Borenstein: Borrowing to pay for pensions? What could possibly go wrong?

Gov. Jerry Brown and state Treasurer John Chiang have a plan to help cover the state's soaring pension payments: Borrow money at low-interest rates and invest it to make a profit. What could go wrong?

Lots.

Unfortunately, as they try to sell this scheme to the public and the state Legislature, the governor and the treasurer fail to mention the risks, or their aggressive assumptions.

Some local governments, like Oakland, that tried similar borrowing-and-investment schemes to help pay pension debts instead lost hundreds of millions of dollars. Similarly, a Boston College nationwide study of such deals concluded that they carry significant risk and that financial success depends largely on when in the economic cycle investments are made.

The state plan presents the same sort of danger, especially because it calls for investing the entire $6 billion of borrowed money next fiscal year at what state analysts forecast could be a high point of the market.

Brown unveiled the plan May 11 as part of his state budget proposal for the 2017-18 fiscal year. Like local governments, the state faces rapidly rising pension payments in coming years to make up for past years of underfunding.

The problem was exacerbated because Brown's so-called pension “reform” of 2012 failed to significantly rein in retirement costs. Statewide pension debt has increased 36 percent since his changes took effect.

Now Brown, with Chiang's full-throated support, proposes this borrow-low, invest-high scheme to help cover payments to the California Public Employees' Retirement System.

The state Legislative Analyst's Office on Tuesday concluded the plan would probably provide fiscal benefits, but the likelihood and magnitude are uncertain, and the administration has failed to carefully consider potential pitfalls. Among the concerns are whether the plan is legal, the strain it will put on other parts of state government and, most significantly, the financial risks.

Brown wants his plan passed next month with the state budget, but the Legislative Analyst's Office wisely recommends that lawmakers apply the brakes until proper financial analyses are completed.

The governor plans to borrow from the state's $50 billion short-term, low-yield savings account, which is generally for managing the state's seasonal cash flow.

Under his proposal, the state would borrow $6 billion at an interest rate pegged to the two-year Treasury security rate, currently about 1.3 percent and forecast to rise to about 3.5 percent by 2021.

It would then invest the money with CalPERS, which forecasts 7 percent annual returns. The difference between the borrowing cost and projected earnings would be profit the state could use to pay part of its approximately $59 billion pension debt.

Reducing that debt would trim the state's annual pension payments, currently forecast to nearly double to $11.2 billion by 2031-32. Under the proposal, the administration claims, the annual payments would instead peak at $10.4 billion.

All told, this plan “will save the state $11 billion over the next two decades,” the administration claims. They don't say it might save $11 billion. They say it will. That sort of hubris, with no mention of downside risk, is what got us into today's pension mess.

In this case, the administration overestimates the likely investment return and understates the borrowing cost.

For projecting the investment return, the administration relies on CalPERS' long-term forecast, ranging from 7 percent to 7.375 percent annually. But CalPERS' consultant expects only an average 6.2 percent in each of the next 10 years.

Moreover, timing is critical. The profit could be greatly reduced if the borrowed money is all invested, as Brown proposes, in the next fiscal year and the nation then hits the recession the governor has been warning about.

As for the borrowing cost, the use of the short-term savings account to fund a loan through 2030 is problematic. Tying up that money, the legislative analyst notes, could force the state to borrow elsewhere at higher interest rates when it needs to cover future cash flow deficits.

Also, if the state savings account makes a long-term loan, legally it must charge an appropriate interest rate. But a cheap two-year treasury rate seems inadequate for the proposed loan of up to 13 years.

It's great that Brown wants to reduce the state's pension debt. But doubling down on market risk at the same time he's warning of a likely recession doesn't make sense.

Daniel Borenstein is a columnist and editorial writer for the Bay Area News Group.