Independent Thinking^®

Howard Cure: California – First in Pension Reform?

Californians need never be bored. There is almost always a pending referendum to argue about. Since the state constitution was opened to amendments by the people in 1911, over 300 have come to a vote, ranging from the sublime to the ridiculous. For municipal bond investors, this time it’s personal.

The Pension Reform Act of 2014, which may appear on the November statewide ballot, would enable cities to modify their existing pension programs, preserving only the vested earnings for existing employees. This change would at last bring the government sector in line with practices adopted by private companies years ago.
 
From the investor’s point of view, it would at last tackle what has become a major – and increasingly detrimental – factor in the long-term credit viability of municipal bond issuers.
 
While states across the country, including Illinois, Rhode Island, New Mexico and Minnesota, have passed significant and contested legislation to reduce these
fixed costs, California is the first to attempt to change its constitution and avoid the associated legal disputes. Cities throughout California are otherwise hamstrung by pension promises they can no longer afford. Stockton and San Bernardino, like Detroit, have filed for bankruptcy, in part because of insurmountable pension costs.
 
At Evercore Wealth Management, we will be closely monitoring developments in California, both on behalf of local investors and those in other states that could be affected.
 

Act 2014, Scene One

The Proposition would amend the California constitution to give government agencies clear authority to negotiate changes to existing employees’ pension or retiree healthcare benefits. The changes would apply going forward, allowing employees to keep the benefits they have earned to date but letting employers reduce what they earn for the remainder of their careers. This change would cause the vesting of public retirement plans in California to be more comparable to those of private retirement plans under the Employee Retirement Income Security Act of 1974, or ERISA.
 
The proposal was submitted to the Attorney General, who has prepared a ballot summary and title to be circulated for signatures to qualify the initiative. The wording can be critical to the success or failure of the proposition and can often elucidate the biases from the Attorney General’s office. The Attorney General has kept the title vague: “Public Employees’ Pension and Retiree Healthcare.” The summary does make it clear, however, that the proposal would eliminate constitutional protections for public workers such as teachers and police officers. The summary notes that the initiative would allow government employers to cut benefits and increase worker contributions during hard times. While many public service employees would have wanted the title to stress the elimination or cuts to pension and retiree healthcare, many supporters of the proposition refute that the measure would take away any public workers’ constitutional rights. Backers now have until June 5, 2014 to circulate petitions and collect the 8% of the votes cast in the last election for governor, which makes their target this time 807,615 signatures.
 
This initiative, assuming the collection of a valid number of signatures, will appear on the November 2014 statewide ballot.
 

Act 2014, Scene Two

There is growing grassroots support for constitutional change, as citizens are made increasingly aware of the benefits afforded these employees at a time when nongovernmental employees are seeing diminished benefits, stagnant wages and increasing tax burdens. The traditional thinking may no longer apply concerning the tradeoff between having a public sector career, with lower pay than the private sector, in exchange for job security and a comfortable retirement.
 
Local initiatives on the California city level that sought to change pension and benefit programs for existing employees have passed overwhelmingly (most recently in San Diego and San Jose) and demonstrate the frustration of many taxpayers in seeing their taxes go to benefits that they, themselves, no longer receive. Taxpayers are also concerned about the reduction in other municipal services, given the cost of addressing pension liabilities accumulated in the past because of a combination of underfunding, expansion of benefits, and poor investment performance. As we have stated in past publications, a government’s financial flexibility and credit strength are increasingly derived from its ability to handle these benefit programs.
 
It’s worth mentioning, however, that many representatives in the state legislature with strong union links are less exposed to the consequences of ballooning pension costs at the local level and that some will oppose reform. Also worth noting are the costs associated with collecting enough valid signatures and the still to-be-determined source of funding for this exercise. Cities are hindered from financing this effort, although looser political funding laws may permit just a few wealthy individuals to supply needed monies. At the same time, many public service workers are adamantly opposed to these changes and will fight tooth and nail against their implementation.
 
It remains to be seen if supporters of the proposal can garner as much enthusiasm and voter turnout as the opposition is likely to muster in outrage.
 

The Way From San Jose

As noted in our October 10, 2013 report, California in Context: Head West, Young Bond Investor, 70% of the voters in San Jose in June 2012 approved a second-tier benefit plan for new city employees that provided far lower pension and health benefits. The measure also altered pension benefits for existing workers, allowing them to choose either a similar plan or to pay 16% more out of their own pockets for the benefits they had come to expect.
 
In San Jose, the city’s annual bill for its retirement plans more than tripled from $73 million to $245 million over a decade, thanks to benefit increases, flawed pension fund assumptions and market losses. Career city police officers and firefighters can now retire as early as age 50 with pensions starting at up to 90% of their last year’s salary with automatic 3% raises for life. Unlike cities in Illinois and New Jersey, San Jose is not guilty of deliberately underfunding its plans, but some degree of underfunding and the sheer magnitude of the pension commitments are putting pressure on both state and local budgets in California. That is not to say that all California cities are facing the same financial burdens. There is often financial distress for poorer cities where a large share of the budget is for public safety and where there are revenue limits due to Proposition 13.
 
On December 23, 2013, a judge ruled that San Jose is prohibited from forcing current employees to contribute significantly more toward their pensions. Specifically, the judge blocked the city from suspending retiree cost-of-living adjustments and mandating that employees increase pension contributions or accept lower benefits for future work. The judge did leave in place the elimination of supplemental pension payouts and increases to employee contributions toward Other Post-Employment Benefits (OPEBs). The San Jose ruling upholds protections both for pension benefits that have already been earned and will be earned going forward. The ruling only has an impact on contracts for current workers. The changes for new workers were implemented and cannot be revoked.
 
It is the legal system, relying on previous rulings by the California courts, that will determine the extent to which government entities in the state can make changes to existing employee’s pension and benefit programs. Here is where the Pension Reform Act of 2014 may be needed to institute those changes. It should be noted that even if this initiative gets voter approval, it could still be challenged under federal contract law despite the state constitutional amendment. It is then possible for the U.S. Supreme Court to get involved, providing even greater attention to this issue.
 

Conclusions

For California, a retroactive expansion of benefits in the late 1990s has made the state’s pensions among the highest in the nation. Compounding the problems for many California cities are the financial constraints placed on them due to Proposition 13, which limits revenue-raising flexibility in what is typically a city’s primary source of funds – property taxes.
 
The structural constraints in California require bold constitutional action, and we anxiously await this new pension ballot initiative. In the meantime, we remain cautious about investing in many California local governments until some resolution is reached regarding this costly burden.
 
The judge in the ongoing Detroit bankruptcy case declared that employee pensions can be treated essentially the same as any other business contract and can be impaired, despite seemingly legal protections imbedded in the Michigan constitution. This ruling has sparked a debate on whether the super-senior nature of public pension contracts could change going forward and also whether this could encourage other local governments with pension problems to explore Chapter 9 as an option to reduce their liabilities. Hopefully, cities in California will not have to resort to this draconian measure.
 
The initiative would provide California municipalities with a way to address their fiscal stress, which is caused in part by pension costs, outside of bankruptcy. While Detroit may signal a change, the bankruptcies in California have not been used as a tool to address pension costs.
 
Howard Cure is the Director of Municipal Research at Evercore Wealth Management. He can be contacted at: [email protected].