California’s New Taxes Are Paying for Pensions

David Crane
Lecturer at Stanford University, President of Govern for California, and Former Economic Adviser to California Governor Arnold Schwarzenegger

What if a corporation raised $500 million in a securities offering on the premise that the proceeds would go for operating expenses, then disclosed a few months later that $300 million of this amount would instead be used to service a debt that wasn’t disclosed in the offering document?

This would be false advertising, subject to sanction by the Securities and Exchange Commission. Unfortunately, the SEC doesn’t have jurisdiction over state politicians engaging in the same behavior, and, in the case of California, involving sums that are 100 times bigger.

Last November, California politicians persuaded voters to support a proposed seven-year, $50 billion tax increase, largely on the vow that the money would go to public education. The first five words of the initiative’s title were “Temporary Taxes to Fund Education.”

Now, just four months after the election, the state’s Legislative Analyst’s Office has announced that the California State Teachers’ Retirement System requires an extra $4.5 billion a year for 30 years — $135 billion — to cover its unfunded liability for teacher pensions and that the money will have to come from some combination of school districts and the state. To the extent that it comes from the school districts, $4.5 billion a year is 167 percent of the annual amount those districts expected from the tax increase. To the extent that it comes from the state, $4.5 billion is more than 100 percent of the annual amount it expected in new revenue.

Inflated Investments

Either way, more than $30 billion over the next seven years will go to the service of a debt that wasn’t disclosed before the voters were asked to approve the tax increase.

None of this is a surprise to longtime observers of many teacher pension funds and of Calstrs specifically. It’s just as I predicted a year ago on Bloomberg View, as the Volcker-Ravitch report on California’s budget outlined last year, and as Bill Gates explained in a 2011 TED talk.

It’s also no surprise to state officials. On the day the proposed tax increase was announced in early 2012, I raised the issue with the leaders of California’s State Assembly and State Senate and later with Governor Jerry Brown, and surely all were aware of the Volcker-Ravitch report.

Worse, the $4.5 billion-a-year requirement is based on the teachers retirement fund’s self-reported unfunded liability, which in turn is based on Calstrs’s self-chosen and unrealistically high investment-return assumption that implicitly forecasts the stock market to double every 10 years. Anything less than that and the cost to service the unfunded liability will be higher (even that frothy assumption presumes bond yields will rise to levels exceeding their current levels and will do so without crushing the principal value of Calstrs’s existing bond portfolio).

To put the far-fetched nature of this annual investment- return assumption in perspective, it’s almost 15 percent higher than the investment return that Warren Buffett assumes for his pension funds, which not only are invested under Buffett’s direction but also are, in size, a tiny fraction of Calstrs’s portfolio and therefore much easier to compound at higher rates of return.

That’s why financial economists working for the Volcker- Ravitch report said last year that, under a more reasonable earnings assumption, the cost to meet the retirement fund’s unfunded liability is closer to $7 billion a year.

Nondisclosure of Calstrs’s liability before the tax vote continues a pattern of deception about California’s pension obligations.

In 1999, California legislators enacted a huge retroactive increase in pensions without voter approval and based upon an assertion by the California Public Employees’ Retirement System that there would be no cost from the increase.

Hiding Risks

Not surprisingly, that prediction — which implicitly forecast the Dow Jones Industrial Average to reach 30,000 by now — didn’t come true, with the result that the pension increase has already cost the state more than $20 billion, with tens of billions more to come. Recently, internal documents exposed that Calpers knew of this risk but chose not to disclose it to the public.

Teachers, who don’t receive outlandish wages or pensions, didn’t cause this problem, and the good news for them is that they will get their pensions because the state is legally required to back up school districts if they can’t meet their commitments.

Likewise, this problem wasn’t caused by defined-benefit pension systems, which can work perfectly fine so long as promises are funded properly when they are made.

But many politicians don’t want to fund pension promises properly. Most want to keep doing the opposite so they can keep making promises that can’t be kept, except at great expense to innocent people down the road. (Some of these politicians voted to remove me from the Calstrs board seven years ago after I repeatedly said investment-return assumptions must be reasonable and contributions must be raised.)

There’s no free lunch here. To the extent that school districts pick up the cost, kids in school today will be hurt because more dollars will go to pension costs and fewer dollars will go to classrooms. To the extent that the state picks up the cost, residents will receive fewer services. Either way, voters will get little for the tax increase they approved in November.

Crossposted on Bloomberg

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