By Ed Mendel
January 31, 2011
A leading credit-rating agency, Moody’s, has begun treating unfunded pensions like bond debt, giving California a combined tax-supported debt of $136.9 billion that is well beyond other states but also may be understated.
The decision to add pensions to bond debt announced by Moody’s Investors Services last week reflects concern about public employee pension costs, which are growing as state budgets plunge deep into the red during a lengthy economic downturn.
“Pension underfunding has been driven by weaker-than-expected investment results, previous benefit enhancements and, in some states, failure to pay the annual required contribution to the pension fund,” said Moody’s analyst Ted Hampton.
“Demographic factors — including the retirement of Baby Boom-generation state employees and beneficiaries’ increasing life expectancy — are also adding to liabilities,” he said in a news release.
In the past, said Moody’s, pension funding levels were factored into state credit analysis. But the annual state debt reports were based only on the value of outstanding bonds as a percentage of income and other factors.
Moody’s and two other firms, Standard & Poor’s and Fitch, set credit ratings that can affect the interest rate and market for government bonds. California currently has one of the lowest bond ratings of any state, A1 from Moody’s.
The poor bond rating is mainly the result of the failure to close a decade-long state budget deficit. The budget proposed by Gov. Brown this month attempts to close a $25 billion gap over 18 months through spending cuts and extending a temporary tax increase.
“Not all states with large debt burdens also suffer from weak pension funding, however,” said the Moody’s report.
“New York (Aa2, stable), Delaware (Aaa, stable) and California (A1, stable) — states with comparatively large debt burdens — are not among the states with the highest combined long-term liabilities,” the report said.
California’s combined bond and unfunded pension debt is 162.6 percent of annual state revenue, Moody’s said, ranking 19th among states. Oregon leads with debt equal to 316.8 percent of revenue, while Nebraska is the lowest, just 2.3 percent.
Similarly, California ranks 21st among states in combined debt as a percentage of personal income, 11.8 percent; 22nd in debt per capita, $3,704, and 22nd as a percentage of gross domestic product, 7.4 percent.
“In general, states’ rankings for debt and pension combined parallel their rankings for debt alone,” said Hampton.
The Moody’s report lists California’s combined debt as $136.9 billion ($87.3 billion bonds and $49.6 billion unfunded pensions).
Two states with well-publicized pension problems have big combined debts: Illinois, $86.4 billion, and New Jersey, $62.7 billion. Some big-population states have smaller debt: New York $50.8 billion, Florida $38.4 billion, and Texas $28 billion.
The Moody’s listing of California’s unfunded pension liability, $49.6 billion, apparently reflecting a lag in annual state reports, is similar to the total before major pension fund investment losses in the 2008 stock market crash.
The unfunded liability separately reported by the three state pension funds as of June 30, 2009, totaled $91.5 billion:
California Public Employees Retirement System $48.6 billion, California State Teachers Retirement System $40.5 billion, and the University of California Retirement Plan $2.4 billion.
The Moody’s report acknowledges a dispute over the way public pension funds estimate their unfunded liability. The funds use their investment earnings forecast, often about 7.75 percent, to offset or “discount” their future pension obligations.
Some economists argue that public pensions should use a lower discount rate based on “risk-free” government bonds because the pensions are “risk-free,” guaranteed by the taxpayer.
The Governmental Accounting Standards Board may adopt a blended discount rate. For any part of future pension obligations not covered by assets assumed to grow at the forecast earnings rate, a lower “risk-free” discount rate would be used.
In addition, some contend that the earnings forecast used by public pensions is unrealistic and masks massive debt. Corporate pension funds are required to use a lower discount rate based on corporate bonds.
A report issued by Stanford graduate students last April said that if a “risk-free” discount rate of 4.1 percent is used, the three state pension funds have an unfunded liability of about $500 billion, not $55 billion as reported with their earning forecasts.
A Stanford report author, Cameron Percy, was appointed to the CalSTRS board by former Gov. Schwarzenegger shortly before he left office. Schwarzenegger appointed his pension adviser, David Crane, a critic of the earning forecasts, to the UC Regents.
The differing pension debt estimates are based on what must be paid to retirees over the next three decades. The immediate cost increases expected by the state are less alarming.
In the governor’s proposed budget, the state payment to CalPERS increases from $3.8 billion to $4.1 billion, CalSTRS from $1.3 billion to $1.4 billion, and retiree health care from $1.4 billion to $1.6 billion.
Last year UC Retirement ended a remarkable two-decade period without employer or employee contributions, operating on investment earnings. UC and its employees resumed contributions, but the deficit-ridden state did not.
Unions with two-thirds of the state workers agreed to increase their pension contributions and reduce benefits for new hires. But retirement, which includes Social Security in addition to pensions, is still a growing budget cost.
About $1.7 billion of the $4.1 billion payment to CalPERS comes from various special funds, such as transportation. But the rest of the total retirement cost, at least $5.4 billion, is more than 6 percent of the deficit-ridden $84.6 billion general fund.
If the state provided the amount needed to fully fund the three retirement systems, the cost would probably be around 9 or 10 percent of the general fund.
The New York Times reported on Jan. 20 that there is a behind-the-scenes move in Congress to find a way to allow states to declare bankruptcy and “get out from under crushing debts,” including pensions.
A University of Pennsylvania law professor, David Skeel, argued in an opinion article in the Wall Street Journal on Jan. 18 that allowing states to declare bankruptcy could avoid the need for a federal bailout.
“California is first on most lists of troubled states — and for good reason,” Skeel said, pointing to the Stanford estimate of a $500 billion pension shortfall and a state budget gap of more than $20 billion.
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