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LA Forecast: Pensions and Budget Will Be Clobbered by Poor Investment Returns

LA WATCHDOG-The California Public Employees’ Retirement System (CalPERS) reported that its investment portfolio lost 1.9% for the first five months of its fiscal year (July to November). 

For the six months, the loss will be even greater because the Dow Jones Industrial Average is down more than 10% for the month of December.  

This would push the loss to more than 4% for the first six months of the fiscal year. 

This adverse investment market will have a negative impact on the City’s two pension plans, the Los Angeles Employees’ Retirement System and the Los Angeles Fire and Police Pensions.  They are already $15.3 billion in the hole when using the more realistic investment rate assumption of 6¼%.  This implies a funding ratio of a dangerously low 72%. 

If the City’s two pension plans were to suffer an annual loss of 4% on the $39 billion investment portfolio, the unfunded pension liability will increase to around $20 billion.  This results in a funded ratio of only 64%.  

[Note: After a nine-year bull market, the City’s pension plans should be overfunded (more than 100%) so that they can withstand a down market.] 

This 30% increase in the unfunded pension liability is a function of the $1.6 billion loss on the investment portfolio and the failure to earn the projected 7¼% return of $2.8 billion that is an integral part of the actuarial calculations in determining the City’s Annual Required Contribution (“ARC”).  

The impact on the ARC on the City’s budget is where the financial hijinks come into play. 

Rather than recognizing the 4% loss in a single year, the City utilizes a “smoothing” technique that allows the City to use a seven-year average rate of return.  This allows the City to avoid wide swings in its ARC caused by variations from its targeted rate of return.  This is a common actuarial practice used by public pension funds, although most public pension funds use a five-year average.     

By using a seven-year average, the rate of return is assumed to be 7.75% as opposed to the 4% loss. This then reduces the unfunded liability by $4 billion because the actuaries recognize a $3 billion gain as opposed to a $1.6 billion loss, lessening the need to amortize the additional unfunded liability. 

It is very difficult to determine the next year’s ARC because of the complexity of the actuarial calculations.  However, the City’s contribution is expected to increase by an estimated 10% ($120 million), a rate substantially higher than the projected growth in City revenues of 2%.  This disparity in growth rates contributes to the City’s Structural Deficit. 

Next year’s expected pension contribution of $1.32 billion is about 20% of the General Fund budget of $6.3 billion.  But this amount is understated because it relies on the overly optimistic investment rate assumption of 7¼%.  If the still optimistic rate of 6 ¼% is used and the assets are marked to market instead of relying on the smoothing assumptions, the pension plans will be shortchanged by anywhere from $600 million to $1 billion.  

This level of contributions would devour over 30% of the City’s $6.3 billion.  

Unfortunately, Mayor Eric Garcetti, City Council President Herb Wesson, Budget and Finance Chair Paul Krekorian, and Personnel Chair Paul Koretz have their heads in the sand, refusing to recognize reality, hoping that a strong market will eliminate the $20 billion unfunded pension liability.  

This is wishful thinking, even for La La Land. 

Now is the time for the City to follow up on the LA 2020 Commission’s recommendation (endorsed by Wesson in a 2014 press conference) to establish a transparent and independent commission to review and analyze the City’s two pension plans and their impact over the next ten years on the City’s budget, using realistic, market-based assumptions.  The commission would also develop recommendations to fully fund the pension plans within 20 to 30 years. 

Without reforms, the financial requirements of the pension plans will continue devour the City’s budget, resulting in even fewer services and/or significantly higher taxes.  

Sorry to be a Grinch on Christmas. 

 (Jack Humphreville writes LA Watchdog for CityWatch. He is the President of the DWP Advocacy Committee and is the Budget and DWP representative for the Greater Wilshire Neighborhood Council.  He is a Neighborhood Council Budget Advocate.  He can be reached at:  lajack@gmail.com.)

-cw