The pension liabilities of all U.S. states and local governments since 2002 have risen 143% to $8.5 trillion dollars as of the most recent third quarter. During the same time, assets put aside to pay for these liabilities have increased by a lower amount, resulting in a shortfall around $4.1 trillion.
A big portion of that shortfall is in California, which as of 2016, had $1.5 trillion in liabilities and $800 billion in assets.
While Orange County cities are doing better, they’re not escaping the crisis.
The extent of the public pension crisis becomes more obvious when the numbers are compared to private sector pensions, where according to the Pension Protection Act of 2006, a plan has a high potential for default if the unfunded liability exceeds 20%. By that standard, almost every state including California is significantly underfunded.
In Orange County, 19 of 20 cities have an unfunded liability ratio above 20% as of 2016, with Seal Beach reporting the highest at 68%.
To better understand why the percentage of California’s unfunded liabilities has grown so rapidly, one needs to focus on CalPERS, which manages funds for the cities and is the nation’s largest public pension fund.
CalPERS pension dollars are generated from employee contributions (13%), state and local government contributions (28%), and investment returns (59%). When returns fall short, state and local governments are required to make up the shortfall—not the public sector workers, who are guaranteed a predetermined amount, no matter how the markets performed.
In 2008, CalPERS had a target return on investments of 7.75%. From 2008 to 2018, it actually returned an annual average of 5.6%. Those returns were affected by a negative 27% in 2008 and a 6.5% drop in 2018.
Over a 15-year period from 2002 to 2016, not once was the state able to make 100% of the recommended payments for any year. Not surprisingly, the growth of pension liabilities has outstripped asset growth.
In future years, additional pressures will widen the gap between pension liabilities and assets. Pension funds are becoming more conservative in their projected investment returns, thereby placing additional burdens on the state and local governments.
For example, CalPERS is moving the target return on investments from 7.75% to 7% by 2025 and has adopted a 20-year amortization period replacing the historical 30-year period. Think what happens to your mortgage payment if it goes from a 30-year to 20-year mortgage. This alone, not accounting for any other factors, will translate to a 12% increase in required funding from state and local governments.
The impact of the ever-expanding unfunded liabilities and increasing pressure on state and local governments to dedicate a growing proportion of their budgets to fund their pension obligations is becoming increasingly clear.
Orange County cities with the highest pension debt per household are shown in the accompanying table.
Perhaps not surprisingly, four of the top 10 cities in pension debt per household pushed for sales tax increases last year, including the city with the highest obligation—Laguna Beach.
On the other hand, the 10 cities with the lowest pension debt per household are not out of the woods. All 10 contract their police and fire services to the Orange County Sheriff’s Department and Orange County Fire Authority. As a result, the real pension obligation is reflected in the Sheriff’s and Fire Authority’s books and not directly on these cities. Nonetheless, the pension obligation will be passed through to these cities when the Sheriff and Fire Authority charge them for their services. The Fire Authority has unfunded liabilities of 27% while it’s difficult to find reliable data on the Sheriff’s Department because its pension is co-mingled with the county’s.
Consequently, almost all cities in Orange County face a looming public pension crisis that is growing in magnitude each year.
We’re now at a tipping point, but there’s still time for a fix.
This will depend mainly on whether leaders emerge who are willing to adopt new approaches to create a more stable and sustainable retirement plan for public workers. Such approaches will likely involve guaranteeing current workers the pension plans they were promised but at the same time moving new workers to 401(k) plans. If agreements can be reached on this, the quid pro quo would be to increase state and local government contributions to pension funds that guarantee existing defined benefit plans, as well as generously fund new defined payment 401(k) plans.
These strategies may seem politically DOA. The alternative, however, is much worse—more bankruptcies and higher rates of taxation to fund pension costs rather than needed public services.
We all watched as San Bernardino, Stockton and Vallejo went through bankruptcy with the largest creditor being their pension funds.
Editor’s Note: Jim Doti is president emeritus of Chapman University and one of the nation’s foremost economists. Fadel Lawandy is director of Chapman’s Hoag Center for Real Estate and Finance.
