Thursday, January 06, 2005

Arnold Fights the Civil Service Pension Monster 

If any further evidence were needed to show that government by sound bite is a stupid idea, the four amendments to the California Constitution that Governor Gropinator proposed to the voters yesterday should convince even the most skeptical. Folk wisdom tells us that "the devils are in the details", and the details are still under wraps, but it's clear from the summaries given to the news media that each proposal holds a whole bagful of devils just itching to be set loose. The last post commented on the problems inherent in budgeting by plebiscite and the practical difficulty in making automatic across-the-board budget cuts, so now let's see what else is in der Governor's special effects kit.

Arnold's second proposal is a state constitutional amendment aimed at wrecking California's public employees retirement system. Technically, it would change the retirement plan offered new state employees from a "defined benefit" system to a "defined contribution" arrangement. "Defined benefit" is a synonym for "pension plan", under which retiring workers receive annuities (a lifelong series of payments) based on their age at retirement, the number of years they worked, and their pay before retirement. [Full disclosure note: one could argue that California's current formula, which provides annual pensions of 2% times final compensation times years of service for those retiring at 55 is overly generous, but as a recent retiree from State University teaching and consequently a recipient of such payments, Professor Tax will leave that task to others.] In a defined contribution plan, on the other hand, some percentage of each employee's pay is set aside each year in an individual account for that employee, whose retirement income will depend on the investment results for that account. These plans are named after tax code sections or have weird acronyms, like "401K" , "403(b)", "SEP-IRAs", and "SIMPLEs" (which they aren't.)

The basic difference between defined benefit and defined contribution plans is in who bears the risk. In a defined benefit plan the employer must make up any shortfall if the plan investments don't produce enough to cover the projected benefits. On the bright side, employer payments into the plan can decrease if the investments do especially well. However, with a defined contribution plan each employee bears the risk. A participant who trustingly puts all their money into the stock of WorldCom -- or whatever enterprise turns out to be the next Worldcom -- will retire in penury. Someone who embraces the safety of a guaranteed but fixed return may well find that inflation turns their working dollars into retirement pennies. Tough luck, buddy -- with a defined contribution plan, you're on your own.

So why does Arnold want the State of California to join the many corporate employers who have been replacing defined benefits with defined contributions in order to shift investment risk onto their employees? Why replace the predictable uniformity of civil service pensions with the wild variability of individual accounts? Surely, Arnold is not worried about his own retirement finances as a rich and successful former movie actor. And
the statistics the Governor invoked in the State of the State address don't make any sense:

"California's pension obligations have risen from $160 million in 2000 to $2.6 billion this year. Another government program out of control, threatening our state."
These numbers just reflect the fact that Cal-PERS, the state's pension fund, benefited from the stock market boom of the late 1990s so state contributions to this defined benefit plan could be reduced. The stock market bubble collapse put a dent in plan assets, so the state contribution had to go up to keep the plan in balance. Is Cal PERS well-managed and efficient? According to the most recent online annual report, CalPERS had administrative expenses of $299 million in the course of paying $7 billion in pensions to 396,000 retirees and tracking over 1 million member accounts, while operating $1.5 billion in health insurance programs and a billion dollar long term care program. Investment expenses came to $219 million -- which seems like a lot, but is only 15 basis points (0.15%) of the huge and highly diversified portfolio which held $144 billion in assets. The investment results match the market, more or less, for the simple reason that an investing behemoth like Cal PERS *is* the market.

Fifteen basis points. That's pretty efficient. Compare that to the fees and transaction costs that individual employees are likely to encounter in trying to manage their own defined contribution plan investments. A December 2004
study by the Investment Company Institute found the total shareholder cost of equity funds (defined as the sum of fund expenses and annualized loads incurred by buyers) was 125 basis points or 1.25% of the amount invested during the year. Bond funds, with generally lower operating expenses, had a total shareholder cost of only 88 basis points.

"Wait a minute, Professor Tax. I don't get it. If Cal PERS's defined benefit plan is less risky for participants and is more efficient at investing, then why does der Governor want to amend the state Constitution to deny these benefits for all new state employees, requiring them to use risky and inefficient defined contribution plans instead? In the long run, won't this mean that Cal PERS will just waste away, because no new members can join and existing members will die, leave or drop out? And it's such a gradual change, as the state employee workforce turns over, that it won't be much help for the state budget in the near future. What's going on here?"

Excellent questions. Professor Tax suspects that two "special interests" -- two of the Governor's own pet devils -- are behind this proposal. It must be very frustrating for investment managers on Wall Street, Montgomery Street or Bunker Hill when they see this enormous pool of assets being managed so cheaply. If the CalPERS asset base were privatized and operated like a typical
mutual fund, there would be an additional 110 basis points = 1.1% = $1.6 billion available for fees and profits for fund management companies. You can practically hear them salivating at the prospect. It is also the case that CalPERS has been a leader in pressing for improved corporate governance in American boardrooms. What a nuisance it is for corporate America to have a large activist shareholder like CalPERS. How nice if CalPERS could be punished for activism by a "reform" that cuts off its funding base.

Think about it. Some folks in Washington want to privatize Social Security in order to generate fees for the investment houses and to motivate workers by making retirement incomes less secure. Now Arnold is giving them an additional chance to vent their irrational hatred of government by wrecking California's civil service retirement system. Better yet, Arnold has people thinking that this is "reform". If it weren't so amusing it would be disgusting.

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