Confronting the Costs of Retirement Benefits

Despite the pitched battles on the national political landscape, San José has launched into 2017 with the wind at our back. Recent rains have provided a reprieve from a seemingly chronic drought. Local job growth continues at a pace that the rest of the nation envies. Last year’s passage of several ballot measures has enabled us to restore some key city services, such as road paving and filling “browned out” fire stations with crews. Construction for major infrastructure projects like BART and Bus Rapid Transit will finish this year, with more to come.

For cities throughout California, however, budgetary clouds are gathering on the horizon. In particular, stories about the growing specter of unfunded pension and retirement burdens further pinching tight budgets will re-emerge in news outlets throughout California. The hundreds of cities and other local governments that participate in CalPERS and CalSTRS face rapidly rising contribution rates-and the state’s own contribution to those funds will climb to $8.1 billion this year. Larger cities with self-funded pension plans, such as San Jose, will similarly dig deeper into their pockets, diluting other budgetary priorities.

This begs the question: after all the political battles and litigation over pension reform over the last decade, why do pensions — and their equally costly cousin, retiree healthcare benefits — still haunt us?

To be sure, Measure F’s passage in November will secure billions in savings for San Jose’s taxpayers — including $42 million this year alone — and will remove from city taxpayers’ shoulders the burden and risk of funding retiree healthcare for new employees.

But independent of that success, larger forces will continue to conspire against us fiscally. Here in San José, these larger forces will cost our General Fund approximately $20 to $25 million more in retirement contributions than initially projected next year. There are four reasons for these looming cost pressures:

First, the large accrued debts haven’t gone anywhere. Although our pension reforms will reduce future costs, particularly for new hires, state constitutional law largely prevents public employers from doing anything that will reduce liabilities that have already accrued (i.e., benefits of current retirees or employees). In San José, that unfunded liability amounts to about $3.7 billion — a debt that must be paid down over time like any mortgage. To worsen the pinch, our Police & Fire Retirement Board recently decided to shorten the amortization period — which will reduce the aggregate, long-term costs but require higher payments from our General Fund in the next several years.

Second, as more Baby Boomers retire, more retirees are receiving benefits while fewer employees are paying into the system than a decade ago. As a result, our actuaries tell us that our Retirement Plans have become much more volatile: any downturn in investment returns will have a far greater impact on contribution rates. This forces our retirement boards to make more conservative investments, shifting their asset allocation away from high-return options, such as equities and real estate, to reduce risk.

Third, like many other retirement funds across the country, market returns have sagged over the prior two years, well below the expected investment returns of these funds. As a result, both the State of California, and cities with independent retirement funds like San José, will be forced to contribute more to cover the gap between projections and reality.

This raises a final issue of greater long-term consequence: for decades, bloated assumptions about the rates of return of the funds’ investments have masked the true cost and size of liabilities in plans like CalPERS and CalSTRS. By simply making optimistic projections for earnings plan assets, employees and taxpayers could avoid having to contribute as much up-front to cover retiree pensions in the future. That’s a short-run strategy, of course, and reality has a way of catching up with rosy projections — which ultimately costs the taxpayers even more in the log-run.

To their credit, San Jose’s retirement boards have moved aggressively to correct the mistakes of the past, reining in the assumed investment return from 8.25% a half-decade ago to 6.875% today, and they may go lower still in future years. While San Jose will continue to lead the way to inject needed transparency in this process, this will come at a cost of additional General Fund contributions. Yes, we’ll pay more now, but the alternative is to pay much, much more later.

In contrast, the state’s retirement fund boards only recently moved to reduce their rate of return assumptions (and, far too slowly, in the view of many experts). Nonetheless, now that the state funds adopt lower return assumptions, many more California cities and school districts will see their retirement contributions rise much more steeply in the years ahead.

Through pension reform, we’ve made great strides in slowing the growth of our retirement costs and generating real savings for our taxpayers. But confronting these larger fiscal realities will continue to pose a challenge and force us to tighten our belt in the coming years.

Yet, there’s an important difference between today and the fast-escalating pension costs more than a decade ago: We’re confronting the problem, not hiding from it. These changes, while costly, will reduce long-term burdens for our children and grandchildren. Hopefully they will learn the lessons that we all learned too late: Don’t make promises we can’t afford, and don’t hide the true costs of those promises.

Sam

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Mayor of San José, California

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Sam Liccardo

Sam Liccardo

Mayor of San José, California

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