JANUARY 31, 2005
Business Week

The Terminator Of Public Pensions?
Schwarzenegger's tough goal: Privatizing part 
of the state's retirement system

IN HIS 30-YEAR ACTING career, Arnold Schwarzenegger has battled
sorcerers, interplanetary villains, and molten cyborgs. Now California's
57-year-old governor is taking on his toughest opponent yet: the Golden
State's 3 million government workers. The state's share of their
retirement costs now tops $2 billion a year -- and makes up a healthy
chunk of California's $8 billion budget deficit.

To trim that, Schwarzenegger, like George W. Bush, wants to take a page
from Corporate America's pension playbook and privatize part of the
state's retirement system. Under his plan, state and local government
workers hired after June, 2007, would no longer get guaranteed annual
pensions when they retire. Instead they would be put in privately
managed, 401(k)-like accounts, to which the state would contribute an
amount equaling up to 6% of their salaries. The job of managing those
funds would fall to the workers, resulting in cost savings and budgeting
predictability for the state, says Keith Richman, the Republican
assemblyman who sponsored the plan.

BROAD APPEAL
Schwarzenegger's gambit may have an audience outside the Golden State.
Already, six states -- Florida, Montana, North Dakota, Ohio, South
Carolina, and Washington -- have optional private accounts. And
legislation has been introduced in 10 more.

America's public pension systems could use some reform. The 127 largest
state and local plans are $200 billion short of the funds they need to
pay beneficiaries, according to the National Association of State
Retirement Administrators. That has forced some states to cut services
or borrow heavily to pay pensioners.

An aging population, mediocre investment returns, and delays by
cash-strapped states in making contributions are partly to blame for the
shortfalls. But promises of rich benefits to workers by lawmakers and
other officials have made the situation worse. In California, recent
changes allow state highway patrollers to retire at age 51 with an
inflation-indexed pension that could be as much as 90% of their highest
annual salary.

Still, the track record of the handful of states that have introduced
private plans has been mixed. A study of Nebraska's system -- which has
offered private accounts to some workers for decades -- found that
employees using the accounts chose cautious investment options and
earned just 6% a year on their money, vs. 11% for the state's
traditional funds managed by professionals. Nor do private accounts
immediately solve the problem of rising costs: Michigan introduced
private accounts for new employees in 1997, yet pension costs have yet
to fall because the state must still make substantial payments into the
old plan.

Critics of privately managed accounts also warn that creating a
two-tiered system could hinder recruitment of new workers, who often
choose jobs in the public sector for less pay but higher benefits. And
public pension funds argue that their large size makes them more
cost-effective managers than private firms. The giant California Public
Employees' Retirement System says its annual management costs are just
0.18% of assets -- about one-sixth of what a typical mutual fund charges.

Perhaps just as significant, under the governor's plan, CalPERS, a
longtime champion of shareholders' rights, would gradually die off along
with its existing members. "I'm not against pension reform," says
Alberto Torrico, a Democrat and chairman of the California State
Assembly's pension committee. "But there are other things we can do to
reduce costs, like cracking down on unnecessary disability payments."

The public sector is far behind Corporate America in introducing private
accounts largely because of the objections of unions that view them as a
reduction in benefits. Their protests killed similar legislation in the
California Senate nine years ago. The governor vows to take his proposal
directly to the voters in a referendum. After all, a popular uprising
put him in office in the first place.

By Christopher Palmeri in Los Angeles and Nanette Byrnes in New York