California’s Pension Woes Exacerbated by Politics

California governor Jerry Brown has been taking a victory lap of sorts after putting forth a budget for fiscal year 2019 that would include a $6 billion surplus, a remarkable turnaround for a state that hemorrhaged red ink in the wake of the great recession.

Of course, much of that surplus arrived via a hefty tax increase, as well as a surfeit of revenue resulting from the stock market boom via capital gains taxes, so attributing this turnaround to fiscal probity might be taking things a bit far.

However, Governor Brown does get credit for at least temporarily righting what seemed to be a sinking ship. What’s more, he seems to realize that this surplus can easily disappear, and he has warned his potential successors to resist spending that surplus. What Brown is fully aware of is that even the most spectacular stock market increase is not enough to erase the state's most pressing financial problem—namely, its underfunded government pension.

Currently, it has enough money set aside to cover just 68% of its future obligations—certainly far from the most indebted state (that would be my own state of Illinois), but still low enough to dismiss any notion that future stock market growth can remedy the problem.

Despite this, the California Public Employees Retirement System, or CalPERS, has put politics ahead of achieving a high rate of return by insisting that the boards of the companies it invests in adhere to various social and environmental practices.

It's nonsense, of course, and it amounts to little more than an extension of politics into a realm that doesn't have room for it.

The problem is that these environmental and social constraints inevitably bring with them a lower rate of return—regardless of what CalPERS and other advocates say to the contrary. And these lower returns will only hasten the day when the state's taxpayers—or, failing that, federal taxpayers—will be on the hook to cover California's pension deficit.

A few of the state's politicians seem to be aware of the conundrum this places on California citizens: A Democratic state senator recently offered a bill that would allow new state employees to opt out of the state pension plan and simply participate in a defined contribution plan. The state university system already allows newly hired professors to opt out—a recognition that a defined benefit plan does not work well for a peripatetic workforce like academics.

Ultimately, moving to a defined contribution plan might make sense from a long-term sustainability perspective, but transitioning to such a system for everyone would require someone (namely, current taxpayers and state workers) to cover promises already made to current and future state retirees while new employees build up their own retirement balances. In short, someone’s going to be left holding the bag in the ponzi scheme that is a pay-as-you-go public pension plan.

That's a tricky path to navigate: Utah did such a thing for its new employees with a much smaller per-capita shortfall, accomplishing it by making those new employees fork over a portion of their income to cover promised benefits. It is not clear even that will be sufficient for the state.

California will need every dime it can get its hands on to fund its pension shortcomings, and with the country's highest income tax rate it probably can’t raise personal income taxes too much higher. Governor Brown has commented that the state's retirees should expect a benefit reduction the next time there's a recession but most people think any reductions in promised benefits are precluded by the state's constitution.

At some point a future governor of California will need to figure out how the state’s going to cope with having billions in promised benefits and insufficient money set aside to keep those promises. That calculus will be much easier if CalPERS doesn’t accept a lower rate of return in exchange for dubious political chits.