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California Dreaming

One percent a year returns won’t be enough to pay state pensions.

Jul 30, 2012, Vol. 17, No. 43 • By MARK HEMINGWAY
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Last week, California taxpayers, already accustomed to economic doom and gloom, received an astonishing piece of bad news. The California Public Employees’ Retirement System (CalPERS) had posted a 1 percent return on its investments over the previous year. The California State Teachers’ Retirement System (CalSTRS) didn’t fare much better, with a 1.8 percent return. CalPERS and CalSTRS currently have a combined $383.5 billion in assets, making them the largest public pension system in the country.


Maybe we could sell the fancy building.

That’s a lot of money, but thanks to California’s legendarily generous and corrupt pension programs, the two funds are on the hook for a lot more than they’ll be capable of paying out. It’s long been known that unfunded state pension liabilities were an acute financial problem, but there’s been a raging debate over exactly how big it is​—​the Pew Center on the States estimates the shortfall nationwide is $757 billion, while a recent report from State Budget Solutions says states are a whopping $4.6 trillion short of covering their obligations.

However, the lower-end estimates, such as Pew’s, rely on the states’ own assumptions about the likely rate of return on their pension fund investments. For years now, state projections have been divorced from reality. Most states assume a 7.5 percent to 8.25 percent annual return on their investments. By comparison, the S&P index grew at 5 percent a year over the last decade, and many pension fund assets are tied up in more conservative investments than that broad stock market index.

CalPERS’ performance is a blow to defenders of states’ rosy assumptions. Most states are still loath to admit that the new normal is substantially less than they were betting on​—​CalPERS, for one, lowered its expectations from 7.75 percent all the way down to 7.5 percent in March (ignoring the advice of its own actuary, who suggested lowering it to 7.25 percent). When New York City’s actuary considered a similarly trivial adjustment downwards, Mayor Michael Bloomberg (who actually knows something about this subject) was less than impressed. “The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” he told the New York Times. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”

The good news is that it looks like states won’t be able to get away with this fantasy accounting for much longer. The Governmental Accounting Standards Board (GASB)​—​a non-governmental organization that has authority from the Securities and Exchange Commission to set rules for state and local government accounting​—​is on the verge of adopting new transparency rules for state pensions.

GASB will force inadequately funded pension systems to assume a far lower rate of return. State pension systems that are funded at satisfactory levels could continue using their own investment projections. This would have huge ramifications.

The proposed GASB rules don’t go far enough for Wall Street, however. “I have been saying if there was going to be discipline imposed on the states, it would be through the market, not a regulator,” Robert Novy-Marx, professor of finance at the University of Rochester, recently told Chicago business magazine Crain’s. “I don’t care how long they drag their feet​—​the market will drag them along.”

In its most recent estimate of public pension debt, ratings agency Moody’s applied a 5.5 percent annual return to all state pension funds and calculated state pension shortfalls to be $2.2 trillion. Under the agency’s calculus, in Illinois, whose pension system is one of the nation’s worst, the funding shortfall would jump from $83 billion to $135 billion.

Moody’s also published a report last week noting that pension burdens are major contributors to the recent spate of city bankruptcies, which Moody’s sees as part of an alarming trend of “distressed municipalities .  .  . view[ing] debt service as a discretionary item in their budget.” As such, unsustainable pensions are a major threat to the $3.7 trillion municipal bond market. Unfortunately, state pension problems are often the result of intractable state politics that won’t easily be fixed. Once again, California is the exemplar: In 1998, Phil Angelides was elected state treasurer and began an aggressive campaign to use the fiscal might of California’s pension funds to push all sorts of liberal ideas related to corporate governance and socially responsible investing.

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