December 19, 2013
Pursuant to Elections Code Section 9005, we have reviewed a
constitutional initiative related to pensions for state and local
governmental employees in California (A.G. File No. 13‑0043).
Background
Government Employee Compensation
Three Main Elements of Compensation. State
and local government employers compete with other government and
nongovernment employers to attract workers in the labor market. As part
of their compensation packages, government employers generally offer
full-time employees a salary, retirement benefits (including pension and
perhaps retiree health benefits, discussed in more detail below), and
health benefits for employees and their dependents.
Compensation for Most Employees Established Through
Collective Bargaining. Through the collective bargaining
process, government employer and employee representatives negotiate
terms and conditions of employment generally culminating in a contract,
or “memorandum of understanding.” (If an agreement is not reached, state
and local collective bargaining laws sometimes provide for mediation
and/or a fact-finding process from a neutral third party.) Under certain
circumstances, when these efforts have been exhausted after good-faith
efforts at negotiating, collective bargaining laws allow employers to
declare an impasse and impose terms and conditions of employment for
some groups of employees. The process can take several months and is
subject to administrative and judicial appeals.
Current law establishes the collective bargaining process for most
nonmanagement state and local government employees. These laws establish
who is subject to collective bargaining and what elements of
compensation are within the scope of collective bargaining. Government
employers generally have broad authority to establish compensation for
employees who are not subject to collective bargaining. While pension
benefits for members of the California State Teachers' Retirement System
(CalSTRS) and nonteaching school employees who are members of the
California Public Employees' Retirement System (CalPERS) are established
by the Legislature and generally not subject to collective bargaining,
school and community college districts establish other terms and
conditions of employment for these employees through the collective
bargaining process.
Government Employee Pension Benefits
State and Local Governments Sponsor "Defined
Benefit”Retirement Plans for Their Employees. As part of
employment, the state provides defined benefit retirement plans for its
employees and for those of public schools and community colleges.
CalPERS administers the retirement plans for state employees, California
State University (CSU) faculty and staff, and nonteaching school and
community college employees. The University of California administers
its own retirement plan for its faculty and staff. CalSTRS administers
plans for school and community college teaching employees. Local
governments generally also provide these types of plans for their
employees. Some cities, counties, and special districts have their own
retirement boards to administer their plans. Most cities, counties, and
special districts have CalPERS or their county retirement systems
administer their plans.
Pension Benefits Based on Formula. When a
government employee retires, he or she receives a pension that is
determined using a formula. A typical formula is the number of years of
service credited to the employee multiplied by a rate of accrual
(determined by the employee's age at the time of retirement) multiplied
by the employee's final salary level. Often, retirees receive a
cost-of-living adjustment (COLA) each year to at least partially offset
erosions in purchasing power resulting from inflation. For example, the
rate of accrual for a typical state worker hired before 2007 who retires
at the age of 55 years is 2 percent per year. If this employee earns
$60,000 in his or her final year of service before retiring after
working 18 years for the state, he or she will retire with an annual
pension of $21,600 (18 x .02 x 60,000). This pension may increase by up
to 2 percent each year, depending on actual inflation. (In the event
that the employee's pension allowance falls below 75 percent of its
original purchasing power, the state provides additional inflation
protection.)
Contractual Benefits. Contracts related to
pensions sometimes are included in collective bargaining agreements or
in statutes. In other cases, however, they may be "implicit" (or
unwritten) commitments based on an employer's past practices. Both the
U.S. and California Constitutions contain a clause—known as the Contract
Clauses—that prohibit the state or its voters from impairing contractual
obligations. Interpreting these Contract Clauses, California courts have
ruled for many decades that pension benefits generally vest on the day
an employee is hired. As a result, pension benefits for current and past
public employees can be reduced only in rare circumstances—generally,
when public employers provide a benefit that is comparable and offsets
the pension contract that is being impaired or when employers previously
have reserved the right to modify pension arrangements. In addition, in
some cases, local governments may be able to alter contracts when they
seek protection under Chapter 9 of the U.S. Bankruptcy Code.
Defined Benefit Funding. Defined benefit
plans have three main sources of funding.
- Investment Returns. Investment returns
are the biggest component of defined benefit funding. In the case of
CalPERS, the system reports that most pension benefits paid to
retirees are paid from investment returns. Revenues from investment
returns vary significantly year to year depending on market
performance. In 2010‑11, we estimate that pension systems expected
to receive at least $40 billion from investment returns.
- Employee and Employer Contributions for Normal
Costs. The normal cost is the amount estimated to be
necessary—combined with future investment returns—to pay for
benefits earned by employees in that year. These costs typically are
split between the employer and employee, with the employer paying
about half (or somewhat more) of the total cost. Statewide in
2010‑11, employers’ contributions to normal costs totaled over $8
billion. Total employee contributions to normal costs were in the
range of several billion dollars.
- Employer Contributions for Unfunded Liabilities.
To the extent that a pension plan does not have enough money over
time to pay for benefits, an unfunded liability results. Employers
generally bear all of the responsibility to pay for unfunded
liabilities. Pension boards typically set employer rates to pay off
any unfunded liabilities over a specified number of years—known as
an amortization period. The longer an amortization period, the lower
an employer's annual costs to pay off any unfunded liabilities but
the higher the employer's total costs over the entire amortization
period. Because a fund can incur losses or gains in any given year,
the unfunded liability—and consequently, the employer's
contributions—can vary year to year depending on investment returns.
A plan is considered fully funded when actuaries determine that the
plan—based on an assumed rate of future investment returns and other
assumptions—has sufficient assets to pay for all future benefit
payments earned to date. Statewide, public employer contributions
for unfunded liabilities in 2010‑11 exceeded $8 billion.
In most cases, the amount of resources from each of these three
sources fluctuates based on market conditions, actuarial assumptions,
and other factors. In the case of funding for CalSTRS pension and
related benefits, however, (1) state contributions provide a fourth
source of funding (around $1.2 billion in 2010‑11) and (2) all
contributions (from the state, school or community college district
employer, and employees) are fixed in statute.
Large Pension and Retiree Health Unfunded Liabilities.
The total unfunded liabilities associated with pension and retiree
health plans offered by California government employers is in the range
of hundreds of billions of dollars. To close this funding gap, most
pension systems have required employers to make additional payments
toward pensions. With regard to retiree health plans, most employers do
not prefund their plans, but pay benefits to retirees on a pay-as-you-go
basis. These health care costs are significant and have generally been
rising for most government employers as health premiums and the number
of retirees increase.
Efforts to Reduce Pension Costs. Many
government employers have made efforts in recent years to reduce their
annual pension costs by shifting some of the costs onto employees and/or
reducing benefits for future employees. In some cases, these changes
were negotiated with employee representatives. In 2012, the Legislature
passed legislation making these types of changes for most government
pension plans in California. In addition, some local government
employers—including the cities of San Diego and San Jose—have attempted
to change benefits for current employees. These cities’ pension
changes are the subject of ongoing legal challenges.
Pension Boards as Fiduciary. In 1992,
voters approved Proposition 162. This proposition amended the California
Constitution to give the board of each public pension system plenary
authority and fiduciary responsibility for investment of moneys and
administration of the pension system. As a result of this proposition,
the California Constitution makes a pension board the exclusive
authority over the investment decisions and administration of its
respective pension system. In managing the pension system, pension
boards determine how much risk the pension fund should be exposed to by
determining the fund’s investment asset allocation. The pension board
also adopts all actuarial assumptions used to calculate normal cost and
unfunded liabilities—including the amortization period of the unfunded
liabilities and discount rate. In the case of the discount rate, the
board’s decision is largely based on its investment strategy and assumed
rate of return.
Plan Termination. From time to time,
government employers terminate their relationship with a pension board.
While the procedures pension boards follow vary, some pension boards
require the terminating agency to pay any unfunded liabilities in a lump
sum and calculate the unfunded liability using a discount rate that is
lower than the discount rate used for active plans. The lower discount
rate, which increases the unfunded liability amount, reflects the
pension board's assessment that it must invest this portion of the
plan’s assets to minimize risk.
Government Retiree Health Benefits
State and Many Local Governments Provide Retiree Health
Benefits. The state and many local governments provide
health benefits to retired employees. In some cases, these benefits
expire when an employee becomes eligible to enroll in Medicare; in other
cases, the employer-sponsored retiree health benefit becomes a
supplemental insurance to the coverage provided by Medicare. Some
government employers—including the state—require employees to work for
the employer for a specified number of years before the employee is
eligible to receive employer-sponsored retiree health benefits.
Few Government Employers Prefund Retiree Health Benefits.
Unlike pension plans, few government employers prefund retiree health
benefits. That is, most government employers and employees do not make
annual contributions to either the normal cost or unfunded liabilities
associated with the benefit. Instead, employers pay premium costs for
retiree health benefits as they incur after employees have retired—a
method of payment referred to as“pay-as-you-go.”Some government
employers recently have started prefunding these benefits. In 2010‑11,
the state paid about $1.4 billion towards these benefits for retired
state and CSU employees. We estimate that local employers paid an equal
or greater sum for these benefits for their employees and retirees.
Proposal
This measure amends the California Constitution to expand the
authority of state and local government employers to change public
employee pension and retiree health benefits for work performed in the
future. Under the measure, the Legislature is considered the government
employer for members of CalSTRS for purposes of pension benefits and
school and community college districts are the government employer for
purposes of retiree health benefits.
Alters Automatic Vesting for Pension and Retiree Health
Benefits for Future Service. Under the measure, pension
and retiree health benefits for future government employees would be
earned and vested as the employee performs work and only in proportion
to the work performed. With regard to current government employees, the
measure specifies that their pension or retiree health benefits
generally would be considered vested contractual rights only for work
the employees have already performed.
Allows Employers to Reduce Pension and Health Benefits
for Future Service. A government employer could reduce
future pension and retiree health benefits for current and future
employees if the government employer (1) finds its pension or retiree
health care plan is substantially underfunded and at risk of not having
sufficient funds to pay benefits to retirees or future retirees or (2)
declares a fiscal emergency. With regard to pension and retiree health
benefits, a government employer could (1) reduce the rate of accrual for
benefits to be earned in the future, (2) reduce the rate of COLAs to be
made in the future, (3) increase the retirement age for benefits earned
in the future, (4) require employees to pay a larger share of the cost,
or (5) make any other reductions or modifications agreed upon during
collective bargaining. If any of the benefit changes are within the
scope of collective bargaining, the measure requires the government
employer to submit the changes to collective bargaining. If good-faith
efforts at negotiating, mediation, and/or fact-finding have been
exhausted, the measure appears to permit employers to impose—to the
extent permissible under collective bargaining laws for some groups of
employees—the benefit changes summarized above under numbers one through
four. In cases where these changes are not within the scope of
collective bargaining, the government employer could implement the
changes directly.
Requires Most Employers to Develop Pension and/or Retiree
Health Care Funding Status Reports. The measure requires
government employers to prepare a funding status report for any pension
or retiree health plan with assets equaling less than 80 percent of its
liabilities. The report must specify actions designed to fully fund the
benefit plan within 15 years—including any changes in benefits or
employer and employee annual costs. The government employer would be
required to hold a public hearing on the funding status report (or
reports) each year until the benefit plan’s actuary finds that it is
fully funded.
Restricts Pension Plan Administrator Authority in Certain
Cases. The measure requires retirement plan administrators
to use the same discount rate in their management of plans that have
been modified, frozen, or terminated as they use for active plans.
Pension boards could not use different discount rates to account for
different asset allocations between plans.
Requires Employers With Terminated Plans to Make Annual
Payments. The measure requires retirement plan
administrators to establish contributions for employers with terminated
plans using the same amortization schedule and other methodologies that
govern the retirement plan administrator's other plans. This means
that—instead of current practice where some terminating employers make a
one-time payment of the unfunded liability calculated with a lower
discount rate—terminating employers would make annual payments to the
unfunded liability calculated with the same discount rate as other
plans.
Fiscal Effects
There is significant uncertainty as to the measure's fiscal effects
on state and local governments. The measure gives government employers
authority to reduce current and future government employee retirement
benefits for work not yet performed. Many of these provisions could be
subject to a variety of legal challenges, including suits alleging that
the measure impairs contract obligations under the U.S. and/or
California Constitutions. Our analysis discusses the possible fiscal
effects for state and local governments assuming the measure’s
provisions are fully implemented.
Report Development and Plan Administrator Costs
Developing Funding Status Reports. Based on
the current funding status of government employee pension and retiree
health plans, most government employers would be required to develop
funding status reports for their pension and retiree health plans.
Because California has several thousand public agencies and most
employers have multiple pension and retiree health plans, the measure
could require government employers statewide to prepare over 8,000
reports. The cost to government employers to develop these reports and
update them annually until fully funded (possibly 15 years or longer)
would depend on many factors, including the extent to which they relied
upon actuarial and legal specialists to develop them or used standard
cost estimating models developed by plan administrators. If the average
cost to develop a report was in the range of $5,000 to $20,000, the
total statewide costs to develop the reports would be in the range of
tens of millions to hundreds of millions of dollars. The annual costs to
government employers to update these reports likely would be less.
Plan Administrator Costs. Pension and
health plan administrators likely would experience some administrative
costs to comply with the terms of the measure. These costs—which would
be passed on to government employers—could include costs to (1) modify
information technology systems to reflect reductions in benefits
provided to employees for future work and (2) provide each agency in a
"pooled" pension plan with agency-specific information regarding its
funding status. (Plan administrators frequently pool the pension assets
and liabilities of smaller government employers to achieve economies of
scale.) Overall, these administrative costs to state and local
governments are not known, but could total tens of millions of dollars
initially and likely lesser sums annually thereafter.
Potential Net Decrease in Annual Personnel Costs
Potential Reduced Personnel Costs. . . The
measure gives government employers the authority to reduce pension
and/or retiree health benefits earned for future work performed by (1)
employees hired after the date this measure is approved, (2) managers
and supervisors not subject to collective bargaining, and (3) teachers
and other employees whose pension and/or retiree health benefits
generally are outside the scope of collective bargaining. In addition,
the measure increases government employers' authority to negotiate
changes in benefits for other government employees through the
collective bargaining process up to and including—when
applicable—imposing such changes after negotiating efforts have been
exhausted. Government employers could use this authority to reduce their
costs for pensions and retiree health care by decreasing benefits and/or
shifting a share of these costs to employees. Because government
employers currently pay over $20 billion each year for pensions and
retiree health care, even small changes (such as reducing future
benefits or shifting a share of the normal costs to employees) could
result in major near-term savings by government employers, potentially
in the range of hundreds of millions of dollars each year or more. Over
the longer term, benefit reductions could result in savings in the
billions of dollars annually.
. . .Offset by Increases in Other Elements of
Compensation. The potential savings discussed above would
be at least partially offset by increases in salary and/or other
elements of employee compensation. The magnitude of these potential
offsetting costs relative to the savings from government actions
discussed above would likely vary significantly by employer. In some
cases, for example, a government's annual savings from reducing its
costs for retiree benefits could be fully offset by pressure to increase
wages or other benefits paid to employees. In other cases, however,
governments would only agree to compensation changes that resulted in
net savings over time.
Potential Long-Term Net Savings to Pay Unfunded Liabilities
Potential Increased Costs to Implement Funding Status
Reports. The total unfunded liabilities associated with
pension and retiree health plans offered by California government
employers is in the range of hundreds of billions of dollars. In the
case of government pension plans, most employers are making payments
towards these liabilities based on an approximately 30-year amortization
period. With regards to retiree health plans, most employers do not
prefund their plans, but pay benefits to retirees on a pay-as-you-go
basis. Under the measure, most employers would be required to create
detailed funding status reports specifying actions designed to fully
fund their pension and retiree health plans within 15 years. Using a
15-year amortization period to pay pension and retiree health unfunded
liabilities would greatly increase government employer costs relative to
what is paid today-possibly by tens of billions of dollars annually for
at least the next 15 years. While the measure does not require
government employers to implement the provisions in their reports, some
government employers might take some actions to do so in response to the
measure's provisions enhancing public visibility of these unfunded
liabilities. While the amount of these potential increased contributions
by state and local government cannot be predicted with precision, the
sum could be major—potentially hundreds of millions or billions annually
over the next few decades if government employers choose to change their
funding practices.
Accelerating Payment of Liabilities Reduces Future Costs.
To the extent that some government employers increase employer and/or
employee contributions in the near term to accelerate payment of pension
and retiree health liabilities, those government employers could
increase their retirement funds' assets and investment returns and
dramatically reduce the amount of employer contributions needed over the
long term. These state and local government savings would depend on the
extent to which these government employers contribute additional
resources to accelerate payment of their unfunded liabilities. These
government employers would experience major savings, beginning in a few
decades. Over time, this future savings generally would more than offset
the higher near-term costs associated with accelerating payment of the
liabilities.
Other Effects
Savings and Long-Term Costs for Terminated Plans.
The measure changes how pension plan administrators calculate unfunded
liabilities for government employers that terminate pension plans in the
future. Under the measure, pension plan administrators no longer could
require these government employers to pay unfunded liabilities in a lump
sum calculated using a lower discount rate. Instead, the plan
administrator must establish employer contributions for unfunded
liabilities using the same amortization schedule and other methodologies
that they use for other plans. This change would have different fiscal
effects on employers, depending in part on whether they were planning to
terminate their pension plans under current law. Specifically, employers
that would have terminated their plans under current law could
experience short-term savings and higher long-term costs under the
measure. It is not possible to determine the magnitude of these fiscal
effects on these employers. In other cases, however, employers may
decide to terminate their pension plans due to the measure's provisions
that reduce the up front costs associated with a plan termination. Over
the long term, these employers terminating their pension plans could
realize significant savings-particularly if the employers do not replace
their terminated pension plans with other defined benefit pension plans.
The amount of these savings would depend, in part, on other actions the
employer takes to increase salary or other benefits to employees.
Potential Broader Economic Effects. The
potential reduction in government spending for pensions and retiree
healthcare also could have broad effects on the economy that are
difficult to predict. For example, some public employees might spend
less of their salaries during their years of active employment and
invest these funds in private retirement savings plans. This could
affect the level of state and local tax revenues and the level of
resources available for capital investment. Alternatively, some public
employees might not increase their savings and find that they have
insufficient funds to support themselves in retirement. This could
increase the likelihood that some government retirees eventually rely on
health or social services funded in part by state and local governments.
The magnitude of these indirect economic effects would in all likelihood
be smaller than the direct effects on employer costs and employee wages.
Summary of Fiscal Effects
This measure would result in the following major fiscal effects for
state and local governments.
- Potential net reduction of hundreds of millions to billions of
dollars per year in state and local government costs. Net
savings-emerging over time-would depend on how much governments
reduce retirement benefits and increase salary and other benefits.
- Increased annual costs-potentially in the hundreds of millions
to billions of dollars-over the next two decades for those state and
local governments choosing to increase contributions for unfunded
liabilities, more than offset by retirement cost savings in future
decades.
- Increased annual costs to state and local governments to develop
retirement system funding reports and to modify procedures and
information technology. Costs could exceed tens of millions of
dollars initially, but would decline in future years.
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