Pension Crisis: Former California state controller warns about CalPERS

The potential for a state and municipal fiscal and public pension crisis is a defining issue for the next downturn. Underfunding guarantees problems. The question is whether the next downturn crystallizes a crisis.

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This morning a commentary on pensions caught my eye. I learned that Steve Westly, a former voting member of public pension fund CalPERS’ board, was concerned about a pension crisis. And he was tweeting about it. Westly was also the California state Controller from 2003 to 2007. So he knows a thing or two about the state’s finances.

This is something that has been off my radar for a while. But it becomes relevant if we are anywhere close to the end of this business cycle. And a pension crisis would have wide-ranging consequences.

Detroit, Puerto Rico and Meredith Whitney

Remember Meredith Whitney? She was a Wall Street bank analyst who rose to fame during the Great Financial Crisis. Her prescient warnings about the vulnerability of the bank sector made her a media darling back in 2008 and 2009. But in 2010, she veered off into coverage of municipal finance. She warned the next shoe to drop was in municipal bonds. And it was all about state and local public pensions. That caused a huge uproar in the muni space. Muni veterans defended their market as safe for investors, and took Whitney to task again and again.

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Eventually her warnings proved wrong. And she faded from view. But the gist of Whitney’s muni forecast was valid. That’s what Alice Schroeder told Bloomberg in early 2011. Schroeder, the author of the only approved biography of Warren Buffet, is also a former Wall Street analyst.

I covered the municipal issue back then. And I said “my takeaway is that recovery means no crisis.” The problems were there. However, the economic and market recovery put them off for most US states and municipalities. Nevertheless, I warned to “wait for the next downturn and then we’ll see a lot of defaults.”

After Whitney’s call, there weren’t a lot of municipal problems. Again, that owes to the economic recovery. We had the Detroit bankruptcy and that was very difficult. The Detroit experience left emotional scars that probably helped Donald Trump win Michigan in 2016’s Presidential election. But that’s just one city. Later, there was the meltdown in Puerto Rico too. The devastation from natural disaster makes the fiscal crisis there all the more heartbreaking. However, the issues in Puerto Rico are idiosyncratic. And Puerto Rico is not a systemic risk.

But what about California’s pensions?

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California is the biggest state in the country. It has an economy bigger than all but a handful of countries. This is where a municipal crisis would be systemic. Enter Dan Walters:

The essence of California’s pension crisis was on display last week when the California Public Employees Retirement System made a relatively small change in its amortization policy.

The CalPERS board voted to change the period for recouping future investment losses from 30 years to 20 years.

The bottom line is that it will require the state government and thousands of local government agencies and school districts to ramp up their mandatory contributions to the huge trust fund.

Client agencies – cities, particularly – were already complaining that double-digit annual increases in CalPERS payments are driving some of them towards insolvency and the new policy, which will kick in next year, will raise those payments even more.

“What we are trying to avoid is a situation where we have a city that is already on the brink, and applying a 20-year amortization schedule would put them over the edge,” a representative of the League of California Cities, Dane Hutchings, told the CalPERS board before its vote.

But CalPERS itself may be on the brink, and the policy change is one of several steps it has taken to avoid a complete meltdown.

The system, once more than 100 percent funded, now has scarcely two-thirds of what it would need to fully cover all of the pension promises to current and future retirees – and that assumes it will hit an investment earnings target (7 percent per year) that many authorities criticize as being too optimistic.

Walters’s view: “So on one hand, CalPERS is doing what it has to do to remain financially solvent, but on the other hand its self-protective steps threaten local government solvency. That’s the crisis in a nutshell.”

Pension crisis in the next downturn?

Walters is talking about dire state and municipal finances during the best economic conditions of this business cycle. What happens when the economy turns down? And what happens in the next tough bear market in equities or bonds? The seven percent annual return assumption will look ridiculously optimistic then.

And California’s problems will be repeated throughout the country in places like Illinois and New Jersey. Those are two of the biggest states that have precarious municipal finances. And have you seen what’s happening in Oklahoma, with teachers working at Walmart on Mondays? That’s not the future that other states want to reckon with.

No one’s talking about this – at least not in my circles. I don’t hear it on the news or read about it in the paper. For me, the potential for a state and municipal fiscal and public pension crisis is a defining issue for the next downturn. Problems in this arena are guaranteed given the underfunding of public pensions throughout the United States. The question is whether the downturn in the economy and in financial markets crystallizes a crisis.

If we do have a pension crisis, it will be a systemic issue, both economically and politically. The issue with CalPERS tells you that.

Editor’s note: This article initially attributed the article quotation to Steve Westly instead of Dan Walters.

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