Public pension plans devastate budgets.

Imagine that you are the owner of a business with 50 employees. Assume that your net profit is 20 percent and that your labor cost is twenty-five percent of revenues. Next, assume that you must pay for fifty additional employees that are not working and not generating additional revenues. Now your business is operating at a 5 percent net loss instead of a 20 percent net profit.

This is what is happening to California. With the current defined benefit public pension plans, California is paying two payrolls, one for current employees and a second for retired employees. This situation is a major contributor to our structural deficit, which is now estimated at between six and ten billion dollars. If the pension system is not changed, without additional revenues, the structural deficit will continue to grow.

One might ask: "How did we get into this mess?" The answer is that our elected representatives increased the pension benefits based on an assumption that state revenues would continue to increase. This assumption was made during the dot.com era when stocks were being sold at significant gains and state revenues from taxes on these gains were soaring. Unfortunately, dot.com became dot.bomb and the revenues dried up. The Dow dropped by more than 30 percent and the NASDAQ dropped by more than 50 percent. As a result, investments held by the pension plans also took a tumble. The only thing that didn't drop was the unfunded liability for the increased pension costs.

The costs of public pension plans increased from $160 million in 2000 to $2.6 billion in 2005 and are projected to increase to $3.5 billion in 2009. Furthermore, there is more than $30 billion in additional unfunded costs for future state and local government retirees. Current pension costs are devastating state and local budgets and taking away money seriously needed for investments in education, health care, transportation and public safety. Numerous counties have chosen to establish their own retirement systems under the County Employees Retirement Law of 1937 Act ('37 Act). A number of these counties implemented defined benefit plans and are now facing unfunded liability problems similar to the state. San Diego County's pension fund is facing a $1.2 billion unfunded liability due to generous benefit increases and investment losses. Sacramento County's general fund is continually bleeding as a result of the skyrocketing costs of its pensions and health care coverage for retirees.

So, what is the solution? In 2002 when San Diego County first realized there was a problem, the Board of Supervisors decided the prudent thing to do was to borrow money on the open market. Their rationale was that the county could get a lower interest rate borrowing on the open market than it was obligated to pay the pension fund for the unpaid portion of the future obligation. This solution failed miserably. Although the county borrowed $737 million in 2002 and $454 million in 2004, the unfunded liability continues to grow.

Fix introduced

On January 6, 2005, in an attempt to solve the state's problem, with the support of Gov Schwarzenegger, Assemblymember Keith Richman (R-Northridge) introduced a bill into the special session of the Assembly. The bill, known as ACAX 11, amends the state constitution to prohibit all non-federal public employees in California hired on or after July 1, 2007 from enrolling in a defined benefit plan. Instead, it establishes the California Public Employee Defined Contribution Plan for these newly hired employees. Rather than burdening the state with the obligation of a defined benefit plan that provides specific guaranteed benefits upon an employee's retirement, which, according to a statement in the bill, can result in providing some employees with more than 100 percent of their final year's salary at age 50, this bill would provide a 401 (k) type defined contribution plan for new hires whereby a participant's benefit would be based upon the contribution by the participant, any employer contributions and investment gains or losses.

Some argue that if state-provided benefits are reduced, it will be impossible to attract well-qualified employees. It is contended that public employees are paid less than those in the private sector for similar jobs. The state's attraction to obtain the higher-skilled employees has been better job security and higher benefits than are available in the private sector.

Perhaps a better solution would be a Defined Benefit Plan with guaranteed benefits based on a reduced percentage applied to an average of the employee's last three-years of salary, combined with a Defined Contribution Plan with voluntary employee and employer contributions. Another alternative might be to adopt the provisions of ACAX1 1 with an added requirement that salaries be increased to be competitive with the private sector. Whatever the best solution is, it is clear that we cannot afford to continue providing the current system of benefits to new hires.

Gregory N. Lippe, CPA, is managing partner of the Woodland Hills-based CPA firm of Lippe, Hellie Hoffer & Allison LLP (LHHA) and a director and vice chair of the Valley Industry and Commerce Association