This piece first published June 6, 2017, Debtwire Municipals
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California Governor Jerry Brown’s (D) proposal to double the state’s FY18 pension contribution by borrowing from a USD 70bn pooled money account is a gamble, said Joe Nation, a professor at Stanford University and former state lawmaker.

On one side of the bet is an arbitrage between the 7% the California Public Employee Pension System discount rate and 88bps that the pooled money account yields. On the other is the risk of a cash shortfall should the economy falter or federal policy turn against the state.

California’s budget faces some uncertainty in coming years – the combination of uncertainty of federal actions and the economy could create challenges to the state’s general fund, said Chris Hoene, executive director of the California Budget and Policy Center. But that uncertainty might be why it makes sense for the state to control mounting pension costs now, he said.

The worst-case scenario is a situation in which the money loaned from the pooled cash fund was needed to finance operations, a possibility in a downturn economy or another extreme situation, said Brad Williams, partner at Capitol Matrix Consulting.

“The differences in the rates of return are large enough that even if market conditions change, it likely works out in the state’s favor,” Hoene said.

Make your money work for you

Brown recommends a USD 12bn contribution to the California Employees Retirement system (CalPERS) in his FY18 budget, beginning 1 July – more than twice the amount of the USD 5.8bn actuarially required contribution (ARC).

The surplus funds would come from the state’s USD 70bn Pooled Money Investment Account, California’s short-term savings account, which has an average effective yield of 0.88%, according to the Legislative Analyst’s Office (LAO).

CalPERS reported the state’s plans have an unfunded liability totaling USD 59.5bn and a 65% funding ratio in FY16, according to Brown’s revised budget. At normal funding levels, California’s ARC is expected to grow by about 58% to USD 9bn by 2024 as CalPERS reduces the discount rate to 7% from 7.5% by 2020.

The proposal seeks to capitalize on projected investment returns from CalPERS over the next two decades. That expected rate of return far exceeds the 88bps return currently accumulating on the Pooled Money Investment Account. By frontloading an ARC payment now, the state expects to reduce the cost of employer contributions by USD 12bn over the same time period.

“It’s a gamble, and the question is whether or not they feel lucky enough to do this,” Nation said. “The assessment’s been made, (they believe) it’s worth the gamble, but my gut tells me it’s not worth the gamble and it’s better to work on the fundamentals of the problem.”

More reform necessary

The proposal is “creative,” though a better strategy for boosting CalPERS is addressing the underlying problems, Nation said. One of the problems is CalPERS’s unrealistic economic assumptions, he said.

“Although they’re moving in the right direction, in terms of reducing the (discount) rate to 7%, that even contradicts their own internal assessment they’ll earn 5.8% in the next years,” Nation said.

But any plan that works to reduce CalPERS’s unfunded liability is worth consideration, said Williams. Given the surplus in the pooled cash fund, circumstances make sense to increase the pension contribution, accelerating repayment of a portion of the state’s existing USD 59.5bn liability to CalPERS, he said.

Even if the rate of return on pension investments declines, or if the rate of return on the short-term investment account increases, the arbitrage still benefits the state and allows the increase of payments to CalPERS without sacrificing the general fund, Hoene said.

Cashflow and investment risk

There are risks associated with the plan, Williams said. Some of the programs that need day-to-day funding could be at risk where you face a cashflow crisis, though it seems remote given how flush the fund is, Williams said.

The state’s general fund will be on the hook for contributions to CalPERS in the next few years that will increase and if the state doesn’t do something to mitigate the impacts and increase of contributions, it will come at the expense of other vital state programs and services, Hoene said.

“There’s no question there are (investment) risks associated with this proposal, but it may be a worthwhile risk. It’s a historic opportunity given the (pooled cash fund’s) balance,” Williams said. “It ought to make sense, but it’s not risk-free.”

The State of California is rated Aa3/stable by Moody’s Investors Service, and AA-/stable by S&P Global Ratings and Fitch Ratings.

A USD 77.8m tranche of 5% Series 2017 State of California general obligation bonds due 2030 last traded in odd lots at 121.329 to yield 2.445% on 1 June.

By Maria Amante