The tiny Sierra Nevada mountain town of Loyalton, Calif.—population: 862—has become the poster child for cities that want to check out of the California Public Employee’s Retirement System, but can’t swallow the insurmountable cost of leaving. Loyalton’s oft-repeated tale appeared again this week, on Sunday in the Los Angeles Times.

All the familiar characters are there, in the Times story. There’s CalPERS demanding far more money than the city spends on its entire annual budget. There are cash-strapped city officials struggling to make ends meet (even though their spending priorities were criticized by a 2014 grand-jury report). And there are retirees looking to get by on 40 percent of their promised pensions.

The only thing missing is a solution.

Sen. John Moorlach, R-Costa Mesa, has proposed a serious solution in the state Capitol, but the legislation has a ballpark-zero chance of passage given the power of union-allied Democrats. His Senate Bill 681 would allow an agency to “terminate its contract with CalPERS in a manner that does not result in excessive costs or penalties” while ensuring that the agency is responsible for the full costs of its employees without shifting them onto other CalPERS participants.

Though it would seem fair – and would better protect promised benefits in Loyalton and other agencies facing a similar situation – the measure is opposed by several unions. They know that once an agency has exited the system, CalPERS cannot collect anything from it in the future. That’s why CalPERS’ current approach reminds Moorlach of the lyrics from the Eagles’ song, Hotel California: “You can check out any time you like, but you can never leave.”

In 2013, the Loyalton City Council voted to end its contract with the California Public Employees’ Retirement System, the $300 billion behemoth that manages pensions for the city’s four retirees and single full-time employee. Loyalton “voted to pull out of CalPERS when its last pension-eligible employee retired,” according to the recent Times article, “deciding the monthly payments were too steep for a town that for years flirted with insolvency.”

But CalPERS wasn’t about to let the city go. In June 2014, it handed Loyalton a bill for a $1.66 million “termination” fee. Given its small $1 million annual budget, Loyalton couldn’t come up with the funds. The result was every public employee’s nightmare: Beginning last November, retirees had their modest pension checks cut by 60 percent. Some other small agencies that left the CalPERS system are looking at major cuts in retiree benefits, too.

The fund, whose sole purpose is to protect the retirement benefits of California public employees, was remarkably cold-hearted about the situation. “As a board, we have a fiduciary responsibility to keep CalPERS Fund on secure footing, and as part of this duty we must ensure that employers adhere to the contracts they agreed to,” CalPERS wrote in a November statement.

Certainly, contracts need to be honored, but there’s something seedy about the way the system is designed. During a recent legislative hearing, Moorlach focused on the most relevant point: “When you want to exit, they use a whole different discount rate … It could be like 2 percent.” That’s a shocking revelation, although it needs some explanation.

The predicted rate of return on CalPERS’ investments determines the size of the system’s unfunded liabilities – i.e., the shortfalls to meet promises made to California public employees. CalPERS expects to earn 7 percent(recently lowered from 7.5 percent) on those investments. The higher the predicted return, the better the financial shape of the system.

Public employees are promised a pension based on a formula (the number of years worked multiplied by a percentage of the final years’ salary) and taxpayers are responsible for any shortfalls. So the pension fund, and the unions and politicians, have a vested interest in keeping the earnings assumptions as high as possible to downplay any predicted shortfalls.

Moorlach revealed a dirty little secret. The agency is bullish about the stock market when the public’s money is at risk, figuring that 7 percent is a fair rate to expect. But when cities want to exit the fund, CalPERS becomes shockingly conservative, given that its own money is on the line. It then assumes a miniscule rate of return. CalPERS assesses those high termination fees to make up the difference between its overall fund and the special fund for terminated agencies, which can no longer depend on taxpayers to make up for future downturns.

As that Times article noted, the federal judge handling the Stockton bankruptcy case “called the fee a ‘golden handcuff’ and ‘poison pill’ that prevents cities and other local governments from leaving CalPERS to find other options for employee pension benefits.” When the fund tried to assess a $1.6 billion fee on Stockton, that city stayed in CalPERS and didn’t reduce pensions for current employees and retirees. Those current and former employees still enjoy lush deals, even as the city raised taxes.

Ironically, CalPERS’ defenders criticized a 2011 Stanford study that projected a 4.1 percent rate of return as realistic, yet the fund’s handling of the Loyalton exit is a tacit acknowledgment that the system’s expected returns are unrealistically high and that pension debts are far larger than the state will acknowledge.

Meanwhile, CalPERS maintains big surpluses in the special fund for those agencies that terminated their accounts — $111 million, according to the Times. CalPERS apparently has thrown a handful of low-earning, small-town public employees under the bus to make an example for other agencies and protect the inordinately high earnings of many public employees, especially those in the public-safety and management professions.

Former San Jose Mayor Chuck Reed, a Democrat who had placed a pension-reform measure on that city’s 2012 ballot (it passed with 70 percent support, but was gutted by the courts), has described the Loyalton situation as a “wake-up call” for underfunded pension systems. “Failure to fund pension obligations as they are incurred makes retirement security impossible,” he wrote in the San Diego Union-Tribune in December.

For now, these retirement-security issues fall heaviest on some small agencies with the audacity to try to leave the nation’s largest state pension fund. Presumably, public employees and retirees in agencies deemed “too big to fail” can continue to sleep without fear. But it reminds one of another line from Hotel California: “Up ahead in the distance, I saw a shimmering light.” How long will it be before Loyalton’s problems afflict bigger California cities?

Image by 01010011Portfoliolab

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