Public Pension and Retiree Health Benei ts: An Initial Response To the Governor’s Proposal

8/3/2019 Public Pension and Retiree Health Benei ts: An Initial Response To the Governors Proposal

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Public Pension and Retiree Health Benefts:

An Initial ResponseTo the Governors Proposal

M A C T A Y L O R L E G I S L A T I V E A N A L Y S T N O V E M B E R 8 , 2 0 1 1


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A N L A O R E P O R T

2 Legislative Analysts Office www.lao.ca.gov


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EXECUTIVE SUMMARYTe Governor presented a 12-point plan to change pension and retiree health benefts or Caliornias

state and local government workers on October 27, 2011. Tis report provides background on the states

retirement policy issues and our initial response to the Governors proposals.

Our Of ces Key Principles on Public Retirement Benets. As we have noted in the past, we do not

view the current system o defned beneft pensions or Caliornias public employees as an intrinsically bad

thing at all. Rather, we view pensions and retiree health benefts as just one part o overall public employee

compensationin many cases, as benefts oered in lieu o what otherwise might be higher salaries over

the course o a public-service career. Moreover, we believe that encouraging public or private workers to

deer a portion o their compensation to retirement represents sound public policy. Well-managed and

properly unded retirement systems, thereore, are meritorious.

What Is the Problem With Public Retirement Benefts?

Caliornias current structure o public employee pension and retiree health benefts has some

substantial problems. Tere is a notable tendency in the current system or public employers and employeesto deer retirement beneft costswhich should be paid or entirely during the careers o retirement system

membersto uture generations. Tis leads to ununded liabilities that have spiraled higher in recent years

and are producing cost pressures or the state and many local governments that will persist or years to

come. Under the current system, governments have very little exibility under case law to alter beneft and

unding arrangements or current employeeseven when public budgets are stretched, as they are today.

Finally, there is a substantial disparity between retirement benefts that are oered to public workers and

those oered to other workers in the economy.

Sustaining a fnancially manageable system o public employee retirement beneftsone that is more

closely aligned with the benefts oered private-sector workerswill require substantial, complex, and

di cult changes by the Legislature, the Governor, local governments, and voters.

Governors Proposal Is a Bold, Excellent Starting Point

Would Help Increase Public Condence in Caliornias Retirement Systems. We view the Governors

proposal as a bold starting point or legislative deliberationsa proposal that would implement substantial

changes to retirement benefts, particularly or uture public workers. His proposals would shi more o

the fnancial risk or public pensionsnow borne largely by public employersto employees and retirees.

In so doing, these proposals would substantially ameliorate this key area o long-term fnancial risk or

Caliornias governments. At the same time, the Governors proposals aim or a uture in which career

public workers receive a package o retirement benefts that would be (1) su cient to sustain employeesstandards o living during their retirement years and (2) more closely aligned with beneft packages oered

to private-sector workers. For all o these reasons, we believe that the Governors proposals could increase

public confdence in the states retirement beneft systems.

Many Details Le Unaddressed in Governors October 27 Presentation. Despite the strengths o the

Governors pension and retiree health proposal, it leaves many questions unanswered. In particular, we do

not understand key details o how his hybrid beneft and retirement age proposals would work. Moreover,


www.lao.ca.gov Legislative Analysts Office 3


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the Governors plan leaves unaddressed many important pension and retiree health issues, including

how to address the huge unding problems acing the states teachers retirement und, the University o

Caliornias (UCs) signifcant pension unding problem, retiree health beneft liabilities, and other issues.

In making signifcant changes to pension and retiree health benefts, we would urge the Legislature also to

tackle these very di cult issues concerning theundingo benefts.

Raising Current Workers Contributions Is a Legal and Collective Bargaining Mineeld. TeGovernor proposes that many current public employees be required to contribute more to their pension

benefts. Others have proposed reducing the rate at which current employees accrue pension benefts

during their remaining working years. Our reading o Caliornias pension case law is that it will be very

di cultperhaps impossibleor the Legislature, local governments, or voters to mandate such changes

or many current public workers and retirees. Moreover, employer savings rom these changes likely will be

oset to some extent by higher salaries or other benefts or aected workers. Given all o these challenges,

we advise the Legislature to ocus primarily on changes to uture workers benefts. Such changes should

produce net taxpayer savings only over the long run but are certain to be legally viable.

A Golden Opportunity to Make These Benefts More Sustainable

Clearly, there is signifcant public concern about public pension and retiree health benefts. In our

view, the current structure o these beneftswherein state and local governments provide compensation

in orms that are very dierent rom that oered in the private sectorimpairs the publics ability to assess

whether government is careully managing its unds and can aect the publics trust in government itsel.

We believe that the Legislature, the Governor, and voters should change these beneftsas well as the way

in which governments and workers und the beneftsin order to address these problems. Tese changes

will involve di cult, complex choices. In the end, however, we believe that such changes can result in the

public becoming more comortable with public retirement benefts. Tis, in turn, will help ensure that the

state and local governments can continue oering such benefts in the uture.




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BACKGROUND: PUBLIC PENSION AND

RETIREMENT BENEFITS TODAYA Complex System o Public Pensions

Not Just One Pension SystemBut Many.During the frst hal o the 20 th Century, Caliornia

began to implement a public policy to provide

a comprehensive set o retirement benefts to

its retired public employees. Public employees

typically begin to accumulate rights to receive

uture benefts the moment that they are hired,

and the longer that they work in the state or local

government sector in the state, the more pension

and other retirement benefts they accumulate. Tis

policy continues today.

oday, pension and retiree health benefts or

Caliornias public employees are determined in

a largely decentralized ashion. Tis means that

employees o the state, the public universities,

school districts, community college districts, cities,

counties, special districts, and other local govern-

ments earn a variety o dierent pension and retiree

health benefts during their careers. As such, any

eort to modiy pension and retiree health benefts

or public employees will prove complex, dealing

as it may with a variety o dierent governments,

beneft plans, and pension systems.

A Variety o Dened Benet Pension Plans.

Caliornia has both statewide and local public

pension plans that oer defned benefts. Defned

beneft pensions provide a specifc amount aer

retirement that is generally based on an employees

age at retirement, years o service, salary at or

near the end o his or her career, and type owork assignment (or instance, public saety or

non-public saety work assignment). In total,

about our million Caliornians11 percent o the

populationare members o one or more o the

states 85 defned beneft public pension systems.

Tis our million fgure includes about one million

people who now receive beneft payments and

around 700,000 inactive membersthat is,

individuals who were once, but are not currently,

public employees and who do not yet receive

pension benefts.

Te two largest entities managing state and

local pension systems in the state are the Caliornia

Public Employees Retirement System (CalPERS)

and the Caliornia State eachers Retirement

System (CalSRS). Combined, these two statewide

systems serve 3.1 million active and inactive

members, including around 750,000 membersand benefciaries now receiving beneft payments.

While both CalPERS and CalSRS operate

pursuant to state law, they are very dierent.

Members o CalPERS include current and

past employees o state government and Caliornia

State University (CSU), as well as judges and

classifed (nonteacher) public school employees. In

addition, hundreds o local governmental entities

(including some cities, counties, special districts,

and county o ces o education) choose to contract

with CalPERS to provide pension benefts or their

employees. Local governments can choose rom

a variety o plan options in CalPERS, as allowed

in the states Public Employees Retirement Law.

Governmental employers make contributions to

their current and past employees pension benefts,

as in most cases, do public employees themselves.

Each employer generally is responsible or its

own employees costs in CalPERS, meaning thatthe state does not directly contribute to CalPERS

to cover pension costs or local government

employees. (Local governments, however, oen

do use a portion o various unding streams they

receive rom the state government to pay a part o

their own pension costs.)




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Dierent governmental entities in CalPERS

have a variety o pension contribution arrange-

ments with their employee groups, meaning that

some employees pay more or less than other,

similarly situated employees o other governmental

entities. In practice, various elements o CalPERSbeneftsbeneft amounts and employee contribu-

tionsnow are determined in collective bargaining

with unions that represent rank-and-fle state and

local government employees.

Compared to CalPERS, CalSRS oers

an entirely dierentoen less generousset

o benefts to teachers and administrators o

Caliornias public school and community college

districts. Benefts oered by CalSRS, as well as

required payments by employees, districts, and the

state, are specifed on a statewide basis in the states

Education Codethat is, they apply on a generally

equal basis to alldistricts. As such, CalSRS

benefts generally are notdetermined through

collective bargaining. Unlike many CalPERS

members, CalSRS members generally do not

participate in Social Security.

In addition to CalPERS and CalSRS, about

80 other defned beneft state and local pensionsystems (such as the University o Caliornia

Retirement Plan [UCRP], the Los Angeles County

Employees Retirement Association, and the Los

Angeles City Employees Retirement System)

serve about one million other Caliornians,

including about 300,000 who currently receive

beneft payments. County pension plans generally

are governed by the states County Employees

Retirement Law o 1937 (known as the 1937

Act). Benefts and employee and employer

contributions in these various other plans can

vary widelytypically, subject to negotiation with

rank-and-fle employee unions.

Dened Contribution Plans Also Now in

Place or Some Public Employees. Many public

employees currently are enrolled in defned

contribution plans, which are intended to

supplement their defned beneft pensions aer they

retire. Defned contribution plans include 401(k),

403(b), and 457 plans in which the rate o contri-

bution by the employer is fxed, sometimes serving

in practice as a match to amounts depositedto those unds by employees. Accordingly, an

employees defned contribution plan benefts

equal what amount the accumulated employee and

employer contributions can provide at retirement,

plus investment earnings. Unlike defned beneft

plans, thereore, defned contribution plans do not

promise a specifc amount to be paid to the retiree

each month or each year. Some governmental

entities manage defned contribution plans, oen

in conjunction with private-sector investment

managers. For example, state employees can

enroll in defned contributions plans managed by

the Savings Plus Program o the Department o

Personnel Administration (DPA). Some teachers

also enroll in CalSRS Pension2 supplemental

savings plan. A variety o other public and private

defned contribution plans serve Caliornias local

governments and school districts.

Social Security. Social Securityestablishedin the 1930sinitially did not provide benefts

to public employees, but in the 1950s, the ederal

government approved amendments to the Social

Security Act to allow states to enter into agree-

ments with the Social Security Administration to

provide such benefts to their public employees.

Over time, Congress has added to these require-

ments, essentially mandating Social Security

or specifed public employees not covered by a

qualifed public pension plan.

It has been estimated that only about one-hal

o Caliornias public employees participate in the

ederal Social Security program. eachers and most

public saety o cers, including corrections o cers,

police, and frefghters, generally are not enrolled

in Social Security. Tere are a variety o reasons




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why this is so. Public saety o cers generally

are eligible or retirements at earlier ages than

envisioned under Social Securitys beneft ormulas.

Moreover, it is expensive or a government to

initiate enrollment o its employees into Social

Security without, at the same time, enacting reduc-tions in its other pension benefts. While there has

been some discussion over the years at the ederal

level o requiring allstate and local employees to

be enrolled in Social Security, this proposal has

not been accepted to date, in part because o the

cost pressures or state and local governments that

would be aected.

Generally speaking, employees and employers in

Social Security each contribute 6.2 percent o pay

up to the Social Security earnings cap (now

$106,800 per year)to the ederal government in

the orm o Social Security payroll taxes. (Congress

reduced employee payroll taxes in 2011 to help

stimulate the economy.) Te ederal government

essentially uses these undsin addition to amounts

paid rom the ederal governments general undto

pay Social Security benefts to current retirees. (Tis

means that Social Security beneftsunlike state and

local pension beneftsare paid on a pay-as-you-go basis, essentially making Social Security a social

insurance system, rather than a pension system, as

we think o it here in Caliornia.) Over time, as baby

boomers age and the ratio o workers to retirees in

the United States alls urther, the ederal general

und will have to pay more and more to cover the

cost o Social Security benefts. For this reason, in

the uture it is likely that Congress will have to enact

revenue increases and/or beneft reductions in order

to keep the ederal budget on a sustainable path.

For individuals born between 1943 and

1954, the Social Security normal retirement

ageat which ull Social Security benefts can

be receivedis now 66. For individuals born in

the years 1955 through 1959, the Social Security

normal retirement age is somewhere between

age 66 and 67, as specifed in law. For individuals

born in 1960 and aer, the Social Security normal

retirement age is 67. (Individuals generally can receive

reduced benefts i they retire earlier than the normal

retirement age, provided that they are at least 62.)

Even More Variety or Retiree Health Benefts

Medicare. Medicare is a ederal health program

that covers individuals age 65 and older. It was

established in 1965 and has long enrolled many

state and local government employees. State and

local government employees hired or rehired

aer March 31, 1986, are subject to mandatory

coverage by Medicare. Employers and employees

each currently pay a 1.45 percent tax on earnings

to cover part o Medicare program costs, which

consist o Part A (hospital insurance), Part B

(outpatient medical insurance), Part C (Medicare

Advantage plans), and Part D (prescription drug

insurance). Individuals are eligible or premium-

ree Medicare Part A i they are age 65 or older

and worked or at least 10 years (40 quarters)

in Social Security and/or Medicare-covered

employment. Accordingly, Medicare is now the

core element o retiree health coverage or bothpublic and private retirees in the United States. In

many public pension plans, including CalPERS,

Medicare-eligible retirees generally must enroll

in Part B benefts at age 65 (or earlier, i they are

qualifed due to a disability). In 2011, Medicare Part

B premiums typically have been around

$100 per month.

Retiree Health Programs o State and Local

Governments. While Medicare is now the core

component o retiree health coverage or state and

local workers, there is much variety among state

and local governments in the area o retiree health

care. Many local governmentsespecially school

districtsoer virtually no retiree health care

benefts. Te state and many other local govern-

ments, however, oer a range o retiree health




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benefts that vary rom small to expansive. O these

governments, many, including the state, provide

health benefts to pre-Medicare retirees, and

othersalso including the stateoer Medicare

supplement plans to retirees aer age 65. Retiree

health benefts have been subject to extreme costpressures in recent years due to the general growth

o health care expenses, a rise in the number o

retirees drawing the benefts, and costs resulting

rom growing ununded liabilities, which are

discussed below.

For Many Career Employees, a

Generous Set o Benefts

As described above, there is considerable

variety among Caliornias public retirement

systems. As such, it is di cult to generalize about

the specifc beneft packages provided to public

workers and retirees today. Moreover, there have

been numerous changes to benefts in recent

yearssome enacted through legislation and others

negotiated at the bargaining table. In the late 1990s

and early 2000s, a wave o beneft enhancements

most notably, those related to Chapter 555, Statutes

o 1999(SB 400, Ortiz)aected benefts or state and many

local employees. More recently, governmental budget

problems, combined with growing public concern

about retirement beneft costs, have resulted in a

wave o beneft reductionsparticularly or uture

employeesand employee contribution increases.

Tese have aected most state employee groups, as

well as some local employee groups.

Replacement Ratio: Less Income Generally

Needed in Retirement. A persons income needs

generally are less in retirement than when working.

Tis is because clothing and daily travel expenses

decline, home mortgages may be paid o at this

point in lie, and retirees may be in a lower tax

bracket than when working. As a result, retirees

typically need less income to maintain the same

standard o living as when they worked.

Te percentage o income a person has in

retirement compared to his working income prior

to retirement is called the replacement ratio or

replacement rate by retirement experts. Whenpension benefts are compared to each other, it

is typically this replacement ratio that is being

compared. When we speak o pension benefts

being generous, we mean that they provide a

relatively high replacement ratio compared to other

beneft plans in the public and/or private sectors.

In 2005, a publication o Boston Colleges

Center or Retirement Research said, Overall,

the range o studies that have examined [the]

issue consistently fnds that middle class people

need between 65 percent and 75 percent o their

pre-retirement earnings to maintain their liestyle

when they stop working. Tis paper indicated

that the majority o households retiring today are

in pretty good shape, with about two-thirds o

households then in that 65 percent to 75 percent

replacement ratio range. Te paper, however,

suggested that the coming way o baby boom

retireeswill see lower replacement rates romSocial Security and less certain income rom

employer pensions. Similar to the 2005 study,

a 2010 U.S. Census Bureau paper ound that

replacement rates or the median individualas o

2004was between 66 percent and 75 percent o

pre-retirement income.

State and Local Government Benets (Not

Including eachers). In our 2005 publication, Te

2005-06 Budget: Perspectives and Issues (see page

132), we compared state miscellaneous (non-public

saety) pensions then in place with those o 15 other

states. O the states we surveyed, Caliornia oered

the highest retirement benefts. We also discussed

the generous nature o public saety pension benefts

and local government benefts then in place.




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Since 2005, the state and some local govern-

ments have enacted pension beneft changes

particularly or new employees hired aer a given

dateand increased employee contributions,

oen through negotiation with rank-and-fle

union representatives. Nevertheless, some localgovernments have continued to oer particularly

generous pension benefts, including 2.5 percent

at 55, 2.7 percent at 55 and 3 percent at 60 or

miscellaneous employees, as well as 3 percent at

50 benefts or public saety employees. In pension

parlance, or example, 2.5 percent at 55 meansin

simplifed termsthat a retiree can receive a

beneft equal to 2.5 percent (the beneft actor or

multiplier) o his or her fnal compensation multi-

plied by the number o years o service i retiring at

55. Lesser benefts are available i they retire earlier

than 55, and higher benefts may be available in a

ormula i a person retires aer the age indicated

in the ormula. As we suggested in our 2005

report, these kinds o generous beneft levels result

in some career public service workers receiving

pension benefts aboveand in some cases, well

abovethe 65 percent to 75 percent replacement

ratio described above, particularly when SocialSecurity and other sources o retirement income

are considered. While the state and some other

public entities have negotiated with employees

or reductions in these generous beneft ormulas,

CalPERS most recent annual report shows that

a ew governments were still switching to some

o these particularly costly beneft packages as

recently as 2009-10.

Te most recent version o a public pension

comparison report prepared periodically by the

Wisconsin Legislative Council indicates that,

or public employees in Social Security, pension

beneft multipliers o 2.1 percent or higher are

rareavailable or only 7 percent o surveyed plans.

Te report ound that, among comparable plans, the

average pension beneft multiplier was 1.94 percent.

For pension plans serving public employees not in

Social Security, the report ound the average beneft

multiplier was 2.3 percent.

We believe that the data shows that defned

pension benefts oered to Caliornias state, city,

county, and special district employees have beenamong the most generous in the country in recent

years. While there have been some reductions in

these benefts recently, some Caliornia govern-

ments still oer among the most generous defned

pension benefts available anywhere in the United

States public or private labor market today. In many

cases, Caliornia public pension benefts or career

public employeescoupled with other sources o

retirement incomecan replace ar more than the

65 percent to 75 percent income replacement ratio

described earlier.

eachers. Several reports have indicated that

teachers enrolled in CalSRS receive less generous

benefts than other kinds o public employees in

Caliornia. In 2009, CalSRS sta presented to

the eachers Retirement Board a study examining

replacement ratios or teachers under CalSRS

beneft ormulas that were to be in eect in 2011.

Te CalSRS report ound that the medianCalSRS retiree as o 2011 (retiring aer

29 years o serv ice) would have a retirement

income replacement ratio o 78 percent. Tis

consisted o a CalSRS defned beneft o

$3,914 per month, a defned beneft supplement

program payment o $93 per month, and a

supplemental annuity payment rom a defned

contribution plan o $613 per month. (Tis

defned contribution component represented

about 13 percent o the total assumed retirement

income or the median CalSRS retiree.) Te

study assumed that the median CalSRS retiree

invested $100 per month over a 25-year career in a

defned contribution account.

In addition to considering the median

CalSRS retiree, the study also showed




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replacement ratios or CalSRS retirees at the 25th

and 75th percentiles o income, respectively. Te

replacement ratio or the 25th percentile retiree

(retiring aer 18 years o serv ice) was 42 percent,

while the replacement ratio or the 75th percentile

retiree (retiring aer 35 years o service) was103 percent. Te report said that teachers retiring

without employer-subsidized health coverage

would need more income to maintain a suitable

replacement ratio. Specifcally, it listed a recom-

mended replacement ratio o around 77 percent

o fnal compensation or those retired teachers

with health care benefts and around 89 percent

or those without health care benefts.

Retirees With Benets o $100,000 Per Year or

More. In recent years, there has been considerable

public attention related to retired Caliornia public

employees receiving annual pension benefts o

$100,000 or more. Tese individuals are a small,

but growing, segment o Caliornias public sector

retirees. About 2 percent o CalPERS and CalSRS

retirees currently receive such payments. Payments

to these retirees now equal around 7 percent to

9 percent o total pension payments rom the two

systems. During their working lives, these retireesgenerally were among the longest-serving and

highest-paid public employeesor example, senior

executives and managers o some state and local

agencies, school districts, and community colleges,

as well as some employees in public saety agencies.

Te percentage o CalPERS, CalSRS, and

other public retirees receiving pension benefts o

over $100,000 per year will grow in the uture or

several reasons. Tese reasons include the eects o

ination (which tends to increase all employees pay

and pension benefts over time) and the eects o

increased pension beneft provisions put in place in

the late 1990s and early 2000s.

Beyond the group o retirees receiving

payments o $100,000 or more per year, many

public retirement systems can expect to see the

percentage o their retirees with higher pension

beneftsand the amounts o those beneftsgrow

or these same reasons. Tis trend is already

apparent in data provided by the pension systems.

In its fnancial reports, or example, CalPERS

publishes statistics on the characteristics oemployees retiring in each fscal year. In 2003-04,

4,831 people retired with 30 or more years o

service, and this group retired with an average

monthly pension o $4,553 (equating to $54,636

per year). In 2008-09, there were 5,801 retirees

with 30 or more years o service, and they had an

average monthly pension o

$5,569 ($66,828 per year)up 22 percent in

non-ination adjusted terms compared to the

initial beneft o the 2003-04 retiree group. Growth

in monthly pension benefts was even greater in

percentage terms during this period or employees

retiring with 10 to 30 years o service. For retirees

with 25 to 30 years o service or example, the

average initial pension grew rom $3,308 per month

($39,696 per year) or 2003-04 retirees to $4,432 per

month ($53,184 per year) or 2008-09 retireesup

34 percent in non-ination adjusted terms.

Tis data rom CalPERS annual reportsuggests that while the average pension beneft or

allCalPERS retirees (including those who retired

decades ago) is around $25,000 per year, such

average retirees are not responsible or the bulk o

benefts that CalPERS will pay out in the uture.

For public employees who retired in 2008-09, the

newest retiree group or which data is available,

it appears that around 60 percent o CalPERS

beneft costs are being paid to retirees with 25 or

more years o service. Te average annual beneft

or this group is somewhere between $53,000 and

$66,000over double the amount paid to the

average retiree in the system. For those 2008-09

retirees with 25 to 30 years o service, their monthly

defned beneft pension is replacing an average

67 percent o their fnal career compensation; or




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those retirees with 30 or more years o service, the

monthly defned beneft pension is replacing an

average 79 percent o their fnal career compen-

sation. Some o these retirees also receive Social

Security benefts, and some also have defned

contribution savings, which would increase theirreplacement ratios urther. Over time, retirees like

the 2008-09 cohort will become more o the norm

in CalPERS and other public pension systems.

Tendency to Deer Costs to Future Generations

Ununded Pension Liabilities. A troubling

trend o Caliornias state and local public pension

systems has been the growth o substantial

ununded actuarial accrued liabilities (UAAL).

Put in very simple terms, an ununded liability is

the amount that would need to be invested into a

public pension plan today such that, when coupled

with amounts already deposited in the und plus

assumed uture investment earnings, all benefts

earned to date by public employees would be

unded upon their retirement. While there is some

disagreement on how to value ununded liabilities

o pension systems, it is clear that Caliornias state

and local systems are coping with very large short-alls. Tese shortalls will push costs upward

above what they otherwise might beor years to

come, in some cases.

As o June 30, 2009, CalPERS reported that

its UAAL in its main pension und or state and

local governments was over $49 billionconsisting

o about $23 billion or the state and $26 billion

or other public agencies. Because the UAAL

uses data that smoothes investment gains and

losses over extraordinarily long periods o time,

CalPERS tends to communicate its unded status

by another, more volatile measure that relies on

the market value o its investments at any given

time. By this measure, CalPERS main pension

und was 61 percent unded with a $115 billion

ununded liability, split between the state and other

public agencies. In 2009-10, buoyed by avorable

investment perormance, CalPERS reports that

its unded status improved somewhatto around

65 percent when measured based on the market

value o assets. Fiscal year 2010-11 saw even more

avorable investment returns.Unlike CalPERS, but like most other pension

systems, CalSRS recognizes investment gains and

losses in its actuarial valuations over a multiyear

period. Due to the near-collapse o world fnancial

markets in 2008, CalSRS and other pension

systems sustained heavy losses, and the continued

recognition o those losses is the major driver o the

systems growing reported UAAL. Te most recent

CalSRS valuation indicates the systems UAAL

grew rom $40.5 billion as o the 2009 valuation to

just over $56 billion as o June 30, 2010. Tis means

that CalSRS reported unded ratio dropped rom

78 percent as o the 2009 valuation to 71 percent in

the June 30, 2010 valuation.

Pension systems in Caliornia and elsewhere

reported growth in their UAALs aer the 2008

market collapse and then experienced a recovery

in their unded status during the relatively strong

investment markets o 2009-10 and 2010-11.Tese trends illustrate a primary reason that

ununded liabilities emerge: weaker-than-expected

investment returns. Lower-than-expected

investment returns have been a primary reason

or growth o ununded pension liabilities in the

last decade. Such investment weaknessrelative to

some pension systems assumption o 7.5 percent

to 8 percent investment return per yearhas given

uel to critics, who believe that these assumptions

are imprudent and understate costs that govern-

ments and employees should contribute or a given

set o benefts.

Other reasons or ununded liabilities include

beneft increases that are implemented retroactively

(that is, applied to previous years o service beore

the beneft enhancement is implemented) and




12/36

demographic and pay changes among employees

and retirees. I retirees live longer than expected

by plan actuaries, ununded liabilities can result. I

employees are paid more than expected during their

career relative to assumptions o plan actuaries, this

also can contribute to ununded liabilities.Ununded Retiree Health Liabilities. For many

governments, the size o ununded retiree health

liabilities has rivaled or exceeded their ununded

pension liabilities. In contrast to pensions, govern-

ments typically have not pre-unded their retiree

health liabilities. In other words, they generally

have never set aside undsor required employees

to do soto cover the uture costs o retiree health

benefts earned during their working lives. Tis

means that uture taxpayers may bear a larger

cost burden or these benefts. Unlike pensions,

there are no investment returns under this type

o unding structure to cover a large portion o

beneft costs. While a small portion o governments

have begun to pay down their ununded retiree

health liabilities, such liabilities will remain a

pressing burden or many Caliornia public entities

as the decades progress. Te state governments

ununded retiree health liabilities alone total about

$60 billion, as o June 30, 2010, according to theState Controllers O ce. A report released by a

commission in early 2008 estimated that all public

entities in the state had a combined retiree health

ununded liability o over $118 billion as o that

time; that total probably has grown since then.

Ununded Liabilities and Growing Benets

Have Increased Costs. Increased benefts and

the emergence o large ununded liabilities have

increased pension and retiree health costs or many

Caliornia governments in recent years. In Figure 1,

we show the trend o increasing state General Fund

costs or retirement benefts in nominal dollars. A

major reason or the magnitude o recent growth

in state costs is the act that public employers

generally benefted rom

pension holidays in the

late 1990s and early 2000s

due to the stock market

bubble that temporarilyresulted in systems like

CalPERS being ully

unded or close to it.

Figure 2 shows the

contribution rates paid by

the state as a percentage

o pay or several key

employee groups. (While

state contributions as

a percentage o pay

were slightly higher in

1980beore the period

covered in Figure 2that

period is not directly

comparable to the present

day since CalPERS at

State Retirement Costs Have Been Growing

General Fund (In Billions)

Figure 1

1

2

3

4

5

$6

1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 2008-09 2011-12

CalSTRSCalPERS Retirement Programsa

CalPERS Retiree Health Programb

Other

aAmount for 1997-98 includes an over $1 billion state payment related to a major court case involvingCalPERS.

bIncludes the budget item for these costs and LAO estimate of the General Fund share of the implicitsubsidy for annuitant benefits that is paid along with employees health premiums.




13/36

that time invested primarily in fxed-income bond

instruments and assumed an annual investment

return o only 6.5 percent.

Inexible Benefts, Inexible Costs

Strict Legal Limits on Changing Benetsand Reducing Government Costs. In our view,

perhaps the most signifcant retirement beneft

challenge acing Caliornia governments is that

there is very little exibility or governmental

employers under decades o case law that are

extremely protective o employee and retiree

pension rights. In Caliornia, pension benefts

or public employees are an element o a public

employees compensation. He or she begins to

accumulate pension rights at the moment o hiring,

and these benefts accumulate throughout a public

service career. Tere is a detailed case law in the

state that protects these benefts as contracts under

the State and U.S. Constitutions. Pension beneft

packages, once promised to an employee, generally

cannot be reducedeither retrospectively or

prospectivelywithout a governments oering

comparable and osetting advantages (which,

themselves, can be quite expensive). Te case law

suggests that governments do have some power to

alter benefts when they ace emergency situations,

but these powers are very limited, and govern-ments, according to case law, generally will have to

alter benefts temporarily, with interest accruing

to employees and retirees in the meantime. In

some cases, local governments may be able to

alter contracts when they seek protection under

Chapter 9 o the U.S. Bankruptcy Code.

Negotiations Can Help, but Unions Must

Represent Teir Members. In general, the primary

way that the state and local governments can

change pension benefts or current and past

employees is to negotiate with employee groups. As

discussed above, the state and some local govern-

ments have successully reduced pension costs

recently through such negotiations. Te challenge

with this approach, however, is that unions have an

obligation to represent their members, and so, in

State Retirement Contribution Rates Have Increased

As Percent of Payroll by Retirement Category

Figure 2

Miscellaneous Tier 1

Correctional Officer and Firefighter

California Highway Patrol Officers

5

10

15

20

25

30

35

40%

1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07 2008-09 2010-11




14/36

exchange or pension concessions, they generally

will be duty bound to seek comparable, osetting

benefts or their members. For example, many o

the recent state employee agreements that increased

employee contributions to their pensions included

uture pay increases roughly equivalent to theincrease in the employee pension contributions.

Tis is understandable, given the history o the

states beneft commitments and the obligations

o unions to represent their members, but it limits

governments to an extent rom achieving lasting

cost savings or current and past employees

through the negotiation process.

For Future Employees, Government Can

Alter Pension and Retiree Health Benets. While

governments have very little exibility with regard

to current and past employees retirement benefts,

it is clear that they may change beneft promises

prospectively or uture hires without limit.

Disparity Between Public and

Private Retirement BeneftsUnderlying the real policy and fscal problems o

current public retirement systems is a sharp divide

between public-sector and private-sector workers.

Public-sector workers have guaranteed, defned-

beneft pension plans, and many, but not all, o them

have retiree health plans too. Private-sector workers

by and large have none o these things anymore. Te

Governors proposal, in essence, aims to reduce this

substantial disparity.

he Governor released his 12-point pension

plan on October 27, 2011. In addition to making

remarks at a press conerence, the Governor

released a short description o the goals o

his plan. While some o the elements o the

plan have been included in prior legislativevehicles (and the Governor released language

or similar proposals on March 31), our rev iew

below is based primarily on the Governors

pension handout rom October 27 and his press

conerence, as well as subsequent contacts with

administration sta concerning the plan. Drat

legislative language to implement the Governors

proposals would need to ill in many details

absent rom his October 27 presentation.

Below, we wil l review each o the 12 points in

turn, providing, in some cases, some background

inormation, a description o the Governors

proposal, and our initial comments.

EQUAL SHARINGOF PENSION COSTS

Background

Normal Cost and Ununded Liability

Contributions. Contributions to pension plans

rom employers and employees consist o two

main components: (1) normal cost contributions,

which generally are equal to the amount actuaries

estimate is necessarycombined with assumed

uture investment returnsto pay the cost o uture

pension benefts that current employees earn in

that year and (2) contributions to retire ununded

liabilities. For example, CalPERS estimates that

the normal cost or state Miscellaneous ier 1

workers (such as state o ce workers and most CSUemployees) is now 14.4 percent o their payroll. In

addition, the annual cost to retire ununded liabil-

ities or Miscellaneous ier 1 workersplus some

related beneft costsequals 10.4 percent o payroll,

or a total required contribution o 24.8 percent

o payroll. For CalPERS state Peace O cer and

Firefghter workers (principally state correctional

GOVERNORS 12-POINT PLAN




15/36

o cers), the normal cost is now 25.4 percent o their

payroll, and the annual cost to retire ununded

liabilities is 11.3 percent o payroll, or a total

required contribution o 36.7 percent o payroll.

Most State Workers Pay One-Hal o Normal

Costs and One-Tird o otal Costs. Followingthe recent agreements o state employee unions to

increase their employees contributions to CalPERS,

over 70 percent o Miscellaneous ier 1 workers

contribute approximately 8 percent or more o

monthly pay to cover pension costs. Tis 8 percent

exceeds 50 percent o the normal cost contributions

or these employees, but, or most, represents only

about one-third o the totalrequired contribution,

including both normal costs and ununded liability

contributions. In the state Peace O cer and

Firefghter group, about 80 percent o workers now

contribute about 11 percent o their monthly pay

to cover pension costs. Tis represents just under

one-hal o the normal cost contributions or these

employees, but less than one-third o the total

required contribution.

With Fixed Employee Contributions,

Employers Cover Any Cost Changes. In current law

and most employee contracts, employee contributionsto their pensions generally are fxed. Tis means that

the portion o the total required contribution not paid

by workers generally is paid by the public employer

in this example, the state. While normal costs tend to

remain airly stable over time, assuming no changes

in the pension beneft structure, ununded liabilities

can change markedly rom year to year due mainly to

upturns and downturns in the investment markets.

Since employee contributions generally are fxed in

labor agreements or state or local law, this means

that the public employer can experience signifcant

increases in total required contributions as ununded

liabilities increase and signifcant decreases in total

required contributions when those liabilities drop.

Public Employee Contributions Vary. Like the

state, some local public employers recently have

negotiated with their unions to increase employee

contributions to local pension plans. As the

Governor points out, however, there remains a wide

disparity among public employers in what portion

o normal costs and total required contributions

is borne by public employees themselves. In somecases, public employees make no such contribu-

tions. Various laws, agreements, and precedents

allow some employers to pay a portion o their

employees contributions to pension plans. In many

cases, such a payment merely substitutes or pay

the employers otherwise might choose to give to

employees, but it means that some employees may

see no real costs or their pension benefts when

reviewing their pay stubs. Tere is concern among

some that many o these public employees view

their substantial pension as a sort o ree good.

Proposal

Equal Sharing o Normal Costs, but Unclear

I Sharing Would Apply to Other Costs. Te

Governors plan proposes that all current and

uture public employees be required to pay at least

50 percent o the normal costs o their defned

pension benefts. Tis seemingly would mean thatthere would be no more employer payments o

required employee pension contributions. Tis

requirement would be phased in at a pace that

takes into account current contribution levels,

current contracts and the collective bargaining

processapparently, over several years.

Te Governors proposal explicitly addresses

only the employee share o normal costs and is

unclear as to whether the 50 percent requirement

also would apply to ununded liability contri-

butions. It is also unclear i the 50 percent

requirement would apply to defned contribution

und deposits (which also can be split 50/50

between employers and employees, in theory).

Governor Says Tis Provides Real Near-erm

Savings.By applying the increased employee




16/36

payment requirement to both current and uture

public employees, the Governor states that this

change would provide near-term cost relie or

some public employers, since increased employee

contributions would reduce contributions that

public employers otherwise would have to make.

LAO Comments

Governors Proposal a Good Start in Tis

Area. We agree with the Governor that uture

public employees should be required to pay or

a portion o pension contributions. We believe

it would enhance public confdence in state and

local retirement systems or there to be a clear,

unambiguous statewide policy in this area. Tere

is no single correct percentage o total required

contributions that employees should be required

to pay, but 50 percent is a reasonable starting

point or the discussion.

Important or Employees to Share in

Ununded Liability Costs oo. We urge the

Legislature to require that uture public

employees bear a portion o not only pension

normal costs, but also ununded liability

contributions. When public employers seetheir pension contributions go up due to a

downturn in the stock market or similar reasons,

employees should see their contributions rise

as well. Similarly, when public employers see

their pension contributions drop due to stock

market upticks, employees should beneit rom a

reduction in their contributions.

Like many others, we are concerned that

public retirement boards make excessively

optimistic assumptions concerning uture

investment returns. We believe that requiring

public employees to bear a portion o the cost

(or beneit rom a port ion o the savings) when

these assumptions prove inaccurate wi ll incen-

tivize retirement boards to make more prudent

investment assumptions. Moreover, requir ing

employees to bear a portion o ununded liability

costs would reduce the year-to-year volatility

o government contributions to pensions. In

eect, this change would transer a portion o

this volatility risk rom employers (who now

generally pay all increases due to unundedliabilities) to employees.

Case Law: Possible or Some Current

Employees, but Probably Not or Many Others.

At his press conerence announcing the proposal,

the Governor said his proposal addressed

existing employees by increasing their contri-

bution rate. He added, One thing we know or

sure: under constitutional law, the employer can

require higher contributions.

We do not share the Governors belie that

existing constitutional law clearly allows the

state to require current public employees to

contribute more to pensions. o the contrary,

such a proposal seems to run counter to existing

constitutional protections in case law that may

protect many current and past public employees.

In the nearby box (see page 18), we summarize

the case and statutory law in this area, which

suggests that it might be possible to increasecontributions or some current employees, but

not or others. For many current employees, such

contribution increases probably could be imple-

mented only through negotiations, and in any

event, would result in many employers increasing

pay or other compensation to oset the inancial

eect o the higher pension contributions. Since

increasing current employees contributions is

one o the only ways to substantially decrease

employer pension costs in the short run, the legal

and practical challenges that we describe mean

that the Governors plan may ail in its goal to

deliver noticeable short-term cost savings or

many public employers.




17/36

HYBRID PENSION PLANFOR FUTURE EMPLOYEES

Background

Hybrid pension plans generally combine

a defned beneft pension with a defned contri-

bution retirement savings plan. Accordingly, it

is important to understand the characteristics o

both such plans. Te key dierence between such

plans is the handling o investment risk. In most

defned beneft plans, such as Caliornias state

and local pension systems, employers bear almost

all investment risk. Tis means that i investment

returns o the systems over time are less than

projected, public employer costs rise, but public

employee costs do not change. By contrast, indefned contribution plans, an employer is obligated

to make only a specifc amount o contributions

in the years that employees work. I investment

returns are less than desired, the employer is not

obligated to contribute anything more to a defned

contribution plan. In defned contribution plans,

thereore, employees and retirees generally bear all

investment risk.

Proposal

Hybrid Plan or Future Public Employees.

Te Governor proposes that uture public

employees be enrolled in hybrid retirement plans.

Details o the Governors idea are somewhat

unclear, but he appears to envision employer

and employee contributions to both defned

beneft and defned contribution plans, as well as

employees participation in Social Security (except,

presumably, or uture teachers and most publicsaety workers). Te Governor seems to propose

that the state Department o Finance be empowered

to design such hybrid plans based on the ollowing

general goals:

Non-Public Safety Employees. Te

hybrid plans would be based on employer

and employee contribution schedules

that would aim to produce a 75 percent

replacement ratio or non-public saety

employees assuming a 35-year public-

sector career. Te defned beneft pension

plan would be responsible or aboutone-third o the 75 percent replacement

income, the defned contribution plan

another one-third, and Social Security the

fnal one-third. For teachers and others

not in Social Security, the defned beneft

would be responsible or two-thirds o

the 75 percent replacement income, with

defned contribution plans responsible or

the remaining one-third.

Public Safety Employees. Te hybrid

plans would be based on employer and

employee contribution schedules that

would aim to produce a 75 percent

replacement ratio or public saety

employees assuming a 30-year public-

sector career. For those employees not

in Social Security, as with teachers, the

defned beneft would be responsible or

two-thirds o the 75 percent replacement

income, with defned contribution plans

responsible or the remaining one-third.

Benet Cap or High-Income Public

Employees. Te Governors plan also reerences a

cap on the defned beneft portion o the proposed

hybrid plan requirement so that public employers

do not ace high costs or pension benefts o

uture high-income public workers. Such a cap

might aect uture public workers like the small,

but growing, portion o current public pensioners

who receive pension beneft payments exceeding

$100,000 per year. Te Governors plan provides no

detail on how such a cap might work.




18/36

Strict Legal Protections Limit Governments Flexibility

Our understanding o Caliornias detailed case law on public pensions over the last century is as

ollows: in order to have the exibility to unilaterally implement cost-saving reductions to the pensions o

current and past employees, public employers need to have explicitly preserved their rights to make such

changes either at the time o an employees hiring or in subsequent, mutually-agreed amendments to the

pension arrangement. Otherwise, reductions or these employees and retirees require that comparable,

osetting advantages be grantedadvantages that tend to negate the pension savings.

Comparable New Advantages Generally Required When Disadvantaging Employees. Te 1955

Caliornia Supreme Court case,Allen v. Long Beach, is an important landmark in Caliornia pension law.

Te court ruled that changes in a pension plan which result in disadvantage to employees should be accom-

panied by comparable new advantages. One o the pension amendments invalidated inAllen increased

each employees pension contribution rom 2 percent to 10 percent o salary. Te Supreme Court, in act,

declared that this increased contribution requirement obviously constitutes a substantial increase in the

cost o pension protection to the employee without any corresponding increase in the amount o the beneftpayments he will be entitled to receive upon his retirement.

In Pasadena Police O cers Association v. City o Pasadena (1983), a state appellate court said the

precedent inAllen meant that where the employees contribution rate is a fxed element o the pension

system, the rate may not be increased unless the employee receives comparable new advantages or the

increased contribution. Te appellate court added that while an increase in an employees contribution rate

operates prospectively only and in eect reduces uture salaryinAllen the Supreme Court struck down

such a change on the grounds that it modifed the system detrimentally to the employee without providing

any comparable new advantages.

What About Changing Future Benet Accruals?Te logic in theAllen and Pasadena Police O cers

Association cases, among others, makes it very di cult to assume that state or local governments could

unilaterally change the rate at which current employees accrue pension benefts or theiruture service, as

has been suggested by various recent proposals. (Te Governor does not make such a proposal.)

In a 1982 case, Carman v. Alvord, the Caliornia Supreme Court noted that upon entering public

service an employee obtains a vested contractual right to earn a pension on terms substantially equivalent

to those then oered by the employer. In the 1991 case concerning Proposition 140, the court considered

that measures termination o then-incumbent legislators rights to earn uture pension benefts through

continued service. In that case, the court said the termination o the beneft accrual rights or these legis-

lators was a contract impairment and was unconstitutional under the U.S. Constitutions contract clause

because it inringed on their vested pension rights. (Proposition 140, it should be noted, did end pension

benefts or legislators elected aerits passage.) Furthermore, in the Pasadena Police O cers Association

case, the appellate court noted that an employee has a vested right not merely to preservation o benefts

already earnedbut also, by continuing to work until retirement eligibility, to earn the benefts, or their

substantial equivalent, promised during his prior service.

Signicant Challenges to Mandating Tat Current Workers Contribute More. While the case

law described above is protective o current and past public employees pension rights, it indicates that




19/36

governments may be able to unilaterally (that is, outside o negotiations) change elements o the pension

arrangement i they have explicitly preserved the right to do so. For example, in International Association

o Firefghters, Local 145 v. City o San Diego (1983), the Caliornia Supreme Court ruled that a city could

increase employee contribution rates pursuant to city charter and ordinance provisions that allowed it

to do so. Accordingly, some public employers that have careully preserved such rights could unilaterallyimplement increases in current workers pension contributions.

We suspect that many local governments may not be in a good position to deend their ability to

implement such increases. While several sections o the states CalPERS and 1937 Act laws purport to

preserve the Legislatures ability to increase certain CalPERS contribution rates or make clear that state law

itsel does not limit local governments ability to periodically increase, reduce, or eliminate their payments

to oset required employee contributions, local governmentspromising, as they do, a wide variety o

retirement packages through dozens o retirement systemsmay obligate themselves contractually.

Even in a 2009 decision upholding San Diegos ability to impose higher employee pension costs at a

bargaining impasse, the Ninth Circuit ederal appeals court distinguished between legislatively enacted

reductions in employers payment o a share o employees required pension contributions (allowable, the

court ruled) and legislatively imposed increases in the totalamounto required employee pension contribu-

tions themselves (implying the latter may be unallowable under contract law). Te Ninth Circuit stressed

that looking into a state or local legislative bodys intentwas key to determining whether a retirement

beneft provision was contractually protected. Accordingly, some local governments may have intended to

include low employee contributions as a part o their pension contract, while others may not. Tis muddled,

uncertain legal ramework seems to us inconsistent with the Governors claim that governments have broad

legal ability to mandate current employee contribution increases. Furthermore, even i unilateral increases

are permissible under contract law, they will directly or indirectly result in many governments having to pay

more to employees in salaries or other orms o compensation in order to remain competitive in the labormarket. For example, recent increases in most state employees contributions negotiated with rank-and-fle

employees were accompanied by uture salary increases o similar amounts.

Since increasing current employees contributions is one o the only ways to substantially decrease

employer pension costs in the short run, these substantial legal and practical hurdles mean that the

Governors plan may ail in its goal to deliver noticeable short-term cost savings to many public employers.

Key Lesson From Case Law: Governments Should Be Clear AboutTeirPension Rights. Te case

law makes clear to us that governments oen have not been clear about what aspects o pension and retiree

health benefts and contributionsi anythey can change unilaterally in the uture and which they

cannot. For this reason, we have recommended that the Legislature require local governments to explicitly

disclose to employeespreerably, on the day that they are hiredwhich aspects o pension and retiree

health benefts and contributions the public entity can change unilaterally (that is, without negotiation) and

which it cannot. I it chose to do so, the Legislature could require that such disclosures reect the results o

collective bargaining and apply only to uture employees. (Approval o such a requirement by voters may be

necessary to avoid the state having to reimburse local governments or this disclosure mandate.)




20/36

LAO Comments

Excellent Starting Point or Discussion. We

previously have recommended that the Legislature

take steps to ensure that uture public workers are

enrolled in hybrid plans. Tis can reduce substan-

tially the risk o uture ununded pension liabilities

by shiing a signifcant portion o the risk that

public employers now bear or defned beneft plans

to defned contribution plans instead. In defned

contribution plans, employers bear no risk or

uture investment returns, and ununded liabilities

or these plans are not possible.

Major Policy Shi Would Make Public

Employees More Like Private-Sector Workers.

We believe that moving uture public employees tohybrid plans would address a key policy concern

relating to the current public employee pension

systemthe growing disparity between public-

sector and private-sector employee retirement

benefts and security. Moving to a hybrid plan would

bring public employees retirement packages closer

in line with those o their private-sector counterparts

and serve to discourage uture public employees

rom retiring as early as their predecessors do today.

Finally, we believe that the Governors goal to have

career public workers have a retirement income

equal to about 75 percent o their career income

makes sense and is in line with studies indicating

the replacement ratio to preserve an employees

liestyle in retirement. (Tis is particularly true i

the employee has supplemental employer-subsidized

health coverage during retirement.)

We discuss our concerns related to the

proposed cap or high-income public workers laterin this report. Also, as discussed immediately

below, there appear to be discrepancies between

this part o the Governors proposal and his

proposal to increase uture public employees

retirement ages.

INCREASED RETIREMENT AGESFOR FUTURE EMPLOYEES

Background

In Caliornia, public employee pension

ormulas oen are reerenced in a type o

shorthandsuch as 2 percent at 55that implies

there is a single retirement age (in this case, 55).

Actually, current Caliornia public employees in

this group are eligible to begin receiving service

retirement benefts at age 50although with a

lower beneft actor. In most cases, however, these

employees work longer so that they can increase

their retirement benefts through a higher actor.

For example, in the 2 percent at 55 group ornon-public saety state employees, employees can

max out their actor at 2.5 percent at age 63. Even

this, however, is not the maximum retirement

age, as workers generally can continue to increase

their benefts by working more years beyond age 63.

As shown in Figure 3, in the states three largest

public employee retirement systems, the average

state or local employee retired at about age 60 as

o 2009-10. Public saety employees tend to retire a

ew years earlier. Moreover, due to recent changes

in benefts or newly hired state employees and

some local employees, average retirement ages in

many o the groups shown in the fgure will tend

to increase somewhat in the coming decades under

current policies, even i the Governors proposal is

not adopted.

It is also worth noting that many retirees

receiving benefts rom public retirement systems

also work in other jobs during their lietime,including private-sector positions. Tese partial

career employees can receive relatively small

pension benefts. Calculations o the average

monthly or annual pension benefts paid by public

pension systems oen include these partial-career

workers. I such workers were excluded rom these




21/36

calculations, average monthly benefts paid would

be higher than shown by public pension systems in

many cases, and average retirement ages shown in

Figure 3 also could be aected.

ProposalWork to a Later Age Would Be Required or

Full Benets. Te Governors plan seemingly

requires that all uture public employees work to a

later age to qualiy or ull retirement benefts. Te

Governor proposes that non-public saety pensions

or uture employees target a retirement age at

67 (the current Social Security retirement age or

those workers). Future public saety workers would

target a lower retirement age commensurate with

the ability o those employees to perorm their jobs

in a way that protects public saety. (As discussed

below, it is not clear exactly what the Governor

means in this part o his proposal. Presumably,

this would be addressed when the administration

provides additional details about its plan.)

Te Governor points out that these changes

would reduce signifcantly both pension and

retiree health costs or governments. In particular,

employees would haveewer, i any, years

between retirement

and reaching the age

o Medicare eligibility.

Aer the age o Medicare

eligibility, a substantial

portion o public-sector

retiree health care costs

shi to the ederal govern-

ments Medicare program.

LAO Comments

Increasing Average

Retirement Ages

Is Essential. Given

increased longevity, we

believe it is appropriate to increase retirement

ages or uture public employees. Failing to do so

would risk a growing long-term fscal burden or

governments supporting pension programs, since

uture increases in longevity would then produce

proportionate or greater increases in pension andretiree health beneft costs. Tere is no single right

age to target, especially or public saety workers. It

will be important, however, or the Legislature to

set a specifc policy or public saety workers rather

than the nebulous one that the Governors proposal

seems to suggest.

Te Legislature also may wish to consider

whether the current age o minimum service

retirement eligibility or most public employees

age 50should be increased.

Possible Conict With Other Parts o the

Proposal. We are uncertain how the Governors

retirement age proposal squares with other aspects

o his proposal. Specifcally, i uture non-public

saety workers are to work until age 67 to receive

ull retirement benefts, this suggests that a public

employee entering government service right out

o college or high school might have to work or

Figure 3

Average Retirement Ages for Selected PublicEmployee Groups in 2009-10

Age

California Public Employees Retirement Systema

California Highway Patrol Officers 53

Local public safety officers 55

State correctional officers and firefighters 60

Other state and local employeesb 60-61

California State Teachers Retirement Systema

School district and community college teachers 62

University of California Retirement Plan

Professional and support staff members 59

Academic faculty 63a Includes service retirements only. Disability retirements, on average, occur 8 to 11 years earlier for

CalPERS members and about 6 years earlier for CalSTRS members.b Includes state and local miscellaneous employees, such as government office workers.

CalPERS = California Public Employees Retirement System; CalSTRS = California State TeachersRetirement System.




22/36

over 40 years to receive such benefts. Yet, the

Governors hybrid proposal envisions a 75 percent

replacement ratio or such workers aer only 35 years

o government service. Accordingly, it is not clear

how the Governors plan intends to mesh the key

variables o the expected length o a working career,replacement ratios, and retirement age.

LIMIT SPIKINGFOR FUTURE EMPLOYEES

Background

Benets or Many Still Based on Single

Highest Year o Salary. Many current public

employees are entitled to receive pension benefts

based on their single highest year o government

salary. As we discussed in our 2005 P&Ireport on

public pensions, this single-year ormula or deter-

mining pension benefts is very rare among state

and local employees in the United States; in act,

it is a eature o public pensions in Caliornia and

almost nowhere else.

In recent years, the state and some local

governments have moved to change the single-year

ormula or newly hired employees by instead

calculating their pension benefts based on theirhighest average annual compensation over a three-

year period. Tis discourages pension spiking,

which includes eorts o employees to change jobs

or receive increased pay during their fnal one

or two years o employment that increases their

eventual pension beneft by a large amount.

Proposal

Require Tree-Year Final Compensation or

Future Employees. Te Governor proposes that all

uture public employees have their defned beneft

pensions calculated based on their highest average

annual compensation over a three-year period.

LAO Comments

Broad Consensus or Tis Change. We previ-

ously have recommended the Governors proposal.

Tere seems to be broad public consensus or this

change, and it would be a small step to increase

public confdence in public employee pension

systems. We caution, however, that, despite

requent headlines concerning pension spiking,

this change probably would result in substantial

pension cost savings or a relatively small group

o uture employees. It is not likely to result in

signifcant cost savings or governments.

BASE BENEFITSON REGULAR, RECURRING PAY

Background

Current Rules Can Result in Some Abuses.

Tere are some instances when public pensions

reportedly are increased as a result o employees

receiving additional pay rom bonuses, unused

vacation time, overtime, and other perks. Many

pension systems, however, already prohibit such

compensation items rom being used to calculate

fnal compensation or purposes o pension benefts.

Proposal

Establish Uniorm Rule to Prevent Abuses. Te

Governor proposes that all public defned beneft

pension systems prohibit these types o compen-

sation items rom being included in fnal compen-

sation used to determine annual pension benefts or

uture employees.

LAO Comment

Broad Consensus or Tis Change. We

recommend passage o this proposal. Such a change,

i rigorously enorced by all pension systems and

employers, should help increase public confdence

in Caliornias state and local pension systems.




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Tis change, however, might lower costs or only a

small percentage o uture employees. Tis part o

the proposal seems unlikely, thereore, to produce

substantial pension cost savings or governments.

LIMIT POSTRETIREMENT EMPLOYMENTFOR ALL EMPLOYEES

Background

Currently, Individuals Can Return to Public

Sector Aer Retirement. Caliornia governments

oen rely on retired annuitants and retired

workers rom other public employers to work

part-time or ull-time. Such retired workers can

bring considerable expertise to public agencies.

Some pension systems, such as CalPERS, limit

retired members to working or only 960 hours

per year or certain state and local agencies, and

these retired annuitants services do not result in

their accruing any additional retirement benefts.

In other cases, an individual may be able to retire

rom one retirement system and work or an

employer in a dierent public retirement system,

while accruing additional retirement credit in

that second system. (Tis latter scenario probablyoccurs very inrequently.)

Proposal

Extending CalPERS Limits to All Public

Employers. Te Governor proposes to limit all

current and uture employees in their post-retirement

work or Caliornia governments. Specifcally, the

Governor wants to limit all current and uture

employees rom retiring rom public service and

working more than 960 hours per year or a public

employeressentially extending the CalPERS

post-retirement employment rules to all public

employees. Te Governor also would prohibit all

retired employees rom earning retirement benefts or

service on public boards and commissions.

LAO Comments

Important to Strike the Right Balance With

Tese Changes. While the Governors proposal

in this area lacks some detail, it seems reasonable

to us, in that it seems to strike the right balance

on limitations on postretirement employment. In

many cases, public employers can beneft rom the

expertise o retired workers while saving money

paying them little or nothing in the way o benefts.

(A ull-time worker, by contrast, typically would

receive substantial benefts that would add to his

or her personnel costs.) We observe, however, that

it will be very di cult or pension systems across

the state to enorce this provision i it is indeed

applied to limit a public retirees work or any stateor local employer in the state. For example, it might

be di cult or the Los Angeles County Employees

Retirement Association to identiy a newly hired,

middle-aged employee who happened to be a

retiree o, say, the UCRP.

LIMIT FELONS RECEIPTOF PENSION BENEFITS

Proposal

Foreit o Pension and Related Benets.

Te Governor proposes that public o cials and

employees convicted o a elony in carrying out

o cial duties, in seeking elected or appointed o ce,

or in connection with obtaining salary or pension

benefts oreit their pension and related benefts.

LAO Comments

Proposal Raises Various Issues. Te Legislature

may want to explore certain issues regarding thisproposal. For instance, it is unclear to us whether

this type o change would be constitutional in

all cases as applied to current and past public

employees. For uture public employees, however,

the state clearly may impose such a oreiture

requirement. In addition, would such oreiture

be prospective only, or would repayments o some




24/36

or all previously paid pensions to retired elons be

required? What i the elon cannot repay such costs?

PROHIBIT RETROACTIVE PENSION INCREASES

BackgroundContributor to Recent Ununded Liability

Increases. In recent years, many Caliornia govern-

ments have retroactively applied pension beneft

increases to some or all employees prior years o

service. Tis can mean, or instance, that an employee

who worked nearly all o his career earning benefts

based on one pension beneft ormula (or example,

2.5 percent at 55) was able to complete that career on

a higher pension beneft ormula (such as 3 percent

at 50). When the change is applied retroactively, that

worker may earn a pension beneft equal to 3 percent

o his fnal compensation multiplied by his years o

service, even though both he and his employer made

contributions throughout his working lie based

on a 2.5 percent beneft actor. Accordingly, when

that worker retires, the government is le with an

ununded liability to address in the coming decades.

ProposalBan Retroactive Benet Increases. Te

Governor proposes to ban uture retroactive

pension increases or all public employees. Prior

retroactive increases are constitutionally protected

and generally cannot be changed.

LAO Comment

An Important Change to Make. History

suggests that, particularly at times when pension

systems temporarily appear overunded, retroactive

beneft increases can be very tempting or public

employers and employeesessentially a kind o

ree money to provide to career public servants.

Yet, as the Governor correctly points out, such ree

money generally will end up costing taxpayers,

since pension systems rarely remain overunded or

long and ununded liabilities almost always result

rom such retroactive beneft grants. Moreover,

retroactive grants oen will play no roleor even a

counterproductive rolein encouraging employee

recruitment and retention. New recruits certainly

do not beneft rom a higher pension beneft appliedto prior years o service. Valued career employees

oen will be incentivized to retire earlierthan they

otherwise would due to their ability to receive a

higher retirement beneft.

Given the history o public employers in this

area and the limited instances in which such retro-

active beneft grants would be o real value to public

employers, we recommend that the Legislature

approve this element o the Governors proposal.

PROHIBIT PENSION HOLIDAYS

Background

A Relic o Past Boom Years in the Financial

Markets. During the late 1990s and early 2000s,

the tech bubble years in the stock market when

public pension systems temporarily reported that

they were overunded, many public employers

substantially reduced or entirely eliminated theirannual pension contributions and, in some cases,

public employee contributions were reduced as well.

Tis is the key reason why state pension contribu-

tions to CalPERS were so low in some years o

the late 1990s, as shown in Figures 1 and 2. State

contributions to CalSRS defned beneft program

also were reduced during this period, contributing

to CalSRS recent unding problems.

Proposal

Limit Ability o Employers to Suspend

Contributions. Te Governors proposal would

prohibit all employers rom suspending employer

and/or employee contributions (related to both

current and uture public employees) necessary to

und annual pension costs.




25/36

LAO Comments

Getting Details Right Is the Key. We agree

that employers should be sharply limited in their

ability to suspend regular employer or employee

contributions. History tells us that such periods o

overunding oen are eeting and may be based on

temporary stock market bubbles.

In 2008, the Public Employee Post-Employment

Benefts Commission (PEBC) appointed by the

prior Governor and legislative leaders agreed to

a recommendation to restrict pension unding

holidays. Te PEBC recommended that employers

be permitted to implement contribution holidays

only based on the amortization o their surplus

over a 30-year period. In other words, contribu-tions could all to zero only in instances when

the surplus is so great it can und 30 ull years o

normal costs. We suggest that the Legislature use

PEBCs recommendation as a starting point in the

discussion in this area.

PROHIBIT AIRTIME PURCHASES

Background

Widely Available, but Very Dif cult to Price.

Pursuant to state legislation or other law, CalPERS

and many other public pension systems have

allowed certain eligible public employees to buy

airtime, which is additional retirement service

credit or years not actually worked. For example,

a state employee can add fve years o service

creditand, accordingly, increased retirement

benefts laterby paying a signifcant sum o

money to CalPERS. In theory, the public employeepays or the entire cost o this additional defned

beneft pension credit. In practice, however, airtime

Public Pension and Retiree Health Benei ts: An Initial Response To the Governor’s Proposal

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