The 2017-18 Budget: Governor’s CalPERS Borrowing Proposal

The 2017-18 Budget: Governor’s CalPERS Borrowing Proposal MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • MAY 16, 2017 Summary In this brief we analyze the Governor’s May Revision proposal to borrow $6 billion from state government funds in the Pooled Money Investment Account. These funds would be used to make a one-time payment to reduce state pension liabilities at the California Public Employees’ Retirement System. The Governor proposes that the state General Fund and special funds repay this loan with interest over a period of about eight years. Administration Proposes Large Commitment of Resources Without Sufficient Planning. We think the plan would probably save the state money over the long run, although uncertainties remain about the likelihood and magnitude of this benefit. However, the administration is asking the Legislature to approve a large commitment of public resources with insufficient consideration. The administration has provided few of the legal or quantitative analyses that the Legislature should expect when receiving a request of this magnitude and complexity. In particular, additional pension cost analyses should have been prepared by professional actuaries. In addition, the administration should have already conducted a review to determine how many of the state’s special funds will have difficulty making loan repayments under the proposal. (Instead, the administration plans to conduct this analysis after the Legislature has approved the loan.) Finally, the administration should have conducted a more thorough legal analysis of such a novel proposal. Recommend Legislature Act on Plan Later in Session. The administration has introduced this proposal as part of the May Revision—with only weeks before the constitutional deadline for the Legislature to approve the budget. We doubt that all of the issues we raise can be reviewed by the June 15 budget deadline. However, there is no reason that the Legislature must make a decision before June 15. We recommend the Legislature wait to act on this plan until after the administration has submitted more analysis. At that point, the Legislature could decide whether or not to approve the proposal. 2017-18 BUDGET INTRODUCTION The state has large unfunded liabilities from its short-term savings account to make a associated with retirement benefits earned by state one-time payment to CalPERS to reduce these employees. A recent decision by the California unfunded liabilities and save the state money over Public Employees’ Retirement System (CalPERS) the long term by lowering annual pension costs. board will require the state to contribute more This brief describes and evaluates the Governor’s money each year to pay down pension liabilities. As proposal. In addition, we provide comments and part of his May Revision to the 2017-18 budget, the recommendations for the Legislature to consider as it Governor proposes that the state borrow $6 billion decides whether to approve the Governor’s proposal. BACKGROUND In this section, we provide background on Money Investment Fund (SMIF), the portion of the the administration’s proposal. This background PMIA that holds most balances of the state’s special includes information related to the state’s funds. short-term savings and investments, the use of PMIA Reserve Balances Are High. The roughly those accounts to help the state manage cash $70 billion in the PMIA includes money from the flows, budgetary borrowing to address budget state’s main operating account and hundreds of shortfalls, the state’s retirement liabilities, and other funds (including special funds). Working the constitutional minimum amounts the state capital needs for hundreds of separate state funds— must spend on annual debt payments under needed to manage seasonal cash flows of each fund Proposition 2 (2014). and pay state bills on time—always total in the tens of billions of dollars. Reserve balances in both the State’s Short-Term Savings and Investments General Fund and other funds tend to grow during State’s Short-Term Savings Accounts. The periods of economic expansion when revenues Pooled Money Investment Account (PMIA) is are higher. The current economic expansion has the state’s short-term savings account. The PMIA lasted nearly eight years, one of the longest periods holds funds on behalf of the state, as well as cities, of uninterrupted economic growth on record. counties, and other local entities in the separate For these reasons the PMIA now has significant Local Agency Investment Fund (LAIF). As of the balances—billions more than needed to cover all quarter that ended in March 2017, the balance state working capital needs in the near term. of the PMIA was roughly $70 billion. The state’s PMIA Is Managed by the State Treasurer and portion accounted for two-thirds of this total Governed by Board. The Investment Division of while the local portion represented the remaining the State Treasurer’s Office manages the PMIA and one-third. LAIF balances are never used by the invests its money in safe instruments. The PMIA state. However, investment returns from the PMIA is governed by the Pooled Money Investment are accrued to the entire pool, so changes in those Board (PMIB), which includes the Treasurer, the returns affect the LAIF. Much of the state funds Controller, and the Director of Finance. The PMIB invested in the PMIA are held in the Surplus has a fiduciary duty to safeguard the interests of its 2 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET investors—the state and local governments with deficits during the early months of the state fiscal funds invested in the LAIF. year when the state typically has more spending PMIA Yield Has Varied Over Time. The than receipts. This is because state tax collections Treasurer typically invests funds in the PMIA are concentrated in the second half of the fiscal in safe instruments with short-term maturity year, especially in April (the annual income tax schedules. The average effective yield of those payment deadline), January, and June. Figure 2 (see investments is currently 0.88 percent. However, as next page) displays the state’s month-by-month shown in Figure 1, these average yields have varied cash surpluses and deficits in 2016-17. over time. In the early 1980s, they were generally Internal Borrowing From PMIA Used to above 10 percent and fell to around 9 percent in the Manage State’s Cash Flow. In addition to serving early 1990s. For much of the late 1990s and 2000s, as the state’s short-term investment account, the the yield averaged around 6 percent, although it PMIA is an important tool to help the state manage fell after the dot-com bust and ensuing recession seasonal cash deficits, as noted above. During times in the early 2000s. After the rate fell in 2008, it has of cash imbalances, the General Fund borrows remained near zero as inflation and U.S. Treasury billions of dollars from other state funds held in the yields have also remained low. PMIA. The General Fund pays the PMIA back with interest each year. The administration estimates the Cash Management costs of internal borrowing for cash management Cash Deficits Often Occur During the First purposes will be roughly $20 million in 2017-18. Half of the Fiscal Year. Cash flows in the General State Can Use External Borrowing to Manage Fund can swing widely throughout the year. In Cash Deficits. Internal sources are not always particular, the state usually faces seasonal cash sufficient to allow the General Fund to address Figure 1 Average Monthly PMIA Yields Over Time 14% 12 10 8 6 4 2 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 PMIA = Pooled Money Investment Account. www.lao.ca.gov Legislative Analyst’s Office 3 2017-18 BUDGET the General Fund budget Figure 2 as long as the loans do Actual and Projected General Fund not interfere with the core Cash Surpluses and Deficits in 2016-17 “object for which the special (In Billions) fund was created.” At their $10 Cash Surplus Projected peak in 2013, special fund 8 budgetary loans outstanding 6 totaled $4.6 billion. The 4 state, however, now has 2 repaid most of those loans—largely by using -2 debt payment funds from -4 Proposition 2. According Cash Deficit -6 to the administration’s Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun current estimates, about $1.4 billion of these loans its monthly cash flow deficits. In these cases, the now are outstanding. (In state uses a short-term external cash borrowing addition, the state has roughly $2 billion in other instrument, known as a Revenue Anticipation Note outstanding transportation-related loans that the (RAN), to address cash flow. Although the state administration tracks separately.) has not issued a RAN since 2014-15, RAN issuance Special Fund Balances. These special fund occurred every year between the mid-1980s and loan repayments and the current economic 2014-15 (except 2000-01), in both good and bad expansion have both contributed to increasing budgetary situations. RANs are typically issued special fund balances. In 2011-12, aggregate early in a fiscal year and are repaid prior to the end reserves in California’s special funds totaled of the fiscal year of issuance. RANs are repaid at a $8 billion. In January, the administration estimated market rate of interest to municipal bond investors. that aggregate special fund reserves would reach $16 billion in 2016-17 (excluding the Budget Budgetary Borrowing to Stabilization Account). Even with proposed Address Budget Shortfalls spending increases in this year’s budget, special Borrowing to Help Balance Annual State fund reserves—sometimes cautiously estimated in Budget. When the state faced significant budget the past—are estimated to remain above $12 billion. shortfalls during the 2000s, the Legislature (Balances held in the PMIA at any given time authorized the General Fund to borrow large include special fund and other state fund reserves amounts from dozens of specific special funds. and funds’ working capital, including expenses Unlike cash management borrowing, which is committed but not yet distributed.) In January, repaid within the fiscal year, these “budgetary we suggested—as we have in prior years—that the loans” from special funds have sometimes state’s elected leaders should review some special remained outstanding for several years. California funds with significant balances to determine if courts have opined that the Legislature has broad one-time or ongoing fee reductions—or changes in discretion to authorize such loans to help balance the funds’ spending—are needed. 4 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET Retirement Liabilities the benefits earned by future employees. Through the collective bargaining process, the state has Large Unfunded Liabilities. There are three implemented its plan for most state employees. major categories of state liabilities—retirement, infrastructure, and budgetary liabilities. According Proposition 2 Debt Payment Requirements to the administration’s estimates, nearly one-half Establishes Minimum Annual Debt Payments of the nearly $282 billion of outstanding liabilities Toward Certain Eligible Debts. Passed by across these three categories are attributable to voters in 2014, Proposition 2 amended the State pension and retiree health benefits earned to date Constitution to require the state to make certain by active and former state employees. Specifically, extra annual debt payments and budget reserve CalPERS pension liabilities are estimated to be deposits each year. The goals of the measure were about $60 billion and the state’s unfunded liabilities to bolster state reserves and accelerate payments associated with state employee retiree health on certain state debts. These payments are required benefits are estimated to exceed $76 billion. through 2029-30. Thereafter, the required annual Recent Assumption Change Contributed to debt payments become optional, but amounts not Increasing Contributions. CalPERS pensions spent on debt must be deposited into the rainy are funded from three sources: investment day reserve. Unlike reserve requirements, which gains, employer contributions, and employee the Governor and Legislature may reduce during contributions. CalPERS reports that about a budget emergency, the state may not reduce the two-thirds of benefit payments are paid from past required annual amounts of debt payments under investment gains. CalPERS expects investment Proposition 2 for any reason through 2029-30. returns over the next decade to be lower than Certain Payments Toward State-Level past returns. At its December 2016 meeting, the Pension Plans Are Eligible. There are three types CalPERS board voted to lower the investment of outstanding debts eligible for payments under return assumption from 7.5 percent to 7.0 percent Proposition 2. They are: (1) certain budgetary over the next three years. By assuming less money liabilities (including the amounts the state’s comes into the system through investment gains, General Fund owes special funds, as described the state will be required to contribute more above), (2) certain payments of statewide pension money to pay for higher normal costs and a larger system liabilities, and (3) prefunding for state unfunded liability. CalPERS estimates that the retiree health benefits. Proposition 2 requires state’s contributions will increase from $5.9 billion payments for pension and retiree health liabilities in 2017-18 to over $9 billion by 2023-24. to be “in excess” of “current base amounts.” State Beginning to Prefund Retiree Health Total Required Amounts Will Vary Each Year. Benefits. Until recently, like most governments in A formula determines the required minimum the United States, California did not fund health amount of extra Proposition 2 debt payments each and dental benefits for its retirees during their year. First, the state must set aside 1.5 percent of working careers in state government. This has General Fund revenues and transfers. Second, resulted in large unfunded liabilities for those the state must set aside a portion of capital gains benefits. The state has begun implementing its plan tax revenues that exceed a specified threshold (we to address retiree health benefit liabilities through refer to this as “excess capital gains taxes”). The (1) employer (state) and employee contributions state must split these totals between debt payments to prefund these benefits and (2) a reduction in www.lao.ca.gov Legislative Analyst’s Office 5 2017-18 BUDGET and reserve deposits. While the 1.5 percent Planned Proposition 2 Payments for State amount is relatively steady, excess capital gains Retiree Health Plan. At least until 2020-21, the taxes can vary significantly with fluctuations in administration proposes to count all of the state’s capital gains revenues, which are very volatile. current and future costs of prefunding retiree The administration currently projects required health benefits toward Proposition 2. This year, Proposition 2 debt repayments will vary from those General Fund costs are about $90 million, but $1.7 billion in 2017-18 to $1.2 billion in 2020-21. under the administration’s current projections they will rise to $300 million in 2020-21. GOVERNOR’S PROPOSAL This discussion considers information received detail below.) As a result, we understand that this about the plan as of Monday, May 15, 2017. Draft proposal would not reduce individual special funds’ statutory language was received after that date. balances on official fund condition statements when the transaction is executed in 2017-18. Initial Loan Contribute Money to CalPERS Over Administration Proposes Borrowing Course of 2017-18. The administration proposes $6 Billion. In the May Revision, the Governor depositing the borrowed money with CalPERS proposes borrowing $6 billion from the state’s on a periodic basis throughout the 2017-18 fiscal portion of the PMIA to make a supplemental year to accommodate cash flow needs. The precise payment to CalPERS. This $6 billion contribution plan—such as the size and amount of each of those would be in addition to the actuarially required installments—was still being worked out as we contributions to CalPERS—referred to as an prepared this analysis. “additional discretionary payment” to CalPERS. Higher Payment Today Reduces Future Costs. The administration chose this figure based on a Any additional discretionary payment reduces a variety of qualitative factors. In particular, the pension plan’s unfunded liabilities and the future administration says this amount would: (1) reduce contributions that must be made to the system. the state’s long-term pension costs resulting from In general, paying more earlier reduces long-term the lower discount rate, (2) make the state’s 2017-18 pension costs because these contributions have CalPERS contributions roughly double what it more time to compound investment returns, otherwise would be, and (3) be low enough that it reducing the need for future contributions. would not cause a strain on the PMIA. CalPERS estimates that the $6 billion additional Borrowing Would Occur From State’s discretionary payment would substantially Share of PMIA, Not Individual Special Funds. mitigate state employer contributions as a result Mechanically, the proposal represents a borrowing of the recent change in the investment return technique that is a shift from past practice for assumption. Specifically, CalPERS estimates that loans scheduled in the annual budget. Rather the state’s employer pension contributions would than borrow from individual special funds as the be 6.7 percent lower (reducing the state’s annual state has done in past, this loan would come from contribution by about $638 million) by 2023-24 PMIA as a whole. (Repayments, however, would because of the additional discretionary payment. be apportioned by fund, which we discuss in more These benefits would be distributed among the 6 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET General Fund and special funds that make pension Pay Loan Back Over Next Eight Years or So. payments. The administration estimates that this The administration has not determined a precise would reduce total employer contribution costs plan for the state General Fund and other funds by roughly $12 billion over 30 years. (In addition, to repay the $6 billion loan from the PMIA. The there would be about $1 billion of interest costs, for administration provided our office a “working a net state budgetary benefit of about $11 billion.) plan” that would pay the loan off in eight years. The pension savings grow over time, as shown in While the administration indicates that this Figure 3. payment period is flexible, it intends to take no longer than ten years to pay off the loan. Under Loan Repayments the working plan, the General Fund would cover Interest Rate Charged to Loan Would Vary repayments on behalf of both itself and associated With Two-Year Treasury Rate. The administration special funds in 2017-18 with a $427 million proposes to repay the loan with interest each repayment (consisting of a $365 million principal year. This rate would float (vary) with a two-year payment plus a $62 million interest payment) Treasury rate—specifically, an index based on the counted toward Proposition 2 debt payment average yield of a range of Treasury securities, requirements. Other funds would begin making adjusted to the equivalent of a two-year maturity. payments in 2018-19 and would later proportionally In recent years, this two-year Treasury rate has compensate the General Fund for the 2017-18 averaged somewhat above the PMIA quarterly yield payment. Figure 5 (see next page) shows the (0.6 percent compared to 0.45 percent). Figure 4 administration’s projections of future principal and (see next page) compares these rates over time. interest payments until 2024-25. Figure 3 Projected Savings From Lower Employer Contributions All Funds (In Millions) $900 800 700 600 500 400 300 200 100 2017-18 2019-20 2021-22 2023-24 2025-26 2027-28 2029-30 2031-32 2033-34 2035-36 2037-38 2039-40 2041-42 2043-44 2045-46 2047-48 www.lao.ca.gov Legislative Analyst’s Office 7 2017-18 BUDGET and other funds would be Figure 4 charged for around 60 percent On Average, Two-Year Treasury Rate and 40 percent of these Somewhat Higher Than PMIA Yield costs, respectively. Under 1.6% the administration’s current 1.4 projections, over the life of 1.2 the loan, the General Fund 1.0 would repay $4.4 billion and 0.8 special funds will collectively Quarterly Treasury Rate 0.6 repay $2.5 billion. Figure 6 0.4 shows the administration’s 0.2 Quarterly PMIA Yield anticipated repayments by fund type using its projected JunOct FebJunOctFebJunOctFebJun OctFebJun OctFebJun OctFebJun OctFebJunOctFeb 09 09 10 10 10 11 11 11 12 12 12 13 13 13 14 14 14 15 15 15 16 16 16 17 interest rates. PMIA = Pooled Money Investment Account. Proposition 2 Would Cover General Fund Portion Administration Estimates the State of Loan Repayments. For the Repayments Would Total Roughly $7 Billion. General Fund’s share of future loan repayments, the Under the administration’s current projection of administration proposes establishing General Fund interest costs, total loan repayments—principal repayments based on the varying Proposition 2 and interest payments—would be roughly debt payment requirements. The administration $7 billion. The administration’s proposal would, argues the repayments are consistent with the as we understand it, distribute these costs across spirit of the law. In particular, the additional the General Fund and other funds based on the payment would be (1) for the purpose of reducing proportional split of pension contributions by unfunded liabilities for state-pension benefits and fund source. Consequently, the General Fund (2) “in excess of current base amounts” required to be paid Figure 5 to CalPERS each year. Administration's Projection of Special Funds Would Future Principal and Interest Payments on the Loan Repay Loan Using Available (In Millions) Resources. Under the $1,400 administration’s projections, 1,200 the benefits of the loan in Principal 1,000 terms of lower employer contribution rates would 800 eventually offset the full 600 annual costs of the loan 400 repayment. However, under 200 Interest the same projections, the full benefits of those lower 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23 2023-24 2024-25 rates would not materialize 8 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET until 2022-23. In the interim Figure 6 years, we suspect that some Administration's Projection of special funds and other state General Fund and Special Fund Repayments funds may face a net cost (In Millions) from this loan. Some of these $900 funds may not have sufficient General Fund 800 resources to cover those 700 costs. In these cases, interim 600 Other Funds General Fund support may be 500 400 necessary—essentially to loan 300 some special funds and other 200 funds money to cover their 100 initial annual cots under this 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23 2023-24 plan. Affected special funds would then owe this money (with interest) to the General Representatives of the administration have told Fund. The administration has not assessed how us they would work out these details during the many funds would face this issue, nor the amount summer after the final budget is adopted. of General Fund resources needed to support them. LAO COMMENTS Based on the information we have been long-term savings of $12 billion from lower provided to date, we think the Governor’s pension employer contribution rates and long-term costs of borrowing proposal is promising from an overall $1 billion from interest on the loan. These benefits state budgetary perspective. That said—as we would be distributed among the General Fund and discuss in this section—there are a number of special funds. uncertainties about the Governor’s proposal and Budget Savings Likely, but Hard to Predict. questions that we suggest the Legislature consider Over the long term, it is likely that the General as it assesses this proposal. Unaddressed, these Fund and special funds would experience net issues could reduce the overall benefit of the savings as a result of the one-time deposit to proposal to the state or result in more risk for state CalPERS. While the administration projects this and local governments. benefit would be $11 billion, the precise amount of the benefit is unknown. The extent to which these Fiscal Benefit to State Likely, savings are realized for the General Fund and all of But Uncertainties Remain the special funds would depend on a number of key Administration Anticipates Net Benefits of factors: $11 Billion. The administration anticipates this • Investment Returns. The extent to which proposal would have a net benefit to the state, over the $6 billion additional discretionary the long run, of $11 billion. This benefit assumes payment to CalPERS in 2017-18 reduced www.lao.ca.gov Legislative Analyst’s Office 9 2017-18 BUDGET state contributions—and therefore savings from the proposal could increase or generated state savings—would depend decrease. largely on investment returns. The • Interest Rates. Under the administration’s administration assumes CalPERS proposal, the cost of the loan over its investments will earn an average return lifetime will depend, in large part, on of 7 percent each year. However, this changes in a specific index of two-year return depends largely on the U.S. stock Treasury yields (which will determine the market, which fluctuates significantly. interest rate, and therefore interest costs To illustrate fluctuations in the market, of the loan). Figure 8 shows historic yields Figure 7 shows the annual returns of the of this index and the administration’s S&P 500 over the past 30 years. The state assumptions about rates over the course could be investing the $6 billion at a high of the loan. Under these assumptions, point in investment markets—both our the interest cost of the loan would be office and the administration’s economic $874 million over its lifetime. If interest projections assume that stock prices rates remained lower, or climbed higher, stagnate over the next few years—which these costs would vary accordingly. would mean the actual savings to the state would be different from (and potentially • Cash Flow and External Borrowing Costs. less than) the administration suggests. If While the state has not used a RAN for actual returns on the $6 billion deposit are cash flow purposes in a few years, the higher or lower than 7 percent, the realized state almost certainly will need to use Figure 7 Annual S&P 500 Return 50% 40 30 20 10 -10 -20 -30 -40 -50 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 10 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET this tool again in the future. By reducing either increase fees or reduce services the balance in the PMIA as a whole, the provided to fee payers in some years in proposal reduces the state’s available cash order to balance their budgets. cushion for internal borrowing. Therefore, • Length of the Loan. The length of the implementing the proposal would likely loan would, in part, be determined by the mean the state would need to issue a Proposition 2 debt payment requirements, RAN sooner or in greater amounts than it which are not very predictable. In would have otherwise. This would result particular, the administration proposes in higher state General Fund costs for to vary General Fund repayments RAN interest—potentially up to a couple dependent on other, future Proposition 2 hundred million dollars in some years. requirements. Under the administration’s • Internal Borrowing Costs. To the extent current projections, General Fund that the General Fund must cover special repayments from Proposition 2 would fund repayment costs, special funds reach $800 million in 2021-22. In some will need to pay back the General Fund years, however, required debt payments with interest. In the next couple of years, may not cover both the proposed CalPERS additional costs to the General Fund loans loan repayments as well as needed funds could be significant, perhaps as high as to continue the administration’s plan a few hundred million dollars over the to prefund retiree health benefits. (As period. Moreover, these shorter-term loans, discussed earlier, this is also a multiyear coupled with the overall PMIA loan, could Proposition 2 obligation.) For example, strain some special funds’ finances. This retiree health benefit prefunding costs could require that those special funds are expected to reach $300 million in Figure 8 Two-Year Treasury Yields 16% Administration Projection 14 12 10 8 6 4 2 1977-78 1982-83 1987-88 1992-93 1997-98 2002-03 2007-08 2012-13 2017-18 2022-23 www.lao.ca.gov Legislative Analyst’s Office 11 2017-18 BUDGET 2020-21, and likely will increase thereafter. paid from the state’s general taxing authority—such In years when capital gains revenues are as general obligation bonds to be paid from the low, Proposition 2 debt payment amounts General Fund—generally requires voter approval. will only include the base amount (which Over the years, courts have ruled that certain could be less than $1 billion, depending on types of borrowing (including short-term debt to other revenue performance). Under these cover cash shortfalls and some bonds paid from circumstances, the administration suggests specific revenue sources, such as specific revenues it may be desirable to repay the loan more in a state special funds) can occur without voter slowly—and extend the life of the loan. approval. Second, the courts have prevented certain Changing the length of the loan would types of state borrowing. In 2003, for example, the affect its costs. Legislature—without voter approval—authorized issuance of a type of pension obligation bond, to Detailed Analysis About Benefits and Risks be sold to municipal bond investors to fund and Desirable. We believe there is a high probability refund certain state pension obligations. The state that the administration’s proposal would result sought a court ruling validating the legality of the in net savings to the state over the long run. proposed pension obligation bond. The courts ruled No one definitively can predict the net benefits; against the state, concluding the proposed pension however, professional actuaries often use a type obligation bonds violated the constitutional debt of statistical analysis referred to as “stochastic limit. Finally, Proposition 58, passed by voters in modelling” that uses random variations in 2004, prohibits most borrowing to fund a “year-end assumptions—like market returns—to determine state budget deficit, as may be defined by statute.” a range of possible outcomes. One type of Because the Governor’s proposal is novel, stochastic modeling is referred to as “Monte Carlo none of the constitutional debt limitations discuss simulations.” These simulations test the effect of the legality of state borrowing from the PMIA many random investment return scenarios in the for this purpose explicitly. Legal analysis would future to determine a range of probable changes be needed to reach firm conclusions on the debt to contributions to a pension system over time. limitations’ applicability or lack of applicability to This type of analysis increasingly is a standard this proposed borrowing. for evaluating state and local pension proposals. Is This Type of Borrowing a Precedent the Such analysis would provide the Legislature a Legislature Wants to Establish? This proposal much better sense of the risks associated with the represents a large and novel innovation in administration’s proposal. California’s state budgeting. The state has never Questions for Legislative Consideration borrowed from the PMIA like this before. Assuming this plan is constitutional, there may In addition to the fiscal issues we have be no limits in state law on how such a borrowing identified above, there are a number of important could be used in the future. For example, the state policy and legal questions for the Legislature to could arguably borrow from the PMIA to cover consider before approving the Governor’s proposal. the costs of a large infrastructure project or fund Is This Proposal Legal? There are a variety programs—very different goals from the objectives of limits on the state’s ability to borrow. First, the of this proposal to lower future pension costs. We State Constitution limits the ability of the state to would strongly advise the Legislature against such borrow funds without voter approval. Debt to be 12 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET practices in the future. However, a question now is is a promising way to further reduce the state’s this: Is the Legislature comfortable with a type of sizeable unfunded liability. We also commend borrowing that could potentially be used in such a the administration for prioritizing the reduction problematic way in the future? of future pension costs and putting forward a Is Proposal Consistent With PMIB’s proposal for addressing it. Fiduciary Duty? The PMIB has a fiduciary duty . . . But Administration Has Not Carefully to its investors, including the state government Considered Its Implications. However, the and local governments with funds in the LAIF. administration is asking the Legislature to approve Section 16480.2 of the Government Code also a large commitment of public resources without directs the PMIB to invest funds “in such a way careful analysis. The administration claims the as to realize the maximum return consistent with proposal will save the state $11 billion without safe and prudent treasury management.” While seriously analyzing the probability this level of we think the structure of the $6 billion loan—with savings will actually emerge over time using a floating interest rate roughly consistent with standard actuarial estimating techniques. The the PMIA’s typical earnings—could perhaps pass Department of Finance has conducted no review these fiduciary tests, the state’s obligations to local or analysis to determine how many of the state’s governments suggest the need for a thorough, open special funds will have difficulty making loan process to review these issues. For example, that repayments under the proposal. Instead, the process could consider if the interest rate under this administration plans to conduct this analysis after proposal is enough to compensate LAIF investors. the Legislature has approved the loan. Apparently, A ten-year loan may need to be based on a higher the administration has not sought a fiduciary interest rate than a two-year Treasury yield. counsel opinion to determine if this large, novel transaction meets the PMIB fiduciary duties. LAO Bottom Line Neither has there been, as best we can tell, a period Fiscal Benefit to the State Seems Likely . . . The for review and comment on the proposal by local administration is asking the Legislature to approve governments with funds in the LAIF. Finally, the a large commitment of public resources that will administration has not published legal opinions on have long-term effects on the state’s finances. the constitutionality of this proposal. From a fiscal perspective, we think this proposal LAO RECOMMENDATIONS The administration has introduced this recommend below an approach that would allow proposal as part of the May Revision—with only the Legislature to carefully analyze and consider weeks before the constitutional deadline for the the implications of this proposal before approving Legislature to approve the budget. All of the issues or rejecting it. we have raised regarding this proposal cannot be Recommend Legislature Direct reviewed by the June 15 budget deadline. In our Administration to Complete Planning Analysis. view, however, there is no reason why this proposal Before the Legislature acts on the Governor’s needs to be approved by that time. Rather, we proposal, we recommend requiring the www.lao.ca.gov Legislative Analyst’s Office 13 2017-18 BUDGET administration to perform more due diligence and • Special Funds’ Ability to Pay. We report the results publicly. Specific items we think recommend that the administration be are needed in this analysis are: required to identify state funds that likely • Legal Opinions. We recommend the cannot make the repayments in the first few years of implementation, the amount administration be required to consult of those shortfalls, and a proposed solution with fiduciary counsel—whether at the that would allow each fund to pay over the Attorney General’s Office or elsewhere—to long term. The administration could be determine if the proposal has problematic required to provide (1) its best estimates fiduciary implications for either the of how much money special funds will PMIB or CalPERS board. In addition, we need to borrow from the General Fund to recommend the administration be required make their payments, by year, and how to seek an Attorney General opinion and/ their repayments to the General Fund or a public validation proceeding in the will be structured, and/or (2) specific courts regarding the constitutionality plans to change each affected special of borrowing from the PMIA for these fund’s revenues or spending to cover these purposes. shortfalls. • Risks and Uncertainties. We recommend Recommend Legislature Consult With that the administration be required to California Actuarial Advisory Panel (CAAP). report to the Legislature a comprehensive The CAAP consists of eight actuaries and was analysis conducted by professional established in statute in 2008 to provide public actuaries—using stochastic modeling and agencies with impartial and independent other actuarial simulations—quantifying information on pensions, retiree health benefits, the uncertainties around the proposal and best practices. We recommend that the listed above. This analysis could include Legislature formally ask the CAAP to provide a determination of the probability that an opinion on (1) the administration’s plans and the proposal will produce a net benefit estimates and (2) whether the state should make for the state—considering both CalPERS such a payment towards either pension or retiree and the PMIA’s respective investment health liabilities. (The CAAP could coordinate its returns in the future. This analysis could works with that of the other professional actuaries also consider alternatives for prepayments described above.) in terms of their net benefit. For example, Recommend Legislature Act on Plan Later would a prepayment for state retiree health in Session After Receiving More Information. unfunded liabilities have a greater net Final legislative action on the administration’s benefit in the long run? Would smaller proposal can wait until after June 15. In particular, annual Proposition 2 supplemental we recommend the Legislature wait to act on this payments to CalPERS over time—rather plan until after the administration has submitted than a large, lump-sum loan—have a the analyses listed above, which perhaps could be greater chance of success? developed by the end of the 2017 legislative session. 14 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET If the analyses showed a high likelihood of net administration’s proposed $427 million repayment benefit to the state and there were no major legal would be released if the Legislature adopted concerns, the Legislature could pass implementing implementing legislation later in the session. If no legislation to adopt the proposal. such legislative plan passed, the budget package Recommend Flexible Proposition 2 Debt would include an alternative purpose for the Payments in Budget Plan. To pass a budget in June, $427 million loan repayment. For example, the the Legislature must include a schedule of required Legislature could direct the administration to make debt payments under Proposition 2. Instead of an additional, supplemental payment to CalPERS approving the proposal now without sufficient of this amount—but without any borrowing from analysis, the Legislature could “pencil in” a flexible the PMIA. plan for Proposition 2. Under these provisions, the www.lao.ca.gov Legislative Analyst’s Office 15 2017-18 BUDGET LAO Publications This brief was prepared by Ann Hollingshead and Nick Schroeder, and reviewed by Jason Sisney. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This brief 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. 16 Legislative Analyst’s Office www.lao.ca.gov