California state government observers have wondered in recent months why the California Public Employees' Retirement System (CalPERS), the nation's largest state pension fund and one of Wall Street's most muscular financial players, has taken such a hamfisted approach toward one of California's tiniest and least-powerful cities. There's a rational, albeit troubling, reason for its approach.

After the Sierra County city of Loyalton (pop: 862) could no longer afford its monthly payments to CalPERS to pay the pension benefits for its one employee and four retirees, the City Council voted in 2013 to pull out of the pension fund. In response, CalPERS slapped it with a $1.66 million "termination fee"—far more than the city's annual budget. That means that, as recent news reports reveal, Loyalton's retirees will soon have their pension benefits slashed by 60 percent, which is a massive hit for a small number of people.

CalPERS is sending a message to other cities that want to leave the fund: agencies will pay dearly if they attempt to loosen CalPERS' grip on their finances. The pension fund is taking a similarly hard line with some agencies in Southern California.

"The CalPERS Board of Administration in March voted to cut the pensions of close to 200 retirees from the East San Gabriel Valley Human Services Consortium," reported the Los Angeles Times this month. That agency, known as LA Works, folded in 2014. On July 1, "CalPERS sliced the pension checks for the consortium's retirees by 63 percent." The Timesalso pointed to the Niland Sanitary District in Imperial County, which is currently negotiating with CalPERS over exit terms.

Every city's payment for the "defined benefit" pensions that CalPERS administers is based in part on financial assumptions. The most important of these: the fund's assumption that it will earn 7 percent on its investments (down from 7.5 percent). It calculates the fees that cities and other agencies have to pay based on benefit formulas and these assumptions about investment earnings.

As soon as an agency decides to leave the pension fund, CalPERS places its investments in what it calls the Terminated Agency Pool, or TAP. For agencies in the TAP, CalPERS assumes a rate of return of around 2 percent.

As I explained last month, this highlights a dirty little secret: The pension fund is bullish about the stock market when the public's money is at risk, given that any shortfalls in investments ultimately are backed by California taxpayers. But when agencies leave the fund, CalPERS can no longer rely on taxpayers and future returns for those dollars. Its own money is at risk, so it then assumes a minuscule rate of return. That assumption increases dramatically what a local agency owes CalPERS.

CalPERS could have negotiated a deal for Loyalton, says Dan Pellissier, a former aide to Republican Gov. Arnold Schwarzenegger and well-known pension reformer. He points to California law that states the CalPERS "board may negotiate with the governing board of the terminating agency" regarding the "terms and conditions of the termination" from the pension fund.

"CalPERS offered to negotiate payment options under the government code that you cited, but Loyalton said they couldn't make those payments either," CalPERS spokesperson Amy Morgan told me. "That is when they were moved into the terminated agency pool."

But CalPERS also confirmed that "the negotiations were based on what the city could afford on the $1.6 termination liability cost that they owed, not the discount rate." There's obviously no way that a city that said it couldn't afford its modest annual payment (reportedly around $3,500 a month) in the 7.5 percent fund could begin to afford the higher payments based on 2 percent earnings.

This is par for the course for CalPERS "negotiations." When the city of San Jose tried to extricate its small pension plan for council members from CalPERS and move to a 401(k) system, CalPERS hit back. CalPERS had calculated the city's liabilities at around $900,000 for that fund, but CalPERS wanted San Jose to pay around $5 million to exit.

"CalPERS does everything it can to keep the rats from leaving the sinking ship," former Mayor Chuck Reed told me. "And they treat you like rats, too."

Reed says CalPERS could have come up with a deal to let San Jose pay off the remaining pensions without adding new members. The pension fund has claimed that it isn't statutorily allowed to do so, but that's an open question. Moreover, CalPERS itself could push for a legislative change. "They do not want to help," Reed said. "Clearly, they do not want people to leave."

The point of the termination pool is to deal with agencies that become defunct. Loyalton still has an annual budget and government-owned assets such as a city hall. It's a different story with LA Works and those handful of agencies that actually have dissolved. Those sorts of situations are what termination pools were designed to address.

Even when agencies actually go out of business, there's room for a settlement. CalPERS' termination pool has a surplus of $111 million, so it's 200 percent funded. The idea is to have extra funds to cover shortfalls. LA Works would appear to have a good argument that this is an appropriate use of some of those funds.

"Upon termination, CalPERS becomes the guarantor of benefits for all members and beneficiaries whose benefits are paid from the TAP and has no future ability to obtain funds from former contracting employers," wrote CalPERS CEO Marcie Frost, in a letter last month to the state Senate. She was responding to Sen. John Moorlach (R–Costa Mesa) who harshly criticized the disparity between the assumed rates in the two investment pools.

But Frost's rebuttal bolsters what pension reformers have been arguing. The TAP makes investments in "low-risk, U.S. government-issued securities" as a way to "minimize funding risk" because CalPERS then becomes the guarantor of all benefits. These are the investment assumptions CalPERS uses when it wants to be sure that it doesn't lose any money.

"If you felt that 2 percent is the interest rate, you should be basing it on that rate the whole time," Moorlach told me, rather than basing it on 7.5 percent and then lowering it to 2 percent once an agency wants to leave the system. "I've paid what you charged me. You've undercharged me. That's your problem," he added.

The bigger problem, of course, is that if CalPERS tried to move the entire system to a sustainable basis—i.e., one that is priced like a private fund that didn't rely on public subsidies and future bull markets –it would need to increase dramatically what it charges member cities and agencies. Those public agencies already are slashing services to pay their current, escalating bills.

CalPERS' "number one strategy is to preserve the defined benefit and get more employees into defined-benefit plans," Pellissier said. So the fund "absolutely" is making an example of Loyalton to keep other cities from getting the wrong idea.

In the meantime, a reasonable negotiated settlement with Loyalton and other exiting agencies would quietly preserve the relatively small pensions of a handful of employees. However, it could also send the message to other cities and agencies that leaving CalPERS might be a doable alternative. Given its current union tilt, the pension fund certainly can't allow that idea to gain traction.

This column was first published by the California Policy Center.