The Truth Behind California's Pension Shortfall

The forces that have been tormenting the financial markets were nowhere to be seen last Friday. Maybe they decided to take a long weekend. Whatever the case, the Dow Jones Industrial Average rebounded 125 points, several European markets produced modest gains and the euro advanced for the fourth straight trading session.

The financial market tormentors might also take Monday off, but we would expect them to return to work very soon. Friday’s upticks have a decidedly counter-trend feel to them. The problem, dear reader, is one of too much public debt and too little private capital.

“The Greek situation,” Bill Bonner remarked last week, “is not very different from the situation in dozens of other countries – including Portugal, Spain, Italy, Britain and the USA.

“America is unique…and just the same,” Bill continued. “It is already so deep in debt that even if you taxed 100% of Americans’ income, the resulting take wouldn’t be enough to cover the deficit…And if you cut the Pentagon budget by 100%, you’d still have a deficit too. It would take a remarkable act of political courage and discipline to put the US back on the path towards sound public finances.

“It is probably too late already,” Bill concludes. “We are probably past the point of no return, as economists Rogoff and Reinhart insist. In our view, the US could still save itself IF it could make an extraordinary commitment to budget cutting. But we won’t hold our breath.”

Unfortunately, America’s “official” national indebtedness in only one little atoll in the nation’s vast debt archipelago. As of last September, total US federal debt outstanding totaled to $12.0 trillion – or 84% of GDP. Based on GAAP accounting however (which includes the present value of long-term liabilities like Social Security and Medicare), the debt number mushrooms to $70.7 trillion – or nearly 5 times GDP!

“[Based on] the GAAP-based deficit from US Treasury reporting,” observes John Williams on his very insightful website, “total federal obligations as of September 30, 2009, stood at $70.7 trillion, up from $65.6 trillion the year before… [These] numbers are not just unsustainable, they remain uncontainable. Taxes cannot be raised enough to put the annual results in the black, and the level of program slashing needed in Social Security, Medicare, etc. to reduce costs appears to be well beyond the scope of any foreseeable political will in Washington.”

Unfortunately, our woeful tale of unfunded liabilities does not end in Washington. Several state governments are also racking up large annual deficits and even larger unfunded pension liabilities. Right here at home, in the Golden State, government finances have rapidly slipped from “okay” to “abysmal.”

California State Pension Budget

And once again, the official debt numbers tell only a small part of the story. According to a study by the Stanford Institute for Economic Policy Research, California’s pension shortfall is nearly 10 times worse than the official estimate of $56 billion.

The Stanford study examined the California Public Employees’ Retirement System (CalPERS), the California State Teachers’ Retirement System (CalSTRS) and the University of California’s Retirement System (UCRS). According to the Stanford researchers, California’s pension shortfall is not $56 billion; it is $535 billion.

Why the $479 billion discrepancy between these two calculations? One number is pure fantasy; the other is a reasonable guess. When calculating their future liabilities, the California pension systems assume annualized investment returns of 7.5 to 8 percent. The Stanford team, by contrast, ratcheted down those return expectations to 4.14% – a number that much more closely resembles both current realities in the financial markets and the pension funds’ recent, historic returns.

Based on the 4.14% rate, the Stanford team calculated the combined funding shortfall of CalPERS, CalSTRS, and UCRS prior to the 2008/2009 recession to be $425.2 billion. However, the research team reported, “Due to the $109.7 billion loss the three funds collectively sustained [in the most recent fiscal year], we estimate the current shortfall at more than half a trillion dollars.”

What will become of these debts and liabilities? How can we Americans (and Californians) possibly finance them? Most politicians in the land still pretend that America’s massive construct of debt-financed services and promises is viable. Your editors are not convinced. We think the American system of “debt-financed everything” has taken a bad idea and run too far with it. It is not a system at all. It is a fraud wrapped inside a mass deception.

Deception and capital preservation don’t mix very well. That’s why your editors here at The Daily Reckoning continuously urge investors to seek opportunities that are straightforward…not complex…and where the chances of deception are very low.

That’s why your editor fears financial stocks. He has no personal grudge against the financial sector; he is simply not smart enough to invest in it successfully. He is not insightful enough to recognize a prudent banker, much less an honest, prudent banker.

“Sell risk, buy caution. Sell complexity, buy simplicity,” your editor advised in a July 2008 presentation to the Vancouver Investment Symposium. The events of the last two years have not altered his perspective one iota.

Eric Fry
for The Daily Reckoning