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California: The Trouble With Kicking the Can Down the Road

It didn't have to be this way. Had California accounted for its promises, billions would not have to be taken from discretionary programs, which is just the first wave of a massive tsunami: our underfunding is simply staggering.
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During the current state budget crisis we've heard a lot about "kicking the can down the road." Of course, everyone knows what that phrase means in the traditional sense -- "to put off" -- but not everyone understands what it means in a fiscal sense.

It boils down to this: while Governor Schwarzenegger and legislators agree that reforms are needed in order to reduce waste, fraud and abuse, what some legislators, including Speaker Bass, have seemed to disagree about is when to undertake those reforms. The Governor says we should get to them now because they can help both close the current deficit and save money going forward, while the Speaker says we should put them off until later and just close the current deficit even if that means higher costs down the road.

To understand the importance of this difference of opinion, let's examine the impact of just one such kicked can.

On September 10, 1999, the California State Legislature promised tens of billions of dollars of future pension payments to government employees, but kicked to the future the funding of those promises. The legislation -- the equivalent of racking up credit card debt without the ability or a plan to pay it back -- became law, and the money was never set aside. Now, the promises are coming due and the bill is being paid by taking money from higher education, environmental protection, health care, welfare and other discretionary programs long supported by Democrats like me.

When added to already-issued-but-underfunded pension and retiree health care promises totaling over a trillion dollars, the 1999 promises effectively were a death-knell for those programs. This year alone California must contribute $3 billion to meet past pension promises -- $3 billion that otherwise could've gone to those programs. And those costs will just rise from here.

Worse, even that $3 billion is just a tiny fraction of what's really owed and what'll be paid. That is because, using accounting practices not unlike those employed by General Motors (GM) to kick its own can down the road, California has dangerously under-reported the size of these promises.

Here's how it works. When promises for deferred compensation such as pensions and retiree health care are made to employees, sufficient monies are supposed to be set aside at the same time and invested in order to grow large enough to meet the promises. The amount of money to be set aside is a function of how successfully that set-aside money is expected to be invested. The greater the assumed investment return, the lower the set-aside when the promise is made, and vice versa. If those assumed investment earnings arise, all's well. But if not, money must be added in the future to meet the promise.

GM's trick was to assume an unrealistically high investment return. That way, when the promises were made, less money had to be set aside, making GM's earnings look rosier. And that way GM could have its cake -- make labor happy without hurting earnings -- and eat it too.

But at some point all such promises come due, and that's when their costs are revealed. We saw how GM's can-kicking turned out, with the company going into bankruptcy, retired employees losing full retirement benefits, active workers losing their jobs, and shareholders losing their investments.

For decades now California and other state and local governments have been doing exactly the same thing. By assuming unattainable investment returns, the state has been making promises but underfunding them, assuring massive demands on future general funds. But there are two big differences between the state and the corporate sector: first, unlike GM's workers, state employees will receive their pensions no matter what, because the state cannot go bankrupt and therefore budgets for the University of California, California State University, health, welfare and other discretionary programs will be invaded to make good on the promises; and second, public pension problems are much bigger.

As Warren Buffett puts it:

"Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate."

It didn't have to be this way. Had the state accounted for its promises rather than kicking that can down the road, true costs would've been revealed, proper funding would have been required or no such promises would've been made, and discretionary programs would've been protected. But instead, politicians chose to kick the can, and down a very low road.

As a result, the billions taken from discretionary programs this year is just the first wave of a massive tsunami because the amount of our underfunding is simply staggering and our aging workforce is rapidly retiring. Our state pension funds refuse to provide anything but a GM-like disclosure, but with New York City as an example -- Mayor Bloomberg's administration supplies a more conservative accounting of pension promises alongside its official, GM-style, accounting -- California has kicked that can into a $200-300 billion obligation that grows every year that it's kicked down the road again. That's three to five times the amount of our general obligation bonds, and just as real of an obligation.

To be clear, we are supposed to have that $200-300 billion on hand for investment by our pension funds right now. Every year we don't, the can grows. As an indication of just how much money will need to be taken from discretionary programs to fulfill these promises, paying off that liability over 15 years would require $19-28 billion per year. Over 30 years would require $12-18 billion per year. New York has just predicted that local pension contributions will triple by 2015, and even that is short of what they need.

Also, unlike Medicare and Social Security, our promises are contractual. Congress can eradicate Social Security and Medicare obligations at any time by changing the law, but our promises are binding, no different than our obligations on GO bonds. So make no mistake: these staggering amounts will be paid, and the more we kick them, the more they'll be. And there's no end in sight, because we continue to make more such underfunded promises every day.

During recent budget discussions, some of our state politicians have acted as if they are unaware of the negative impact of these unfunded promises on programs they champion. Indeed, one of the sad ironies of today's state budget debate is that some of the same politicians who are outraged at the plan to cut expenditures in order to close today's deficit voted in 1999 for that bill that retroactively and prospectively boosted pension promises, the effect of which was to issue billions of dollars of new obligations that can only be paid by -- you guessed it -- taking money from the very programs they're outraged now about cutting. They may not have known it then, but on that fall day in 1999, they issued a death sentence for those programs.

While there is nothing we can do about promises already made, we can do something about reducing the size of new promises. No single step would reduce the burden on discretionary programs more than reducing future pension payments. And we can face up to the oncoming tsunami and stop hoping that mythical investment returns or fairy-tale general fund revenue boosts will somehow bail us out. The same goes for tax increases, because not even the most left-leaning legislator is likely to call for a $200-300 billion tax increase and even fewer are going to vote for one. This year's increase in pension contributions is no fluke, our general fund is going to be inundated by demands for hundreds of billions to satisfy past promises, and we must plan for their funding.

And we must stop kicking ALL cans down the road, treating our kids as our piggy bank and failing to properly account for our obligations. Every unneeded, wasted or fraudulently-obtained dollar is a dollar that must be taken from UC, CSU, health, welfare and environmental protection. This is why now is the time to reform pensions, adopt a welfare reform along the lines of the reform championed in 1997 in Illinois by then-State Senator Obama, and impose common-sense requirements to obtain In-Home Health Service money.

So next time your legislator tells you he or she will get to those problems later, just remind them that's been said before, and now it is "later."

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