Orange County cities are facing a pension fund crisis, brought on by the COVID-19 global pandemic and the subsequent stock market crash.
City and state governments are now clamoring for the next round of federal bailouts. Critics of excessive government spending, meanwhile, fear the bailouts may be used not to keep area businesses alive, or to keep essential services running smoothly, but rather to fund these cities’ chronic shortfalls in funding pensions.
Either way, our analysis clearly shows that required pension payments are putting enormous stress on OC’s biggest cities. Those cities may be forced to pay the equivalent of 49% to 66% of their payrolls to the state’s pension system.
That pressure comes on top of the municipal revenue shortfalls created by the pandemic, thanks to closed hotels, restaurants and malls. Ultimately, it’s likely to cause a shortage of essential services, and perhaps municipal bankruptcies.
Our estimates suggest that state and local total pension assets, as a percent of total pension liabilities in the accounts of their fund manager, have decreased from 55% in 2017-18 to 47% as of April, propelling unfunded pension liabilities to $1 trillion.
Most of that decrease was caused by the recent market drop in the value of all asset classes.
‘Incremental’ Obligations
Before examining the implications of this decline in our local cities and their required pension payments to CalPERS, it is important to understand how these payments relate to the widening gap between assets and liabilities. This discrepancy is resolved principally by requiring the state and cities to pay additional amounts to CalPERS.
Contractually, the state and cities pay a “normal” percentage of their current payrolls to fund the ongoing regular pension contribution for their active workers. Cities must pay that amount even if their pension obligations were fully funded. But because the pension funds’ assets are insufficient to meet the estimated pension obligations, the state and cities are required to pay an additional “incremental” percentage to CalPERS.
Table 1 shows the normal and incremental percentages that a sample of five of the larger Orange County cities pays CalPERS to meet their annual pension obligations. This table represents a weighted average of total pension payments to cover all classes of municipal employees, including fire, police, safety, and miscellaneous governmental services.
Notice Table 1’s wide variation in incremental payments ranging from a low of 18.1% for Irvine to a high of 42.7% for Santa Ana. In dollar terms, that means that while Irvine must pay an additional $16.2 million, Santa Ana must come up with $44.5 million to meet its 2019-20 incremental payments.
The pension payments shown in Table 1, both “normal” and “incremental,” are based on the pre-COVID-19 financial conditions when markets were riding high, and CalPERS was returning 6.7% for the fiscal year 2018-19.
Market Challenges
The challenge posed by the recent market crash is the impact this reversal will have on state and city budgets. While that impact is a complex amalgam of discounting formulas and actuarial assumptions, we were able to estimate the degree to which a drop in returns correlates to an increase in the city’s expected annual payments to CalPERS.
Those estimated payments that will be required to meet total (normal and incremental) pension payments to CalPERS, assuming a negative 15% decline in returns, are presented in Table 2.
The change in the required payments in dollar terms is presented in Table 3.
Yes—you are looking at that correctly—Anaheim is obligated to pay the equivalent of 49% of its payroll to CalPERS while Santa Ana is facing 67%. A healthy city might devote 15% as percentage of payroll to the pension fund.
Clearly, the current defined benefit public pension system is out of control. One can understand why there is opposition in Congress to bailing out cities.
Table 3 points to increases in payments to CalPERS, ranging from a low of $4.9 million for Orange to $15.8 million for Anaheim.
When additional payments like these are happening while municipal revenues are cratering, especially sales tax revenues, the ability for cities to fund these higher payments is called into serious question.
Think, for example, how the loss in hotel bed taxes and the concurrent expectation of funding an additional $15.8 million in pension payments will affect Anaheim’s coffers and financial stability.
Budgetary Tsunami
We believe, given the budgetary tsunami hitting cities, that cities will have a compelling argument for reducing their required payments to CalPERS.
Such forbearance presents longer-run problems.
The reason that cities are already in a bind is because their pension assets fall far short of their pension obligations. As shown in Table 4, the total unfunded accrued liabilities range from a low of $167.3 million for Irvine to $817.2 million for Santa Ana. The staggering nature of these accrued liabilities for cities explains why their incremental pension payments to CalPERS are so high.
For every dollar that cities fall short in meeting the 2020-21 expected payments shown in Table 3, the unfunded accrued liabilities shown in Table 4 will increase. That means much higher incremental payments in future years.
These ever-increasing payments to CalPERS will further crowd out municipal spending in critical areas like police, safety, fire, and other areas of municipal oversight.
Now is the time that city governments and public employee unions should come together to develop meaningful long-term solutions to the widening chasm between public pension assets and liabilities.
As we have argued previously (see our OC Leader Board contribution in Feb. 25, 2019), such solutions will likely involve guaranteeing current workers the defined payment pension plans they were promised.
At the same time, though, new workers should be moved to alternative defined contribution types of plans. The quid pro quo would be to increase state and local “normal” contributions to pension funds in order to generously supplement newly defined contribution plans.
These strategies take on heightened importance considering the COVID-19 shutdown and the impact it will have on the “crowding-out” effect. Even more ominous is the likelihood of municipal bankruptcies for those cities whose unfunded liabilities make it impossible for them to fund necessary municipal services.
Editor’s Note: James L. Doti, is president emeritus and professor of economics at Chapman University. Fadel N. Lawandy is director of Chapman’s Hoag Center for Real Estate and Finance.
