"California was in the middle of this incredible boom," Levy said in a recent interview. "It was coming off a period when the stock market had far exceeded the rate of return that was being assumed."
In this period of excess, the decisions Palo Alto and other cities made to grant greater pension benefits to employees seemed far from unreasonable, particularly given the high salaries offered in Silicon Valley's thriving private sector. Back then, the cities' contributions to CalPERS were miniscule compared to the current level because everyone assumed the good times would keep on rolling and the rates of return would remain high, he said. In 2003, for example, the city paid only $2.3 million in pension expenses, compared with $23.1 million now. It's projected to balloon further.
"Part of the reason we're behind is that everyone took a vacation when the stock market was doing good," Levy said. "We underinvested. We were assuming that the dot-com stock market would keep going. It was easy."
The problem with this approach became apparent after the economy tanked in late 2008, sending CalPERS investments on a downward spiral. As the stock market plummeted and the real-estate bubble popped, the pension funds' investments took a sizeable hit. The fund lost about $100 million in its failed investment in Page Mill Properties, a company that tried to buy more than half of East Palo Alto's rental-housing stock but later lost it in foreclosure; and another $500 million in its investment in rental housing in New York.
The pension fund's "predictable" income plummeted by $12.5 billion in fiscal year 2008 (which began July 1, 2007) and by $57.4 billion the following year. It rebounded in the 2010 and 2011 with increases of $25.6 billion and $43.6 billion. Still, the damage has been done. In March, CalPERS officials decided to adjust the discount rate (that is, the expected rate of return) from 7.75 percent it to 7.5 percent, a rate that many view as still far too optimistic. This was the first time in 10 years that the pension fund changed the rate.
The new discount rate means cities will now have to contribute millions more annually to meet their pension obligations. Joe Nation, an analyst at the Stanford Institute for Economic Policy Research, estimated in a December report (tellingly titled, "Pension Math: How California's Retirement Spending Is Squeezing the State Budget") that each percentage-point decrease in the CalPERS discount rate increases municipalities' contribution rates by an average of 10 percent. In Palo Alto, where benefits already take up a growing chunk of employee spending, the trend is expected to extend well into the future.
"Even a quarter of percentage is a multi-million-dollar cost impact on our annual pension requirements," City Manager James Keene said in a recent interview. "And there's preliminary indication that the returns for this coming year will fall far, far short of that guideline (the 7.5 percent rate of return). This means we'll get hit with higher pension contributions."
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