BY GRANT BONHAM

It’s been nine years since the Lehman Brothers filed bankruptcy and kicked off the world's largest financial crisis since the Great Depression. This summer, the California Public Employee’s Retirement System (CalPERS) filed a lawsuit against the once-colossal investment bank, alleging the Lehman Brothers owed the state pension system compensation for damages resulting from the fallout of the 2007 to 2010 financial crisis. The two systems are more interrelated than this lawsuit suggests, and the Lehman Brothers’ legacy has precipitated what could be the next large scale financial collapse: the fall of California’s public pensions. Since 2008, politicians across the country have learned little about long-term market volatility. This could result in yet another financial crisis that is largely uncriticized by the public. The fall of CalPERS would shake the foundation of the American retirement system and effectively eliminate the retirement savings of over 1.8 million people. The fall of CalPERS would stem from two major issues: the failure of collective action now, and the poorly designed system that it has become.

CalPERS is broadly defined as a benefit plan with payouts allocated based on a formulaic approach. This formula loosely looks at the number of years worked, the age of retirement, payment into the plan, and average income to determine what an employee’s payout from the pension fund would be. This means that an individual paying into CalPERS locks into a retirement payment and is able to dictate their retirement with great stability over time. In 1930, voters approved an amendment to the California constitution that created pensions for state employees. Nine years later, this pension fund was granted to all public employees and, in 1962, CalPERS benefits expanded to include health insurance. CalPERS has seen significant growth since 1990, with the total dollar value rising from $49.8 billion to $295.8 billion. Pension systems, especially ones as substantive as CalPERS, are incredibly diverse financial institutions that help individuals save more for retirement and provide a base of long-term income for a large portion of the state. In conjunction with the “California Rule,” where this predetermined payout cannot be changed retroactively, the state is constitutionally bound to paying their projected pension payments. This is one of the key tenets of the CalPERS payout system. But these large payouts are only financially sound if they are supported by equal amounts of income.

CalPERS has three primary sources of income: investment profits, public employee payments, and government agency payments. While public employees have fixed portions of their income diverted into the fund, public institutions often match this fund in a fixed percentage taken from their payroll. The individual institutions and employees negotiate what percentages will be paid, and, depending on its function, these percentages can vary by job. The final component of the pension system’s income is the investment portfolio. Most investments are in equities, while real estate, real assets, and fixed income account for the rest of the investment types. While multiple income sources make pension systems dynamic, they are also very dependent on the health of the economy. With economic instability, this can have drastic consequences.

What once functioned as a safe and reasonable pension system has gradually become riskier and more prone to collapse. Policies implemented in the bull market of the 1980s and 1990s have had lasting effects on income and payout of the pension system.  Proposition 21 passed in 1984 and enabled fund managers to invest in risky stocks, moving away from their previously safe bonds. When S.B. 400 passed in 1999 and increased pension payouts for California Highway Patrol officers by 50 percent, other state agencies sought to replicate it. This led to the pension system having increased liabilities and riskier portfolios, rendering it immediately susceptible to the economic instability of the 2000s and leaving the system only able to fund 68 percent of its current liabilities.

This system, built on the economic health of both cities and the stock market, became vulnerable to crashing after the 2007 financial crisis. Payments to the pension system slowed as riskier investments unravelled in recession of 2008, and city tax revenues declined. Public employees’ wages decreased, local governments began instituting austerity policies, and three large cities in California (Vallejo, Stockton and San Bernardino) all declared bankruptcy. The recession following had lasting effects on the complex CalPERS system. Pressure was pushing down the system’s income while simultaneously keeping the payouts the same, or raising them higher, over time. Consequently, the current the pension system is disastrously underfunded. The state has no one to blame but themselves.

It took a collective effort to strip CalPERS of its financial stability, and it will take a collective effort to restabilize it. Voters and the state legislature both approved measures that contributed to the current predicament of CalPERS, and they will need to come together in support of effective policies to tame the beast they have created. So far, no consensus solution has been proposed by voters, the legislature, or Governor Jerry Brown. Brown has teamed up with California State Treasurer, John Chiang, to propose a band-aid plan that would use money from the California general fund to pay part of its liabilities at an interest rate lower than the debt. A bipartisan coalition emerged earlier this year proposing a halt or cap on all cost of living adjustments (COLA) for current retirees to help stop the flow of greater pension payments as the cost of living goes up. Finally, solutions have already been partially instituted to quell the problem before it triggers a collapse. Earlier this year, the projected growth rate was dropped from 7.5 percent to 7 percent to show that the fund’s predictions were not as high as previously calculated, and tighten the gap between assets and liabilities.

With no agreed upon solution from local and state governments, it is clear that nothing will be enough to stave of this impending crisis. Brown and Chiang have only proposed a temporary fix for the problem, and proposals to pause COLA have been widely dismissed. The public seems strongly against propositions cutting down the benefits of police and firefighters. Moreover, local governments are largely powerless when negotiating their contracts with CalPERS. This will be a defining policy for California's next governor and the health of the American economy will largely rely on this pension system’s success. If CalPERS collapses, millions of young Americans who were not responsible for its mismanagement will be responsible for its cleanup. The politicians of years past have left a ticking time bomb for those of the future.