Anthony P. Archie is a public policy fellow in Business and Economic Studies. Prior to joining Pacific Research Institute, Anthony earned his masters degree in public policy from Pepperdine University, specializing in economics and regional/local policy. As part of his graduate work, he co-authored Crisis in California: Reforming Workers’ Compensation, a proposal that drew praise from an esteemed panel of scholars and policy advisors. Mr. Archie has held internships on Capitol Hill and in the State Assembly. He received his B.A. in economics and political science from Pepperdine University. [Archie index]

California’s Taxing Pension System
Unstable and underperforming...
[Anthony P. Archie] 2/23/05

As the pension debate finally begins here this week, California’s legislators should take note. California’s current pension system is inherently unstable and its huge costs jeopardize the state’s taxpayers.

CalPERS’s annual unfunded liability has grown substantially in recent years. In 2000, taxpayers had to cover a $160 million shortfall. In 2005, that number has climbed to $2.6 billion. These figures represent the amount of General Fund dollars allocated in a given year’s budget, all derived from taxpayer money.

While visibly generous benefits and instances of disability fraud have impacted these costs, the problem lies within the structure of the pension system itself.

California’s current defined-benefit pension plan allows a retiree to obtain a pension based upon a combination of peak salary, age, and years of service. Pension amounts are guaranteed under state law upon retirement.

This ensures that the employee will obtain a set amount no matter how the funds are performing. This detachment from the success of the investments reveals the inherent dilemma. The taxpayers are liable for the pensions while the employees are entitled to them automatically. Since the investment risk is borne by the taxpayers, the government must fund the pension account regardless of whether the system can allow for it. The crux of the issue is that defined-benefit plans have unpredictable costs.

A defined-benefit plan depends on the success of the collective investment portfolio. If the investments are under-performing and can’t meet the pension obligations, the taxpayers must foot the bill. Under-performance can be a result of various factors, primarily the overall success of the market.

During a recession, investment gains usually slow along with the economy. Tax revenue tends to do the same. Therefore, state and local governments that operate under defined-benefit pension systems must deal with the problem of having to cover pension deficits at a time when revenue does not provide for it. This increases the incentive for cuts in services, borrowing, and tax increases, all unpopular moves.

Conversely, with an economic boom, investment returns and revenues are most likely abundant. Rarely though is the windfall given back to the taxpayers. In fact, in California it is illegal to use CalPERS’s surpluses as General Fund allocations.

The volatility of the pension costs makes it unpredictable to plan for pension allocations out of a government’s budget. This has occurred in local governments throughout the state. In Contra Costa County, for example, retirement expenses have ballooned from $37.8 million, or 5.6 percent of the budget in 1995, to an estimated $143.4 million, or 12.26 percent of the budget in 2005.

As our elected officials take a good look at our current pension structure, they should see the writing on the wall. California deserves a stable, fully funded pension system.

The governor’s proposed defined-contribution plan would save the state and local governments from fluctuating pension costs. By predetermining pension contributions, elected officials can allocate accordingly in their budgets. This predictability will allow for future revenue planning, delivering piece of mind to taxpayers against sudden tax hikes or unpleasant cuts in services. CRO

copyright 2005 Pacific Research Institute

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