Legislative Analyst's Office
Analysis of the 2003-04 Budget Bill
The state makes annual contributions to the Public Employees' Retirement System (PERS) and the State Teachers' Retirement System (STRS) to fund retirement benefits that will be paid out in the future. In 2003-04, the estimated state contribution to PERS is $2.1 billion ($1.1 billion General Fund). The General Fund provides the entire benefits contribution to STRS, which is estimated at $448 million in the budget year.
In certain past years, due to budget constraints, the state deferred payment of these retirement obligations. Subsequent court decisions, however, have strictly limited the state's ability to defer these contributions. In addition, Proposition 162, which was approved by voters in November 1992, gave PERS and STRS independent authority to administer the pension systems. Thus, any decision not to make scheduled annual retirement contributions necessitates substantial care regarding legal requirements.
The Governor's budget proposes two alternatives to the standard payment of the state's 2003-04 contributions to PERS and STRS: (1) issue pension obligation bonds or (2) borrow the necessary funds from the systems. The proposal aims to achieve General Fund savings in the budget year to help address the state's fiscal condition. At this point, the administration is pursuing the feasibility of both alternatives.
If the proposal applies solely to General Fund retirement contributions, the state would reduce budget-year expenditures by $1.5 billion. If the proposal includes the special fund contributions to PERS as well, the total expenditure reduction would be $2.5 billion.
Normal Cost Versus Unfunded Liability. The estimated $2.1 billion budget-year contribution to PERS consists of two components:
The state contribution to STRS does not currently include an unfunded liability component.
The first alternative the administration proposes is the issuance of pension obligation bonds to pay the state's 2003-04 retirement contributions for PERS and STRS benefits. Under this alternative, the state would issue general obligation bonds, payable over 20 years.
Bonds Have Been Used to Pay Off Unfunded Liabilities. Normally, government agencies with unfunded liabilities pay off a portion of it in annual retirement contributions over a set period of time. This payment includes interest calculated at the pension system's assumed rate of return on its investments.
Since 1993, however, more than two dozen cities and counties in California have issued taxable pension obligation bonds to pay off, in a lump sum in today's dollars, their unfunded liabilities. The State of New Jersey has issued pension obligation bonds as well. These transactions in effect substitute payments to the pension system with payments to bondholders. The difference in interest charges between the pension system's higher assumed rate of return and bond payments can generate savings for the governmental entity.
Typically, general obligation bonds must be approved by the voters because they are backed by the full faith and credit of the issuing government. In proceedings regarding local governments, however, courts have held that pension obligation bonds constitute payment of an existing obligation rather than new indebtedness. In this case, the transaction exchanges one debt (the unfunded liability) for another (payments owed bondholders). Thus, the sale of pension obligation bonds does not apply to debt limit provisions, and voter approval is not required.
Governor's Proposal Departs From Standard Use. In our review of other governments' actions, we did not find an example where pension obligation bonds were used solely to pay for an annual retirement contribution, as the Governor proposes. In issuing pension obligation bonds to pay off their unfunded liabilities, some entities have included one or two years' worth of ongoing contributions for some budget relief. But retiring the unfunded liability has always been the driving factor—not relieving budget pressure by incurring debt to pay regular retirement contributions.
Does the General Obligation Bond Exception Apply to the State? It is our understanding that both the administration and the Attorney General believe the exception to voter approval that courts have held applies at the local level can legitimately be applied to the state as well. Yet the budget proposal is fundamentally different than previous pension obligation bonds, which have paid off unfunded liabilities. The state would primarily be financing its normal costs, rather than an existing debt. As a result, it is unclear to us if local government precedents would apply.
Special Funds Too? The administration has not determined whether to include the $980 million special fund retirement contributions to PERS in this alternative. (As noted above, the state's STRS contributions are entirely from the General Fund.) The Department of Finance (DOF) indicates that if this 2003-04 obligation were included, the special fund amounts could be transferred to the General Fund in the budget year to address the shortfall. This is because the General Fund would incur the future obligation to pay off the bonds.
Under the second alternative, the state would not pay its budget-year retirement contributions in 2003-04. Instead, the administration would enter loan agreements with PERS and STRS. The state's budget-year loans would become part of the systems' investment portfolios. The state would pay the amounts due over time, plus a fixed interest rate that would be lower than the pension systems' assumed rates of return—8.25 percent for PERS and 8 percent for STRS. The DOF has indicated that the administration would not pursue this alternative if PERS and STRS demanded additional retirement benefits in exchange for the loan agreement, due to the significant additional cost this would likely entail.
At this point, the administration is still determining the viability of both alternatives. According to DOF, a working group consisting of representatives from DOF, PERS, STRS, the Attorney General, the State Treasurer, and the State Controller is meeting to determine the workability of the pension bond alternative and to attempt to iron out the details.
At the time of this analysis, DOF had not met with STRS on the loan option. In addition, PERS has indicated that this alternative is "off the table" for their consideration because (1) it raises tax-exemption issues for the pension fund's investments and (2) the administration is not proposing a retirement benefit enhancement in exchange for the loan.
We recommend that the Legislature reject the administration's debt alternatives to pay 2003-04 state retirement contributions. Incurring years of debt to avoid an annual operating expense as a budget-balancing tool is poor fiscal policy.
As discussed above, we have not discovered an instance where pension obligation bonds have been used solely to pay annual retirement contributions—an ongoing operating expense. Rather, these bonds have been used to pay off a retirement system's unfunded liability—an obligation already incurred. Incurring decades worth of debt to avoid an annual operating expense as a budget-balancing tool is poor fiscal policy. Our conclusion also applies to the loan option, which would similarly obligate the state to several years' worth of payments with interest for the 2003-04 state retirement contributions. Consequently, we recommend that the Legislature reject these debt proposals.
State May Wish to Consider Bonds for Unfunded Liability. The state could consider issuing pension obligation bonds for some of the unfunded liability associated with PERS. For example, if the state issued bonds to pay the unfunded liability portion of its 2003-04 contribution ($0.5 billion), this obligation would no longer be charged through the PERS annual contribution rate. This would achieve one-time budget-year savings by reducing the 2003-04 state contribution by the same $0.5 billion.