|Budget Issue:||Perspectives on the CalSTRS funding scenarios discussed at the March 19, 2014 joint hearing.|
|Finding or Recommendation:||This note provides additional perspectives concerning the funding scenarios presented by representatives at CalSTRS at the March 19, 2014 informational hearing of the Senate and Assembly public employment and retirement committees.|
On Wednesday, March 19, the Senate and Assembly public employment and retirement committees held a joint informational hearing concerning the history of and possible future funding scenarios for the California State Teachers' Retirement System (CalSTRS). Representatives of CalSTRS and our office made presentations (available here and here). CalSTRS has significant unfunded liabilities that will require changes to the system's funding, as we have discussed with legislators on previous occasions. These changes will have to be adopted by the Legislature.
CalSTRS' presentation on possible plans to fund the system's unfunded liabilities was complex. (Unfunded liabilities are a discounted actuarial estimate of the cost of pension benefits already earned by current and past workers that are not funded by pension system assets on hand.) Below, we highlight some key points about CalSTRS' presentation.
Faster Paydown of Unfunded Liabilities Reduces Long-Term Costs. Paying down CalSTRS' unfunded liabilities—now estimated to be $71 billion—will be costlier the longer that we wait. Moreover, a plan that aims for full funding over a longer period (over 40 years, for example, as opposed to 30 years) will cost more and impose those costs on a larger number of future taxpayers and teachers. This is akin to the higher total costs—including interest—from paying a credit card balance off over a longer period of time. If the state and districts were able to fully pay off the unfunded liability all at once today, the total costs would be about $71 billion. Various CalSTRS estimates showed how total costs would grow for plans that aim to pay off the unfunded liabilities over longer time frames, as follows:
Note: Plans listed above are those with an assumed state contribution to defined benefits of 4.607 percent of teacher payroll per year.
Legislature Faces Big Decision About How to Allocate Increased Costs. The CalSTRS scenarios display the largest share of additional contributions to address the unfunded liability under the columns labeled "employer" (meaning, in this case, school districts and community college districts that employ teachers and administrators in CalSTRS). For example, in the 30-year paydown plan described above, CalSTRS shows 77 percent of the long-term contribution increases in the columns for these district employers, 16 percent for teachers, and only 7 percent from higher contributions from the state.
As we understand CalSTRS' position, however, the system is not implying that these costs would have to be borne in such large proportion by districts. Rather, these scenarios were prepared mainly for illustrative purposes. In the final analysis, the Legislature will have to make the determination about what portion of the higher costs will be borne by districts, teachers, and the state, respectively. In our office's presentation today, we listed as an example a long-term funding plan that placed 50 percent of the long-term costs on the state (generally, in our suggested framework, the non-Proposition 98 portion of the state budget), 35 percent on districts, and 15 percent on teachers. We have stated that it is reasonable for the state to choose to pay a significant share of the long-term costs to address today's unfunded CalSTRS liabilities.
How Can the Legislature Implement the Desired Cost Allocation? Once the Legislature reaches a determination about what portion of higher CalSTRS contributions should be borne by the state, districts, and teachers, respectively, it has a number of options for how to implement the funding plan. For example, similar to what was displayed in CalSTRS' scenarios, the largest share of the costs could be placed on districts, but a portion of this cost or all of this cost could be offset with an upward adjustment in the state's Proposition 98 budget, which provides funding to local school and community college districts. (This could mean that the state effectively would be bearing part or all of these costs, even though districts technically would be paying them.) An upward adjustment in the state's Proposition 98 budget may constrain the non-Proposition 98 portion of the state budget, which funds health, human services, higher education, criminal justice, and other non-education state programs.
Alternatively, a larger share of the cost burden could be placed on the state directly and paid to CalSTRS—as such state contributions traditionally have been—from the non-Proposition 98 portion of the state budget. This too could constrain the non-Proposition 98 portion of the state budget. In either scenario, the state could pay basically any share it chooses of the long-term funding plan costs.
Why Did CalSTRS Peg Future State Contributions at 4.065% or 4.607% of Teacher Payroll? The CalSTRS presentation includes a helpful history of changing state, district, and teacher contributions to CalSTRS' defined benefit program and its predecessor programs over the last century. (In addition to these defined benefit contributions, the state also contributes about 2.5 percent of prior-year teacher payroll to the system's supplemental benefit maintenance account, which helps preserve the purchasing power of pension benefits.)
In 1990, the state adopted the most comprehensive prior plan to address CalSTRS' persistent unfunded liabilities. As of 1997, the state's contributions totaled 4.607 percent of teacher payroll. During the "dot-com" boom, sharp increases in investment returns made it appear that the system was overfunded, and various changes to system benefits and contributions began to be made. In 2000, the state's contributions were lowered to their present basic level in the law, 2.017 percent of prior-year teacher payroll. Current law, however, also requires the state to pay some additional funds in certain circumstances of underfunding. While these additional payments are nowhere near enough to address the system's existing unfunded liabilities, they are scheduled to increase the state's annual contributions from 2.017 percent of teacher payroll (where they had been set for much of the last decade) to 3.522 percent by 2015-16.
The 4.607 percent state contributions in the CalSTRS scenarios represent the state's contributions as of 1997, while 4.065 percent represents the halfway point between the 3.522 percent contribution described above and 4.607 percent (in other words, ([3.522+4.607]/2=4.065). CalSTRS' scenarios show that if the state were to pay 4.607 percent of teacher payroll beginning in October 2014, an additional $263 million of state payments—above those already budgeted—would be paid to the system in 2014-15.
We observe that these particular contribution levels by the state—set in law over a decade ago—have no meaningful significance now, given the current, much higher level of unfunded liabilities. While the Legislature can choose to place more or less of the CalSTRS' funding costs on the state budget, we can think of no particular reason that these figures—derived from an old law—should represent a target for state funding of CalSTRS over the long term.
How Should the Legislature Consider the Possibility of Overfunding CalSTRS? The CalSTRS scenarios each list a statistically-derived estimate of the probability that the system's defined benefit program would be overfunded (defined as actuarial assets exceeding 110 percent of liabilities for benefits already earned) in 30 years. It is well established that sound pension systems should regularly strive to keep or return to 100 percent funding of liabilities for benefits already earned over the long term. Over the long term, a well-funded pension system that minimizes intergenerational transfers of costs would tend to be between, say, 85 percent funded and 115 percent funded, given normal year-to-year volatility of investment returns. Given this, a sound CalSTRS, over the long term, should have about a 50 percent chance of being overfunded at a given point in time. This leaves a roughly 50 percent chance that it would have less than a 100 percent funding ratio at any given point in time. In the event that the system reaches overfunding and remains there for a prolonged period, contributions could be lowered.
How Should the Legislature Consider the Possibility That CalSTRS Will Run Out of Money? Each CalSTRS scenario also displays the probability that the system will "run out of money" within 75 years. Only in the 20-year funding scenarios does this probability fall to 1 percent or less. The 30-year funding scenarios show at least a 25 percent probability of funding depletion, while the 60-year funding scenarios show a 47 percent probability of this occurring.
All of these scenarios represent an improvement over the funding structure in current state law, in which full fund depletion is likely in around 30 years. Nevertheless, we stress that well-designed pension systems should have no meaningful prospect of fund depletion ever occurring. This is because most pension systems—unlike CalSTRS—have the ability to adjust contribution rates regularly based on changing actuarial and investment trends.
Last year, we recommended that the Legislature ask the Teachers' Retirement Board of CalSTRS directly whether particular funding plan scenarios would fulfill the contractual commitment provided to teachers for a financially sound pension plan. In general, it would seem that the 50-year and 60-year funding scenarios presented by CalSTRS would have less of a chance of meeting this standard than the faster funding plans. Plans that amortize unfunded liabilities over a longer period of time increase long-term overall costs, increase intergenerational transfers of expenses, and increase the risk that the pension system will not be able to provide earned benefits in future decades in full and on time.
Our recommendation is for the state to adopt a comprehensive funding plan that aims to pay off CalSTRS' existing unfunded liabilities within 30 years or so. This will require additional funding from the state, districts, and/or teachers combined of likely over $5 billion per year by the time the funding plan is fully ramped up—presumably a few years from now.
The Legislature will face difficult decisions about how to allocate the substantial costs of addressing the unfunded liability over the next three decades or so. We think it is reasonable for the state to bear a substantial share of these costs, particularly as part of a long-term funding strategy that culminates in an end to direct state payments to the system a few decades from now—once today's unfunded liabilities are fully paid off. This year, given that the state's budgetary condition is much improved from that of recent years, we think it is reasonable for the state to set aside a portion of its reserve in anticipation of forwarding those funds to CalSTRS once payments ramp up under a comprehensive long-term funding plan.