduc- Even More Variety for Retiree Health Benefi ts tions in its other pension benefi ts. While there has been some discussion over the years at the federal Medicare. Medicare is a federal health program level of requiring all state and local employees to that covers individuals age 65 and older. It was be enrolled in Social Security, this proposal has established in 1965 and has long enrolled many not been accepted to date, in part because of the state and local government employees. State and cost pressures for state and local governments that local government employees hired or rehired would be aff ected. aft er March 31, 1986, are subject to mandatory Generally speaking, employees and employers in coverage by Medicare. Employers and employees Social Security each contribute 6.2 percent of pay— each currently pay a 1.45 percent tax on earnings up to the Social Security earnings cap (now to cover part of Medicare program costs, which $106,800 per year)—to the federal government in consist of Part A (hospital insurance), Part B the form of Social Security payroll taxes. (Congress (outpatient medical insurance), Part C (Medicare reduced employee payroll taxes in 2011 to help Advantage plans), and Part D (prescription drug stimulate the economy.) Th e federal government insurance). Individuals are eligible for premium- essentially uses these funds—in addition to amounts free Medicare Part A if they are age 65 or older paid from the federal government’s general fund—to and worked for at least 10 years (40 quarters) pay Social Security benefi ts to current retirees. (Th is in Social Security and/or Medicare-covered means that Social Security benefi ts—unlike state and employment. Accordingly, Medicare is now the local pension benefi ts—are paid on a “pay-as-you- core element of retiree health coverage for both go” basis, essentially making Social Security a social public and private retirees in the United States. In insurance system, rather than a pension system, as many public pension plans, including CalPERS, we think of it here in California.) Over time, as baby Medicare-eligible retirees generally must enroll boomers age and the ratio of workers to retirees in in Part B benefi ts at age 65 (or earlier, if they are the United States falls further, the federal general qualifi ed due to a disability). In 2011, Medicare Part fund will have to pay more and more to cover the B premiums typically have been around cost of Social Security benefi ts. For this reason, in $100 per month. the future it is likely that Congress will have to enact Retiree Health Programs of State and Local revenue increases and/or benefi t reductions in order Governments. While Medicare is now the core to keep the federal budget on a sustainable path. component of retiree health coverage for state and For individuals born between 1943 and local workers, there is much variety among state 1954, the Social Security “normal retirement and local governments in the area of retiree health age”—at which full Social Security benefi ts can care. Many local governments—especially school be received—is now 66. For individuals born in districts—off er virtually no retiree health care the years 1955 through 1959, the Social Security benefi ts. Th e state and many other local govern- normal retirement age is somewhere between ments, however, off er a range of retiree health www.lao.ca.gov Legislative Analyst’s Offi ce 7 AN LAO REPORT benefi ts that vary from small to expansive. Of these typically need less income to maintain the same governments, many, including the state, provide standard of living as when they worked. health benefi ts to pre-Medicare retirees, and Th e percentage of income a person has in others—also including the state—off er Medicare retirement compared to his working income prior supplement plans to retirees aft er age 65. Retiree to retirement is called the “replacement ratio” or health benefi ts have been subject to extreme cost “replacement rate” by retirement experts. When pressures in recent years due to the general growth pension benefi ts are compared to each other, it of health care expenses, a rise in the number of is typically this replacement ratio that is being retirees drawing the benefi ts, and costs resulting compared. When we speak of pension benefi ts from growing unfunded liabilities, which are being “generous,” we mean that they provide a discussed below. relatively high replacement ratio compared to other benefi t plans in the public and/or private sectors. For Many Career Employees, a In 2005, a publication of Boston College’s Generous Set of Benefi ts Center for Retirement Research said, “Overall, As described above, there is considerable the range of studies that have examined [the] variety among California’s public retirement issue consistently fi nds that middle class people systems. As such, it is diffi cult to generalize about need between 65 percent and 75 percent of their the specifi c benefi t packages provided to public pre-retirement earnings to maintain their lifestyle workers and retirees today. Moreover, there have when they stop working.” Th is paper indicated been numerous changes to benefi ts in recent “that the majority of households retiring today are years—some enacted through legislation and others in pretty good shape,” with about two-thirds of negotiated at the bargaining table. In the late 1990s households then in that 65 percent to 75 percent and early 2000s, a wave of benefi t enhancements— replacement ratio range. Th e paper, however, most notably, those related to Chapter 555, Statutes suggested that “the coming way of baby boom of 1999 retirees…will see lower replacement rates from (SB 400, Ortiz)—aff ected benefi ts for state and many Social Security and less certain income from local employees. More recently, governmental budget employer pensions.” Similar to the 2005 study, problems, combined with growing public concern a 2010 U.S. Census Bureau paper found that about retirement benefi t costs, have resulted in a replacement rates for the median individual—as of wave of benefi t reductions—particularly for future 2004—was between 66 percent and 75 percent of employees—and employee contribution increases. pre-retirement income. Th ese have aff ected most state employee groups, as State and Local Government Benefi ts (Not well as some local employee groups. Including Teachers). In our 2005 publication, Th e Replacement Ratio: Less Income Generally 2005-06 Budget: Perspectives and Issues (see page Needed in Retirement. A person’s income needs 132), we compared state “miscellaneous” (non-public generally are less in retirement than when working. safety) pensions then in place with those of 15 other Th is is because clothing and daily travel expenses states. Of the states we surveyed, California off ered decline, home mortgages may be paid off at this the highest retirement benefi ts. We also discussed point in life, and retirees may be in a lower tax the generous nature of public safety pension benefi ts bracket than when working. As a result, retirees and local government benefi ts then in place. 8 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT Since 2005, the state and some local govern- For pension plans serving public employees not in ments have enacted pension benefi t changes— Social Security, the report found the average benefi t particularly for new employees hired aft er a given multiplier was 2.3 percent. date—and increased employee contributions, We believe that the data shows that defi ned oft en through negotiation with rank-and-fi le pension benefi ts off ered to California’s state, city, union representatives. Nevertheless, some local county, and special district employees have been governments have continued to off er particularly among the most generous in the country in recent generous pension benefi ts, including “2.5 percent years. While there have been some reductions in at 55,” “2.7 percent at 55” and “3 percent at 60” for these benefi ts recently, some California govern- miscellaneous employees, as well as “3 percent at ments still off er among the most generous defi ned 50” benefi ts for public safety employees. In pension pension benefi ts available anywhere in the United parlance, for example, 2.5 percent at 55 means—in States public or private labor market today. In many simplifi ed terms—that a retiree can receive a cases, California public pension benefi ts for career benefi t equal to 2.5 percent (the benefi t factor or public employees—coupled with other sources of multiplier) of his or her fi nal compensation multi- retirement income—can replace far more than the plied by the number of years of service if retiring at 65 percent to 75 percent income replacement ratio 55. Lesser benefi ts are available if they retire earlier described earlier. than 55, and higher benefi ts may be available in a Teachers. Several reports have indicated that formula if a person retires aft er the age indicated teachers enrolled in CalSTRS receive less generous in the formula. As we suggested in our 2005 benefi ts than other kinds of public employees in report, these kinds of generous benefi t levels result California. In 2009, CalSTRS staff presented to in some career public service workers receiving the Teachers’ Retirement Board a study examining pension benefi ts above—and in some cases, well replacement ratios for teachers under CalSTRS above—the 65 percent to 75 percent replacement benefi t formulas that were to be in eff ect in 2011. ratio described above, particularly when Social Th e CalSTRS report found that the median Security and other sources of retirement income CalSTRS retiree as of 2011 (retiring aft er are considered. While the state and some other 29 years of service) would have a retirement public entities have negotiated with employees income replacement ratio of 78 percent. Th is for reductions in these generous benefi t formulas, consisted of a CalSTRS defi ned benefi t of CalPERS’ most recent annual report shows that $3,914 per month, a defi ned benefi t supplement a few governments were still switching to some program payment of $93 per month, and a of these particularly costly benefi t packages as supplemental annuity payment from a defi ned recently as 2009-10. contribution plan of $613 per month. (Th is Th e most recent version of a public pension defi ned contribution component represented comparison report prepared periodically by the about 13 percent of the total assumed retirement Wisconsin Legislative Council indicates that, income for the median CalSTRS retiree.) Th e for public employees in Social Security, pension study assumed that the median CalSTRS retiree benefi t “multipliers” of 2.1 percent or higher are invested $100 per month over a 25-year career in a rare—available for only 7 percent of surveyed plans. defi ned contribution account. Th e report found that, among comparable plans, the In addition to considering the median average pension benefi t multiplier was 1.94 percent. CalSTRS retiree, the study also showed www.lao.ca.gov Legislative Analyst’s Offi ce 9 AN LAO REPORT replacement ratios for CalSTRS retirees at the 25th percentage of their retirees with higher pension and 75th percentiles of income, respectively. Th e benefi ts—and the amounts of those benefi ts—grow replacement ratio for the 25th percentile retiree for these same reasons. Th is trend is already (retiring aft er 18 years of service) was 42 percent, apparent in data provided by the pension systems. while the replacement ratio for the 75th percentile In its fi nancial reports, for example, CalPERS retiree (retiring aft er 35 years of service) was publishes statistics on the characteristics of 103 percent. Th e report said that teachers retiring employees retiring in each fi scal year. In 2003-04, without employer-subsidized health coverage 4,831 people retired with 30 or more years of would need more income to maintain a suitable service, and this group retired with an average replacement ratio. Specifi cally, it listed a “recom- monthly pension of $4,553 (equating to $54,636 mended replacement ratio” of around 77 percent per year). In 2008-09, there were 5,801 retirees of fi nal compensation for those retired teachers with 30 or more years of service, and they had an with health care benefi ts and around 89 percent average monthly pension of for those without health care benefi ts. $5,569 ($66,828 per year)—up 22 percent in Retirees With Benefi ts of $100,000 Per Year or non-infl ation adjusted terms compared to the More. In recent years, there has been considerable initial benefi t of the 2003-04 retiree group. Growth public attention related to retired California public in monthly pension benefi ts was even greater in employees receiving annual pension benefi ts of percentage terms during this period for employees $100,000 or more. Th ese individuals are a small, retiring with 10 to 30 years of service. For retirees but growing, segment of California’s public sector with 25 to 30 years of service for example, the retirees. About 2 percent of CalPERS and CalSTRS average initial pension grew from $3,308 per month retirees currently receive such payments. Payments ($39,696 per year) for 2003-04 retirees to $4,432 per to these retirees now equal around 7 percent to month ($53,184 per year) for 2008-09 retirees—up 9 percent of total pension payments from the two 34 percent in non-infl ation adjusted terms. systems. During their working lives, these retirees Th is data from CalPERS’ annual report generally were among the longest-serving and suggests that while the average pension benefi t for highest-paid public employees—for example, senior all CalPERS retirees (including those who retired executives and managers of some state and local decades ago) is around $25,000 per year, such agencies, school districts, and community colleges, average retirees are not responsible for the bulk of as well as some employees in public safety agencies. benefi ts that CalPERS will pay out in the future. Th e percentage of CalPERS, CalSTRS, and For public employees who retired in 2008-09, the other public retirees receiving pension benefi ts of newest retiree group for which data is available, over $100,000 per year will grow in the future for it appears that around 60 percent of CalPERS several reasons. Th ese reasons include the eff ects of benefi t costs are being paid to retirees with 25 or infl ation (which tends to increase all employees’ pay more years of service. Th e average annual benefi t and pension benefi ts over time) and the eff ects of for this group is somewhere between $53,000 and increased pension benefi t provisions put in place in $66,000—over double the amount paid to the the late 1990s and early 2000s. average retiree in the system. For those 2008-09 Beyond the group of retirees receiving retirees with 25 to 30 years of service, their monthly payments of $100,000 or more per year, many defi ned benefi t pension is replacing an average public retirement systems can expect to see the 67 percent of their fi nal career compensation; for 10 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT those retirees with 30 or more years of service, the public agencies. In 2009-10, buoyed by favorable monthly defi ned benefi t pension is replacing an investment performance, CalPERS reports that average 79 percent of their fi nal career compen- its funded status improved somewhat—to around sation. Some of these retirees also receive Social 65 percent when measured based on the market Security benefi ts, and some also have defi ned value of assets. Fiscal year 2010-11 saw even more contribution savings, which would increase their favorable investment returns. replacement ratios further. Over time, retirees like Unlike CalPERS, but like most other pension the 2008-09 cohort will become more of the norm systems, CalSTRS recognizes investment gains and in CalPERS and other public pension systems. losses in its actuarial valuations over a multiyear period. Due to the near-collapse of world fi nancial Tendency to Defer Costs to Future Generations markets in 2008, CalSTRS and other pension Unfunded Pension Liabilities. A troubling systems sustained heavy losses, and the continued trend of California’s state and local public pension recognition of those losses is the major driver of the systems has been the growth of substantial system’s growing reported UAAL. Th e most recent unfunded actuarial accrued liabilities (UAAL). CalSTRS valuation indicates the system’s UAAL Put in very simple terms, an unfunded liability is grew from $40.5 billion as of the 2009 valuation to the amount that would need to be invested into a just over $56 billion as of June 30, 2010. Th is means public pension plan today such that, when coupled that CalSTRS’ reported funded ratio dropped from with amounts already deposited in the fund plus 78 percent as of the 2009 valuation to 71 percent in assumed future investment earnings, all benefi ts the June 30, 2010 valuation. earned to date by public employees would be Pension systems in California and elsewhere funded upon their retirement. While there is some reported growth in their UAALs aft er the 2008 disagreement on how to value unfunded liabilities market collapse and then experienced a recovery of pension systems, it is clear that California’s state in their funded status during the relatively strong and local systems are coping with very large short- investment markets of 2009-10 and 2010-11. falls. Th ese shortfalls will push costs upward— Th ese trends illustrate a primary reason that above what they otherwise might be—for years to unfunded liabilities emerge: weaker-than-expected come, in some cases. investment returns. Lower-than-expected As of June 30, 2009, CalPERS reported that investment returns have been a primary reason its UAAL in its main pension fund for state and for growth of unfunded pension liabilities in the local governments was over $49 billion—consisting last decade. Such investment weakness—relative to of about $23 billion for the state and $26 billion some pension systems’ assumption of 7.5 percent for other public agencies. Because the UAAL to 8 percent investment return per year—has given uses data that “smoothes” investment gains and fuel to critics, who believe that these assumptions losses over extraordinarily long periods of time, are imprudent and understate costs that govern- CalPERS tends to communicate its funded status ments and employees should contribute for a given by another, more volatile measure that relies on set of benefi ts. the market value of its investments at any given Other reasons for unfunded liabilities include time. By this measure, CalPERS’ main pension benefi t increases that are implemented retroactively fund was 61 percent funded with a $115 billion (that is, applied to previous years of service before unfunded liability, split between the state and other the benefi t enhancement is implemented) and www.lao.ca.gov Legislative Analyst’s Offi ce 11 AN LAO REPORT demographic and pay changes among employees have begun to pay down their unfunded retiree and retirees. If retirees live longer than expected health liabilities, such liabilities will remain a by plan actuaries, unfunded liabilities can result. If pressing burden for many California public entities employees are paid more than expected during their as the decades progress. Th e state government’s career relative to assumptions of plan actuaries, this unfunded retiree health liabilities alone total about also can contribute to unfunded liabilities. $60 billion, as of June 30, 2010, according to the Unfunded Retiree Health Liabilities. For many State Controller’s Offi ce. A report released by a governments, the size of unfunded retiree health commission in early 2008 estimated that all public liabilities has rivaled or exceeded their unfunded entities in the state had a combined retiree health pension liabilities. In contrast to pensions, govern- unfunded liability of over $118 billion as of that ments typically have not “pre-funded” their retiree time; that total probably has grown since then. health liabilities. In other words, they generally Unfunded Liabilities and Growing Benefi ts have never set aside funds—or required employees Have Increased Costs. Increased benefi ts and to do so—to cover the future costs of retiree health the emergence of large unfunded liabilities have benefi ts earned during their working lives. Th is increased pension and retiree health costs for many means that future taxpayers may bear a larger California governments in recent years. In Figure 1, cost burden for these benefi ts. Unlike pensions, we show the trend of increasing state General Fund there are no investment returns under this type costs for retirement benefi ts in nominal dollars. A of funding structure to cover a large portion of major reason for the magnitude of recent growth benefi t costs. While a small portion of governments in state costs is the fact that public employers generally benefi ted from “pension holidays” in the Figure 1 late 1990s and early 2000s State Retirement Costs Have Been Growing due to the stock market bubble that temporarily General Fund (In Billions) resulted in systems like $6 CalPERS being fully CalSTRS 5 CalPERS Retirement Programsa funded or close to it. CalPERS Retiree Health Programb Figure 2 shows the Other 4 contribution rates paid by the state as a percentage 3 of pay for several key employee groups. (While 2 state contributions as 1 a percentage of pay were slightly higher in 1980—before the period 1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 2008-09 2011-12 covered in Figure 2—that a Amount for 1997-98 includes an over $1 billion state payment related to a major court case involving CalPERS. period is not directly b Includes the budget item for these costs and LAO estimate of the General Fund share of the implicit comparable to the present subsidy for annuitant benefits that is paid along with employees’ health premiums. day since CalPERS at 12 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT that time invested primarily in fi xed-income bond prospectively—without a government’s off ering instruments and assumed an annual investment comparable and off setting advantages (which, return of only 6.5 percent. themselves, can be quite expensive). Th e case law suggests that governments do have some power to Infl exible Benefi ts, Infl exible Costs alter benefi ts when they face emergency situations, Strict Legal Limits on Changing Benefi ts but these powers are very limited, and govern- and Reducing Government Costs. In our view, ments, according to case law, generally will have to perhaps the most signifi cant retirement benefi t alter benefi ts temporarily, with interest accruing challenge facing California governments is that to employees and retirees in the meantime. In there is very little fl exibility for governmental some cases, local governments may be able to employers under decades of case law that are alter contracts when they seek protection under extremely protective of employee and retiree Chapter 9 of the U.S. Bankruptcy Code. pension rights. In California, pension benefi ts Negotiations Can Help, but Unions Must for public employees are an element of a public Represent Th eir Members. In general, the primary employee’s compensation. He or she begins to way that the state and local governments can accumulate pension rights at the moment of hiring, change pension benefi ts for current and past and these benefi ts accumulate throughout a public employees is to negotiate with employee groups. As service career. Th ere is a detailed case law in the discussed above, the state and some local govern- state that protects these benefi ts as contracts under ments have successfully reduced pension costs the State and U.S. Constitutions. Pension benefi t recently through such negotiations. Th e challenge packages, once promised to an employee, generally with this approach, however, is that unions have an cannot be reduced—either retrospectively or obligation to represent their members, and so, in Figure 2 State Retirement Contribution Rates Have Increased As Percent of Payroll by Retirement Category 40% 35 Miscellaneous Tier 1 Correctional Officer and Firefighter 30 California Highway Patrol Officers 25 20 15 10 5 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07 2008-09 2010-11 www.lao.ca.gov Legislative Analyst’s Offi ce 13 AN LAO REPORT exchange for pension concessions, they generally to current and past employees’ retirement benefi ts, will be duty bound to seek comparable, off setting it is clear that they may change benefi t promises benefi ts for their members. For example, many of prospectively for future hires without limit. the recent state employee agreements that increased Disparity Between Public and employee contributions to their pensions included Private Retirement Benefi ts future pay increases roughly equivalent to the increase in the employee pension contributions. Underlying the real policy and fi scal problems of Th is is understandable, given the history of the current public retirement systems is a sharp divide state’s benefi t commitments and the obligations between public-sector and private-sector workers. of unions to represent their members, but it limits Public-sector workers have guaranteed, defi ned- governments to an extent from achieving lasting benefi t pension plans, and many, but not all, of them cost savings for current and past employees have retiree health plans too. Private-sector workers through the negotiation process. by and large have none of these things anymore. Th e For Future Employees, Government Can Governor’s proposal, in essence, aims to reduce this Alter Pension and Retiree Health Benefi ts. While substantial disparity. governments have very little fl exibility with regard GOVERNOR’S 12-POINT PLAN The Governor released his 12-point pension E QUAL S HARING OF P ENSION C OSTS plan on October 27, 2011. In addition to making remarks at a press conference, the Governor Background released a short description of the goals of Normal Cost and Unfunded Liability his plan. While some of the elements of the Contributions. Contributions to pension plans plan have been included in prior legislative from employers and employees consist of two vehicles (and the Governor released language main components: (1) “normal cost” contributions, for similar proposals on March 31), our review which generally are equal to the amount actuaries below is based primarily on the Governor’s estimate is necessary—combined with assumed pension handout from October 27 and his press future investment returns—to pay the cost of future conference, as well as subsequent contacts with pension benefi ts that current employees earn in administration staff concerning the plan. Draft that year and (2) contributions to retire unfunded legislative language to implement the Governor’s liabilities. For example, CalPERS estimates that proposals would need to fill in many details the normal cost for state Miscellaneous Tier 1 absent from his October 27 presentation. workers (such as state offi ce workers and most CSU Below, we will review each of the 12 points in employees) is now 14.4 percent of their payroll. In turn, providing, in some cases, some background addition, the annual cost to retire unfunded liabil- information, a description of the Governor’s ities for Miscellaneous Tier 1 workers—plus some proposal, and our initial comments. related benefi t costs—equals 10.4 percent of payroll, for a total required contribution of 24.8 percent of payroll. For CalPERS’ state Peace Offi cer and Firefi ghter workers (principally state correctional 14 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT offi cers), the normal cost is now 25.4 percent of their negotiated with their unions to increase employee payroll, and the annual cost to retire unfunded contributions to local pension plans. As the liabilities is 11.3 percent of payroll, for a total Governor points out, however, there remains a wide required contribution of 36.7 percent of payroll. disparity among public employers in what portion Most State Workers Pay One-Half of Normal of normal costs and total required contributions Costs and One-Th ird of Total Costs. Following is borne by public employees themselves. In some the recent agreements of state employee unions to cases, public employees make no such contribu- increase their employees’ contributions to CalPERS, tions. Various laws, agreements, and precedents over 70 percent of Miscellaneous Tier 1 workers allow some employers to pay a portion of their contribute approximately 8 percent or more of employees’ contributions to pension plans. In many monthly pay to cover pension costs. Th is 8 percent cases, such a payment merely substitutes for pay exceeds 50 percent of the normal cost contributions the employers otherwise might choose to give to for these employees, but, for most, represents only employees, but it means that some employees may about one-third of the total required contribution, see no real costs for their pension benefi ts when including both normal costs and unfunded liability reviewing their pay stubs. Th ere is concern among contributions. In the state Peace Offi cer and some that many of these public employees view Firefi ghter group, about 80 percent of workers now their substantial pension as a sort of “free good.” contribute about 11 percent of their monthly pay Proposal to cover pension costs. Th is represents just under one-half of the normal cost contributions for these Equal Sharing of Normal Costs, but Unclear employees, but less than one-third of the total If Sharing Would Apply to Other Costs. Th e required contribution. Governor’s plan proposes that all current and With Fixed Employee Contributions, future public employees be required to pay at least Employers Cover Any Cost Changes. In current law 50 percent of the normal costs of their defi ned and most employee contracts, employee contributions pension benefi ts. Th is seemingly would mean that to their pensions generally are fi xed. Th is means that there would be no more employer payments of the portion of the total required contribution not paid required employee pension contributions. Th is by workers generally is paid by the public employer— requirement would be phased in “at a pace that in this example, the state. While normal costs tend to takes into account current contribution levels, remain fairly stable over time, assuming no changes current contracts and the collective bargaining in the pension benefi t structure, unfunded liabilities process”—apparently, over several years. can change markedly from year to year due mainly to Th e Governor’s proposal explicitly addresses upturns and downturns in the investment markets. only the employee share of normal costs and is Since employee contributions generally are fi xed in unclear as to whether the 50 percent requirement labor agreements or state or local law, this means also would apply to unfunded liability contri- that the public employer can experience signifi cant butions. It is also unclear if the 50 percent increases in total required contributions as unfunded requirement would apply to defi ned contribution liabilities increase and signifi cant decreases in total fund deposits (which also can be split 50/50 required contributions when those liabilities drop. between employers and employees, in theory). Public Employee Contributions Vary. Like the Governor Says Th is Provides “Real Near-Term state, some local public employers recently have Savings.” By applying the increased employee www.lao.ca.gov Legislative Analyst’s Offi ce 15 AN LAO REPORT payment requirement to both current and future employees to bear a portion of unfunded liability public employees, the Governor states that this costs would reduce the year-to-year volatility change would provide near-term cost relief for of government contributions to pensions. In some public employers, since increased employee effect, this change would transfer a portion of contributions would reduce contributions that this volatility risk from employers (who now public employers otherwise would have to make. generally pay all increases due to unfunded liabilities) to employees. LAO Comments Case Law: Possible for Some Current Governor’s Proposal a Good Start in Th is Employees, but Probably Not for Many Others. Area. We agree with the Governor that future At his press conference announcing the proposal, public employees should be required to pay for the Governor said his proposal addressed a portion of pension contributions. We believe “existing employees by increasing their contri- it would enhance public confi dence in state and bution rate.” He added, “One thing we know for local retirement systems for there to be a clear, sure: under constitutional law, the employer can unambiguous statewide policy in this area. Th ere require higher contributions.” is no single correct percentage of total required We do not share the Governor’s belief that contributions that employees should be required existing constitutional law clearly allows the to pay, but 50 percent is a reasonable starting state to require current public employees to point for the discussion. contribute more to pensions. To the contrary, Important for Employees to Share in such a proposal seems to run counter to existing Unfunded Liability Costs Too. We urge the constitutional protections in case law that may Legislature to require that future public protect many current and past public employees. employees bear a portion of not only pension In the nearby box (see page 18), we summarize normal costs, but also unfunded liability the case and statutory law in this area, which contributions. When public employers see suggests that it might be possible to increase their pension contributions go up due to a contributions for some current employees, but downturn in the stock market or similar reasons, not for others. For many current employees, such employees should see their contributions rise contribution increases probably could be imple- as well. Similarly, when public employers see mented only through negotiations, and in any their pension contributions drop due to stock event, would result in many employers increasing market upticks, employees should benefit from a pay or other compensation to offset the financial reduction in their contributions. effect of the higher pension contributions. Since Like many others, we are concerned that increasing current employees’ contributions is public retirement boards make excessively one of the only ways to substantially decrease optimistic assumptions concerning future employer pension costs in the short run, the legal investment returns. We believe that requiring and practical challenges that we describe mean public employees to bear a portion of the cost that the Governor’s plan may fail in its goal to (or benefit from a portion of the savings) when deliver noticeable short-term cost savings for these assumptions prove inaccurate will incen- many public employers. tivize retirement boards to make more prudent investment assumptions. Moreover, requiring 16 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT H YBRID P ENSION P LAN FOR F UTURE E MPLOYEES and employee contribution schedules that would aim to produce a 75 percent Background replacement ratio for non-public safety employees assuming a 35-year public- “Hybrid” pension plans generally combine sector career. Th e defi ned benefi t pension a defi ned benefi t pension with a defi ned contri- plan would be responsible for about bution retirement savings plan. Accordingly, it one-third of the 75 percent replacement is important to understand the characteristics of income, the defi ned contribution plan both such plans. Th e key diff erence between such another one-third, and Social Security the plans is the handling of investment risk. In most fi nal one-third. For teachers and others defi ned benefi t plans, such as California’s state not in Social Security, the defi ned benefi t and local pension systems, employers bear almost would be responsible for two-thirds of all investment risk. Th is means that if investment the 75 percent replacement income, with returns of the systems over time are less than defi ned contribution plans responsible for projected, public employer costs rise, but public the remaining one-third. employee costs do not change. By contrast, in defi ned contribution plans, an employer is obligated • Public Safety Employees. Th e hybrid to make only a specifi c amount of contributions plans would be based on employer and in the years that employees work. If investment employee contribution schedules that returns are less than desired, the employer is not would aim to produce a 75 percent obligated to contribute anything more to a defi ned replacement ratio for public safety contribution plan. In defi ned contribution plans, employees assuming a 30-year public- therefore, employees and retirees generally bear all sector career. For those employees not investment risk. in Social Security, as with teachers, the defi ned benefi t would be responsible for Proposal two-thirds of the 75 percent replacement Hybrid Plan for Future Public Employees. income, with defi ned contribution plans Th e Governor proposes that future public responsible for the remaining one-third. employees be enrolled in hybrid retirement plans. Benefi t “Cap” for High-Income Public Details of the Governor’s idea are somewhat Employees. Th e Governor’s plan also references a unclear, but he appears to envision employer cap on the defi ned benefi t portion of the proposed and employee contributions to both defi ned hybrid plan requirement so that public employers benefi t and defi ned contribution plans, as well as do not face high costs for pension benefi ts of employees’ participation in Social Security (except, future high-income public workers. Such a cap presumably, for future teachers and most public might aff ect future public workers like the small, safety workers). Th e Governor seems to propose but growing, portion of current public pensioners that the state Department of Finance be empowered who receive pension benefi t payments exceeding to design such hybrid plans based on the following $100,000 per year. Th e Governor’s plan provides no general goals: detail on how such a cap might work. • Non-Public Safety Employees. Th e hybrid plans would be based on employer www.lao.ca.gov Legislative Analyst’s Offi ce 17 AN LAO REPORT Strict Legal Protections Limit Government’s Flexibility Our understanding of California’s detailed case law on public pensions over the last century is as follows: in order to have the fl exibility to unilaterally implement cost-saving reductions to the pensions of current and past employees, public employers need to have explicitly preserved their rights to make such changes either at the time of an employee’s hiring or in subsequent, mutually-agreed amendments to the pension arrangement. Otherwise, reductions for these employees and retirees require that comparable, off setting advantages be granted—advantages that tend to negate the pension savings. “Comparable New Advantages” Generally Required When Disadvantaging Employees. Th e 1955 California Supreme Court case, Allen v. Long Beach, is an important landmark in California pension law. Th e court ruled that “changes in a pension plan which result in disadvantage to employees should be accom- panied by comparable new advantages.” One of the pension amendments invalidated in Allen increased each employee’s pension contribution from 2 percent to 10 percent of salary. Th e Supreme Court, in fact, declared that this increased contribution requirement “obviously constitutes a substantial increase in the cost of pension protection to the employee without any corresponding increase in the amount of the benefi t payments he will be entitled to receive upon his retirement.” In Pasadena Police Offi cers Association v. City of Pasadena (1983), a state appellate court said the precedent in Allen meant that “where the employee’s contribution rate is a fi xed element of the pension system, the rate may not be increased unless the employee receives comparable new advantages for the increased contribution.” Th e appellate court added that while “an increase in an employee’s contribution rate operates prospectively only and in eff ect reduces future salary…in Allen the Supreme Court struck down such a change on the grounds that it modifi ed the system detrimentally to the employee without providing any comparable new advantages.” What About Changing Future Benefi t Accruals? Th e logic in the Allen and Pasadena Police Offi cers Association cases, among others, makes it very diffi cult to assume that state or local governments could unilaterally change the rate at which current employees accrue pension benefi ts for their future service, as has been suggested by various recent proposals. (Th e Governor does not make such a proposal.) In a 1982 case, Carman v. Alvord, the California Supreme Court noted that upon “entering public service an employee obtains a vested contractual right to earn a pension on terms substantially equivalent to those then off ered by the employer.” In the 1991 case concerning Proposition 140, the court considered that measure’s termination of then-incumbent legislators’ rights to earn future pension benefi ts through continued service. In that case, the court said the termination of the benefi t accrual rights for these legis- lators was a contract impairment and was unconstitutional under the U.S. Constitution’s contract clause because it infringed on their vested pension rights. (Proposition 140, it should be noted, did end pension benefi ts for legislators elected aft er its passage.) Furthermore, in the Pasadena Police Offi cers Association case, the appellate court noted that an employee “has a vested right not merely to preservation of benefi ts already earned…but also, by continuing to work until retirement eligibility, to earn the benefi ts, or their substantial equivalent, promised during his prior service.” Signifi cant Challenges to Mandating Th at Current Workers Contribute More. While the case law described above is protective of current and past public employees’ pension rights, it indicates that 18 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT governments may be able to unilaterally (that is, outside of negotiations) change elements of the pension arrangement if they have explicitly preserved the right to do so. For example, in International Association of Firefi ghters, Local 145 v. City of San Diego (1983), the California Supreme Court ruled that a city could increase employee contribution rates pursuant to city charter and ordinance provisions that allowed it to do so. Accordingly, some public employers that have carefully preserved such rights could unilaterally implement increases in current workers’ pension contributions. We suspect that many local governments may not be in a good position to defend their ability to implement such increases. While several sections of the state’s CalPERS and 1937 Act laws purport to preserve the Legislature’s ability to increase certain CalPERS contribution rates or make clear that state law itself does not limit local governments’ ability to periodically increase, reduce, or eliminate their payments to off set required employee contributions, local governments—promising, as they do, a wide variety of retirement packages through dozens of retirement systems—may obligate themselves contractually. Even in a 2009 decision upholding San Diego’s ability to impose higher employee pension costs at a bargaining impasse, the Ninth Circuit federal appeals court distinguished between legislatively enacted reductions in employers’ payment of a share of employees’ required pension contributions (allowable, the court ruled) and legislatively imposed increases in the total amount of required employee pension contribu- tions themselves (implying the latter may be unallowable under contract law). Th e Ninth Circuit stressed that looking into a state or local legislative body’s intent was key to determining whether a retirement benefi t provision was contractually protected. Accordingly, some local governments may have intended to include low employee contributions as a part of their pension contract, while others may not. Th is muddled, uncertain legal framework seems to us inconsistent with the Governor’s claim that governments have broad legal ability to mandate current employee contribution increases. Furthermore, even if unilateral increases are permissible under contract law, they will directly or indirectly result in many governments having to pay more to employees in salaries or other forms of compensation in order to remain competitive in the labor market. For example, recent increases in most state employees’ contributions negotiated with rank-and-fi le employees were accompanied by future salary increases of similar amounts. Since increasing current employees’ contributions is one of the only ways to substantially decrease employer pension costs in the short run, these substantial legal and practical hurdles mean that the Governor’s plan may fail in its goal to deliver noticeable short-term cost savings to many public employers. Key Lesson From Case Law: Governments Should Be Clear About Th eir Pension Rights. Th e case law makes clear to us that governments oft en have not been clear about what aspects of pension and retiree health benefi ts and contributions—if any—they can change unilaterally in the future and which they cannot. For this reason, we have recommended that the Legislature require local governments to explicitly disclose to employees—preferably, on the day that they are hired—which aspects of pension and retiree health benefi ts and contributions the public entity can change unilaterally (that is, without negotiation) and which it cannot. If it chose to do so, the Legislature could require that such disclosures refl ect the results of collective bargaining and apply only to future employees . (Approval of such a requirement by voters may be necessary to avoid the state having to reimburse local governments for this disclosure mandate.) www.lao.ca.gov Legislative Analyst’s Offi ce 19 AN LAO REPORT LAO Comments I R A NCREASED ETIREMENT GES F E Excellent Starting Point for Discussion. We FOR UTURE MPLOYEES previously have recommended that the Legislature take steps to ensure that future public workers are Background enrolled in hybrid plans. Th is can reduce substan- In California, public employee pension tially the risk of future unfunded pension liabilities formulas oft en are referenced in a type of by shift ing a signifi cant portion of the risk that shorthand—such as 2 percent at 55—that implies public employers now bear for defi ned benefi t plans there is a single “retirement age” (in this case, 55). to defi ned contribution plans instead. In defi ned Actually, current California public employees in contribution plans, employers bear no risk for this group are eligible to begin receiving service future investment returns, and unfunded liabilities retirement benefi ts at age 50—although with a for these plans are not possible. lower benefi t factor. In most cases, however, these Major Policy Shift Would Make Public employees work longer so that they can increase Employees More Like Private-Sector Workers. their retirement benefi ts through a higher factor. We believe that moving future public employees to For example, in the 2 percent at 55 group for hybrid plans would address a key policy concern non-public safety state employees, employees can relating to the current public employee pension “max” out their factor at 2.5 percent at age 63. Even system—the growing disparity between public- this, however, is not the “maximum retirement sector and private-sector employee retirement age,” as workers generally can continue to increase benefi ts and security. Moving to a hybrid plan would their benefi ts by working more years beyond age 63. bring public employees’ retirement packages closer As shown in Figure 3, in the state’s three largest in line with those of their private-sector counterparts public employee retirement systems, the average and serve to discourage future public employees state or local employee retired at about age 60 as from retiring as early as their predecessors do today. of 2009-10. Public safety employees tend to retire a Finally, we believe that the Governor’s goal to have few years earlier. Moreover, due to recent changes career public workers have a retirement income in benefi ts for newly hired state employees and equal to about 75 percent of their career income some local employees, average retirement ages in makes sense and is in line with studies indicating many of the groups shown in the fi gure will tend the replacement ratio to preserve an employee’s to increase somewhat in the coming decades under lifestyle in retirement. (Th is is particularly true if current policies, even if the Governor’s proposal is the employee has supplemental employer-subsidized not adopted. health coverage during retirement.) It is also worth noting that many retirees We discuss our concerns related to the receiving benefi ts from public retirement systems proposed cap for high-income public workers later also work in other jobs during their lifetime, in this report. Also, as discussed immediately including private-sector positions. Th ese partial below, there appear to be discrepancies between career employees can receive relatively small this part of the Governor’s proposal and his pension benefi ts. Calculations of the average proposal to increase future public employees’ monthly or annual pension benefi ts paid by public retirement ages. pension systems oft en include these partial-career workers. If such workers were excluded from these 20 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT calculations, average monthly benefi ts paid would believe it is appropriate to increase retirement be higher than shown by public pension systems in ages for future public employees. Failing to do so many cases, and average retirement ages shown in would risk a growing long-term fi scal burden for Figure 3 also could be aff ected. governments supporting pension programs, since future increases in longevity would then produce Proposal proportionate or greater increases in pension and Work to a Later Age Would Be Required for retiree health benefi t costs. Th ere is no single right Full Benefi ts. Th e Governor’s plan seemingly age to target, especially for public safety workers. It requires that all future public employees work to a will be important, however, for the Legislature to later age to qualify for full retirement benefi ts. Th e set a specifi c policy for public safety workers rather Governor proposes that non-public safety pensions than the nebulous one that the Governor’s proposal for future employees target a retirement age at seems to suggest. 67 (the current Social Security retirement age for Th e Legislature also may wish to consider those workers). Future public safety workers would whether the current age of minimum service target a lower retirement age “commensurate with retirement eligibility for most public employees— the ability of those employees to perform their jobs age 50—should be increased. in a way that protects public safety.” (As discussed Possible Confl ict With Other Parts of the below, it is not clear exactly what the Governor Proposal. We are uncertain how the Governor’s means in this part of his proposal. Presumably, retirement age proposal squares with other aspects this would be addressed when the administration of his proposal. Specifi cally, if future non-public provides additional details about its plan.) safety workers are to work until age 67 to receive Th e Governor points out that these changes full retirement benefi ts, this suggests that a public would reduce signifi cantly both pension and employee entering government service right out retiree health costs for governments. In particular, of college or high school might have to work for employees would have fewer, if any, years Figure 3 between retirement Average Retirement Ages for Selected Public and reaching the age Employee Groups in 2009-10 of Medicare eligibility. Age Aft er the age of Medicare California Public Employees’ Retirement Systema eligibility, a substantial California Highway Patrol Offi cers 53 Local public safety offi cers 55 portion of public-sector State correctional offi cers and fi refi ghters 60 retiree health care costs Other state and local employeesb 60-61 shift to the federal govern- California State Teachers’ Retirement Systema ment’s Medicare program. School district and community college teachers 62 University of California Retirement Plan LAO Comments Professional and support staff members 59 Academic faculty 63 Increasing Average a Includes service retirements only. Disability retirements, on average, occur 8 to 11 years earlier for Retirement Ages CalPERS members and about 6 years earlier for CalSTRS members. b Includes state and local “miscellaneous” employees, such as government offi ce workers. Is Essential. Given CalPERS = California Public Employees’ Retirement System; CalSTRS = California State Teachers’ Retirement System. increased longevity, we www.lao.ca.gov Legislative Analyst’s Offi ce 21 AN LAO REPORT over 40 years to receive such benefi ts. Yet, the LAO Comments Governor’s hybrid proposal envisions a 75 percent Broad Consensus for Th is Change. We previ- replacement ratio for such workers aft er only 35 years ously have recommended the Governor’s proposal. of government service. Accordingly, it is not clear Th ere seems to be broad public consensus for this how the Governor’s plan intends to mesh the key change, and it would be a small step to increase variables of the expected length of a working career, public confi dence in public employee pension replacement ratios, and retirement age. systems. We caution, however, that, despite frequent headlines concerning pension spiking, L S F E IMIT PIKINGFOR UTURE MPLOYEES this change probably would result in substantial pension cost savings for a relatively small group Background of future employees. It is not likely to result in Benefi ts for Many Still Based on Single signifi cant cost savings for governments. Highest Year of Salary. Many current public employees are entitled to receive pension benefi ts B ASE B ENEFITS ON R EGULAR , R ECURRING P AY based on their single highest year of government salary. As we discussed in our 2005 P&I report on Background public pensions, this single-year formula for deter- Current Rules Can Result in Some Abuses. mining pension benefi ts is very rare among state Th ere are some instances when public pensions and local employees in the United States; in fact, reportedly are increased as a result of employees it is a feature of public pensions in California and receiving additional pay from bonuses, unused almost nowhere else. vacation time, overtime, and other “perks.” Many In recent years, the state and some local pension systems, however, already prohibit such governments have moved to change the single-year compensation items from being used to calculate formula for newly hired employees by instead fi nal compensation for purposes of pension benefi ts. calculating their pension benefi ts based on their highest average annual compensation over a three- Proposal year period. Th is discourages pension “spiking,” Establish Uniform Rule to Prevent Abuses. Th e which includes eff orts of employees to change jobs Governor proposes that all public defi ned benefi t or receive increased pay during their fi nal one pension systems prohibit these types of compen- or two years of employment that increases their sation items from being included in fi nal compen- eventual pension benefi t by a large amount. sation used to determine annual pension benefi ts for future employees. Proposal Require “Th ree-Year Final Compensation” for LAO Comment Future Employees. Th e Governor proposes that all Broad Consensus for Th is Change. We future public employees have their defi ned benefi t recommend passage of this proposal. Such a change, pensions calculated based on their highest average if rigorously enforced by all pension systems and annual compensation over a three-year period. employers, should help increase public confi dence in California’s state and local pension systems. 22 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT Th is change, however, might lower costs for only a LAO Comments small percentage of future employees. Th is part of Important to Strike the Right Balance With the proposal seems unlikely, therefore, to produce Th ese Changes. While the Governor’s proposal substantial pension cost savings for governments. in this area lacks some detail, it seems reasonable to us, in that it seems to strike the right balance L P -R E IMIT OST ETIREMENT MPLOYMENT on limitations on postretirement employment. In A E FOR LL MPLOYEES many cases, public employers can benefi t from the expertise of retired workers while saving money— Background paying them little or nothing in the way of benefi ts. Currently, Individuals Can Return to Public (A full-time worker, by contrast, typically would Sector Aft er Retirement. California governments receive substantial benefi ts that would add to his oft en rely on “retired annuitants” and retired or her personnel costs.) We observe, however, that workers from other public employers to work it will be very diffi cult for pension systems across part-time or full-time. Such retired workers can the state to enforce this provision if it is indeed bring considerable expertise to public agencies. applied to limit a public retiree’s work for any state Some pension systems, such as CalPERS, limit or local employer in the state. For example, it might retired members to working for only 960 hours be diffi cult for the Los Angeles County Employees per year for certain state and local agencies, and Retirement Association to identify a newly hired, these retired annuitants’ services do not result in middle-aged employee who happened to be a their accruing any additional retirement benefi ts. retiree of, say, the UCRP. In other cases, an individual may be able to retire from one retirement system and work for an L IMIT F ELONS ’ R ECEIPT OF P ENSION B ENEFITS employer in a diff erent public retirement system, while accruing additional retirement credit in Proposal that second system. (Th is latter scenario probably Forfeit of Pension and Related Benefi ts. occurs very infrequently.) Th e Governor proposes that public offi cials and employees convicted of a felony in carrying out Proposal offi cial duties, in seeking elected or appointed offi ce, Extending CalPERS Limits to All Public or in connection with obtaining salary or pension Employers. Th e Governor proposes to limit all benefi ts forfeit their pension and related benefi ts. current and future employees in their post-retirement work for California governments. Specifi cally, the LAO Comments Governor wants to limit all current and future Proposal Raises Various Issues. Th e Legislature employees from retiring from public service and may want to explore certain issues regarding this working more than 960 hours per year for a public proposal. For instance, it is unclear to us whether employer—essentially extending the CalPERS this type of change would be constitutional in post-retirement employment rules to all public all cases as applied to current and past public employees. Th e Governor also would prohibit all employees. For future public employees, however, retired employees from earning retirement benefi ts for the state clearly may impose such a forfeiture service on public boards and commissions. requirement. In addition, would such forfeiture be prospective only, or would repayments of some www.lao.ca.gov Legislative Analyst’s Offi ce 23 AN LAO REPORT or all previously paid pensions to retired felons be long and unfunded liabilities almost always result required? What if the felon cannot repay such costs? from such retroactive benefi t grants. Moreover, retroactive grants oft en will play no role—or even a P R P I ROHIBIT ETROACTIVE ENSION NCREASES counterproductive role—in encouraging employee recruitment and retention. New recruits certainly Background do not benefi t from a higher pension benefi t applied Contributor to Recent Unfunded Liability to prior years of service. Valued career employees Increases. In recent years, many California govern- oft en will be incentivized to retire earlier than they ments have retroactively applied pension benefi t otherwise would due to their ability to receive a increases to some or all employees’ prior years of higher retirement benefi t. service. Th is can mean, for instance, that an employee Given the history of public employers in this who worked nearly all of his career earning benefi ts area and the limited instances in which such retro- based on one pension benefi t formula (for example, active benefi t grants would be of real value to public 2.5 percent at 55) was able to complete that career on employers, we recommend that the Legislature a higher pension benefi t formula (such as 3 percent approve this element of the Governor’s proposal. at 50). When the change is applied retroactively, that P P H ROHIBIT ENSION OLIDAYS worker may earn a pension benefi t equal to 3 percent of his fi nal compensation multiplied by his years of Background service, even though both he and his employer made contributions throughout his working life based A Relic of Past Boom Years in the Financial on a 2.5 percent benefi t factor. Accordingly, when Markets. During the late 1990s and early 2000s, that worker retires, the government is left with an the “tech bubble” years in the stock market when unfunded liability to address in the coming decades. public pension systems temporarily reported that they were overfunded, many public employers Proposal substantially reduced or entirely eliminated their Ban Retroactive Benefi t Increases. Th e annual pension contributions and, in some cases, Governor proposes to ban future retroactive public employee contributions were reduced as well. pension increases for all public employees. Prior Th is is the key reason why state pension contribu- retroactive increases are constitutionally protected tions to CalPERS were so low in some years of and generally cannot be changed. the late 1990s, as shown in Figures 1 and 2. State contributions to CalSTRS’ defi ned benefi t program LAO Comment also were reduced during this period, contributing An Important Change to Make. History to CalSTRS’ recent funding problems. suggests that, particularly at times when pension Proposal systems temporarily appear overfunded, retroactive benefi t increases can be very tempting for public Limit Ability of Employers to Suspend employers and employees—essentially a kind of Contributions. Th e Governor’s proposal would “free money” to provide to career public servants. “prohibit all employers from suspending employer Yet, as the Governor correctly points out, such free and/or employee contributions (related to both money generally will end up costing taxpayers, current and future public employees) necessary to since pension systems rarely remain overfunded for fund annual pension costs.” 24 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT LAO Comments Proposal Getting Details Right Is the Key. We agree Ban Airtime Purchases. Th e Governor that employers should be sharply limited in their proposes banning airtime purchases for current ability to suspend regular employer or employee and future employees. Prior airtime purchases contributions. History tells us that such periods of presumably would remain valid. overfunding oft en are fl eeting and may be based on LAO Comments temporary stock market bubbles. In 2008, the Public Employee Post-Employment Agree With Governor. In light of the diffi culty of Benefi ts Commission (PEBC) appointed by the pricing airtime accurately and its tendency to result prior Governor and legislative leaders agreed to in the creation of unfunded liabilities and higher a recommendation to restrict pension funding taxpayer costs, we recommend that the Legislature holidays. Th e PEBC recommended that employers approve this part of the Governor’s plan. be permitted to implement contribution holidays C C P B HANGE OMPOSITIONOF ENSION OARDS only based on the amortization of their surplus over a 30-year period. In other words, contribu- Background tions could fall to zero only in instances when the surplus is so great it can fund 30 full years of Proposition 162 Limits Ability to Change normal costs. We suggest that the Legislature use Pension Boards. California’s public retirement PEBC’s recommendation as a starting point in the systems are governed by boards that generally discussion in this area. consist of appointees of public offi cials and public employees and retirees elected by system P A P ROHIBIT IRTIME URCHASES members (or, in some cases, appointed by public offi cials). In 1992, Proposition 162—sponsored Background by public employee groups in response to eff orts Widely Available, but Very Diffi cult to Price. of Governor Wilson and the Legislature to alter Pursuant to state legislation or other law, CalPERS fi nancial arrangements relating to CalPERS— and many other public pension systems have placed in the Constitution a limitation on the allowed certain eligible public employees to buy Legislature’s ability to change the composition “airtime,” which is additional retirement service of state and local public retirement systems. credit for years not actually worked. For example, Accordingly, the Legislature generally may not a state employee can add fi ve years of service alter the number, terms, method of selection, credit—and, accordingly, increased retirement or method of removal of state or local pension benefi ts later—by paying a signifi cant sum of board members. To do so, a vote of the electors of money to CalPERS. In theory, the public employee the jurisdiction aff ected by the pension board is pays for the entire cost of this additional defi ned required. For CalPERS, for example, a statewide benefi t pension credit. In practice, however, airtime vote is required to change board membership. is nearly impossible to price accurately and, in Proposal the past, oft en has been priced far too low, which has resulted in the creation of a small portion of Change CalPERS Board. Th e Governor existing unfunded pension liabilities. proposes to add two public members with fi nancial expertise to the CalPERS board. Th ese board www.lao.ca.gov Legislative Analyst’s Offi ce 25 AN LAO REPORT members would be “independent,” in the sense that employees would be required to work for a full neither they, nor anyone in their family, may be a 25 years for the maximum state contribution to CalPERS member or have any material fi nancial retiree health premiums. Many current employees interest in an entity that contracts with CalPERS. must work only 20 years for this maximum Th e Governor also would replace the current contribution. Moreover, the Governor proposes representative of the State Personnel Board (a quasi- to reduce the current maximum retiree health independent state entity) that sits on the CalPERS subsidy for state retirees. Th e “100/90 formula,” board with the Director of Finance, a gubernatorial whereby the state contributes up to 100 percent of appointee. Th e Governor also apparently wants average employee health premium costs to retiree similar changes on other pension boards. health benefi ts, seemingly would be reduced to something more akin to around 80 percent LAO Comments of average premium costs (more typical of the No Issues With the Governor’s Proposal. subsidy current state workers receive during their We concur with the Governor that, ideally, more careers). Th e 100/90 formula, which therefore members of CalPERS and other pension boards provides a greater health subsidy in retirement would have signifi cant fi nancial expertise. We are than many state workers received during their unsure, however, whether this requirement would careers, was fi rst approved in 1978. lead to that, since “fi nancial expertise” is a fairly LAO Comments subjective term that could be met in a variety of ways, some of which may not be particularly Paired With Other Proposals, Potentially Huge relevant to pension board membership. Long-Term Cost Decrease. Combined with other We also agree that, given the state’s role proposals in the Governor’s package, which would as CalPERS’ largest fi nancial contributor, it is encourage employees to retire later, this change could appropriate for the Director of Finance to sit on dramatically reduce long-term state retiree health costs the system’s board. Other state offi cials currently below what they otherwise would be under current on the CalPERS board—the State Controller, the law. Moreover, by reducing retiree health subsidies State Treasurer, and the Director of the DPA—each to future workers in retirement, this change may have only a limited role in the state budget process. encourage some workers to retire a bit later, thereby Being the principal executive branch offi cial reinforcing other proposals in the Governor’s package. involved with the state budget process, the Director Th ere are many details of this proposal to work out, of Finance would be a valuable addition. but, in general, we believe that changes of this type are reasonable. Th e Legislature also could consider basing R R H B EDUCE ETIREE EALTH ENEFITS future employees’ retiree health subsidies on Medicare F S E FOR UTURE TATE MPLOYEES supplement plan costs (rather than active employees’ average premium costs—the basis in current law) and Proposal changing all or a part of retiree health subsidies for future Continues Eff ort to Increase Years of Service workers to defi ned contribution retiree health plans. In Required for Benefi ts. Th e Governor proposes defi ned contribution retiree health plans, employees, that all future state employees be required to work rather than the employer, bear the risk of future for 15 years before they become eligible for any investment returns and health care cost increases. state subsidy for retiree health premiums. Th ese 26 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT What About Funding Retiree Health Liabilities? current system of defi ned retiree health benefi ts (where governments promise a specifi c type of Governor Does Not Seem to Prioritize Addressing subsidy to health benefi t costs for public employees Retiree Health Funding Problems. Th e Governor’s in retirement), both the state and local governments plan does not seem to prioritize addressing the lack should transition gradually over time to requiring of prefunding of retiree health liabilities at either employer and/or employee contributions to cover the state or local level. As we have noted in several the costs of these future benefi ts. By authorizing prior publications—including Retiree Health Care: A CalPERS to establish the California Employers’ Retiree Growing Cost for Government (2006) and California’s Benefi t Trust (CERBT) Fund and working with First Retiree Health Valuation: Questions and some employee groups to begin funding state retiree Answers (2007)—it is important for governments and health liabilities, the Legislature already has taken employees to fund retiree health benefi ts as they accrue the fi rst steps to making retiree health prefunding a (that is, during the working lives of employees, when viable possibility for the state and other governmental they earn the right to receive these benefi ts). Because entities. Moreover, a number of governments—in the state and local governments, along with employees, addition to some state government employee groups— have long set aside funding for defi ned benefi t already have begun to prefund their retiree health pensions, these pensions are funded largely from benefi t liabilities through CERBT and other funding investment returns generated by these contributions. arrangements. In considering changes to pensions Yet, retiree health liabilities generally are not funded and retiree health benefi ts, the Legislature may wish at all by governments during the working lives of their to consider additional steps to require governments employees. Th is means that no investment returns are to properly fund their defi ned retiree health benefi t available to off set costs of governments and retirees systems. Such steps surely would need to be gradual, and adds substantially to the costs of providing these given the increased near-term budgetary costs they benefi ts. would impose on governments currently coping with Addressing Th is Problem Is Very Diffi cult When signifi cant fi scal challenges. Budgets Are Tight. Assuming continuation of the LAO PERSPECTIVES ON THE GOVERNOR’S PROPOSAL A B OLD P ROPOSAL W ORTHY OF in line with those of private-sector employees. L EGISLATIVE C ONSIDERATION It undoubtedly would make public retirement systems more sustainable over the long run by Reasonable Set of Pension Benefi ts and reducing public entities’ vulnerability to increased Reduced Long-Term Costs. Our overall perspective costs resulting from unfunded liabilities. Because is that the Governor’s proposal is a bold one. It defi ned benefi t pension and retiree health benefi ts would result in substantial changes to the current would be reduced from current levels, unfunded public employee retirement benefi t system, liabilities simply would be unlikely to grow so big particularly for future employees. In our view, as to threaten the fundamental fi scal health of it would increase public confi dence in state and public entities. local pension systems over the long term and Th e Governor’s proposed changes probably bring public employees’ retirement benefi ts more would not produce much short-term budgetary www.lao.ca.gov Legislative Analyst’s Offi ce 27 AN LAO REPORT savings for state government and many local should very rarely, if ever, be a need for future governments, but they would produce substantial exceptions. Furthermore, extending certain long-term savings, potentially in the billions of pension and retiree health limitations to charter dollars per year (in current dollars). Finally, we cities, charter counties, and UC probably would believe the Governor’s proposals generally would require constitutional amendments. leave future public employees with a reasonable, We are concerned, however, about placing fi ne though reduced, set of pension benefi ts in exchange details of a hybrid pension plan or other pension for working longer during their public-service and retiree health structural provisions in the careers. We believe the package is worthy of serious Constitution. Aft er all, all pension plans will require legislative consideration in the coming months. modifi cation and adjustment—including “clean up bills” to modify certain provisions—from time to G D R ETTINGTHE ETAILS IGHT time. Th e clearest example is for tax law changes; Legislature Should Take a Few Months to Get periodic changes in tax law or regulations oft en will the Details Right. Like the Governor, we believe require minor changes for pension plans. Th e package there is much merit in fashioning broad-based should include a path to making such necessary pension policy changes that aff ect all public pension changes for pension and retiree health plans, even if plans in the state. Yet, with several thousand public elements of the plan are placed in the Constitution. employers and many diff erent pension and retiree We suggest that the Legislature fashion a health packages off ered to public employees, it is constitutional package for submission to voters, very diffi cult to fashion a workable, fair, sustainable along with a companion piece of statutory legis- set of legislative provisions that accomplishes lation containing various provisions, such as hybrid the type of changes envisioned by the Governor. plan design elements. In the proposed constitu- We strongly urge the Legislature to take several tional amendment, the Legislature could preserve months to fashion a pension plan in response to for itself—and, in some cases, perhaps, for local the Governor’s proposals. Th ere are many details governments—the ability to adjust such detailed to sort out in such a plan, yet there is plenty of time design elements with supermajority votes. to fashion a package that would be ready for voter Review Savings Estimates Carefully. Pensions approval in November 2012. and retiree health cost estimates are very diffi cult What Should Be in the Constitution? A to understand. Th ey are constructed by actuaries basic choice facing the Legislature is which according to highly technical, detailed rules and pension changes should be enshrined in the State assumptions. Th e assumptions, if changed, can Constitution and which in statute. Constitutional materially alter cost or savings estimates related changes are harder to undo over time. to benefi t changes by large margins. Legislative We agree with the Governor and others that committees considering the Governor’s proposal— some pension changes may be so important that and alternatives—probably will want actuarial they warrant a place in the Constitution. Perhaps estimates of the costs and savings of such changes. the clearest cases for placement in the Constitution In the fi nal analysis, actuaries will inform the are the prohibitions on retroactive benefi t increases Legislature that proposals of the magnitude of the and pension funding holidays. Structured properly, Governor’s can save billions of dollars of state and these are workable, practical reforms where there local funds (in current dollars) annually in the long 28 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT term and, perhaps, in some cases there might be to private-sector employees would promote trans- limited short-term savings based on increases in parency to the public and allow the public to more current employee pension contributions. easily compare the generosity of public employee Cost estimates may be particularly useful in compensation packages with compensation packages comparing diff erent pension savings proposals—for with which they are familiar. Conversely, the current example, to determine which competing proposal structure—wherein state and local governments is likely to save more money over the long run—but provide compensation (defi ned benefi t pension plans even then, such analyses are highly dependent and, in some cases, retiree health benefi ts) in forms on assumptions that are open to broad debate. that are very diff erent from that off ered in the private Moreover, it will be diffi cult—perhaps impossible— sector—impairs the public’s ability to assess whether to secure estimates of how pension and retiree government is carefully managing its funds and can health changes will aff ect all plans in the state. aff ect the public’s trust in government. Th ere are simply too many such plans to make such S I C …N J S OME NCREASED OSTS OT UST AVINGS estimates viable in the foreseeable future. “Total Compensation” and the Public A P P LIGNING UBLICAND RIVATE Workforce. A governmental entity competes with S C ECTOR OMPENSATION employers in the public and private sectors to attract Setting Public Employee Compensation and retain a talented workforce. One measure of Levels is Diffi cult. About 6 percent of Californians a government’s competitiveness as an employer is currently work for the state or a local government. to compare total compensation levels off ered by Determining the appropriate compensation and the state with those off ered by other employers. benefi t levels for these public employees is a diffi cult An employee’s total compensation includes balancing act. If government sets employee compen- salary, retirement, and other employment benefi ts sation and benefi ts at rates that are too low, it can such as health benefi ts. Unlike salary and health be diffi cult for government to recruit and retain a benefi ts, retirement benefi ts are a form of deferred skilled workforce. Conversely, if government sets compensation. An employee forgoes some level of compensation and benefi ts at rates that are too high, compensation today (higher salary) with the expec- it can undermine public confi dence in government’s tation that she or he will receive an off setting level of ability to manage funds, as well as impose unnec- compensation in the future. Studies have illustrated essary costs for public services. that retirement benefi ts help make the public sector’s Current Compensation Structure Diffi cult current total compensation levels competitive for Public to Evaluate and Accept. Given these with those off ered in the private sector. Th is seems tensions, we think the best strategy is for state and especially true in the case of employees with higher local governments to broadly align the structure levels of education and skills. and amount of public employee compensation with Need for Higher Salaries, Especially for compensation packages provided to comparable High-Skill Public Workers. Under the Governor’s employees in the private-sector. While we recognize proposal, the pension benefits offered to future that making comparisons between the work respon- public employees would be less than the current sibilities of public- and private-sector employees is benefits. This change would reduce the value diffi cult, making the structure of public employee of the total compensation offered to public compensation packages similar to those off ered employees. In the case of some highly educated www.lao.ca.gov Legislative Analyst’s Offi ce 29 AN LAO REPORT and highly skilled public employees (for example, governments would gain some budgetary fl exibility. some groups of scientists, medical professionals, Second, salary, employee health benefi ts, and engineers, academics, and lawyers), public most other forms of compensation do not create employers’ current total compensation levels the risk of unfunded liabilities associated with likely would no longer be competitive if pensions pensions and retiree health benefi ts. Other forms are reduced and no other pay or benefits are of compensation are paid as they accrue, with little increased. It is conceivable that in the current, or no risk of their costs being transferred in large weak economy, the state and local governments amounts to later generations. Pensions and retiree could attract these types of employees even at the health benefi ts are a very diff erent story. Reduced reduced levels of total compensation implied in unfunded liability risk due to lower defi ned benefi t the Governor’s plan. In the long term, however, pension and retiree health commitments could the public sector in California may have diffi- mean less budgetary volatility for governments in culty attracting highly skilled, highly educated the long run. employees of the caliber and quantity needed Finally, while we expect that some salaries to provide public services under this proposal. will rise because of retirement benefi t reductions, Accordingly, to the extent that the Governor’s governments will not have to raise all salaries proposal reduces total employee compensation— or otherwise off set all retirement cost savings particularly for highly skilled, highly educated elsewhere in their compensation structure. Over state and local employee classifications—higher the long run, substantial net savings—perhaps salaries or other benefits probably will need to in the billions of dollars annually—could result be offered to these groups over the long term. A from pension and retiree health changes of the cap on defined benefit pensions for high-income magnitude proposed by the Governor. public employees, as the Governor proposes, C S /L ONSIDERINGTHE TATE OCAL could exacerbate these problems. Such higher R T A ELATIONSHIPIN HIS REA costs will offset an unknown portion of the savings generated from pension and retiree Currently, Signifi cant Autonomy for Cities, health benefit reductions. Counties, and Special Districts. California cities, Why Change Pensions if Net Savings Are So counties, and special districts and their rank-and- Hard to Achieve? Reductions in one element of fi le employees currently have signifi cant authority compensation—such as pensions—oft en result to collectively bargain retirement benefi ts. For in salary or other compensation increases, as example, local governments and employees can, described above. Nevertheless, we urge the in many instances, negotiate: (1) the selection Legislature to pursue changes to pension and of a retirement plan from among the many other retirement benefi ts for a number of reasons, plans off ered by CalPERS, a 1937 Act county including the likely long-term net budgetary retirement system, or certain other retirement benefi t that these changes would produce for systems; (2) the share of the plan’s cost to be governmental budgets. paid by the employee and employer; and (3) the First, by moving more employee compensation provision of plan enhancements (such as basing from infl exible pension benefi ts to somewhat pension benefi ts upon a single year of fi nal more fl exible salaries and other compensation, compensation). Th e Governor’s proposal imposes 30 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT signifi cant limits on local retirement plan compo- by the Governor fi lls in some important details nents and the division of pension costs between concerning 11 of the items covered in the employees and employers. March 31 press release, plus additional guber- Do Local Governments Need to Be “Saved natorial proposals concerning retirement ages From Th emselves?” In general, we think that and retiree health care. Th e one policy mentioned local elected offi cials should have the authority in the Governor’s March 31 release that seems to determine compensation levels, including to be left largely unaddressed in the October 27 retirement benefi ts, which meet the needs of gubernatorial plan is CalSTRS’ massive unfunded their workforce. We note, however, that it is liability, which totaled over $56 billion as of June oft en diffi cult for local governments to weigh the 2010, according to CalSTRS actuaries. While the major, lasting costs of public pensions against Governor’s proposals may perhaps reduce costs the near-term benefi t of maintaining a skilled for future teachers enrolled in CalSTRS, it does workforce. As a result, aft er the state authorized not appear to include anything to address these local governments to off er enhanced retirement liabilities already accrued, but not funded, for benefi ts in the late 1990s, many local agencies— current and past employees. seeing competitor agencies off er higher benefi ts— At Least $4 Billion Per Year Needed to Pay also agreed to provide enhanced benefi ts. Since that Liabilities Over Th ree Decades. Most problemati- time, the cost of these benefi ts (combined with the cally, because CalSTRS contributions by employers, signifi cant retirement system investment losses), has employees, and the state are fi xed in the Education imposed major fi scal pressures on many California Code, there are not any plans in place for any entity local governments—fi scal pressures that will last ever to fund those promised benefi ts. If additional for decades. Due to all of these factors, some local contributions were provided immediately to CalSTRS, offi cials believe that state policy is needed to impose they would need to total about $3.9 billion per year lower pension benefi ts—such as those proposed by (in current dollars) for at least the next three decades. the Governor—or limit maximum employer pension (Th ose fi gures assume that CalSTRS hits its annual costs in order to prevent them and their successors investment targets, which many observers believe will from adding to pension and retiree health cost be unlikely in the coming decades.) Given the state’s concerns in the future. budget problems, as well as the funding issues facing How Should the Legislature Approach Th is school and community college districts, it is very Issue? It seems to us, therefore, that a key policy unlikely such funding can be identifi ed immediately. question that the Governor’s plan poses to the Th e longer that a funding solution waits, however, Legislature is whether some diminution in local the more that this $4 billion annual tab will tend to control over retirement benefi ts is merited given the increase. Addressing the CalSTRS unfunded liability, long-term nature of pension costs and the potential therefore, is one of the most diffi cult long-term for competition among local and state employers. fi nancial challenges facing California. Funding Solution Should Be Identifi ed as Part W A C STRS? HAT BOUT AL of Th is Legislative Process. Given the commitment On March 31, 2011, the Governor produced an of the Legislature and the Governor to discuss signif- early version of a 12-point pension plan through icant structural changes to state pension systems a press release and committed to introduce the now, we believe that a part of this discussion should 12 pension reforms. Th e October 27 proposal be CalSTRS’ long-term funding plan. Discussing www.lao.ca.gov Legislative Analyst’s Offi ce 31 AN LAO REPORT changes in CalSTRS and other pension benefi ts Under these proposals, we do not see why there without discussing how to fund benefi ts already in would continue to be a direct state role in funding place does not make sense to us. Accordingly, we future teachers’ benefi ts. (Payments related to urge the Legislature to tackle the CalSTRS funding current teachers and the existing unfunded liability, problem as part of a pension package. however, will likely have to continue for decades.) We believe that the state—which has had the We urge the Legislature to take this opportunity sole responsibility for setting CalSTRS’ benefi t and to (1) commit the state to increasing payments funding levels in the past—will have to play a key over time to retire existing unfunded liabilities role in addressing the existing unfunded liability. and continue to make payments related to current Moreover, given that the only other theoretical CalSTRS members over the next few decades and sources for addressing the liability are school and (2) require that districts and CalSTRS members be community college districts and their employees, the sole contributors to the Teachers’ Retirement the state ultimately would be pressured to increase Fund for future teachers enrolled in the plan that funding for those public entities in any event, emerges from this legislative discussion. Over even if there were a way to require districts and the next few decades, under this approach, state employees to pay more to address the funding contributions in CalSTRS would dwindle, and over problem. Accordingly, the state probably will need time, districts and employees and retirees of the to gradually increase contributions to CalSTRS in system could gradually take over the state’s existing the coming years and maintain those contribu- seats on the Teachers’ Retirement Board. CalSTRS tions for several decades until existing unfunded should become a system of districts and teachers— liabilities are retired. completely fi nancially separate from the state. If the Take Steps to End State Funding of CalSTRS Legislature adopts this change, it should be careful to Over the Long Term. School and community require pension benefi t levels of school districts that college districts, unlike almost all other public can be sustained within the existing contribution employers in the state, have practically no fl exibility levels that school districts and teachers already pay. in setting retirement benefi ts for their employees, In this new structure, we believe that school and they are shielded in current law—due to districts, their employee and retiree groups, and fi xed contribution rates for both districts and CalSTRS itself would have a much greater incentive employees—from higher (or lower) costs that to establish prudent, rather than optimistic, may result from future increases (or decreases) investment return assumptions, given that they and in CalSTRS’ unfunded liabilities. Th e Governor’s they alone will be responsible for keeping the system plan envisions major changes in benefi ts for future well-funded for future teachers. teachers and administrators enrolled in CalSTRS Consider Infl ation Benefi ts. Pension systems and a reinforcement of the current require- in California typically include provisions to ments that districts and teachers share pension protect retirees from having their benefi ts eroded costs. Given the altered levels of defi ned benefi ts excessively over time by the eff ects of infl ation. envisioned in the Governor’s plan, maintenance Th ese are sometimes called “purchasing power” of the existing contribution requirements for the benefi ts. In CalPERS, for instance, infl ation state, districts, and teachers probably would make protection generally is “built into” the benefi t, and no sense for future teachers; these contribution governmental entities like the state—along with requirements will have to be changed. employees—pay for it in their regular contributions 32 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT to the system. In CalSTRS and perhaps some Unlike other systems, however, UC and its other systems, purchasing power protection is employees are struggling to fi nd a way to cover less straightforward. In CalSTRS, for instance, normal costs, as well as unfunded liabilities, given the Supplemental Benefi t Maintenance Account is that neither of them had contributed to the system guaranteed a fi xed amount of state funding now for two decades. Th e university and its employees to provide purchasing power benefi ts. If, in the have already moved to change certain benefi t future, infl ation were to outpace the growth of commitments for current and future employees, those contributions, CalSTRS retirees could see and they continue to engage in hard talks on how signifi cant erosion in their benefi ts. to increase contributions to cover the costs of For CalSTRS and perhaps some other systems, both past and future benefi t commitments. Th e therefore, the Legislature will need to consider university, however, believes that it may have to future pension benefi t design in the area of raise tuition more or cut student services or other infl ation protection as well. With newly reduced employee costs in order to fund its entire share of defi ned benefi ts, are changes in existing purchasing pension costs in the future. As a result, UC seeks power benefi ts warranted? While the state and several hundred million dollars of additional nation have been in a long period now of relatively annual state funding beginning within a few low infl ation, there is no guarantee this trend years so that it can cover normal costs and retire will persist forever. Accordingly, any substantial unfunded liabilities over the next several decades. changes in purchasing power benefi ts could prove Th e state has no apparent legal commitment to to be expensive under certain actuarial scenarios. provide such additional funding, and the state does not directly set benefi t levels for UC employees. W A UC? HAT BOUT To date, the Legislature has chosen not to provide UCRP Also Has a Major Funding Problem. additional funding to UC for this purpose, despite From 1990 to 2010, UC and its employees enjoyed the university’s requests. a remarkable two-decade pension funding holiday UC May Well Need Additional State Funding due principally to (1) substantial overfunding for Retirement Costs. Th e magnitude of UC’s of UCRP during the 1980s by the state and the unfunded liability costs not covered from other university and (2) very strong investment returns funding sources (such as enterprise units and for UCRP during the 1980s and 1990s. Th e state the federal government) is so large—hundreds of also benefi ted from the funding holiday, since it millions of dollars per year—that the university had contributed to UCRP regularly in prior decades will face very diffi cult decisions in the coming years and used the elimination of contributions as a about how to cut costs or raise tuition further if the budget solution during the fi scal crisis of the early Legislature does not provide additional funding 1990s. Given that UCRP continued to enroll new related to UCRP. Extending the Governor’s proposed employees and provide additional service credit to pension changes for other public employees to UC existing employees, it would have been impossible employees as well may reduce UC’s future personnel for such a funding holiday to continue forever. Th e costs and help the university address the UCRP investment market downturn of 2008 caused the funding problem over the long term. In the short already dwindling surplus in UCRP to fade away, run, however, costs to address existing benefi t and now the system has an unfunded liability. commitments will remain very diffi cult to address within existing resources of the university. www.lao.ca.gov Legislative Analyst’s Offi ce 33 AN LAO REPORT We urge the Legislature to consider the accrued by current public employees and even long-term funding strategy for UCRP during these current public-sector retirees. Th e motivation for legislative discussions on overall pension policy. these suggestions seems to be the disparity between Specifi cally, the Legislature could resubmit a request public- and private-sector workers’ retirement to UC that it provide a comprehensive, detailed benefi ts, as well as a desire to reduce public costs proposal for a long-term funding strategy. (Th at and transfers of obligations to future generations. same request was included in the 2010-11 Budget We understand these concerns, but the fact is Bill, but was vetoed by Governor Schwarzenegger.) these types of changes oft en have been attempted by It will be very diffi cult for the state to consider a other California governments in recent decades, and long-term UCRP funding policy without such a in most cases, struck down. Other than increasing detailed proposal being submitted and without fi rm current employees’ pension contributions (which agreement on the plan from all UC employee groups. may be possible for some governments that have rigorously protected their right to do so), there is W A D B ? HAT BOUT ISABILITY ENEFITS almost no viable way to decrease pension costs for Governor’s Proposals Focus on Service current and past employees outside of the negoti- Retirement, Not Disability Retirement. California’s ating process. Case law in California is exceptionally public pension systems oft en provide certain benefi ts clear. In fact, California’s protections for public to disabled public employees, including employees employee pension contracts may be more protective disabled as a result of their work assignment. Death than those embodied in the U.S. Constitution. benefi ts also are sometimes provided to employees’ Reductions in current and past employees’ pension survivors. benefi ts almost always will require that governments In recent years, some public pension systems have provide a comparable and off setting new advantage tightened their scrutiny of disability retirement appli- in return. Only in cases of extreme emergency does cants considerably, but given the magnitude by which the case law suggest that more drastic changes may the Governor proposes to reduce future employees’ be possible and, even then, the changes typically pension benefi ts, there may nevertheless be a spike in would have to be temporary, with interest costs the future in disability retirement applications if the accruing to the aff ected employees or retirees Governor’s proposals succeed. Accordingly, in consid- during the time of the temporary pension cost ering the Governor’s proposals, the Legislature may reduction. Moreover, even when governments can wish to engage pension systems on ways to further increase employee pension contributions, collective reduce incentives for improper disability retirement bargaining and the need to remain competitive requests in the future. in the labor market will lead to salary or other compensation increases that may off set much of the F L T OCUSONTHE ONG ERM retirement cost savings. Achieving Major Near-Term Savings Will Be For all of these reasons, it may not be worth- Very Diffi cult—Perhaps Impossible. California while for the Legislature to devote signifi cant time has decades of case law in this area based in part during this process attempting to reduce current on U.S. Supreme Court precedent in the area of and past employees’ retirement benefi t costs. Th e contract law. During the past year, there has been debate, in our view, is best spent considering where a substantial increase in public discussion of the California’s public retirement systems will go in the possibility of reducing sharply the pension benefi ts future. 34 Legislative Analyst’s Offi ce www.lao.ca.gov AN LAO REPORT In the Short Run, Retirement Contributions hybrid or defi ned contribution plans, furthermore, Will Have to Increase. In the short run, the may result in a decrease in some systems’ hard truth is that state and local pension and investment returns, thereby increasing employer retiree health contributions generally will have to costs in the near term. By enacting reductions in increase—in some cases, substantially—to fund the retirement costs for future public employees, liabilities already accrued and earned by current however, the Legislature can realize major long-run and past employees. Th e clearest example of this is savings and also help “soft en the blow” of such the need to increase funding to CalSTRS to pay for near-term cost increases. its unfunded liabilities. Transitioning employees to www.lao.ca.gov Legislative Analyst’s Offi ce 35 AN LAO REPORT LAO Publications This report was prepared by Jason Sisney, Deputy Legislative Analyst. The Legislative Analyst’s Offi ce (LAO) is a nonpartisan offi ce which provides fi scal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an E-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 36 Legislative Analyst’s Offi ce www.lao.ca.gov