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Termination Liability Blues

Columnist: Bob Andrews
January, 2017 Issue

Bob Andrews
All articles by columnist

 What happens if the CalPERS investments don’t earn 7.5 percent, as they haven’t in recent years?

Do you still hold out hope that officials are telling you the truth about the public employee pension crisis? Let me tell you a sad story.

 Several years ago, a friend contacted me asking for help on behalf of her sister and her husband. For more than 20 years, that couple had owned a small but very successful market. They were ready to retire, and their primary retirement asset was their market, which, they hoped, was worth $1 million.

The market included a meat counter with two union meat cutters, both of whom intended to retire when the market sold. The couple notified the union pension plan administrator that the market’s participation in the plan would end. Over the years, they’d contributed every dollar of annual pension plan funding, as directed by the union. They thought the termination process would be simple and painless. They thought wrong.

The union wrote back and acknowledged that the plan could terminate—after a final termination liability payment of $1 million. Just imagine receiving such a letter: “Surely this is an administrative error,” you’d think. “We’ve always paid the calculated contributions. We can’t owe another million dollars. If we do, we have no equity in our business.”

Yet it was true. Administrators of union pension plans have wide powers—often hidden from scrutiny—to impose termination liability payments. I put the couple in touch with a pension lawyer who specialized in union plans, but he wasn’t optimistic about getting the payment reduced, let alone eliminated.

The discount rate

Fast forward to September 2016, when the Finance and Administration Committee of CAlPERS met to consider what to do about three “contracting agencies” which, due to financial distress and/or the desire to have a less expensive retirement plan for employees, had stopped making payments to CalPERS. One entity, the city of Loyalton in Sierra County, had actually terminated its participation in CalPERS.

Although Loyalton made the required pension contributions for years, CalPERS demanded another $1.6 million—more than the city’s annual budget—as a termination liability payment. Sound familiar? CalPERS backed up its demand for money from all three entities with a threat: “Failure to pay the termination liabilities required by the contracts will result in a reduction of retirement benefits under Government Code Section 20577.”

Yes, CalPERS threatens to reduce retirees’ pensions, which have seemed bullet-proof under California law from just about any other reduction (even with respect to benefits not-yet-earned). The threatened reduction in pension for one Loyalton retiree was 60 percent. How can there be such a discrepancy between an ongoing plan and a terminated plan? The answer is in what the pension actuaries use as the “assumed rate of return,” also called the “discount rate.”

It turns out that CalPERS maintains two sets of books, one based on an assumed rate of return on investments of 7.5 percent and another using a “termination liability discount rate” of about 3.5 percent. The higher rate minimizes current contributions. Employers like it because it results in lower current costs. Union employees like it because it leaves more money on the table for pay and benefits negotiations. And what happens if the CalPERS investments don’t earn 7.5 percent, as they haven’t in recent years? Employers—cities and counties—have to contribute more money. It’s not the employees’ responsibility to contribute a single penny more.

Why do cities and counties constantly propose more tax and bond measures, or extensions of taxes that were supposed to end? Because the financial demands of defined benefit pension plans are insatiable. To make sure that stressed entities like Loyalton don’t drop out, CalPERS has a big hammer—termination liabilities and slashed pensions—to keep them in line.

Do the math

My friend Ken Churchill, who’s done yeoman work on public employee pension issues for years, recently looked at past years’ actuarial reports for the city of Santa Rosa. Using an assumed rate of return of 7.5 percent, the actuarial report for 2015 showed an unfunded liability (and pension obligation bond debt) of $287 million. At an assumed rate of return of 6.5 percent, the big, bad unfunded liability soars to $425 million. If you take it all the way down to a 3.5 percent rate of return, the unfunded liability is a sparkling $967 million. The average net rate of return on Santa Rosa’s investments (through CalPERS) from 2001 to 2015 is about 5.5 percent.

Keep in mind that CalPERS itself believes that an assumed rate of return of 3.5 percent is the safest assumption for a termination plan. So, why is 7.5 percent acceptable—as opposed to delusional—for an ongoing plan? Even with the higher assumed rate of return, Santa Rosa’s required pension contributions have soared from $1.5 million to $21 million in the last 15 years. And yet none of the recent candidates for Santa Rosa’s city council identified the cost of pensions as a crisis. Go figure…literally.

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