Public Pension and Retiree Health Benei ts: An Initial Response To the Governor’s Proposal
Transcript of Public Pension and Retiree Health Benei ts: An Initial Response To the Governor’s Proposal
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Public Pension and Retiree Health Benefts:
An Initial ResponseTo the Governors Proposal
M A C T A Y L O R L E G I S L A T I V E A N A L Y S T N O V E M B E R 8 , 2 0 1 1
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EXECUTIVE SUMMARYTe Governor presented a 12-point plan to change pension and retiree health benefts or Caliornias
state and local government workers on October 27, 2011. Tis report provides background on the states
retirement policy issues and our initial response to the Governors proposals.
Our Of ces Key Principles on Public Retirement Benets. As we have noted in the past, we do not
view the current system o defned beneft pensions or Caliornias public employees as an intrinsically bad
thing at all. Rather, we view pensions and retiree health benefts as just one part o overall public employee
compensationin many cases, as benefts oered in lieu o what otherwise might be higher salaries over
the course o a public-service career. Moreover, we believe that encouraging public or private workers to
deer a portion o their compensation to retirement represents sound public policy. Well-managed and
properly unded retirement systems, thereore, are meritorious.
What Is the Problem With Public Retirement Benefts?
Caliornias current structure o public employee pension and retiree health benefts has some
substantial problems. Tere is a notable tendency in the current system or public employers and employeesto deer retirement beneft costswhich should be paid or entirely during the careers o retirement system
membersto uture generations. Tis leads to ununded liabilities that have spiraled higher in recent years
and are producing cost pressures or the state and many local governments that will persist or years to
come. Under the current system, governments have very little exibility under case law to alter beneft and
unding arrangements or current employeeseven when public budgets are stretched, as they are today.
Finally, there is a substantial disparity between retirement benefts that are oered to public workers and
those oered to other workers in the economy.
Sustaining a fnancially manageable system o public employee retirement beneftsone that is more
closely aligned with the benefts oered private-sector workerswill require substantial, complex, and
di cult changes by the Legislature, the Governor, local governments, and voters.
Governors Proposal Is a Bold, Excellent Starting Point
Would Help Increase Public Condence in Caliornias Retirement Systems. We view the Governors
proposal as a bold starting point or legislative deliberationsa proposal that would implement substantial
changes to retirement benefts, particularly or uture public workers. His proposals would shi more o
the fnancial risk or public pensionsnow borne largely by public employersto employees and retirees.
In so doing, these proposals would substantially ameliorate this key area o long-term fnancial risk or
Caliornias governments. At the same time, the Governors proposals aim or a uture in which career
public workers receive a package o retirement benefts that would be (1) su cient to sustain employeesstandards o living during their retirement years and (2) more closely aligned with beneft packages oered
to private-sector workers. For all o these reasons, we believe that the Governors proposals could increase
public confdence in the states retirement beneft systems.
Many Details Le Unaddressed in Governors October 27 Presentation. Despite the strengths o the
Governors pension and retiree health proposal, it leaves many questions unanswered. In particular, we do
not understand key details o how his hybrid beneft and retirement age proposals would work. Moreover,
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the Governors plan leaves unaddressed many important pension and retiree health issues, including
how to address the huge unding problems acing the states teachers retirement und, the University o
Caliornias (UCs) signifcant pension unding problem, retiree health beneft liabilities, and other issues.
In making signifcant changes to pension and retiree health benefts, we would urge the Legislature also to
tackle these very di cult issues concerning theundingo benefts.
Raising Current Workers Contributions Is a Legal and Collective Bargaining Mineeld. TeGovernor proposes that many current public employees be required to contribute more to their pension
benefts. Others have proposed reducing the rate at which current employees accrue pension benefts
during their remaining working years. Our reading o Caliornias pension case law is that it will be very
di cultperhaps impossibleor the Legislature, local governments, or voters to mandate such changes
or many current public workers and retirees. Moreover, employer savings rom these changes likely will be
oset to some extent by higher salaries or other benefts or aected workers. Given all o these challenges,
we advise the Legislature to ocus primarily on changes to uture workers benefts. Such changes should
produce net taxpayer savings only over the long run but are certain to be legally viable.
A Golden Opportunity to Make These Benefts More Sustainable
Clearly, there is signifcant public concern about public pension and retiree health benefts. In our
view, the current structure o these beneftswherein state and local governments provide compensation
in orms that are very dierent rom that oered in the private sectorimpairs the publics ability to assess
whether government is careully managing its unds and can aect the publics trust in government itsel.
We believe that the Legislature, the Governor, and voters should change these beneftsas well as the way
in which governments and workers und the beneftsin order to address these problems. Tese changes
will involve di cult, complex choices. In the end, however, we believe that such changes can result in the
public becoming more comortable with public retirement benefts. Tis, in turn, will help ensure that the
state and local governments can continue oering such benefts in the uture.
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BACKGROUND: PUBLIC PENSION AND
RETIREMENT BENEFITS TODAYA Complex System o Public Pensions
Not Just One Pension SystemBut Many.During the frst hal o the 20 th Century, Caliornia
began to implement a public policy to provide
a comprehensive set o retirement benefts to
its retired public employees. Public employees
typically begin to accumulate rights to receive
uture benefts the moment that they are hired,
and the longer that they work in the state or local
government sector in the state, the more pension
and other retirement benefts they accumulate. Tis
policy continues today.
oday, pension and retiree health benefts or
Caliornias public employees are determined in
a largely decentralized ashion. Tis means that
employees o the state, the public universities,
school districts, community college districts, cities,
counties, special districts, and other local govern-
ments earn a variety o dierent pension and retiree
health benefts during their careers. As such, any
eort to modiy pension and retiree health benefts
or public employees will prove complex, dealing
as it may with a variety o dierent governments,
beneft plans, and pension systems.
A Variety o Dened Benet Pension Plans.
Caliornia has both statewide and local public
pension plans that oer defned benefts. Defned
beneft pensions provide a specifc amount aer
retirement that is generally based on an employees
age at retirement, years o service, salary at or
near the end o his or her career, and type owork assignment (or instance, public saety or
non-public saety work assignment). In total,
about our million Caliornians11 percent o the
populationare members o one or more o the
states 85 defned beneft public pension systems.
Tis our million fgure includes about one million
people who now receive beneft payments and
around 700,000 inactive membersthat is,
individuals who were once, but are not currently,
public employees and who do not yet receive
pension benefts.
Te two largest entities managing state and
local pension systems in the state are the Caliornia
Public Employees Retirement System (CalPERS)
and the Caliornia State eachers Retirement
System (CalSRS). Combined, these two statewide
systems serve 3.1 million active and inactive
members, including around 750,000 membersand benefciaries now receiving beneft payments.
While both CalPERS and CalSRS operate
pursuant to state law, they are very dierent.
Members o CalPERS include current and
past employees o state government and Caliornia
State University (CSU), as well as judges and
classifed (nonteacher) public school employees. In
addition, hundreds o local governmental entities
(including some cities, counties, special districts,
and county o ces o education) choose to contract
with CalPERS to provide pension benefts or their
employees. Local governments can choose rom
a variety o plan options in CalPERS, as allowed
in the states Public Employees Retirement Law.
Governmental employers make contributions to
their current and past employees pension benefts,
as in most cases, do public employees themselves.
Each employer generally is responsible or its
own employees costs in CalPERS, meaning thatthe state does not directly contribute to CalPERS
to cover pension costs or local government
employees. (Local governments, however, oen
do use a portion o various unding streams they
receive rom the state government to pay a part o
their own pension costs.)
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Dierent governmental entities in CalPERS
have a variety o pension contribution arrange-
ments with their employee groups, meaning that
some employees pay more or less than other,
similarly situated employees o other governmental
entities. In practice, various elements o CalPERSbeneftsbeneft amounts and employee contribu-
tionsnow are determined in collective bargaining
with unions that represent rank-and-fle state and
local government employees.
Compared to CalPERS, CalSRS oers
an entirely dierentoen less generousset
o benefts to teachers and administrators o
Caliornias public school and community college
districts. Benefts oered by CalSRS, as well as
required payments by employees, districts, and the
state, are specifed on a statewide basis in the states
Education Codethat is, they apply on a generally
equal basis to alldistricts. As such, CalSRS
benefts generally are notdetermined through
collective bargaining. Unlike many CalPERS
members, CalSRS members generally do not
participate in Social Security.
In addition to CalPERS and CalSRS, about
80 other defned beneft state and local pensionsystems (such as the University o Caliornia
Retirement Plan [UCRP], the Los Angeles County
Employees Retirement Association, and the Los
Angeles City Employees Retirement System)
serve about one million other Caliornians,
including about 300,000 who currently receive
beneft payments. County pension plans generally
are governed by the states County Employees
Retirement Law o 1937 (known as the 1937
Act). Benefts and employee and employer
contributions in these various other plans can
vary widelytypically, subject to negotiation with
rank-and-fle employee unions.
Dened Contribution Plans Also Now in
Place or Some Public Employees. Many public
employees currently are enrolled in defned
contribution plans, which are intended to
supplement their defned beneft pensions aer they
retire. Defned contribution plans include 401(k),
403(b), and 457 plans in which the rate o contri-
bution by the employer is fxed, sometimes serving
in practice as a match to amounts depositedto those unds by employees. Accordingly, an
employees defned contribution plan benefts
equal what amount the accumulated employee and
employer contributions can provide at retirement,
plus investment earnings. Unlike defned beneft
plans, thereore, defned contribution plans do not
promise a specifc amount to be paid to the retiree
each month or each year. Some governmental
entities manage defned contribution plans, oen
in conjunction with private-sector investment
managers. For example, state employees can
enroll in defned contributions plans managed by
the Savings Plus Program o the Department o
Personnel Administration (DPA). Some teachers
also enroll in CalSRS Pension2 supplemental
savings plan. A variety o other public and private
defned contribution plans serve Caliornias local
governments and school districts.
Social Security. Social Securityestablishedin the 1930sinitially did not provide benefts
to public employees, but in the 1950s, the ederal
government approved amendments to the Social
Security Act to allow states to enter into agree-
ments with the Social Security Administration to
provide such benefts to their public employees.
Over time, Congress has added to these require-
ments, essentially mandating Social Security
or specifed public employees not covered by a
qualifed public pension plan.
It has been estimated that only about one-hal
o Caliornias public employees participate in the
ederal Social Security program. eachers and most
public saety o cers, including corrections o cers,
police, and frefghters, generally are not enrolled
in Social Security. Tere are a variety o reasons
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why this is so. Public saety o cers generally
are eligible or retirements at earlier ages than
envisioned under Social Securitys beneft ormulas.
Moreover, it is expensive or a government to
initiate enrollment o its employees into Social
Security without, at the same time, enacting reduc-tions in its other pension benefts. While there has
been some discussion over the years at the ederal
level o requiring allstate and local employees to
be enrolled in Social Security, this proposal has
not been accepted to date, in part because o the
cost pressures or state and local governments that
would be aected.
Generally speaking, employees and employers in
Social Security each contribute 6.2 percent o pay
up to the Social Security earnings cap (now
$106,800 per year)to the ederal government in
the orm o Social Security payroll taxes. (Congress
reduced employee payroll taxes in 2011 to help
stimulate the economy.) Te ederal government
essentially uses these undsin addition to amounts
paid rom the ederal governments general undto
pay Social Security benefts to current retirees. (Tis
means that Social Security beneftsunlike state and
local pension beneftsare paid on a pay-as-you-go basis, essentially making Social Security a social
insurance system, rather than a pension system, as
we think o it here in Caliornia.) Over time, as baby
boomers age and the ratio o workers to retirees in
the United States alls urther, the ederal general
und will have to pay more and more to cover the
cost o Social Security benefts. For this reason, in
the uture it is likely that Congress will have to enact
revenue increases and/or beneft reductions in order
to keep the ederal budget on a sustainable path.
For individuals born between 1943 and
1954, the Social Security normal retirement
ageat which ull Social Security benefts can
be receivedis now 66. For individuals born in
the years 1955 through 1959, the Social Security
normal retirement age is somewhere between
age 66 and 67, as specifed in law. For individuals
born in 1960 and aer, the Social Security normal
retirement age is 67. (Individuals generally can receive
reduced benefts i they retire earlier than the normal
retirement age, provided that they are at least 62.)
Even More Variety or Retiree Health Benefts
Medicare. Medicare is a ederal health program
that covers individuals age 65 and older. It was
established in 1965 and has long enrolled many
state and local government employees. State and
local government employees hired or rehired
aer March 31, 1986, are subject to mandatory
coverage by Medicare. Employers and employees
each currently pay a 1.45 percent tax on earnings
to cover part o Medicare program costs, which
consist o Part A (hospital insurance), Part B
(outpatient medical insurance), Part C (Medicare
Advantage plans), and Part D (prescription drug
insurance). Individuals are eligible or premium-
ree Medicare Part A i they are age 65 or older
and worked or at least 10 years (40 quarters)
in Social Security and/or Medicare-covered
employment. Accordingly, Medicare is now the
core element o retiree health coverage or bothpublic and private retirees in the United States. In
many public pension plans, including CalPERS,
Medicare-eligible retirees generally must enroll
in Part B benefts at age 65 (or earlier, i they are
qualifed due to a disability). In 2011, Medicare Part
B premiums typically have been around
$100 per month.
Retiree Health Programs o State and Local
Governments. While Medicare is now the core
component o retiree health coverage or state and
local workers, there is much variety among state
and local governments in the area o retiree health
care. Many local governmentsespecially school
districtsoer virtually no retiree health care
benefts. Te state and many other local govern-
ments, however, oer a range o retiree health
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benefts that vary rom small to expansive. O these
governments, many, including the state, provide
health benefts to pre-Medicare retirees, and
othersalso including the stateoer Medicare
supplement plans to retirees aer age 65. Retiree
health benefts have been subject to extreme costpressures in recent years due to the general growth
o health care expenses, a rise in the number o
retirees drawing the benefts, and costs resulting
rom growing ununded liabilities, which are
discussed below.
For Many Career Employees, a
Generous Set o Benefts
As described above, there is considerable
variety among Caliornias public retirement
systems. As such, it is di cult to generalize about
the specifc beneft packages provided to public
workers and retirees today. Moreover, there have
been numerous changes to benefts in recent
yearssome enacted through legislation and others
negotiated at the bargaining table. In the late 1990s
and early 2000s, a wave o beneft enhancements
most notably, those related to Chapter 555, Statutes
o 1999(SB 400, Ortiz)aected benefts or state and many
local employees. More recently, governmental budget
problems, combined with growing public concern
about retirement beneft costs, have resulted in a
wave o beneft reductionsparticularly or uture
employeesand employee contribution increases.
Tese have aected most state employee groups, as
well as some local employee groups.
Replacement Ratio: Less Income Generally
Needed in Retirement. A persons income needs
generally are less in retirement than when working.
Tis is because clothing and daily travel expenses
decline, home mortgages may be paid o at this
point in lie, and retirees may be in a lower tax
bracket than when working. As a result, retirees
typically need less income to maintain the same
standard o living as when they worked.
Te percentage o income a person has in
retirement compared to his working income prior
to retirement is called the replacement ratio or
replacement rate by retirement experts. Whenpension benefts are compared to each other, it
is typically this replacement ratio that is being
compared. When we speak o pension benefts
being generous, we mean that they provide a
relatively high replacement ratio compared to other
beneft plans in the public and/or private sectors.
In 2005, a publication o Boston Colleges
Center or Retirement Research said, Overall,
the range o studies that have examined [the]
issue consistently fnds that middle class people
need between 65 percent and 75 percent o their
pre-retirement earnings to maintain their liestyle
when they stop working. Tis paper indicated
that the majority o households retiring today are
in pretty good shape, with about two-thirds o
households then in that 65 percent to 75 percent
replacement ratio range. Te paper, however,
suggested that the coming way o baby boom
retireeswill see lower replacement rates romSocial Security and less certain income rom
employer pensions. Similar to the 2005 study,
a 2010 U.S. Census Bureau paper ound that
replacement rates or the median individualas o
2004was between 66 percent and 75 percent o
pre-retirement income.
State and Local Government Benets (Not
Including eachers). In our 2005 publication, Te
2005-06 Budget: Perspectives and Issues (see page
132), we compared state miscellaneous (non-public
saety) pensions then in place with those o 15 other
states. O the states we surveyed, Caliornia oered
the highest retirement benefts. We also discussed
the generous nature o public saety pension benefts
and local government benefts then in place.
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Since 2005, the state and some local govern-
ments have enacted pension beneft changes
particularly or new employees hired aer a given
dateand increased employee contributions,
oen through negotiation with rank-and-fle
union representatives. Nevertheless, some localgovernments have continued to oer particularly
generous pension benefts, including 2.5 percent
at 55, 2.7 percent at 55 and 3 percent at 60 or
miscellaneous employees, as well as 3 percent at
50 benefts or public saety employees. In pension
parlance, or example, 2.5 percent at 55 meansin
simplifed termsthat a retiree can receive a
beneft equal to 2.5 percent (the beneft actor or
multiplier) o his or her fnal compensation multi-
plied by the number o years o service i retiring at
55. Lesser benefts are available i they retire earlier
than 55, and higher benefts may be available in a
ormula i a person retires aer the age indicated
in the ormula. As we suggested in our 2005
report, these kinds o generous beneft levels result
in some career public service workers receiving
pension benefts aboveand in some cases, well
abovethe 65 percent to 75 percent replacement
ratio described above, particularly when SocialSecurity and other sources o retirement income
are considered. While the state and some other
public entities have negotiated with employees
or reductions in these generous beneft ormulas,
CalPERS most recent annual report shows that
a ew governments were still switching to some
o these particularly costly beneft packages as
recently as 2009-10.
Te most recent version o a public pension
comparison report prepared periodically by the
Wisconsin Legislative Council indicates that,
or public employees in Social Security, pension
beneft multipliers o 2.1 percent or higher are
rareavailable or only 7 percent o surveyed plans.
Te report ound that, among comparable plans, the
average pension beneft multiplier was 1.94 percent.
For pension plans serving public employees not in
Social Security, the report ound the average beneft
multiplier was 2.3 percent.
We believe that the data shows that defned
pension benefts oered to Caliornias state, city,
county, and special district employees have beenamong the most generous in the country in recent
years. While there have been some reductions in
these benefts recently, some Caliornia govern-
ments still oer among the most generous defned
pension benefts available anywhere in the United
States public or private labor market today. In many
cases, Caliornia public pension benefts or career
public employeescoupled with other sources o
retirement incomecan replace ar more than the
65 percent to 75 percent income replacement ratio
described earlier.
eachers. Several reports have indicated that
teachers enrolled in CalSRS receive less generous
benefts than other kinds o public employees in
Caliornia. In 2009, CalSRS sta presented to
the eachers Retirement Board a study examining
replacement ratios or teachers under CalSRS
beneft ormulas that were to be in eect in 2011.
Te CalSRS report ound that the medianCalSRS retiree as o 2011 (retiring aer
29 years o serv ice) would have a retirement
income replacement ratio o 78 percent. Tis
consisted o a CalSRS defned beneft o
$3,914 per month, a defned beneft supplement
program payment o $93 per month, and a
supplemental annuity payment rom a defned
contribution plan o $613 per month. (Tis
defned contribution component represented
about 13 percent o the total assumed retirement
income or the median CalSRS retiree.) Te
study assumed that the median CalSRS retiree
invested $100 per month over a 25-year career in a
defned contribution account.
In addition to considering the median
CalSRS retiree, the study also showed
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replacement ratios or CalSRS retirees at the 25th
and 75th percentiles o income, respectively. Te
replacement ratio or the 25th percentile retiree
(retiring aer 18 years o serv ice) was 42 percent,
while the replacement ratio or the 75th percentile
retiree (retiring aer 35 years o service) was103 percent. Te report said that teachers retiring
without employer-subsidized health coverage
would need more income to maintain a suitable
replacement ratio. Specifcally, it listed a recom-
mended replacement ratio o around 77 percent
o fnal compensation or those retired teachers
with health care benefts and around 89 percent
or those without health care benefts.
Retirees With Benets o $100,000 Per Year or
More. In recent years, there has been considerable
public attention related to retired Caliornia public
employees receiving annual pension benefts o
$100,000 or more. Tese individuals are a small,
but growing, segment o Caliornias public sector
retirees. About 2 percent o CalPERS and CalSRS
retirees currently receive such payments. Payments
to these retirees now equal around 7 percent to
9 percent o total pension payments rom the two
systems. During their working lives, these retireesgenerally were among the longest-serving and
highest-paid public employeesor example, senior
executives and managers o some state and local
agencies, school districts, and community colleges,
as well as some employees in public saety agencies.
Te percentage o CalPERS, CalSRS, and
other public retirees receiving pension benefts o
over $100,000 per year will grow in the uture or
several reasons. Tese reasons include the eects o
ination (which tends to increase all employees pay
and pension benefts over time) and the eects o
increased pension beneft provisions put in place in
the late 1990s and early 2000s.
Beyond the group o retirees receiving
payments o $100,000 or more per year, many
public retirement systems can expect to see the
percentage o their retirees with higher pension
beneftsand the amounts o those beneftsgrow
or these same reasons. Tis trend is already
apparent in data provided by the pension systems.
In its fnancial reports, or example, CalPERS
publishes statistics on the characteristics oemployees retiring in each fscal year. In 2003-04,
4,831 people retired with 30 or more years o
service, and this group retired with an average
monthly pension o $4,553 (equating to $54,636
per year). In 2008-09, there were 5,801 retirees
with 30 or more years o service, and they had an
average monthly pension o
$5,569 ($66,828 per year)up 22 percent in
non-ination adjusted terms compared to the
initial beneft o the 2003-04 retiree group. Growth
in monthly pension benefts was even greater in
percentage terms during this period or employees
retiring with 10 to 30 years o service. For retirees
with 25 to 30 years o service or example, the
average initial pension grew rom $3,308 per month
($39,696 per year) or 2003-04 retirees to $4,432 per
month ($53,184 per year) or 2008-09 retireesup
34 percent in non-ination adjusted terms.
Tis data rom CalPERS annual reportsuggests that while the average pension beneft or
allCalPERS retirees (including those who retired
decades ago) is around $25,000 per year, such
average retirees are not responsible or the bulk o
benefts that CalPERS will pay out in the uture.
For public employees who retired in 2008-09, the
newest retiree group or which data is available,
it appears that around 60 percent o CalPERS
beneft costs are being paid to retirees with 25 or
more years o service. Te average annual beneft
or this group is somewhere between $53,000 and
$66,000over double the amount paid to the
average retiree in the system. For those 2008-09
retirees with 25 to 30 years o service, their monthly
defned beneft pension is replacing an average
67 percent o their fnal career compensation; or
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those retirees with 30 or more years o service, the
monthly defned beneft pension is replacing an
average 79 percent o their fnal career compen-
sation. Some o these retirees also receive Social
Security benefts, and some also have defned
contribution savings, which would increase theirreplacement ratios urther. Over time, retirees like
the 2008-09 cohort will become more o the norm
in CalPERS and other public pension systems.
Tendency to Deer Costs to Future Generations
Ununded Pension Liabilities. A troubling
trend o Caliornias state and local public pension
systems has been the growth o substantial
ununded actuarial accrued liabilities (UAAL).
Put in very simple terms, an ununded liability is
the amount that would need to be invested into a
public pension plan today such that, when coupled
with amounts already deposited in the und plus
assumed uture investment earnings, all benefts
earned to date by public employees would be
unded upon their retirement. While there is some
disagreement on how to value ununded liabilities
o pension systems, it is clear that Caliornias state
and local systems are coping with very large short-alls. Tese shortalls will push costs upward
above what they otherwise might beor years to
come, in some cases.
As o June 30, 2009, CalPERS reported that
its UAAL in its main pension und or state and
local governments was over $49 billionconsisting
o about $23 billion or the state and $26 billion
or other public agencies. Because the UAAL
uses data that smoothes investment gains and
losses over extraordinarily long periods o time,
CalPERS tends to communicate its unded status
by another, more volatile measure that relies on
the market value o its investments at any given
time. By this measure, CalPERS main pension
und was 61 percent unded with a $115 billion
ununded liability, split between the state and other
public agencies. In 2009-10, buoyed by avorable
investment perormance, CalPERS reports that
its unded status improved somewhatto around
65 percent when measured based on the market
value o assets. Fiscal year 2010-11 saw even more
avorable investment returns.Unlike CalPERS, but like most other pension
systems, CalSRS recognizes investment gains and
losses in its actuarial valuations over a multiyear
period. Due to the near-collapse o world fnancial
markets in 2008, CalSRS and other pension
systems sustained heavy losses, and the continued
recognition o those losses is the major driver o the
systems growing reported UAAL. Te most recent
CalSRS valuation indicates the systems UAAL
grew rom $40.5 billion as o the 2009 valuation to
just over $56 billion as o June 30, 2010. Tis means
that CalSRS reported unded ratio dropped rom
78 percent as o the 2009 valuation to 71 percent in
the June 30, 2010 valuation.
Pension systems in Caliornia and elsewhere
reported growth in their UAALs aer the 2008
market collapse and then experienced a recovery
in their unded status during the relatively strong
investment markets o 2009-10 and 2010-11.Tese trends illustrate a primary reason that
ununded liabilities emerge: weaker-than-expected
investment returns. Lower-than-expected
investment returns have been a primary reason
or growth o ununded pension liabilities in the
last decade. Such investment weaknessrelative to
some pension systems assumption o 7.5 percent
to 8 percent investment return per yearhas given
uel to critics, who believe that these assumptions
are imprudent and understate costs that govern-
ments and employees should contribute or a given
set o benefts.
Other reasons or ununded liabilities include
beneft increases that are implemented retroactively
(that is, applied to previous years o service beore
the beneft enhancement is implemented) and
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demographic and pay changes among employees
and retirees. I retirees live longer than expected
by plan actuaries, ununded liabilities can result. I
employees are paid more than expected during their
career relative to assumptions o plan actuaries, this
also can contribute to ununded liabilities.Ununded Retiree Health Liabilities. For many
governments, the size o ununded retiree health
liabilities has rivaled or exceeded their ununded
pension liabilities. In contrast to pensions, govern-
ments typically have not pre-unded their retiree
health liabilities. In other words, they generally
have never set aside undsor required employees
to do soto cover the uture costs o retiree health
benefts earned during their working lives. Tis
means that uture taxpayers may bear a larger
cost burden or these benefts. Unlike pensions,
there are no investment returns under this type
o unding structure to cover a large portion o
beneft costs. While a small portion o governments
have begun to pay down their ununded retiree
health liabilities, such liabilities will remain a
pressing burden or many Caliornia public entities
as the decades progress. Te state governments
ununded retiree health liabilities alone total about
$60 billion, as o June 30, 2010, according to theState Controllers O ce. A report released by a
commission in early 2008 estimated that all public
entities in the state had a combined retiree health
ununded liability o over $118 billion as o that
time; that total probably has grown since then.
Ununded Liabilities and Growing Benets
Have Increased Costs. Increased benefts and
the emergence o large ununded liabilities have
increased pension and retiree health costs or many
Caliornia governments in recent years. In Figure 1,
we show the trend o increasing state General Fund
costs or retirement benefts in nominal dollars. A
major reason or the magnitude o recent growth
in state costs is the act that public employers
generally benefted rom
pension holidays in the
late 1990s and early 2000s
due to the stock market
bubble that temporarilyresulted in systems like
CalPERS being ully
unded or close to it.
Figure 2 shows the
contribution rates paid by
the state as a percentage
o pay or several key
employee groups. (While
state contributions as
a percentage o pay
were slightly higher in
1980beore the period
covered in Figure 2that
period is not directly
comparable to the present
day since CalPERS at
State Retirement Costs Have Been Growing
General Fund (In Billions)
Figure 1
1
2
3
4
5
$6
1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 2008-09 2011-12
CalSTRSCalPERS Retirement Programsa
CalPERS Retiree Health Programb
Other
aAmount for 1997-98 includes an over $1 billion state payment related to a major court case involvingCalPERS.
bIncludes the budget item for these costs and LAO estimate of the General Fund share of the implicitsubsidy for annuitant benefits that is paid along with employees health premiums.
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that time invested primarily in fxed-income bond
instruments and assumed an annual investment
return o only 6.5 percent.
Inexible Benefts, Inexible Costs
Strict Legal Limits on Changing Benetsand Reducing Government Costs. In our view,
perhaps the most signifcant retirement beneft
challenge acing Caliornia governments is that
there is very little exibility or governmental
employers under decades o case law that are
extremely protective o employee and retiree
pension rights. In Caliornia, pension benefts
or public employees are an element o a public
employees compensation. He or she begins to
accumulate pension rights at the moment o hiring,
and these benefts accumulate throughout a public
service career. Tere is a detailed case law in the
state that protects these benefts as contracts under
the State and U.S. Constitutions. Pension beneft
packages, once promised to an employee, generally
cannot be reducedeither retrospectively or
prospectivelywithout a governments oering
comparable and osetting advantages (which,
themselves, can be quite expensive). Te case law
suggests that governments do have some power to
alter benefts when they ace emergency situations,
but these powers are very limited, and govern-ments, according to case law, generally will have to
alter benefts temporarily, with interest accruing
to employees and retirees in the meantime. In
some cases, local governments may be able to
alter contracts when they seek protection under
Chapter 9 o the U.S. Bankruptcy Code.
Negotiations Can Help, but Unions Must
Represent Teir Members. In general, the primary
way that the state and local governments can
change pension benefts or current and past
employees is to negotiate with employee groups. As
discussed above, the state and some local govern-
ments have successully reduced pension costs
recently through such negotiations. Te challenge
with this approach, however, is that unions have an
obligation to represent their members, and so, in
State Retirement Contribution Rates Have Increased
As Percent of Payroll by Retirement Category
Figure 2
Miscellaneous Tier 1
Correctional Officer and Firefighter
California Highway Patrol Officers
5
10
15
20
25
30
35
40%
1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07 2008-09 2010-11
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exchange or pension concessions, they generally
will be duty bound to seek comparable, osetting
benefts or their members. For example, many o
the recent state employee agreements that increased
employee contributions to their pensions included
uture pay increases roughly equivalent to theincrease in the employee pension contributions.
Tis is understandable, given the history o the
states beneft commitments and the obligations
o unions to represent their members, but it limits
governments to an extent rom achieving lasting
cost savings or current and past employees
through the negotiation process.
For Future Employees, Government Can
Alter Pension and Retiree Health Benets. While
governments have very little exibility with regard
to current and past employees retirement benefts,
it is clear that they may change beneft promises
prospectively or uture hires without limit.
Disparity Between Public and
Private Retirement BeneftsUnderlying the real policy and fscal problems o
current public retirement systems is a sharp divide
between public-sector and private-sector workers.
Public-sector workers have guaranteed, defned-
beneft pension plans, and many, but not all, o them
have retiree health plans too. Private-sector workers
by and large have none o these things anymore. Te
Governors proposal, in essence, aims to reduce this
substantial disparity.
he Governor released his 12-point pension
plan on October 27, 2011. In addition to making
remarks at a press conerence, the Governor
released a short description o the goals o
his plan. While some o the elements o the
plan have been included in prior legislativevehicles (and the Governor released language
or similar proposals on March 31), our rev iew
below is based primarily on the Governors
pension handout rom October 27 and his press
conerence, as well as subsequent contacts with
administration sta concerning the plan. Drat
legislative language to implement the Governors
proposals would need to ill in many details
absent rom his October 27 presentation.
Below, we wil l review each o the 12 points in
turn, providing, in some cases, some background
inormation, a description o the Governors
proposal, and our initial comments.
EQUAL SHARINGOF PENSION COSTS
Background
Normal Cost and Ununded Liability
Contributions. Contributions to pension plans
rom employers and employees consist o two
main components: (1) normal cost contributions,
which generally are equal to the amount actuaries
estimate is necessarycombined with assumed
uture investment returnsto pay the cost o uture
pension benefts that current employees earn in
that year and (2) contributions to retire ununded
liabilities. For example, CalPERS estimates that
the normal cost or state Miscellaneous ier 1
workers (such as state o ce workers and most CSUemployees) is now 14.4 percent o their payroll. In
addition, the annual cost to retire ununded liabil-
ities or Miscellaneous ier 1 workersplus some
related beneft costsequals 10.4 percent o payroll,
or a total required contribution o 24.8 percent
o payroll. For CalPERS state Peace O cer and
Firefghter workers (principally state correctional
GOVERNORS 12-POINT PLAN
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o cers), the normal cost is now 25.4 percent o their
payroll, and the annual cost to retire ununded
liabilities is 11.3 percent o payroll, or a total
required contribution o 36.7 percent o payroll.
Most State Workers Pay One-Hal o Normal
Costs and One-Tird o otal Costs. Followingthe recent agreements o state employee unions to
increase their employees contributions to CalPERS,
over 70 percent o Miscellaneous ier 1 workers
contribute approximately 8 percent or more o
monthly pay to cover pension costs. Tis 8 percent
exceeds 50 percent o the normal cost contributions
or these employees, but, or most, represents only
about one-third o the totalrequired contribution,
including both normal costs and ununded liability
contributions. In the state Peace O cer and
Firefghter group, about 80 percent o workers now
contribute about 11 percent o their monthly pay
to cover pension costs. Tis represents just under
one-hal o the normal cost contributions or these
employees, but less than one-third o the total
required contribution.
With Fixed Employee Contributions,
Employers Cover Any Cost Changes. In current law
and most employee contracts, employee contributionsto their pensions generally are fxed. Tis means that
the portion o the total required contribution not paid
by workers generally is paid by the public employer
in this example, the state. While normal costs tend to
remain airly stable over time, assuming no changes
in the pension beneft structure, ununded liabilities
can change markedly rom year to year due mainly to
upturns and downturns in the investment markets.
Since employee contributions generally are fxed in
labor agreements or state or local law, this means
that the public employer can experience signifcant
increases in total required contributions as ununded
liabilities increase and signifcant decreases in total
required contributions when those liabilities drop.
Public Employee Contributions Vary. Like the
state, some local public employers recently have
negotiated with their unions to increase employee
contributions to local pension plans. As the
Governor points out, however, there remains a wide
disparity among public employers in what portion
o normal costs and total required contributions
is borne by public employees themselves. In somecases, public employees make no such contribu-
tions. Various laws, agreements, and precedents
allow some employers to pay a portion o their
employees contributions to pension plans. In many
cases, such a payment merely substitutes or pay
the employers otherwise might choose to give to
employees, but it means that some employees may
see no real costs or their pension benefts when
reviewing their pay stubs. Tere is concern among
some that many o these public employees view
their substantial pension as a sort o ree good.
Proposal
Equal Sharing o Normal Costs, but Unclear
I Sharing Would Apply to Other Costs. Te
Governors plan proposes that all current and
uture public employees be required to pay at least
50 percent o the normal costs o their defned
pension benefts. Tis seemingly would mean thatthere would be no more employer payments o
required employee pension contributions. Tis
requirement would be phased in at a pace that
takes into account current contribution levels,
current contracts and the collective bargaining
processapparently, over several years.
Te Governors proposal explicitly addresses
only the employee share o normal costs and is
unclear as to whether the 50 percent requirement
also would apply to ununded liability contri-
butions. It is also unclear i the 50 percent
requirement would apply to defned contribution
und deposits (which also can be split 50/50
between employers and employees, in theory).
Governor Says Tis Provides Real Near-erm
Savings.By applying the increased employee
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payment requirement to both current and uture
public employees, the Governor states that this
change would provide near-term cost relie or
some public employers, since increased employee
contributions would reduce contributions that
public employers otherwise would have to make.
LAO Comments
Governors Proposal a Good Start in Tis
Area. We agree with the Governor that uture
public employees should be required to pay or
a portion o pension contributions. We believe
it would enhance public confdence in state and
local retirement systems or there to be a clear,
unambiguous statewide policy in this area. Tere
is no single correct percentage o total required
contributions that employees should be required
to pay, but 50 percent is a reasonable starting
point or the discussion.
Important or Employees to Share in
Ununded Liability Costs oo. We urge the
Legislature to require that uture public
employees bear a portion o not only pension
normal costs, but also ununded liability
contributions. When public employers seetheir pension contributions go up due to a
downturn in the stock market or similar reasons,
employees should see their contributions rise
as well. Similarly, when public employers see
their pension contributions drop due to stock
market upticks, employees should beneit rom a
reduction in their contributions.
Like many others, we are concerned that
public retirement boards make excessively
optimistic assumptions concerning uture
investment returns. We believe that requiring
public employees to bear a portion o the cost
(or beneit rom a port ion o the savings) when
these assumptions prove inaccurate wi ll incen-
tivize retirement boards to make more prudent
investment assumptions. Moreover, requir ing
employees to bear a portion o ununded liability
costs would reduce the year-to-year volatility
o government contributions to pensions. In
eect, this change would transer a portion o
this volatility risk rom employers (who now
generally pay all increases due to unundedliabilities) to employees.
Case Law: Possible or Some Current
Employees, but Probably Not or Many Others.
At his press conerence announcing the proposal,
the Governor said his proposal addressed
existing employees by increasing their contri-
bution rate. He added, One thing we know or
sure: under constitutional law, the employer can
require higher contributions.
We do not share the Governors belie that
existing constitutional law clearly allows the
state to require current public employees to
contribute more to pensions. o the contrary,
such a proposal seems to run counter to existing
constitutional protections in case law that may
protect many current and past public employees.
In the nearby box (see page 18), we summarize
the case and statutory law in this area, which
suggests that it might be possible to increasecontributions or some current employees, but
not or others. For many current employees, such
contribution increases probably could be imple-
mented only through negotiations, and in any
event, would result in many employers increasing
pay or other compensation to oset the inancial
eect o the higher pension contributions. Since
increasing current employees contributions is
one o the only ways to substantially decrease
employer pension costs in the short run, the legal
and practical challenges that we describe mean
that the Governors plan may ail in its goal to
deliver noticeable short-term cost savings or
many public employers.
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HYBRID PENSION PLANFOR FUTURE EMPLOYEES
Background
Hybrid pension plans generally combine
a defned beneft pension with a defned contri-
bution retirement savings plan. Accordingly, it
is important to understand the characteristics o
both such plans. Te key dierence between such
plans is the handling o investment risk. In most
defned beneft plans, such as Caliornias state
and local pension systems, employers bear almost
all investment risk. Tis means that i investment
returns o the systems over time are less than
projected, public employer costs rise, but public
employee costs do not change. By contrast, indefned contribution plans, an employer is obligated
to make only a specifc amount o contributions
in the years that employees work. I investment
returns are less than desired, the employer is not
obligated to contribute anything more to a defned
contribution plan. In defned contribution plans,
thereore, employees and retirees generally bear all
investment risk.
Proposal
Hybrid Plan or Future Public Employees.
Te Governor proposes that uture public
employees be enrolled in hybrid retirement plans.
Details o the Governors idea are somewhat
unclear, but he appears to envision employer
and employee contributions to both defned
beneft and defned contribution plans, as well as
employees participation in Social Security (except,
presumably, or uture teachers and most publicsaety workers). Te Governor seems to propose
that the state Department o Finance be empowered
to design such hybrid plans based on the ollowing
general goals:
Non-Public Safety Employees. Te
hybrid plans would be based on employer
and employee contribution schedules
that would aim to produce a 75 percent
replacement ratio or non-public saety
employees assuming a 35-year public-
sector career. Te defned beneft pension
plan would be responsible or aboutone-third o the 75 percent replacement
income, the defned contribution plan
another one-third, and Social Security the
fnal one-third. For teachers and others
not in Social Security, the defned beneft
would be responsible or two-thirds o
the 75 percent replacement income, with
defned contribution plans responsible or
the remaining one-third.
Public Safety Employees. Te hybrid
plans would be based on employer and
employee contribution schedules that
would aim to produce a 75 percent
replacement ratio or public saety
employees assuming a 30-year public-
sector career. For those employees not
in Social Security, as with teachers, the
defned beneft would be responsible or
two-thirds o the 75 percent replacement
income, with defned contribution plans
responsible or the remaining one-third.
Benet Cap or High-Income Public
Employees. Te Governors plan also reerences a
cap on the defned beneft portion o the proposed
hybrid plan requirement so that public employers
do not ace high costs or pension benefts o
uture high-income public workers. Such a cap
might aect uture public workers like the small,
but growing, portion o current public pensioners
who receive pension beneft payments exceeding
$100,000 per year. Te Governors plan provides no
detail on how such a cap might work.
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Strict Legal Protections Limit Governments Flexibility
Our understanding o Caliornias detailed case law on public pensions over the last century is as
ollows: in order to have the exibility to unilaterally implement cost-saving reductions to the pensions o
current and past employees, public employers need to have explicitly preserved their rights to make such
changes either at the time o an employees hiring or in subsequent, mutually-agreed amendments to the
pension arrangement. Otherwise, reductions or these employees and retirees require that comparable,
osetting advantages be grantedadvantages that tend to negate the pension savings.
Comparable New Advantages Generally Required When Disadvantaging Employees. Te 1955
Caliornia Supreme Court case,Allen v. Long Beach, is an important landmark in Caliornia pension law.
Te court ruled that changes in a pension plan which result in disadvantage to employees should be accom-
panied by comparable new advantages. One o the pension amendments invalidated inAllen increased
each employees pension contribution rom 2 percent to 10 percent o salary. Te Supreme Court, in act,
declared that this increased contribution requirement obviously constitutes a substantial increase in the
cost o pension protection to the employee without any corresponding increase in the amount o the beneftpayments he will be entitled to receive upon his retirement.
In Pasadena Police O cers Association v. City o Pasadena (1983), a state appellate court said the
precedent inAllen meant that where the employees contribution rate is a fxed element o the pension
system, the rate may not be increased unless the employee receives comparable new advantages or the
increased contribution. Te appellate court added that while an increase in an employees contribution rate
operates prospectively only and in eect reduces uture salaryinAllen the Supreme Court struck down
such a change on the grounds that it modifed the system detrimentally to the employee without providing
any comparable new advantages.
What About Changing Future Benet Accruals?Te logic in theAllen and Pasadena Police O cers
Association cases, among others, makes it very di cult to assume that state or local governments could
unilaterally change the rate at which current employees accrue pension benefts or theiruture service, as
has been suggested by various recent proposals. (Te Governor does not make such a proposal.)
In a 1982 case, Carman v. Alvord, the Caliornia Supreme Court noted that upon entering public
service an employee obtains a vested contractual right to earn a pension on terms substantially equivalent
to those then oered by the employer. In the 1991 case concerning Proposition 140, the court considered
that measures termination o then-incumbent legislators rights to earn uture pension benefts through
continued service. In that case, the court said the termination o the beneft accrual rights or these legis-
lators was a contract impairment and was unconstitutional under the U.S. Constitutions contract clause
because it inringed on their vested pension rights. (Proposition 140, it should be noted, did end pension
benefts or legislators elected aerits passage.) Furthermore, in the Pasadena Police O cers Association
case, the appellate court noted that an employee has a vested right not merely to preservation o benefts
already earnedbut also, by continuing to work until retirement eligibility, to earn the benefts, or their
substantial equivalent, promised during his prior service.
Signicant Challenges to Mandating Tat Current Workers Contribute More. While the case
law described above is protective o current and past public employees pension rights, it indicates that
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governments may be able to unilaterally (that is, outside o negotiations) change elements o the pension
arrangement i they have explicitly preserved the right to do so. For example, in International Association
o Firefghters, Local 145 v. City o San Diego (1983), the Caliornia Supreme Court ruled that a city could
increase employee contribution rates pursuant to city charter and ordinance provisions that allowed it
to do so. Accordingly, some public employers that have careully preserved such rights could unilaterallyimplement increases in current workers pension contributions.
We suspect that many local governments may not be in a good position to deend their ability to
implement such increases. While several sections o the states CalPERS and 1937 Act laws purport to
preserve the Legislatures ability to increase certain CalPERS contribution rates or make clear that state law
itsel does not limit local governments ability to periodically increase, reduce, or eliminate their payments
to oset required employee contributions, local governmentspromising, as they do, a wide variety o
retirement packages through dozens o retirement systemsmay obligate themselves contractually.
Even in a 2009 decision upholding San Diegos ability to impose higher employee pension costs at a
bargaining impasse, the Ninth Circuit ederal appeals court distinguished between legislatively enacted
reductions in employers payment o a share o employees required pension contributions (allowable, the
court ruled) and legislatively imposed increases in the totalamounto required employee pension contribu-
tions themselves (implying the latter may be unallowable under contract law). Te Ninth Circuit stressed
that looking into a state or local legislative bodys intentwas key to determining whether a retirement
beneft provision was contractually protected. Accordingly, some local governments may have intended to
include low employee contributions as a part o their pension contract, while others may not. Tis muddled,
uncertain legal ramework seems to us inconsistent with the Governors claim that governments have broad
legal ability to mandate current employee contribution increases. Furthermore, even i unilateral increases
are permissible under contract law, they will directly or indirectly result in many governments having to pay
more to employees in salaries or other orms o compensation in order to remain competitive in the labormarket. For example, recent increases in most state employees contributions negotiated with rank-and-fle
employees were accompanied by uture salary increases o similar amounts.
Since increasing current employees contributions is one o the only ways to substantially decrease
employer pension costs in the short run, these substantial legal and practical hurdles mean that the
Governors plan may ail in its goal to deliver noticeable short-term cost savings to many public employers.
Key Lesson From Case Law: Governments Should Be Clear AboutTeirPension Rights. Te case
law makes clear to us that governments oen have not been clear about what aspects o pension and retiree
health benefts and contributionsi anythey can change unilaterally in the uture and which they
cannot. For this reason, we have recommended that the Legislature require local governments to explicitly
disclose to employeespreerably, on the day that they are hiredwhich aspects o pension and retiree
health benefts and contributions the public entity can change unilaterally (that is, without negotiation) and
which it cannot. I it chose to do so, the Legislature could require that such disclosures reect the results o
collective bargaining and apply only to uture employees. (Approval o such a requirement by voters may be
necessary to avoid the state having to reimburse local governments or this disclosure mandate.)
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LAO Comments
Excellent Starting Point or Discussion. We
previously have recommended that the Legislature
take steps to ensure that uture public workers are
enrolled in hybrid plans. Tis can reduce substan-
tially the risk o uture ununded pension liabilities
by shiing a signifcant portion o the risk that
public employers now bear or defned beneft plans
to defned contribution plans instead. In defned
contribution plans, employers bear no risk or
uture investment returns, and ununded liabilities
or these plans are not possible.
Major Policy Shi Would Make Public
Employees More Like Private-Sector Workers.
We believe that moving uture public employees tohybrid plans would address a key policy concern
relating to the current public employee pension
systemthe growing disparity between public-
sector and private-sector employee retirement
benefts and security. Moving to a hybrid plan would
bring public employees retirement packages closer
in line with those o their private-sector counterparts
and serve to discourage uture public employees
rom retiring as early as their predecessors do today.
Finally, we believe that the Governors goal to have
career public workers have a retirement income
equal to about 75 percent o their career income
makes sense and is in line with studies indicating
the replacement ratio to preserve an employees
liestyle in retirement. (Tis is particularly true i
the employee has supplemental employer-subsidized
health coverage during retirement.)
We discuss our concerns related to the
proposed cap or high-income public workers laterin this report. Also, as discussed immediately
below, there appear to be discrepancies between
this part o the Governors proposal and his
proposal to increase uture public employees
retirement ages.
INCREASED RETIREMENT AGESFOR FUTURE EMPLOYEES
Background
In Caliornia, public employee pension
ormulas oen are reerenced in a type o
shorthandsuch as 2 percent at 55that implies
there is a single retirement age (in this case, 55).
Actually, current Caliornia public employees in
this group are eligible to begin receiving service
retirement benefts at age 50although with a
lower beneft actor. In most cases, however, these
employees work longer so that they can increase
their retirement benefts through a higher actor.
For example, in the 2 percent at 55 group ornon-public saety state employees, employees can
max out their actor at 2.5 percent at age 63. Even
this, however, is not the maximum retirement
age, as workers generally can continue to increase
their benefts by working more years beyond age 63.
As shown in Figure 3, in the states three largest
public employee retirement systems, the average
state or local employee retired at about age 60 as
o 2009-10. Public saety employees tend to retire a
ew years earlier. Moreover, due to recent changes
in benefts or newly hired state employees and
some local employees, average retirement ages in
many o the groups shown in the fgure will tend
to increase somewhat in the coming decades under
current policies, even i the Governors proposal is
not adopted.
It is also worth noting that many retirees
receiving benefts rom public retirement systems
also work in other jobs during their lietime,including private-sector positions. Tese partial
career employees can receive relatively small
pension benefts. Calculations o the average
monthly or annual pension benefts paid by public
pension systems oen include these partial-career
workers. I such workers were excluded rom these
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calculations, average monthly benefts paid would
be higher than shown by public pension systems in
many cases, and average retirement ages shown in
Figure 3 also could be aected.
ProposalWork to a Later Age Would Be Required or
Full Benets. Te Governors plan seemingly
requires that all uture public employees work to a
later age to qualiy or ull retirement benefts. Te
Governor proposes that non-public saety pensions
or uture employees target a retirement age at
67 (the current Social Security retirement age or
those workers). Future public saety workers would
target a lower retirement age commensurate with
the ability o those employees to perorm their jobs
in a way that protects public saety. (As discussed
below, it is not clear exactly what the Governor
means in this part o his proposal. Presumably,
this would be addressed when the administration
provides additional details about its plan.)
Te Governor points out that these changes
would reduce signifcantly both pension and
retiree health costs or governments. In particular,
employees would haveewer, i any, years
between retirement
and reaching the age
o Medicare eligibility.
Aer the age o Medicare
eligibility, a substantial
portion o public-sector
retiree health care costs
shi to the ederal govern-
ments Medicare program.
LAO Comments
Increasing Average
Retirement Ages
Is Essential. Given
increased longevity, we
believe it is appropriate to increase retirement
ages or uture public employees. Failing to do so
would risk a growing long-term fscal burden or
governments supporting pension programs, since
uture increases in longevity would then produce
proportionate or greater increases in pension andretiree health beneft costs. Tere is no single right
age to target, especially or public saety workers. It
will be important, however, or the Legislature to
set a specifc policy or public saety workers rather
than the nebulous one that the Governors proposal
seems to suggest.
Te Legislature also may wish to consider
whether the current age o minimum service
retirement eligibility or most public employees
age 50should be increased.
Possible Conict With Other Parts o the
Proposal. We are uncertain how the Governors
retirement age proposal squares with other aspects
o his proposal. Specifcally, i uture non-public
saety workers are to work until age 67 to receive
ull retirement benefts, this suggests that a public
employee entering government service right out
o college or high school might have to work or
Figure 3
Average Retirement Ages for Selected PublicEmployee Groups in 2009-10
Age
California Public Employees Retirement Systema
California Highway Patrol Officers 53
Local public safety officers 55
State correctional officers and firefighters 60
Other state and local employeesb 60-61
California State Teachers Retirement Systema
School district and community college teachers 62
University of California Retirement Plan
Professional and support staff members 59
Academic faculty 63a Includes service retirements only. Disability retirements, on average, occur 8 to 11 years earlier for
CalPERS members and about 6 years earlier for CalSTRS members.b Includes state and local miscellaneous employees, such as government office workers.
CalPERS = California Public Employees Retirement System; CalSTRS = California State TeachersRetirement System.
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over 40 years to receive such benefts. Yet, the
Governors hybrid proposal envisions a 75 percent
replacement ratio or such workers aer only 35 years
o government service. Accordingly, it is not clear
how the Governors plan intends to mesh the key
variables o the expected length o a working career,replacement ratios, and retirement age.
LIMIT SPIKINGFOR FUTURE EMPLOYEES
Background
Benets or Many Still Based on Single
Highest Year o Salary. Many current public
employees are entitled to receive pension benefts
based on their single highest year o government
salary. As we discussed in our 2005 P&Ireport on
public pensions, this single-year ormula or deter-
mining pension benefts is very rare among state
and local employees in the United States; in act,
it is a eature o public pensions in Caliornia and
almost nowhere else.
In recent years, the state and some local
governments have moved to change the single-year
ormula or newly hired employees by instead
calculating their pension benefts based on theirhighest average annual compensation over a three-
year period. Tis discourages pension spiking,
which includes eorts o employees to change jobs
or receive increased pay during their fnal one
or two years o employment that increases their
eventual pension beneft by a large amount.
Proposal
Require Tree-Year Final Compensation or
Future Employees. Te Governor proposes that all
uture public employees have their defned beneft
pensions calculated based on their highest average
annual compensation over a three-year period.
LAO Comments
Broad Consensus or Tis Change. We previ-
ously have recommended the Governors proposal.
Tere seems to be broad public consensus or this
change, and it would be a small step to increase
public confdence in public employee pension
systems. We caution, however, that, despite
requent headlines concerning pension spiking,
this change probably would result in substantial
pension cost savings or a relatively small group
o uture employees. It is not likely to result in
signifcant cost savings or governments.
BASE BENEFITSON REGULAR, RECURRING PAY
Background
Current Rules Can Result in Some Abuses.
Tere are some instances when public pensions
reportedly are increased as a result o employees
receiving additional pay rom bonuses, unused
vacation time, overtime, and other perks. Many
pension systems, however, already prohibit such
compensation items rom being used to calculate
fnal compensation or purposes o pension benefts.
Proposal
Establish Uniorm Rule to Prevent Abuses. Te
Governor proposes that all public defned beneft
pension systems prohibit these types o compen-
sation items rom being included in fnal compen-
sation used to determine annual pension benefts or
uture employees.
LAO Comment
Broad Consensus or Tis Change. We
recommend passage o this proposal. Such a change,
i rigorously enorced by all pension systems and
employers, should help increase public confdence
in Caliornias state and local pension systems.
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Tis change, however, might lower costs or only a
small percentage o uture employees. Tis part o
the proposal seems unlikely, thereore, to produce
substantial pension cost savings or governments.
LIMIT POSTRETIREMENT EMPLOYMENTFOR ALL EMPLOYEES
Background
Currently, Individuals Can Return to Public
Sector Aer Retirement. Caliornia governments
oen rely on retired annuitants and retired
workers rom other public employers to work
part-time or ull-time. Such retired workers can
bring considerable expertise to public agencies.
Some pension systems, such as CalPERS, limit
retired members to working or only 960 hours
per year or certain state and local agencies, and
these retired annuitants services do not result in
their accruing any additional retirement benefts.
In other cases, an individual may be able to retire
rom one retirement system and work or an
employer in a dierent public retirement system,
while accruing additional retirement credit in
that second system. (Tis latter scenario probablyoccurs very inrequently.)
Proposal
Extending CalPERS Limits to All Public
Employers. Te Governor proposes to limit all
current and uture employees in their post-retirement
work or Caliornia governments. Specifcally, the
Governor wants to limit all current and uture
employees rom retiring rom public service and
working more than 960 hours per year or a public
employeressentially extending the CalPERS
post-retirement employment rules to all public
employees. Te Governor also would prohibit all
retired employees rom earning retirement benefts or
service on public boards and commissions.
LAO Comments
Important to Strike the Right Balance With
Tese Changes. While the Governors proposal
in this area lacks some detail, it seems reasonable
to us, in that it seems to strike the right balance
on limitations on postretirement employment. In
many cases, public employers can beneft rom the
expertise o retired workers while saving money
paying them little or nothing in the way o benefts.
(A ull-time worker, by contrast, typically would
receive substantial benefts that would add to his
or her personnel costs.) We observe, however, that
it will be very di cult or pension systems across
the state to enorce this provision i it is indeed
applied to limit a public retirees work or any stateor local employer in the state. For example, it might
be di cult or the Los Angeles County Employees
Retirement Association to identiy a newly hired,
middle-aged employee who happened to be a
retiree o, say, the UCRP.
LIMIT FELONS RECEIPTOF PENSION BENEFITS
Proposal
Foreit o Pension and Related Benets.
Te Governor proposes that public o cials and
employees convicted o a elony in carrying out
o cial duties, in seeking elected or appointed o ce,
or in connection with obtaining salary or pension
benefts oreit their pension and related benefts.
LAO Comments
Proposal Raises Various Issues. Te Legislature
may want to explore certain issues regarding thisproposal. For instance, it is unclear to us whether
this type o change would be constitutional in
all cases as applied to current and past public
employees. For uture public employees, however,
the state clearly may impose such a oreiture
requirement. In addition, would such oreiture
be prospective only, or would repayments o some
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or all previously paid pensions to retired elons be
required? What i the elon cannot repay such costs?
PROHIBIT RETROACTIVE PENSION INCREASES
BackgroundContributor to Recent Ununded Liability
Increases. In recent years, many Caliornia govern-
ments have retroactively applied pension beneft
increases to some or all employees prior years o
service. Tis can mean, or instance, that an employee
who worked nearly all o his career earning benefts
based on one pension beneft ormula (or example,
2.5 percent at 55) was able to complete that career on
a higher pension beneft ormula (such as 3 percent
at 50). When the change is applied retroactively, that
worker may earn a pension beneft equal to 3 percent
o his fnal compensation multiplied by his years o
service, even though both he and his employer made
contributions throughout his working lie based
on a 2.5 percent beneft actor. Accordingly, when
that worker retires, the government is le with an
ununded liability to address in the coming decades.
ProposalBan Retroactive Benet Increases. Te
Governor proposes to ban uture retroactive
pension increases or all public employees. Prior
retroactive increases are constitutionally protected
and generally cannot be changed.
LAO Comment
An Important Change to Make. History
suggests that, particularly at times when pension
systems temporarily appear overunded, retroactive
beneft increases can be very tempting or public
employers and employeesessentially a kind o
ree money to provide to career public servants.
Yet, as the Governor correctly points out, such ree
money generally will end up costing taxpayers,
since pension systems rarely remain overunded or
long and ununded liabilities almost always result
rom such retroactive beneft grants. Moreover,
retroactive grants oen will play no roleor even a
counterproductive rolein encouraging employee
recruitment and retention. New recruits certainly
do not beneft rom a higher pension beneft appliedto prior years o service. Valued career employees
oen will be incentivized to retire earlierthan they
otherwise would due to their ability to receive a
higher retirement beneft.
Given the history o public employers in this
area and the limited instances in which such retro-
active beneft grants would be o real value to public
employers, we recommend that the Legislature
approve this element o the Governors proposal.
PROHIBIT PENSION HOLIDAYS
Background
A Relic o Past Boom Years in the Financial
Markets. During the late 1990s and early 2000s,
the tech bubble years in the stock market when
public pension systems temporarily reported that
they were overunded, many public employers
substantially reduced or entirely eliminated theirannual pension contributions and, in some cases,
public employee contributions were reduced as well.
Tis is the key reason why state pension contribu-
tions to CalPERS were so low in some years o
the late 1990s, as shown in Figures 1 and 2. State
contributions to CalSRS defned beneft program
also were reduced during this period, contributing
to CalSRS recent unding problems.
Proposal
Limit Ability o Employers to Suspend
Contributions. Te Governors proposal would
prohibit all employers rom suspending employer
and/or employee contributions (related to both
current and uture public employees) necessary to
und annual pension costs.
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LAO Comments
Getting Details Right Is the Key. We agree
that employers should be sharply limited in their
ability to suspend regular employer or employee
contributions. History tells us that such periods o
overunding oen are eeting and may be based on
temporary stock market bubbles.
In 2008, the Public Employee Post-Employment
Benefts Commission (PEBC) appointed by the
prior Governor and legislative leaders agreed to
a recommendation to restrict pension unding
holidays. Te PEBC recommended that employers
be permitted to implement contribution holidays
only based on the amortization o their surplus
over a 30-year period. In other words, contribu-tions could all to zero only in instances when
the surplus is so great it can und 30 ull years o
normal costs. We suggest that the Legislature use
PEBCs recommendation as a starting point in the
discussion in this area.
PROHIBIT AIRTIME PURCHASES
Background
Widely Available, but Very Dif cult to Price.
Pursuant to state legislation or other law, CalPERS
and many other public pension systems have
allowed certain eligible public employees to buy
airtime, which is additional retirement service
credit or years not actually worked. For example,
a state employee can add fve years o service
creditand, accordingly, increased retirement
benefts laterby paying a signifcant sum o
money to CalPERS. In theory, the public employeepays or the entire cost o this additional defned
beneft pension credit. In practice, however, airtime