Monday, December 6, 2010

California Shipwreck

The State of California just hit an iceberg, which ripped a gash in her hull, and the ship is taking on water. The crew and most of the passengers are as yet unaware of the damage, or of the probability of sinking. They carry on as though nothing were wrong. Indeed, a captain who was at the helm a number of years ago, and who then ran the ship aground, is returning shortly to the bridge to assume the command.

When he does, he will learn that the giant vessel is barely floating, with twenty-five billion gallons of water in her hold, and more being added by the minute. The ship's pumps are inadequate to the task of keeping her afloat, because the crew keeps opening more portholes and hatches in the vain belief that the water will flow out of them, and not into them. Reality is in short supply, and folly is the watchword of the moment. Those on the watch, actually, are missing another huge iceberg in their path which is 99% submerged.

California operates the largest public pension system in the United States. It is called "CalPERS", for California Public Employees Retirement System, and in 2007 it held $261 billion dollars of invested assets. In fiscal 2007-2008, it paid out nearly $11 billion in pensions to retirees, and half that much again in health benefits. In addition, California has two other public pension systems: one for teachers, called CalSTRS, and a much smaller one for professors in the State university system, called the University of California Retirement System.

Each of these retirement systems administers what is known as a "defined benefits" pension program, which tells each retiree, in advance of retirement, exactly how much they will receive each month, based on factors such as years of service, highest wage earned, and the particular contribution factor negotiated by the public-sector unions with their employer, be it the State itself, a county, a school district, a university, or a police or fire department in a city. The plan funds these projected payments by investing the moneys paid in by both the employee and the employer while the employee is working. The problems with defined-benefit plans begin when their investments of the amounts paid in by the employers and employees, in order to fund the specified benefits to be paid out upon retirement, fall short of projections.

And that is just what has happened with California's three public pension plans -- only because together they are so large, the shortfall has happened on a massive scale. One recent study, by Stanford graduate students, estimates that the pension system is currently underfunded by half a trillion dollars, or $500,000,000,000.00. Now let's put that in perspective, shall we?

California's latest annual "budget" (the word is a joke in California), approved almost four months late, was pegged at roughly $86.5 billion dollars (you can download a .pdf summary from this link). (Remember, this so-called "budget" is $25 billion out of balance.) So the first thing to note is that the projected shortfall in California's pension systems is almost six times as great as its current annual "budget" for everything, including pension contributions. California cannot even balance its current budget; so where will it find the money to make up a potential gap which is six times larger than the budget itself?

When the Stanford study came out earlier this year, the heads of CalPERS and CalSTRS claimed that the gap was nowhere near as great as stated. They explained that the plans calculate projections by using their historical long-term rates of return (over a 20- to 30-year time frame), which average around 7.9 % for CalPERS and 8.6 % for CalSTRS. The current market downturns are just a blip on the long-term radar screen, they implied.

The situation is complicated, because CalPERS also invests pension money for many cities and other governmental units around the State, which have collective bargaining agreements with their own employees specifying various rates of payout upon retirement. The contributions by employees are fixed as part of the agreements, but the contributions from the employers vary according to returns earned by the plans. Thus the employing agencies (cities, counties and the State), and not their employees, bear all the risks of investment, and they in turn look to the professional staff at the plans to protect them from catastrophic losses.

This puts enormous pressure on the ways in which the plans calculate the values of their assets, as well as the projected future payouts. And the professional staffs have responded with number manipulations which, as one article notes, are worthy of a Bernie Madoff. They went from using a three-year Average Value of Assets (AVA), for example, to a fifteen-year AVA. The longer term allowed them to inflate asset values with the higher figures during the dot-com boom in the late 1990's, and made the recent huge losses appear much smaller. As the article points out, this accounting gimmick does not eliminate the current losses in the market -- which are very real -- but simply shoves them over to future years, when the piper will have to be paid.

The senior pension actuary for CalPERS openly admitted another such manipulation in a recent talk given to the City Council of Huntington Beach. As this article explains:
Another Madoff-worthy trick then compounded the problem more. After the 2008-2009 losses CalPERS changed their assumptions AGAIN to “smooth” the losses. They then changed the AVA to MVA (market value of assets) ratio to 60% to 140% from [the previous range of 8]0% to 120%. As you can hear the actuar[y] state on the video and it is worth repeating in this story, “that means we will defer most of the loss to future years.” “This means the city will realize another increase in future years. I hate to bring bad news but those are the facts.”
If you watch the five-minute video at the article, you will see that the actuary projects that the coming changes in the projected rate of return (currently 7.75%) to be approved by the Board will result in increased government pension costs starting in 2012. For each 1/4% by which the Board decides to decrease the projected rate, required government contributions on behalf of their employees will go up by 2%, and on behalf of fire, police and safety employees, the required contributions will go up by 4%.

Well, now the bad news is becoming clearer. As this latest piece from the same author reports, the CalPERS Board is projecting an increase of fifty-five percent in required government pension contributions beginning with 2013, and continuing at that level for the next nineteen years. And even if that incredibly higher rate of pay-in could be sustained for that entire period, the actuaries estimate only a 50-50 chance of CalPERS being able to meet its already contracted pension obligations.

What this means is that the California pension system, in the space of some fifteen years, has gone from one that was fully funded to one that is instead going resemble the Ponzi scheme of federal Social Security. The money being paid in for current contributions by those still employed will be required to fund the current payouts to those who have retired. As governments lay off more workers in an attempt to balance their budgets, the effect will be to have still more workers drawing on their vested pension benefits -- much sooner than projected. That will throw the actuarial numbers off again, requiring a further upward shift in government contributions, and exacerbate the budget shortfalls even more.

The retirees most affected, of course, will be the last to understand how such a disaster could happen. To be sure, it happened with the best of intentions, but it became as bad as it has because the employees had been protected, by their unions, from assuming the normal risks of investment. This creates an artificial bubble of security around retirement expectations, which is now about to be punctured by the harsh realities of the current depression.

The picture for California is not pleasant to contemplate -- not pleasant at all. But as usual, California is the harbinger of failure for other, smaller pension plans, as well. Both public and private employee unions have negotiated similar "retirement insurance" all across the country. California is simply the biggest laboratory, and so is where the collision between opposing forces occurs on the most notable scale.

The only solution to this predicament is to change pensions from a defined (guaranteed) benefit basis to a defined contribution basis, which would, like current 401k plans, put the risk of investment entirely on the pensioner. That would also eliminate the need for gigantic bureaucracies such as CalPERS, and would shift the responsibility for future financial security to the individual, where it belongs. But there is precious little support for any such change, because people are used to the system they have. As this very pessimistic article assesses the situation, things will have to get a whole lot worse before anything changes:
As of today, there is no indication that anyone in the U.S. government is paying attention to this crisis. This is hardly surprising. The same “leaders” who have managed to ignore their own future, funding-crisis until it has soared to a total which exceeds global GDP can hardly be expected to act on a similar crisis, but less than 1/10th of that size.

Like lemmings racing for a cliff, the vast majority of Americans remain completely oblivious to their pending “financial suicide”. For this, the pseudo-journalists of the U.S. propaganda-machine bear most of the blame.

As with all Ponzi-schemes, the U.S. economy is totally dependent in maintaining “confidence” in this massive con-game. Thus, while a plethora of U.S. financial crises continue to worsen (including the pension-crisis) all we are likely to hear from the propaganda-machine are chorus after chorus of “Don't Worry, Be Happy”.


  1. As a further example of incompetent captaining of the vessel, CalPERS and CalSTRS have for years been used (or should I say abused) to push political agendas that were divorced from the funds' purpose of maximizing value for its beneficiaries. In my legal practice I helped several very large and financially stable companies respond to CalPERS threats related to the companies' involvement in geographic and subject areas deemed to be politically incorrect by the CalPERS board of managers. CalPERS also withdrew from investment in tobacco stocks invested in low-income neighborhoods in California -- decisions that while well-intentioned ended up harming the financial position of the fund. The cavalier use of money as if it will never run out kind-of reminds us of the leaders of a certain rapidly declining church body in this country, no?

  2. Steven,

    I saw at T19 and you may have seen on the ENS—Episcopal Church Pension Fund will skip 2011 cost-of-living increase.

  3. Many public employee union plans base benefits on the pay that the employee earns in the final year of work. This leads to awards of promotions in the final year, as well as to working massive amounts of overtime (when available) in the final year, all for the purpose of pumping up the "final pay" number for pension benefits. I believe actuaries are somewhat reluctant to build these practices into their assumptions as they are essentially a fraud on the system, yet they work to raise the final obligation of the plans to the employee substantially. It is how some of these employees retire with pensions that equal or exceed 100% of the regular pay they received while actively at work.

    The private sector defined benefit plans that I worked with during my legal career NEVER used just the final year's pay in the benefit formula - it was always average pay, usually over the final 5 or 10 years of employment.

  4. I have a question for the astute who often read this blog.

    What are your top three tactics for dealing with the fallout from the fiscal disarray of states like CA - not to mention the Feds?

    I ask because I have been consistently wrong for the last ten years about investments.

    I did not take in account the arrogant thinking in economic circles that the business cycle can be defeated by "shrewd" fiscal policy and monetary manipulation.

    My concern is that the current brain trust believes that inflation (currency devaluation) is the way forward.

    What are you doing with your investments?

  5. Dear Anglican Curmudgeon,

    What's a Californian and his or her family to do given this "shipwreck" as you call it?

    Extending your metaphor, most people exit shipwrecks. Can you provide a generalized nutshell of a response?

  6. Carl, and TU&D, unfortunately this blog is not suited as a vehicle for the type of advice you seek. However, if you are interested, I will set up a private forum where you and other readers can share ideas, suggestions, and experiences. Please email me for the details (see the Profile page).