Analysis of the 2007-08 Budget Bill: General Government

California State Teachers’ Retirement System (1920)

Under the direction of the Teachers’ Retirement Board (TRB), the California State Teachers’ Retirement System (CalSTRS) administers pension and other benefits for 776,000 current and former educators of California’s school and community college districts. In order to fund defined monthly benefits to eligible retired teachers, CalSTRS uses (1) returns generated from its $156 billion investment portfolio and (2) contributions made pursuant to state law by teachers, districts, and the state.

Under current law, the state must make two separate annual payments to CalSTRS from the General Fund:

• A payment equal to 2 percent of prior-year teacher payroll for CalSTRS’ Defined Benefit (DB) Program, which funds the basic pension benefits for retired educators.

• A payment equal to 2.5 percent of prior-year teacher payroll for CalSTRS’ Supplemental Benefit Maintenance Account (SBMA), which is also known as the “purchasing power account.” Funds in SBMA prevent erosion of the purchasing power of retirees’ benefits by the effects of inflation.

Figure 1 shows that the trend of the state’s CalSTRS contributions in recent years has been volatile due largely to several prior legislative actions that have produced one-time state budget savings. The 2007-08 Governor’s Budget proposes $1 billion of state contributions to CalSTRS, 6.4 percent above those of 2006-07. (In 2006-07, contributions were reduced on a one-time basis due to prior accounting errors by CalSTRS.) The contributions in the Governor’s budget include (1) $501 million for the DB Program—the required amount under current law—and (2) $547 million for SBMA. The proposed SBMA contribution is $75 million less than the 2.5 percent of prior-year teacher payroll that is required under current law. The administration proposes trailer bill language to authorize the lower amount of appropriations. We discuss this proposal later in this write-up.

System's Funded Status Is About Average for Comparable Pension Systems

The most recent California State Teachers’ Retirement System actuarial valuation reported that the system’s unfunded liability declined from $24 billion in 2004 to $20 billion in 2005. Measured as a percentage of the system’s total liabilities, this unfunded liability is about average among comparable public pension systems. The Teachers’ Retirement Board has formulated a general proposal for the Legislature’s consideration, which would attempt to address the unfunded liability.

System Is 86 Percent Funded, With $20 Billion Unfunded Liability. The system’s actuaries reported that, as of June 30, 2005, CalSTRS’s unfunded actuarial obligation for its DB Program was $20 billion, and the actuarially determined value of DB Program assets on hand was $122 billion (the bulk of the system’s assets). This means that the program is 86 percent funded, which is approximately the average reported funding level of major public pension systems nationwide. Figure 2 shows the value of assets and unfunded obligations (as well as the comparable funded status on a percentage basis) for some other large teacher retirement systems.

Proposal to Address Liabilities Would Require Legislature’s Approval. In recent months, the TRB has formulated a general proposal to address the unfunded liability. Among other provisions, the proposal would give TRB the authority to increase required contributions by teachers, districts, and the state. The Legislature must approve any such change in TRB’s authority.

LAO Framework for the Future of CalSTRS. In our Analysis of the 2005-06 Budget Bill, we described the CalSTRS retirement plan for teachers, its funding, and its unfunded liability. We also suggested that comprehensive reform of CalSTRS should place decision making and responsibility for retirement issues at the local level with employers (school and community college districts) and employees (teachers). Virtually all public pension systems in the state, including most benefit programs of the California Public Employees’ Retirement System (CalPERS), adhere to the general principle that retirement benefits should be established mainly through agreements between employers and employees and paid for by those groups. For CalSTRS, on the other hand, the state currently mandates the benefits provided by all employers and shares in the payments for those benefits. We believe that the key principles for any legislative overhaul of CalSTRS’ funding structure should be: (1) increasing local control over the benefits provided, (2) providing districts with flexibility, and (3) defining clearly the local responsibilities for long-term funding of the system. We are currently reviewing the specifics of CalSTRS’ new funding proposal.

State’s Loss of Lawsuit Would Require Payment of Over $650 Million

If an appellate court rules against the administration’s efforts to overturn a court ruling ordering the state to repay the $500 million withheld from the Supplemental Benefit Maintenance Account in 2003-04, the state may be required to transfer over $650 million (the withheld amount plus interest) from the General Fund to the California State Teachers’ Retirement System. Should this payment be required, we recommend that the Legislature fund it from the General Fund reserve if possible. However, if the Legislature chooses to borrow funds to make the payment, it should consider options with the lowest overall interest costs.

Legislature Established SBMA to Improve Retirees’ Purchasing Power. The standard annual benefit adjustment for retired teachers in CalSTRS is 2 percent per year. Unlike cost-of-living adjustments of CalPERS and many other public retirement systems, CalSTRS’ annual adjustment is not compounded. (If, for example, a member received a $3,000 monthly benefit immediately after retirement, his or her annual 2 percent adjustment would increase the monthly benefit by $60 after one year, an additional $60 the next year, and so on.) Therefore, CalSTRS’ annual adjustment may be insufficient to preserve the purchasing power of retirees’ benefits (especially during periods of high inflation). In recognition of this, the Legislature has approved several measures to bolster the benefits’ purchasing power. Since 1990, the Legislature has appropriated General Fund moneys to SBMA. The SBMA’s funds are distributed to keep the purchasing power of all retirees’ monthly benefit allowances at no less than a specified minimum percentage of the retiree’s initial allowance at the time of retirement (based on growth of the California Consumer Price Index over time). In 2001, the Legislature provided that—to the extent funds were available in SBMA and other specified accounts—CalSTRS retirees’ benefits would be adjusted annually to a level equal to 80 percent of the purchasing power of the initial allowance. Currently, 29 percent of CalSTRS’ retirees receive benefit adjustments under this provision. The SBMA currently disburses about $260 million per year in such benefits. (This is a small amount compared to the DB Program’s $6 billion in annual payments.)

State Law Specifies Annual SBMA Contribution Levels. State law provides for a continuous appropriation from the General Fund to SBMA of an annual amount equal to 2.5 percent of prior-year teacher payroll. The law states that it is the Legislature’s intent that the continuous appropriation be a “contractually enforceable promise to make annual contributions” to SBMA. Chapter 6, Statutes of 2003 (SB 20x, Committee on Budget and Fiscal Review), decreased the statutory annual appropriation by $500 million in 2003-04 on a one-time basis to help address the state’s budget deficit that year. Chapter 6 also provides for the state to contribute additional amounts to SBMA in certain instances if needed for the fund to make purchasing power benefit payments to retired teachers through June 30, 2036. The CalSTRS sued the state, claiming that Chapter 6 unconstitutionally violated the contractual rights of system members. In May 2005, a superior court ruled in favor of CalSTRS. The Department of Finance (DOF) appealed the ruling to an appellate court, which is likely to rule at some point during 2007. The superior court ordered the state to pay the $500 million to CalSTRS with 7 percent interest. The California Retired Teachers Association has appealed that part of the ruling to the appellate court, claiming that interest prior to the judgment date in the superior court should be awarded at a rate of 10 percent.

Recommend Legislature Use Reserves or Seek Low-Interest Borrowing Option. Should the appellate court and/or the California Supreme Court issue a final ruling against the state, we estimate that the state’s payment obligations could be somewhere between $650 million and $800 million, depending on the date of the final court order and the interest rate set by the judges. The court may order the state to transfer funds immediately. If so, we recommend that the Legislature consider funding the payment from the General Fund reserve in order to avoid additional costs. Should such a large amount of reserves not be available, the Legislature may be able to borrow the funds. In this case, the Legislature should seek to minimize total interest costs by choosing a debt instrument with (1) a low interest rate and (2) a repayment term that is as short as possible.

Recommend Rejecting Plan to Guarantee Teacher Benefit

We recommend that the Legislature reject the administration’s proposed trailer bill language to (1) guarantee teachers’ purchasing power benefits through California State Teachers’ Retirement System (CalSTRS) and (2) reduce General Fund costs by $75 million in 2007-08. There are risks in assuming that the change proposed in the budget package will generate near-term and ongoing budget savings, and we are concerned about the idea of the state guaranteeing another benefit through CalSTRS, which serves employees of local districts. We do suggest, however, that such a proposal in the context of a future comprehensive reform would warrant consideration by the Legislature.

Budget Proposes Changing Appropriation Language and Guaranteeing the Benefit. The Governor’s budget proposes changing the annual SBMA appropriation amount in the law from 2.5 percent of prior-year teacher payroll to 2.2 percent. In addition, the administration proposes amending the law to guarantee CalSTRS members that they will receive the current SBMA benefit (80 percent of purchasing power). The effect of this proposal would be that CalSTRS’ members would have a new contractual right to receive the 80 percent purchasing power benefit, no matter how well funded SBMA is. While the proposal would alter the contractually enforceable contribution amount in current law, courts have ruled that such changes may be allowed if a new benefit (such as the proposed benefit guarantee) is provided at the same time.

Administration’s Actuary Suggested Proposed Contribution Rate. Because SBMA benefits are not guaranteed, CalSTRS historically has not performed valuations of SBMA similar to those used to identify the unfunded liability of the DB Program. In connection with the SBMA lawsuit discussed above, however, DOF hired an actuary to perform a standard actuarial analysis of SBMA’s financial condition as of June 2003. Reporting that he used CalSTRS’ standard actuarial assumptions, DOF’s actuary found that SBMA had a $6.2 billion unfunded liability. Even so, he concluded that the current 2.5 percent annual contribution rate was “more than sufficient” to allow the fund to disburse promised benefits. The actuary found that, if the actuarial assumptions were accurate, SBMA’s investment balances would grow significantly over the next 60 years to over $150 billion by 2050 and give the account the ability to fund benefits “indefinitely.” In the opinion of the actuary, an annual state contribution of 2.2 percent of teacher payroll (instead of the current 2.5 percent contribution) would be sufficient to retire the unfunded liability within 30 years, assuming that the actuarial assumptions are accurate. The administration’s proposed new contribution rate to SBMA relies on this actuarial analysis of the program as of 2003.

Recommended Rejecting Proposal. The proposal is intriguing in that it purports to reduce state costs, while simultaneously guaranteeing a benefit to teachers. Despite the possibility that the proposal could result in a near-term reduction of state costs, we recommend that the Legislature reject it at this time, for two principal reasons.

• Some Risks for the Projection of Savings. First, we note that under the State Constitution, public pension boards like TRB have “sole and exclusive power” over pension actuarial services. In recent decades, when the Legislature periodically has amended the law to adjust state contribution rates for CalSTRS, it usually has relied on CalSTRS’ actuaries to suggest the appropriate long-term contribution level to be included in law based on actuarial assumptions in use at the time. Should CalSTRS’ valuation of the contributions needed to fund the purchasing power benefit not match those of DOF’s actuary, the proposed funding formula in the Governor’s budget could be vulnerable to (1) legal challenge because it is insufficient to fund the benefit or (2) requirements for increased contributions in the future in order to keep the benefit fully funded. Regardless of what CalSTRS’ actuaries say now, once the purchasing power benefit is guaranteed, the state could be obligated to make much higher contributions in the future if inflation increases SBMA costs or poor investment returns diminish the account’s assets. Under current law, CalSTRS’ members bear financial risk if these negative events occur. By contrast, under the budget proposal, the state’s General Fund would bear the risk.

• Guaranteeing New Benefit Raises Concerns. Second, we believe that the Legislature should be skeptical of any proposal to guarantee a new retirement benefit for state employees or teachers at a time when state pension and retiree health programs—including CalSTRS—have unfunded liabilities approaching $100 billion. (The CalSTRS’ current valuation of DB Program liabilities does not reflect the SBMA unfunded liability identified by the DOF actuary.) We are particularly concerned with the idea that the state would mandate another benefit in a CalSTRS retirement program that serves employees of local school and community college districts. Instead of decreasing state requirements, consistent with the framework for CalSTRS reform that we suggested in the 2005-06 Analysis, the proposal would add one more obligation and move CalSTRS in the wrong direction.

Legislature May Wish to Consider Such a Proposal in the Context of Reform. While we recommend that the Legislature reject the proposal at this time, we can think of a scenario in the future when a similar proposal would warrant consideration. Specifically, should the Legislature wish to adopt significant changes in CalSTRS’ funding structure in the future, we believe that it should use the opportunity to place control of the retirement program in the hands of local school and community college districts, rather than the state. A proposal to guarantee purchasing power benefits for current and past teachers would make more sense as part of an overall package that also gave districts more flexibility to determine benefit levels and funding requirements for their employees in CalSTRS.

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