Carbon Tax & The Public Sector Pensions

About a year ago I participated for a few months with an industry group that was attempting to insert some rationality into what is probably the most irrational, extremist, dangerous, job-killing, regressive laws in the modern history of the United States, AB32, California’s Global Warming Act. Unlike renewable portfolio standards, which can at least be justified by virtue of their potential to improve the U.S. balance of trade and promote energy independence, California’s global warming act is based on uncertain science and propelled by political opportunism. It is an utterly futile gesture, and even if it weren’t, most of the regulations being solidified regulate land use and manufacturing - because that’s where the money is from fees - even though the projected potential greenhouse gas reductions in those areas are relatively trivial compared to simply improving vehicle efficiency. If California’s AB32 isn’t repealed, it will be an unmitigated disaster.

While interacting with these lobbyists and public relations professionals, I ventured a theory that was met initially with skepticism, and later with growing acceptance. I suggested that the biggest source of looming government deficits was the underfunded pensions for public employees, and since public employee unions control our state and local governments, of course they will welcome any law that allows “fees” to be imposed to mitigate global warming, since the scale of these “fees” is estimated to be in the hundreds of billions of dollars, and nothing else can hope to eliminate deficits and make their pension funds solvent.

This is the reason we discuss the issue of public sector reform in this green publication. Global warming payments that flow from the private sector into the public sector - via taxes, fees, and sale of emissions allowances, are the biggest way public sector entities may avoid bankruptcies and drastic roll-backs of their benefit packages, which now exceed that of average private sector workers by a factor of 2-4x. Could this be why everyone in the public sector, including the teachers who are diligently giving our children diluvian nightmares, have completely embraced the global warming panic? Could it be they’re just trying to protect their retirements?

Today on our favorite Pension Reform website Pension Tsunami, there were links to two articles that bear analysis. One, “Hidden Pension Fiasco May Foment Another $1 Trillion Bailout” by David Evans, published on Bloomberg, accurately summarizes how public employee pension funds, for years, have overestimated the returns they can earn, underestimated the amount that needed to be contributed each year to the funds, and have underestimated the benefits these funds would eventually have to pay. This has gotten worse in recent years, as public sector employee unions have consolidated their power in state and local governments by controlling elections, and using as a pretext the phony prosperity of the internet bubble followed by the housing bubble, demanded unsustainable increases to the benefit packages of their members - often retroactively - from politicians whose survival depended on their obedience.

Here is one of the key points Evans made today on Bloomberg - he was referencing CALPERS, one of the nation’s largest public employee pension funds, but similar figures apply to most all public employee pension funds: “The nation’s largest public pension fund, California Public Employees’ Retirement System, has been reporting an expected rate of return of 7.75 percent for the past eight years, and 8 percent before that… Its annual return during the decade from Dec. 31, 1998, to Dec. 31, 2008, has been 3.32 percent, and last year, when markets tanked, it lost 27 percent.”

In response to this article, a spokesperson for CALPERS emailed a comment to Jon Ortiz’s “State Worker” blog, in a post entitled “CalPERS, other pensions, overstate return estimates and understate costs,” published by the Sacramento Bee:

“Beware of the anti-pension ideologues who come out of the woodwork during market downturns. Like vultures, they prey on the highly charged and negative investment environment, looking for ways to convince you a temporary performance downturn will be typical for all time!

They know — but don’t tell you so — that we set our rates based on a fiscal year investment return. They don’t tell you that our assumed rate of return is made based on advice from a range of experts within CalPERS and within the industry and that it is regularly evaluated every two to three years in public session. They don’t tell you what you would learn from a textbook on pension management: that some years investment returns are as expected; other years, they will be more than expected and yes, some years they will be less than expected.

They don’t tell you that over the last 24 years, we have exceed our assumed rate of return 17 times, and eight of those years were more than double the 7 3/4 percent assumed rate of return.
(And here’s an interesting fact: For five years after the Great Depression, there were multiple double digit return years.)

We will withstand the market swings, with our goal in mind: to achieve our assumed rate of return averaged over many, many decades. That’s what we are designed to do. That’s the math that matters.”

Our position on sustainable investment returns, as we document in “Humanity’s Prosperous Destiny” is that it is impossible for a fund as big as CALPERS to earn a sustainable rate of return beyond the real growth rate of the economy in which they invest - and that is about 3.5% per year. Surprise! That’s what CALPERS has earned over the past ten years.

The “math that matters” is indeed how much a large pension fund can earn over the long term, and it is interesting that nowhere in the CALPERS response is a solid rebuttal offered to Evans’ statement they have only earned 3.32% over the past ten years. How high would the preceding 10-20 years of returns have to be, for CALPERS to actually have earned an average rate of return of 7.34%?

To answer this, assume a 30 year timeline, and a fund earning 7.34% on average over these 30 years. Let’s further assume this fund earned 3.32% over the last 10 of those 30 years. An investment that earns 7.34% interest for 30 years will increase in value by a factor of 837%. That is, $100 invested with a return of 7.34% interest per year at the end of 30 years will be worth $837. If in the final 10 years of this period, the rate of return is only 3.32%, then in the first 20 years of the period, the investment would have to earn 9.41% per year. Did CALPERS earn nearly 10% per year on average between 1978 and 1998? Unlikely. Adjusting for inflation - impossible.

Two key factors have converged to make CALPERS and nearly every other public employee pension fund in the United States grossly underfunded if not insolvent, and the recent financial meltdown has only made us confront this reality sooner:

(1) They overestimated their real rates of return. With cost of living adjustments built into public employee pension plans, these funds have to calculate their funding requirements based on a real rate of return. Maybe CALPERS did average 9.41% on their investments between 1978 and 1998 - I doubt it - but the rate of inflation during many of those years was often in double digits. Was their real rate of return, meaning the percentage amount their investments earned each year, less the annual rate of inflation, sufficient to keep pace with future benefit payments? That is far less likely.

(2) They failed to appreciate the impact of retroactive pension benefit increases and pension “spiking.” When union controlled politicians granted increases to public employee pensions of 50% or more, they didn’t require this new benefit to only apply to the years these employees would work from then on, but applied it backwards, to all the years they’d ever worked. This grossly increased the amounts required to be in these funds. And instead of forthrightly stating such a benefit increase would require dramatically increased annual contributions for the funds to remain solvent, these fund managers pretended the recent debt fueled phony growth in the value of equities and real estate would go on forever.

As we explain in “Calculating Employee Compensation,” it isn’t what an employee takes home in gross salary that accurately measures their compensation. It is their total annual cost to the organization during the years they work, their salary and all their present benefits (including vacation and the many other paid days off enjoyed by public sector workers), plus the annual funding requirements for their retirement benefits - health care and pension. And by this measure, public sector workers make about twice what the rest of us make who pay the taxes to support them.

The solution: Unions in the public sector must be strictly regulated. They must be banned from participating in political activity, for starters. And from now on, public sector employees can get social security and medicare just like the American citizens they supposedly serve. If not completely liquidated, public employee pension funds should be phased out, existing only to fulfill some realistically scaled back obligation to existing public sector retirees or those nearing retirement.

The alternative to public sector reform is phony rationing in the name of saving the earth from climate change. Instead of investing in infrastructure - power plants, freeways, bridges, desalination plants, aquaducts, reservoirs, those things that enable prosperity and abundance, and the wealth to address genuine environmental problems - we will screw in expensive toxic mercury lamps to save a few electrons, live like sardines in overpriced cluster homes behind “urban service boundaries,” and cash our carbon chips to BBQ an occasional steak, while public sector nomenklatura will collect the proceeds of the emission auctions, taxes and fees attendant to this “mitigation,” and retire 10-20 years before the rest of us.

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