By Romy Varghese, Bloomberg News

Along with death and taxes, Californians have counted on another inevitability: once pension promises are made to public employees, they can’t be rolled back.

That belief, which has guided officials as they deal with mounting bills to cash-strapped retirement plans, was shaken in August when a state appellate court said benefit cuts are permissible if the pensions remain "reasonable" for workers.

The Marin Association of Public Employees, which lost its lawsuit seeking to prevent the county from reducing the final salary levels used to calculate pension payments, says it will ask the state’s Supreme Court to overturn the ruling. If upheld, it would give California and its local governments a way to cut costs just as lackluster investment returns threaten to leave them under pressure to pump more money into retirement plans.

"It signals that there’s potentially additional reform options on the table that never were there before," said Thomas Aaron, senior analyst at Moody's Investors Service. "That offers an additional way for governments facing budgetary challenges to try and bring their costs down."

State and local pensions across the country have $1.8 trillion less than needed to cover all the benefits owed in the decades ahead, according to Federal Reserve Board data. The need to make up for such shortfalls has contributed to credit-rating cuts to Illinois, New Jersey and Chicago. Such financial pressure has also been acute in California, where it helped bankrupt the cities of Stockton, San Bernardino and Vallejo.

Efforts to reduce retirement costs have focused on steps such as steering new employees into 401(k)-style plans or persuading unions to consent to measures such as increasing retirement ages or cutting cost-of-living adjustments. While the California court case has no impact beyond the state, it could inspire challenges elsewhere by local governments seeking to push through changes over the objections of workers.

"Courts around the country faced with similar litigation would likely hold in a similar fashion," wrote Bank of America Merrill Lynch analysts led by Philip Fischer in a note to clients.

The case in Marin County, a community north of San Francisco that’s among the wealthiest in the U.S., centers around the formula for calculating retiree payouts. Empowered by state law that sought to prevent "pension spiking" — which involved boosting compensation at the end of one’s career in order to elevate pension checks — the county in 2013 barred elements such as payments for waiving health insurance from being included in the formula that determines how much retirees receive. It was one of the first to implement the state law, the court said.

The union sued, saying such factors are considered part of workers’ regular pay and that the county violated legal precedents known as the California rule. Established through court decisions, the guideline prevents benefits for current employees from being decreased unless they received an offsetting advantage.

The appellate court in San Francisco upheld the trial court’s decision against the union that the new calculations didn’t violate workers’ rights. It also said that lawmakers have the power to change the formula before retirement.

“While a public employee does have a 'vested right' to a pension, that right is only to a ’reasonable’ pension — not an immutable entitlement to the most optimal formula of calculating the pension,” the court said.

The judges didn’t define what’s reasonable. That’s sure to lead to lawsuits if officials try to adjust benefits outside of collective bargaining for their current workforce, said Rollie Katz, executive director of the Marin union, which plans to appeal by Sept. 26, the deadline.

"There have been promises made. That's pretty fundamental in our society," said Katz, whose organization represents 1,300 members from custodians to office assistants. "They need to be kept."

The ruling may give them an incentive to find ways to limit benefits, said Chuck Reed, a former mayor of San Jose, California, who’s pushing pension overhauls nationwide through a group called the Retirement Security Initiative.

"Going from an absolute 'no' to a 'yes, if it’s reasonable' is a huge shift in the political debate as well as the legal debate," Reed said. "In order to save their jurisdictions from insolvency, some systems will be motivated to try to make some changes."

(This article originally appeared on Sept. 6)

By Romy Varghese, Bloomberg News

In San Francisco, almost everything is flying high: real estate, start-ups and now, the airport.

Serving a region whose economy is fueled by the technology industry, San Francisco International Airport is embarking on a $5.7 billion expansion as it grapples with traffic that has nearly doubled in nine years. The city’s sale of $881 million in airport bonds, its biggest ever, is the first in a series that will draw demand from municipal investors who’ve snapped up airline-related debt, leaving the securities on pace to outperform the overall municipal market for a sixth straight year.

Overall, airports have benefited from lower fuel costs and the recovering U.S. economy, as higher numbers of passengers boost collections from parking fees and bar tabs. San Francisco's airport is seeing even more travelers, thanks in part to Silicon Valley.

"Traffic has been booming," said Kevin Kone, the airport’s managing director for finance. "Here in the Bay area, the economy is strong. We’re responding to the needs of the traveling public."

At San Francisco International, tourists, budding tech executives and professionals browse high-end boutiques and stretch in yoga rooms as they pass through the region or head to the Pacific Rim. Arrivals and departures total 51.4 million in the 2016 fiscal year, up from 33.9 million nine years ago, documents circulated among investors show. Moody's Investors Service ranks the debt A1, the fifth-highest investment grade, pointing to the hub’s strong market position and ability to scale back expansion plans if needed.

The sale comes amid a streak in airport bonds. In 2015, the securities gained 4 percent, beating the market’s 3.6 percent advance, marking the fifth straight year of outperformance, Bank of America Merrill Lynch data show. So far this year, the debt has continued to have an edge, albeit a smaller one: a 4.6 percent return to the market’s 4.5 percent through Sept. 7.

"The lower hanging fruit has been picked within the sector," said Gabe Diederich, a Menomonee Falls, Wisconsin-based portfolio manager at Wells Fargo Asset Management, which manages about $40 billion of municipals. He may buy the San Francisco deal if the yields are high enough. "If you have a change that’s due to a slowing economy or yields moving up more broadly and that causes outflows from mutual funds, that could certainly change the performance."

For now, airports are still reporting growth in passenger traffic. Moody’s has a positive outlook on the sector as it expects volume to grow as much as 4 percent this year.

"Although it’s notably a cyclical sector in general, the economic expansion seems to be hanging in there," said John Miller, co-head of fixed income in Chicago at Nuveen Asset Management, which oversees $124 billion of munis. He's looking to add more airport debt and will consider San Francisco’s. "It’s prolonged and extended."

San Francisco International may sell bonds once or twice a year for the next five years — which will help keep the pace of such debt steady, as has been the case over the past few years. Similar issues have been easily placed: In May, a consortium sold $2.4 billion in bonds to finance a new terminal at New York’s LaGuardia Airport.

The San Francisco area is "at the vanguard of the national expansion," with personal income rising 6.3 percent this year, according to Moody’s Analytics. That, coupled with demand from California residents for tax-free income, should make the deal "very successful," Miller said.

The city through its airport commission is embarking on the five-year construction project to add six gates, renovate others to alleviate congestion and connect two terminals. The deal is almost twice as big as its second-largest sale of $500 million in 1998, said Kone, the airport finance official.

"There are more airplanes that want to come in than we have gates during peak periods. That would sometimes cause delays," Kone said. "We’re really building to meet today’s demands."

(This article originally appeared on Sept. 9)  

Ever since the Gold Rush, California's economy has been subject to boom and bust, said Gabriel Petek, an analyst for S&P Global Ratings based in San Francisco. Petek began covering the state in 2008. The state's economic dynamism is a key strength, but California has some baggage, including high housing costs and reliance on the personal income tax, Petek said in an interview with Bloomberg Brief reporter Amanda Albright on Sept. 9. This interview has been edited and condensed.

Q: What are California's biggest economic strengths right now?

A: The size and diversity of the state's economy are its key strengths. California is, by far, the leading venture capital recipient state in the nation, which helps fuel its entrepreneurial, high tech and biotech sectors. This gives the state potential for relatively fast economic growth. Since 2012, California's real GDP growth rate has ranked second-best in the nation. True to its Gold Rush legacy, California's economy has always had a tendency toward boom and bust cyclicality, which is magnified in its fiscal profile given its progressive income tax schedule.

Q: Why do you see the lack of affordable housing as a longer term economic concern?

A: It’s a challenge for employers looking to start businesses or looking to relocate to the state. It presents a challenge for their workforce to have a place to live that's accessible. This also starts to touch on its infrastructure network. There's a large funding deficit for maintaining transportation infrastructure. When you combine the congested roadways and lack of affordable housing in the urban areas, it becomes a challenge to the state's employers when they are looking to fill out their workforce.

Q: How much does the venture capital world affect California's economy?

A: It has a turbo-charging effect on the state's growth rates, especially the upper income strata. The state's high income taxpayers have really fared well with the investments in this area. It helps drive the overall economic growth rate of the state, but it does come along with some imbalances because it's skewed towards the top.

Q: How do you evaluate the state's ability to keep selling major bond deals, like the $2.7 billion deal earlier this month?

A: It's really a testament to the magnitude of the state's economy and budget. Despite those nominally large bond issues, its debt ratios have actually trended down for six consecutive years now. What I'm talking about is tax-supported debt as a share of the state's personal income and a share of state GDP has trended down each year since 2011. Similarly, its debt service as a share of general fund expenditures has trended down each year since 2013, when the state paid off its Proposition 1A bonds that were issued in 2009 to help with the state's fiscal crisis. Keep in mind that of its recent $2.65 billion deal, a little over $2 billion of it was for refunding. When you look at it from a credit perspective, the debt trends are very sustainable. Even though they’ve been issuing large bond issues, when you look at it as a share of their economy, it really hasn’t increased, it's actually been decreasing.

Q: An August S&P report on California mentioned the $74 billion unfunded liability for retiree health care benefits. You noted that this weighs on the state's rating, and that the state has failed to fund the benefit program on an actuarial basis. How much of a concern is this?

A: It's not particularly unique to California that their definition of revenues and expenses falls somewhere in

between cash and modified accrual basis of accounting. That’s the first thing. The mismatch between cash accounting and accrual type of accounting is probably most apparent with regard to its outlays for retiree health care benefits. The state funds these primarily on a pay-as-you-go basis. And if you look at the state's fiscal 2017 budget, it includes $1.97 billion in OPEB expenses, but from an actuarial standpoint it's $5.77 billion. From a credit perspective, this is concerning for a couple of reasons.

First, the pay-as-you-go approach to funding the benefits results in the liability ballooning. I looked back, it grew by 24 percent from 2010 to 2015. It stands at more than $74 billion. The trajectory is a concern. The second point is that despite still representing a relatively minor expense, it's not a sustainable approach. Because even though general fund revenues increased 28 percent from 2010 to 2015, the pay-as-you-go expenses for OPEB benefits went up by 68 percent during the same years. You can see the cost of funding these benefits on a pay-as-you-go basis is increasing much more rapidly than revenues. And that's during the period of time when we've been in a bull market for the stock market and the economy has been expanding. State revenues have been growing at a healthy rate. Over the longer term, we view the trajectory of this expense as not sustainable.

Q: Why are these expenses growing so rapidly?

A: It's just a function of how the accounting works for these. The actuarial cost includes money that you set aside, the present value of those expenses that you estimate they will represent in the future when the person retires and starts taking the benefit. But they're actually earning it now. So what happens is that the expense grows over time. By not funding the normal cost, on a current basis, you're sort of kicking the can down the road, so to speak. It winds up costing more in the long run to fund it this way. It's the same thing that happened with pension liabilities.

Q: Is the pay-as-you-go approach unique to California, or do other states do it as well?
A: A majority of states really are still funding less than the actuarial costs of their retiree health care benefits. But there is a movement afoot among the states to address it. Just in the past few years, Oregon, Hawaii, Alaska, South Dakota and Kentucky have taken steps to improve the funding status of their OPEB liabilities.

Q: You did a separate report on the state's ability to handle a recession. How would a recession affect California?
A: We did this stress analysis to estimate how a moderately severe recession could affect several states' budgetary revenues and expense. For all cases, for all the states, the analysis showed the revenues would decline, which is sort of what we would expect, and they would have increased expenditure pressures for services like Medicaid. California stood out because they have kind of a volatile revenue structure and we found that they were subject to a 12 percent revenue shortfall, which is $14.7 billion.

Q: How can California strengthen its position ahead of a potential U.S. recession?
A: The reserve fund, and continuing the state's approach to budget management would be the key ways the state can prepare in the near-term. So far, throughout this economic recovery, the governor has emphasized a restrained approach to adding new ongoing expenditures to the general fund. That’s been key to the state's fiscal recovery. Over the longer term, anything the state could do to smooth out its propensity for revenue volatility would be a key way they could protect the state's budget from the effects of a downturn. But that has a lot of challenging elements to it. Because then you start having to consider the political implications of winners and losers in changing the tax structure. It's much easier said in theory than achieved in the world.

Q: So the state would have to change its tax structure to reduce volatility?
A: [The state is] getting more than 71 percent of general fund revenues from income taxes; 48 percent came from the top 1 percent in 2014, that’s the most recent year we have the data. That top 1 percent that pays almost half of the income taxes, they get more of their income from investments and capital gains income from financial investments. That type of income tends to be much more prone to volatility as a consequence of market gyrations. That volatility gets transmitted directly to the state budget.

To smooth it out, they would have to shift the tax burden away from high income people and increase the taxes in effect paid by the rest of the population. The challenge with that is primarily political, but also if you look at the franchise tax board data, that top 1 percentile have actually seen the most income gains over the last 15 years or so. Not only do they have the most income, as it is, their income has increased the most.

So there's a logic to taxing that segment of the taxpayer base. It becomes challenging to think about shifting the tax burden to the lower income brackets and also the brackets that haven't experienced as much income growth. That's a complex challenge for the state officials.

BY ALISON VEKSHIN, BLOOMBERG NEWS

Reynolds American Inc., Altria Group Inc. and other tobacco companies are steering millions of dollars to defeating a $2 cigarette-tax increase in California, a high-stakes effort and the third such fight in a decade in the most populous U.S. state.

The tobacco industry’s outlay of $55.9 million so far means that it has outspent supporters 3-to-1 in donations to defeat the measure, which starting in April would boost the levy to $2.87 a pack. The initiative would generate from $1 billion to $1.4 billion in revenue in fiscal 2018 for cancer treatment and smoking prevention.

“When one side is spending much more than the other, it’s hard for voters to get a clear picture,” said Daniel G. Newman, president of MapLight, a Berkeley, California-based nonpartisan research organization that tracks money in politics. “Imagine two messages side by side — one blaring from a gigantic movie screen and on the other side from a small cellphone. For voters, that amplification is going to make a difference.”

California, the first U.S. state to eliminate smoking in bars and restaurants and legalize medical marijuana, is an important battleground for the tobacco industry because policies approved there tend to be adopted by other municipalities. Blocking the tax in the state of 39 million people could deter anti-tobacco advocates in more conservative states from pursuing similar changes. That’s led cigarette markers including Altria and Reynolds to steer more cash toward fighting tax proposals in California than in any other state.

The cigarette-tax proposal is among 17 measures on the statewide ballot, including legalizing recreational marijuana use and eliminating the death penalty.

Ballot-measure opponents typically have an advantage in swaying voters, said Jack Pitney, a government professor at Claremont McKenna College, near Los Angeles.

“It’s easier to defeat something than pass it,” he said. “If you’re running the no campaign, all you have to do is create some reasonable doubt.”

Adding $2 to California’s 87 cent tax, one of the lowest in the nation, would push it up to ninth-highest in the U.S., behind New York’s $4.35 and Connecticut’s $3.90, according to data from the Campaign for Tobacco-Free Kids. “A large tax increase is the single-most effective way to reduce smoking,” said spokesman John Schachter.

(This article originally appeared on Sept. 9)