Boosting Pension Contributions Is Fine

But borrowing from a special fund to do so is not.

Governor Jerry Brown has proposed that California borrow $6 billion from a state special fund (SMIF) to finance extra contributions to a state pension fund (CalPERS) in order to reduce future state pension costs.

Borrowing to boost pension fund earnings is not a new idea. That’s what “pension obligation bonds” do. The motivation behind such loans is low short term interest rates relative to what the borrower thinks it can earn by betting on stock and bond markets. Borrowing to bet on rising asset prices can sometimes work and even spectacularly (see eg margin-financed speculation in stocks before 1929 and mortgage-financed speculation on US housing before 2008) but sometimes those bets sour, and when they do, POB’s are extra expensive because they impose two interest costs (the pension obligations and the borrowing).

Brown claims his proposal will generate $11 billion in pension cost savings over 20 years because the borrowed funds will be deployed by CalPERS into assets that will earn seven percent per annum. Seven percent per annum for 20 years translates into nearly a quadrupling of assets. How likely is that to happen? Below are two charts showing historical interest rates and stock market returns.

As the viewer can see, interest rates have nowhere to go but up and stock markets can be flat for long periods of time. Higher interest rates would likely drive stock prices lower and add more interest to the loan. Yet Brown is proposing that citizens borrow to bet that CalPERS can add $6 billion to the $300 billion it already manages and turn that corpus into more than $1 trillion in 20 years.

One benefit of Brown’s proposal is that it clearly exposes that dangerous fallacy by proposing to do at once what the state does every day, as explained here and here.

The more unique aspect of Brown’s proposal is his choice of lender. SMIF (“Surplus Money Investment Fund”) is where the state holds revenues until needed for public services. Eg, gas tax revenues are housed in SMIF until they are needed for, say, road repair. SMIF invests in short-term (as opposed to long-term) instruments because that money is expected to be used in the short term. By expressing a willingness to move $6 billion from short term to long term investments, Brown must believe SMIF has more money than it can use in the short term. If so, then in any event SMIF should move some money to longer-duration and higher-yielding investments. That would be true even if the state had no pension obligations because leaving too much money in a short-term interest-bearing checking account when money isn’t needed for 20 years would be leaving money on the table. It’s no different than if you were collecting money for your new baby’s college education 20 years down the road. But that doesn’t mean SMIF should be a source for the POB, which (based on available information) appears flawed for several reasons:

  1. Citizens have all the risk. Citizens supply SMIF’s funds and are on the hook for state employee pensions regardless of how the bets turn out, and the borrowing is a way to shield employees from sharing in the boosted contributions. In fact, using special fund cash to finance pension contributions would reward CalPERS’s board for keeping normal-cost contributions — the only pension costs shared by employees — unreasonably low.
  2. Brown has selected the state’s Rainy Day Fund as the source of repayment for the loan but that can’t be more than a fig leaf given that the small size of the RDF is woefully insufficient for the state’s budget volatility, as explained here. Using any of that fund for this purpose leaves citizens with even less protection.
  3. SMIF might need the money before the loan is due. SMIF may not need the $6 billion now but circumstances change and the state’s principal responsibility is to provide services. Also, one has to worry that, in order to validate the rationale for using SMIF’s money, the state might down-manage services in such a way as to reduce the need for that $6 billion but at a cost to citizens in the form of fewer road repairs, etc. After all, how would citizens know?
  4. A loan from a special fund — funded entirely by citizens and not at all by employees — for the purpose of financing pension contributions sets a dangerous precedent. In addition to rewarding CalPERS for setting unreasonably low normal-cost contributions, what’s to stop the state from making all special funds available for such purposes and politicians from claiming that taxes filling special funds are going to public services when the money is actually being used to boost pension contributions?

In 2004 I helped Governor Arnold Schwarzenegger engineer “Deficit Reduction Bonds” as a way to address the deficit he acquired upon taking office. But that was a mistake. Those borrowings didn’t solve anything. They just covered up the problem, with interest to boot. The right thing to do then was to raise taxes or cut spending — especially spending that lines powerful pockets but doesn’t produce value for citizens. Brown is in a similar position today with respect to the state’s exploding pension liabilities, which are the result of the state not making sufficient contributions in the past. Brown is half right: the state should boost contributions, but not by borrowing, especially after a long bull market. (Indeed, there’s an inconsistency in Brown recently reminding legislators that a bear market is likely after an eight-year bull market while simultaneously proposing a leveraged bet on that market.) Instead, the state should require appropriate normal-cost contributions, which is achieved by employing a reasonable investment return assumption, and then boost contributions further by raising taxes or cutting spending that’s lining pockets but not producing value for citizens, or both. On the latter subject, the state should start by getting more value for more than $110 billion per year of health care and corrections spending.

The state should also look to reduce extra benefits being added to retiree costs (eg, COLA’s) and benefits for years not yet worked. More than a decade ago, I and others pressed state pension boards to assume reasonable investment return assumptions so that normal-cost contributions would rise at that time. But pension fund boards and legislators under the influence of associations representing pension beneficiaries prevented that from happening. Had they not prevailed the state would not have huge pension deficits today. Citizens have been taking it on the chin ever since as pension costs grab ever larger shares of budgets. Everyone — including those who have benefited from preventing higher contributions in the past — needs to share in the pain.