Public pension plans across the nation are in fiscal distress. Generally underfunded, most now require far greater contributions from governments than initially envisioned. Indeed, high costs associated with retirement benefits contributed to both Stockton’s and Vallejo’s bankruptcies. They now pose serious threats to other localities, and the state as well.
Among California’s cities, Los Angeles has the largest pension obligation. Regularly facing budget deficits, the city has generated increasing scrutiny for the rising costs associated with contributions to its pension plans. Los Angeles faces a $222 million budget deficit for the current fiscal year and a forecasted $427 million deficit for fiscal year 2014-15. Pension costs are a large component of city spending. In 2012-13, Los Angeles’s pension costs are expected to rise to $1.3 billion, or 18% of the city’s budgeted expenditures. In 2002-03, just 10 years ago, pension costs were only $157 million, or 3% of total expenditures. In fact, over the last decade, pension costs have grown at an annual average rate of 25%, significantly outpacing growth among all other major areas of the budget.
The city’s pension costs are rising principally because over the last decade, Los Angeles’s pension funds have performed well below the investment rate those funds assume they will earn. To make up for the failure to earn the expected return, the city has had to make larger and larger annual contributions to these funds in order to fulfill promised obligations to employees and retirees.
In order to have sufficient funding to pay for all benefits earned, Los Angeles should have accumulated $41.1 billion in its pension trust funds. Instead, the city only has $31.7 billion in assets, leaving it with a $9.4 billion unfunded liability. This pension liability is calculated assuming that the pension trust funds will earn a 7.75% average annual rate of return.
Supported by recent investment shortfalls, many have stated that using such a return rate assumption is overly optimistic and that the actual liability is therefore higher than reported in city totals. Moody’s Credit Rating Agency has proposed a change to its methodology: it would use a 5.5% investment assumption that is based on recent average yields on high-grade long-term corporate bonds. Using this assumption for measuring unfunded liabilities would boost Los Angeles’s unfunded balance to $25.9 billion, meaning that the city would have to contribute even more to its pension plans.
To reduce pension costs, to date, city officials focused on reducing pension benefits for new employees, but such an approach is insufficient for achieving significant reform. Reducing benefits for new employees and not current employees and retirees has no impact on the existing unfunded liability and still leaves the city with the tab for pension benefits that have already been earned. Absent meaningful reform and/or greatly improved investment performance, pension costs will continue to rise and more and more of the city’s budget will be directed to retirement benefits instead of public services.
In this analysis of the Los Angeles pension system, we examine in greater detail the growth of the city’s pension expenses, the causes of the growth, and the challenges the city faces in handling its pension problems.
Our findings include the following:
- In 2012-13, Los Angeles’s pension costs are expected to rise to $1.3 billion, or 18% of the city’s budgeted expenditures. In 2002-03, just 10 years ago, pension costs were only $157 million, or 3% of total expenditures.
- Over the last decade, pension costs have grown at an annual average growth rate of 25% and have outpaced spending growth for every major area of the city’s budget.
- In 2012-13, the city of Los Angeles is expected to spend up to 32 cents toward pension benefits for every dollar it spends on total payroll for its employees. Employees will pay 9 cents for every dollar of payroll.
- From 2003 to 2012, the total official funding ratio of the city’s pension plans declined from 99.7% to 77.2%. Correspondingly, the city’s officially-reported unfunded liability increased from $87 million to $9.4 billion, more than a 100-fold increase.
- The growth in the unfunded liability and declines in the funding ratio are largely attributable to investment returns falling below the rate pension plans assumed they would earn (on average 7.75% per annum, net of expenses, on a portfolio consisting largely of bonds and equities). Over the last 10 years, LACERS, LAFPP, and LADWP pension trust funds have earned compound annual rates of return of 6.46%, 6.68%, and 5.11%, respectively. Over the last five years, these return rates were 0.68%, 1.06%, and 1.47%, respectively.
- Using Moody’s investment return assumption (5.5%), the unfunded liabilities would nearly triple to $25.9 billion.