California Pension Death Star Approaching

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Contributed by Chriss Street. Specialist in corporate reorganizations and turnarounds, former Chairman of two NYSE listed companies. His latest book, The Third Way, describes how to achieve management excellence and financial reward by moving organizations from Conflict and Confrontation to Leadership and Cooperation. He lives in Newport Beach, CA.

When Moody’s Investors Services issued a “Request for Comment” last July about their plan to begin recalculating the effect of massive state and local unfunded pension liabilities on credit quality, I warned that this would eventually result in across-the-board slashing of municipal bond credit ratings and numerous municipal bankruptcies in California.  It now appears that I may have understated the risk for California.

The California Public Policy Center (“CPPC”) just released a report analyzing the impact of the Moody’s new policy on six Northern California counties (Alameda, Contra Costa, Marin, Mendocino, San Mateo, and Sonoma).  Their conclusion is that when the new rules are applied, the annual cost of pensions will increase from the equivalent of about 50% to 100% of these counties’ net property tax income.  With the state running new deficits after already raising state income taxes to the highest level in the nation, Californian homeowners should be prepared for their politicians to try to overturn Proposition 13 that for 35 years has limited California property tax rate increases.

Given that California has only 11% of the U.S. population, but issues 20% of all of the nationwide municipal bond volume, Moody’s warned they would be re-assessing the financial condition of all California counties and citiesto reflect the new fiscal realities and the governmental practices“.  Moody’s that a greater share of municipal bankruptcies are expected to come from California.  California State Treasurer’s office tried to reassure the public by calling the Moody’s warning “a little hyperbolic” and stating that “No city’s going to blithely skip into bankruptcy court to avoid its obligations.”  But today over 50 of 482 California cities have declared a “Financial Crisis” and have considered filing for Chapter 9 municipal bankruptcy.

CPPC’s analysis used data from the most recent county Actuarial Valuations to produce four core restatements of solvency – total pension debt, unfunded pension debt, government normal yearly contributions, and amortization payments of unfunded pension.  CPPC determined that for the four adjustments Moody’s is expected to make – two would have very significant impact on county solvency:

  • First, pension debt would be adjusted using a high-grade long term corporate bond rate (5.5% for 2010-2011) instead of a Pension Fund’s target rate of return (7.75% more or less)
  • Second, government payments to Pension Funds would be adjusted to reflect the lower discount rate, the need to fully fund pensions by the time employees retire, and a 17 year level-dollar amortization of unfunded pensions.

In their Actuarial Valuations, the counties claim they have conservatively banked 78% of their pension liabilities in cash and securities, leaving only $4 billion in under-funding.  But with the Moody’s adjustments will increase the unfunded pension obligations by $6 billion, balloon the unfunded liability to $10.2 billion and the cash and securities funding down to a speculative level of 58%.

At a 78% funding level, the six counties are only required to contribute 29% of their payroll, or about $640 million, to fund their pension plans each year.  But under the new Moody’s formula that will drive down their funding level to 58%, the counties required annual pension cost will sky-rocket to 63% of payroll, or $1.4 billion per year!

California has run huge budget deficits for the last decade.  Recently voters passed Proposition 30 as a $6 billion state income tax increase on top earners in hopes of rescuing schools by balancing the state budget.  But according to the California State Controller’s just released December financial statement, state spending is $900 million over budget and state tax revenue is at least $360 million under budget.

For the last 35 years, California politicians have been forbidden from jacking up property taxes by the 1978 voter approved Proposition 13 Initiative.  The initiative has been so popular with homeowners that it has been referred to as the third rail of California politics.  But as the CPPC study demonstrates, the annual cost of pensions will soon increase from the equivalent of about 50% to 100% of these counties’ net property tax income.  With the state already running new deficits on top of the highest income taxes in the nation, it is my belief that California politicians will soon try to over-turn “Prop 13.”

CHRISS STREET & PAUL PRESTON Present
“The American Exceptionalism Radio Talk Show”
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