AUTHOR: Steven Malanga
The Pension Fund That Ate California;
CalPERS’s corruption, insider dealing, and politicized investments have overwhelmed taxpayers with debt.
FULL LINK: The Pension Fund That Ate California by Steven Malanga, City Journal Winter 2013"After spending years dogged by unpaid debts, California labor leader Charles Valdes filed for bankruptcy in the 1990s—twice. At the same time, he held one of the most influential positions in the American financial system: chair of the investment committee for the California Public Employees’ Retirement System, or CalPERS, the nation’s largest pension fund for government workers. Valdes left the board in 2010 and now faces scrutiny for accepting gifts from another former board member, Alfred Villalobos—who, the state alleges, spent tens of thousands of dollars trying to influence how the fund invested its assets. Questioned by investigators about his dealings with Villalobos, Valdes invoked the Fifth Amendment 126 times.
"CalPERS and its legislative allies keep resisting the one
reform that would truly free California taxpayers from this ruinous pension
system: moving it toward a 401(k)-style defined-contribution plan."
California taxpayers help fund CalPERS’s pensions and ultimately guarantee them, so they might wonder: How could a financially troubled former union leader occupy such a powerful position at the giant retirement system, which manages roughly $230 billion in assets? The answer lies in CalPERS’s three-decade-long transformation from a prudently managed steward of workers’ pensions into a highly politicized advocate for special interests. Unlike most government pension funds, CalPERS has become an outright lobbyist for higher member benefits, including a huge pension increase that is now consuming California state and local budgets. CalPERS’s members, who elect representatives to the fund’s board of directors, ignored concerns over Valdes’s suitability because they liked how he fought for those plusher benefits.
CalPERS has also steered billions of dollars into politically connected firms. And it has ventured into “socially responsible” investment strategies, making bad bets that have lost hundreds of millions of dollars. Such dubious practices have piled up a crushing amount of pension debt, which California residents—and their children—will somehow have to repay.
When California’s government-employee pension system was established in 1932, it was a model of restraint. Private-sector pensions were still rare back then, but California lawmakers had a particular reason for wanting a public-sector pension system: without one, unproductive older workers had an incentive to stay on the job and just “go through the motions” to get a paycheck, as a 1929 state commission put it. Pensions would encourage those workers to retire. The commission cautioned, however, against setting a retirement age so low that it would “encourage or permit the granting of any retirement allowance to an able-bodied person in middle life.”
Accordingly, California set its initial retirement age for state workers (and, beginning in 1939, for local-government employees) at 65, at a time when the average 20-year-old entering the workforce could expect to live for another 46 years, until 66. The system’s first pensions were modest, though far from miserly. An employee’s pension equaled 1.43 percent of his average salary over his last five years on the job, multiplied by the total number of years he had worked. That formula typically provided workers with pensions equal to half or more of their final salaries, noted California’s Little Hoover Commission, a government agency, in a 2010 study. For example, a state worker who retired at 65 after 40 years on the job would qualify for a pension equal to 57.2 percent of his average final salary (that’s 40 times 1.43). If that salary was $50,000, his pension would be nearly $29,000.
The pensions were funded by three sources: contributions from employers (that is, state and local governments); contributions from employees (though some governments opted to cover that expense); and money that the pension fund would gain by investing those contributions. With the 1929 stock-market crash in mind, California opted for a cautious investment approach, allowing the fund to buy only safe federal Treasury bonds and state municipal bonds. “An unsound system,” the 1929 commission warned, would be “worse than none.” The employees’ contributions were fixed, so if investment returns weren’t sufficient to fund the promised pensions, the employers’ contributions would have to increase to make up the difference.
In 1961, California enhanced non-public-safety state workers’ retirement packages by enrolling them in federal Social Security, a program that’s optional for state and local government employees. But the state made few other changes to the pension system over its first 30 years.
Then came the late sixties, a time of rapidly growing public-sector union power. In 1968, the California state legislature added one of the most expensive of all retirement perks, annual cost-of-living adjustments, to CalPERS pensions. Other enhancements followed quickly, including, in 1970, a far more generous pension formula: a worker’s pension was calculated from 2 percent, not 1.43 percent, of his average final salary, and he could start getting his pension at 60, rather than 65. Thus, an employee who worked for 40 years and retired at 60 with an average final salary of $50,000 could collect an annual pension equal to 80 percent of that sum, or $40,000; if he kept working for another five years, his pension fattened to 90 percent of his final average. In 1983, public-safety workers got an even better pension formula: 2.5 percent of average final salary for every year worked, which could be taken starting at 55. A police officer or firefighter who began work at 20 and retired 35 years later with a final average salary of $50,000 now qualified for a yearly pension of almost $44,000.
As benefits increased, so did pressure to pay for them by boosting CalPERS’s investment returns. The shift started in 1966 when voters approved Proposition 1, a measure, promoted by CalPERS, that let it invest up to 25 percent of its portfolio in stocks. The timing wasn’t ideal, since the long economic stagnation of the late sixties and seventies had left equity markets struggling for gains. But by the early eighties, markets were roaring again, and CalPERS asked for permission to invest up to 60 percent of its portfolio in stocks. Voters rejected that ballot initiative but approved another, Proposition 21, in 1984, which likewise let CalPERS expand its investments —and didn’t specify a percentage limit. Instead, Prop. 21 supposedly protected taxpayers with a clause that held CalPERS board members personally responsible if they didn’t act prudently. The proposition received the enthusiastic backing of government unions and CalPERS board president Robert Carlson, former head of the powerful California State Employees Association. CalPERS’s conservative investment approach, Carlson and other supporters argued, was shortchanging the state’s taxpayers. After all, the better the investment returns were, the less state and local governments would need to pay into the pension fund.
Despite the new investment strategy, the costs of the enlarged pensions weighed heavily on California’s budget. In 1991, with the nation mired in a recession and the state in a fiscal crisis, the California legislature closed the existing pension system to new workers, for whom it created a second “tier.” This less expensive plan no longer required the worker to make a pension contribution, and it lowered the value of his pension to 1.25 percent of his final average salary for every year he had worked; further, he could begin to receive the pension only at 65. A 40-year veteran with a final average salary of $50,000 would thus qualify for a $25,000 pension, plus Social Security benefits.
The state’s public-sector unions hated the new tier, of course, and their growing influence over CalPERS’s board of directors meant that it, too, was soon lobbying against the 1991 reform. Six of the board’s 13 members are chosen by government workers, and as union power grew in California, those six increasingly tended to be labor honchos. Two more members are statewide elected officials (California’s treasurer and controller), and another two are appointed by the governor—so by 1999, when union-backed Gray Davis became governor and union-backed Phil Angelides became state treasurer, the CalPERS board was wearing a “union label,” noted the New York Times. As the newspaper added, critics worried that the board had become so partisan that its “ability to provide for the 1.3 million public employees whose pensions it guarantees” was in doubt.
The critics were right to worry about CalPERS’s bias. In 1999, the fund’s board concocted an astonishing proposal that would take all the post-1991 state employees and retroactively put them in the older, more expensive pension system. The initiative went still further, lowering the retirement age for all state workers and sweetening the pension formula for police and firefighters even more. Public-safety workers could potentially retire at 50 with 90 percent of their salaries, and other government workers at 55 with 60 percent of their salaries.
CalPERS wrote the legislation for these changes and then persuaded lawmakers to pass it. In pushing for the change, though, the pension fund downplayed the risks involved. A 17-page brochure about the proposal that Cal- PERS handed to legislators reads like a pitch letter, not a serious fiscal analysis. The state could offer these fantastic benefits to workers at no cost, proclaimed the brochure: “No increase over current employer contributions is needed for these benefit improvements.” The state’s annual contribution to the pension fund—$776 million in 1998—would remain relatively unchanged in the years ahead, the brochure predicted.
CalPERS board members also minimized the plan’s risks. Board president William Crist contended in the press that the bigger benefits would be covered by the pension fund’s market returns. Labor leader Valdes blasted critics who warned about potential stock-market declines, saying that they were trying to deny workers a piece of the good times. What the board members didn’t mention was that California law protected government pensions, so that taxpayers would be on the hook for any shortfall in pension funding. In essence, the CalPERS position was that government workers should carry zero risk, sharing the bounty when the fund’s investments did well but losing nothing when the investments went south.
But the board members knew that there was a downside. CalPERS staff had provided them with scenarios based on different ways the market might perform. In the worst case, a long 1970s-style downturn, government contributions to the fund would have to rise by billions of dollars (which is basically what wound up happening). CalPERS neglected to include that worst-case scenario in its legislative brochure. And though the board later claimed that it had offered a full analysis to anyone who asked, key players at the time deny it. Even the state senator who sponsored the law, Deborah Ortiz, says that lawmakers received little of substance from the fund’s representatives. “We probed and probed and asked questions 100 times,” she told the San Jose Mercury News in 2003. “The CalPERS staff assured us that even in the worst-case scenario the state’s general fund would take a $300 million hit,” a manageable sum in a $99 billion state budget. (The actual cost to the state budget, it turned out, was more than ten times that estimate—and it’s still climbing.)
CalPERS also misled legislators and the press about the 1991 pension tier that it was pushing to repeal. In its brochure, the fund implied that the retirement pay that rank-and-file service workers got under the 1991 plan was tantamount to poverty. It didn’t mention that many state workers also received Social Security payments, which add substantially to retirement income.
California lawmakers easily passed the new pension deal in 1999. The bill, signed by Governor Davis with little fanfare, immediately generated pressure on local governments to match the new benefits for their own employees. In 2001, legislators passed a measure allowing municipal workers covered by the CalPERS system to bargain for the same benefits that the state workers had just won. Like state legislators, many local officials believed that CalPERS surpluses would pay for the benefits. Expensive new benefits spread across the state “like a grass fire,” Tony Oliveira, president of the California State Association of Counties, remembered in 2010.
That frenzy to expand benefits took place even though the air was already coming out of the economy. The tech-stock bubble deflated in the spring of 2000, shattering the NASDAQ market and driving down the Dow Jones Industrial Average. The American economy plunged into recession the following year, a slowdown made far worse by the terrorist attacks of September 11. By the close of trading on September 17, 2001, the Dow stood at 8,920.70, down nearly a quarter from its early-2000 all-time high of 11,722.
CalPERS has the exclusive power to determine the size of state and local governments’ contributions into the fund. As its investments tanked, it quickly boosted those contributions to compensate. By mid-decade, local officials were frantically telling the California press that the contributions were squeezing out other forms of spending. Glendale, a Los Angeles suburb, watched its annual pension bill rocket from $1.3 million in 2003 to $13.7 million in 2007—nearly a tenfold increase. San Jose’s tab almost doubled, from $73 million in 2001 to $122 million in 2007, and then rose even faster over the next three years, hitting a jaw-dropping $245 million in 2010. San Bernardino’s annual pension obligations rose from $5 million in 2000 to about $26 million last year. The state budget took a massive hit, too, its pension costs lurching from $611 million in 2001 to $3.5 billion in 2010.
Even those sums understated the problem. As a backlash grew to the larger bills that it was sending to municipalities and the state, CalPERS used a series of fiscal gimmicks to limit the immediate impact on balance sheets. Typically, to protect governments from violent swings in contributions every year, pension funds like CalPERS average their investment returns over three years, hoping that good years offset bad years. In 2005, CalPERS extended the performance average to 15 years, an extraordinarily long period that blended the fund’s losses in the 2000s with its gains way back in the 1990s—thus reducing state and local governments’ immediate costs, which remained overwhelming nevertheless. Then, in 2009, CalPERS told governments that they could pay off the higher bills from the previous year’s scary market drop over the next three decades, pushing the bill for the financial meltdown to the next generation. The pension fund made a similar move in 2011: after revising downward its absurdly optimistic predictions of future investment gains, it gave governments 20 years to finance the higher resulting costs.
............CalPERS and its legislative allies keep resisting the one reform that would truly free California taxpayers from this ruinous pension system: moving it toward a 401(k)-style defined-contribution plan."
(the story continues but really to long for this format i would encourage readers to use the above link to read the expose in the City Journal)