California’s Hidden Expenses: Part II
Governor Brown budgets $9 billion for pension contributions for FY2017–18:
But even that large figure (83% higher than five years ago) is understated by $4.5 billion. That’s because the $9 billion figure is based upon an unrealistic assumption that state pension funds (CalPERS and CalSTRS) will earn a 7.5 percent annual return on pension assets.
Money expected to earn 7.5 percent is expected to double every ten years. CalPERS and CalSTRS invest $500 billion. That means they’re expecting to turn $500 billion into $1 trillion by 2027. And then double again and again because pension liabilities last for decades. Sound realistic to you?
It’s hard to double $500 million, much less $500 billion, every ten years.
A decade ago Warren Buffett explained the folly of such absurd investment returns. Still, CalPERS and CalSTRS continued on the same path. In contrast, Buffett assumes a 6.5 percent return for his pension plan.
A lower return assumption forces larger contributions, as explained here. If CalPERS and CalSTRS assumed a 6.5 percent investment return assumption, state contributions would be ~$13.5 billion.
The failure to contribute an extra $4.5 billion this year will produce an extra $15 billion of pension debt to be paid off by the next generation.
Governor Brown could choose to disclose the truth in his budget. Ie, even though California’s pension funds are using inflated investment return assumptions in order to deflate current pension contributions, Governor Brown could reflect the true cost in his budget. That would both protect future generations and inform current legislators of the true amount of money they have available to spend. The governor should elect this approach in the May Revision to his budget and set a powerful precedent.
NB: California’s pension funds should assume even less than Buffett’s 6.5 percent because $500 billion is much harder to grow than the $13 billion in pension assets managed by Buffett (see footnote 21 here).