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Gov. Brown's pension-reform plan: Painful but necessary

Jerry Brown

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California Governor Jerry Brown announces his public employee pension reform plan October 27, 2011 at the State Capitol in Sacramento, California.

Jerry Brown rolled out his pension reform plan yesterday. The Patt Morrison Show did an entire segment on it. The upshot? it's a humdinger. The New York Times sums it up:

Mr. Brown called for raising the retirement age of new employees who do not work in public safety to 67 from 55. He said employees should pay up to 50 percent of their annual pension costs. To reduce the financial exposure of the state, he said future pensions should be a hybrid of the traditional pension model and a 401(k).

To deal with what have been widely seen as abuses of the retirement system, Mr. Brown said the pensions of all new employees should be based solely on their regular salaries, not taking into account any overtime or bonuses. For existing employees, he said the retirement benefits should be based on an average of the last three years’ salary.

He also said that state employees should be barred from double-dipping: retiring, taking pensions and then taking on another state job.

Forget about the abuse, double-dipping — that stuff is all a sensationistic distraction from the meat of the matter, which is the raising of the retirement age and the "hybrid" model for future pensions. (To be honest, I'm not completely sure what the impact of the 50-percent employee payment would be — that's less a state issue than a municipal one, which the cities might ultimately be unable to afford.)

The retirement age hike is a big deal: a 12-year additional wait to access benefits. For all practical purposes, it ends early retirement on a pension as we know it. Plus, it aligns the California retirement age with what will be the eventual national retirement threshold, also 67 (for retirees born after 1959 — if you were born after 1938, the age will gradually creep up from 65 until it hits 67). 

Who knows whether Brown set the age so much higher because he figures he may ultimately have to compromise on something between 55 and 67. The crux is that it's irresponsible for Calfornia to hold the line on 55 in the face of the pension costs that over time will drive the state into insolvency. Californians are living longer; they're also going to have to work longer.

A bolder change is the move from a traditional pension to a hybrid that would shift the investment risk from the state to individual. Calpers, the big state pension fund, was fully funded in 2007, but now it's only 70 percent funded. Additionally, Calpers needs a 7.75 annual return on its investments to meet its obligations. It's only ever beaten that on a 20-year basis, at 8.38 percent. Since 2006 Calpers has returned 3.41 percent.

Big pension funds have been successfully moving into riskier investments, such as private equity and hedge funds. But this risk obviously makes fund managers and politicans, not to mention current and future retirees, nervous — pension funds are supposed to be conservatively invested, not swinging for the fences in hopes of making up for the bad years.

But Calpers isn't in a position to do that. It needs that 7.75 percent like a drum needs drumsticks. But it's difficult to see where it's going to come from, outside risky plays. A lot of investment pros think they markets will be lucky to return 6.5 percent over the next decade or so.

The thinking in Sacramento is that the risky side of the equation can be offloaded to individuals. The state can then focus on a return that's designed to beat the rate of inflation — say, 4-5 percent — and leave individuals to chase 8-10 percent. This could be a viable solution, as long as the state encourages its hires to educate themselves on how retirement planning works, outside defined-benefit traditional pensions. Many participants in 401(k) plans do a lousy jobs of managing them.

Pensions is California must be reformed (Michael Lewis recently wrote an entire Vanity Fair article on the subject). Gov. Brown has taken the first, very big step. Let's hope that he doesn't wind up falling on his face.

Follow Matthew DeBord and the DeBord Report on Twitter.

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