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Summary of LAO Findings and Recommendations on the 2011-12 Budget

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 Go Back  CalSTRS System officials say budgeted 2011-12 state payment may be more than required by law Informs Legislature of analysis by system officials suggesting that the state's payments to CalSTRS in the Governor's Budget may be more than required by current statutes. 3-01-11

Detailed Narrative

As described below, officials of the California State Teachers' Retirement System (CalSTRS) have informed our office that they interpret the timing requirements of Section 22955(b) of the Education Code in a manner that may reduce the state's 2011-12 payment obligations to CalSTRS by $35 million, compared to the amount included in the Governor's budget. This item provides background information and analysis concerning the state's CalSTRS payment obligations in 2011-12.

Background

Governor's Budget for CalSTRS Contributions. The 2011-12 Governor's Budget assumes that the state General Fund will contribute $1,350,212,000 to the California State Teachers' Retirement System (CalSTRS) in 2011-12. This amount is based on the October 2010 report by CalSTRS of 2009-10 teacher payroll (upon which 2011-12 state contributions are based). The budgeted amount listed above consists of four separate components referenced in three specific sections of the Education Code:

  • Section 22955(a) Payment (Defined Benefit Program). Section 22955(a) of the Education Code requires the General Fund to contribute 2.017 percent of prior-year teacher payroll each fiscal year. The Governor's budget estimates that this payment will total $546.3 million.

  • Section 22954 Payment (Purchaser Power Maintenance). One component of the CalSTRS pension benefit package is the system's Supplemental Benefit Maintenance Account, which makes payments to specified teachers from available funding in order to protect benefits from erosion by inflation. Section 22954(b) of the Education Code requires the General Fund to contribute around 2.5 percent of prior-year teacher payroll each fiscal year. (The 2008-09 state budget package included modifications that reduced this payment by about $70 million per fiscal year.) The Governor's budget estimates that the total payments required by Section 22954 will total $605.1 million in 2011-12.

  • Section 22954.5 Payment (Court-Ordered Interest Payments). The 2003-04 state budget package withheld a $500 million state payment from SBMA on a one-time basis. The courts found this action to be unconstitutional and ordered the state to repay CalSTRS with interest. Section 22954.5 provides an appropriation for these court-ordered interest payments. The Governor's budget includes the next-to-last required interest payment--approximately $57 million--in 2011-12.

  •  Section 22955(b) Payment (Unfunded Liability for 1990 Benefit Structure). Section 22955(f) of the Education Code essentially requires CalSTRS to perform an alternate actuarial valuation each year of its defined benefit program in order to examine what the unfunded liability of the system would be if benefits had not been improved after July 1, 1990. As described on page 31 of CalSTRS' most recent defined benefit program actuarial valuation, this process has "limitations" since it is not known "if members who retired would have done so if the post-1990 benefit enhancements had not been enacted." The most recent valuation--dated August 2010--states that it is "very likely that the current funding for the 1990 benefit structure will become insufficient in the next valuation." This particular unfunded liability arises largely due to the system's large drop in investment assets in 2008, and it appears likely to continue for the foreseeable future. Under Section 22955(b) of the Education Code, when an unfunded liability is identified in the 1990 benefits structure, the state General Fund must begin contributing extra amounts to CalSTRS, starting at 0.524 percent of prior-year teacher payroll. The Governor's budget assumes that this payment requirement begins on July 1, 2011, with four equal quarterly payments to CalSTRS of $35.5 million each, for a total of $141.9 million in the 2011-12 fiscal year.

The 2011-12 Budget Bill currently includes the estimated 2011-12 state contributions to CalSTRS of $1.35 billion in Item 1920-011-0001. These are merely estimated amounts based on the October 2010 report of prior-year teacher payroll by CalSTRS. The actual amounts will be determined instead by the last revised report of prior-year teacher payroll, which CalSTRS is expected to submit on or before April 15, 2011 as required by Section 22955.5 of the Education Code.

History Concerning Section 22955(b).  In 1972 and 1979, the Legislature enacted measures to begin to address CalSTRS' unfunded obligations as of those points in time. By 1990, however, the system still operated with an "normal cost deficit" of $130 million--an amount that effectively rolled new debt each year into the system's unfunded obligation and deferred payments to future taxpayers. Chapter 460, Statutes of 1990 (SB 1370, C. Green)--known as the Elder Full Funding Act (referring to former Assembly Member Dave Elder)--was adopted to address this situation. Under Elder Full Funding, the General Fund was required to contribute 4.3 percent of prior-year teacher payroll. This 4.3 percent was to be used first to fund the normal cost deficit, if any, and second, to pay down unfunded liabilities related to the CalSTRS benefit structure in place on July 1, 1990. Calculations conducted in 1990 indicated that this amount would be sufficient to retire the then-existing unfunded obligation within 45 years.

In March 1998, during the storied 1990s "bull market," CalSTRS actuaries determined that the Teachers' Retirement Fund (TRF) assets equaled 97 percent of its liabilities and that the system's unfunded liabilities would be eliminated by June 30, 2000. As described in the CalSTRS Overview publication (p. 27), "as a result of this finding, an opportunity existed to use General Fund money that had been appropriated to the TRF for purposes of retiring the unfunded liability for improved benefits." In that year, the Legislature enacted measures to increase the CalSTRS benefit for members retiring after January 1, 1999, to a maximum of 2.4 percent at age 63 and to allow members with 30 or more years of service to receive an increase of 2 percent in the system's benefit formula, up to the maximum "age factor" of 2.4 percent.

In 1998, the Legislature also enacted AB 2804 (Public Employees, Retirement, and Social Security Committee), which changed the 4.3 percent Elder Full Funding state contribution to 3.102 percent "to fund increased benefits," according to CalSTRS' Overview publication. AB 2804 also added Section 22955(b) to the Education Code to provide for an annual continuous appropriation of 0.524 percent of prior-year teacher payroll "to fund the normal cost deficit or the unfunded obligation" (on the July 1, 1990 CalSTRS benefit structure) if those specified obligations exist. AB 2804 provided that this continuous appropriation of at least 0.524 percent of prior-year teacher payroll commenced on October 1, 1998. (The October 1, 1998 start date was originally included in the version of AB 2804 as amended in the Senate on August 24, 1998. The designation of the October 1 start date may have resulted merely from the fact that this was the date of the next quarterly payment to CalSTRS at the time AB 2804 was amended in the Senate. As described below, the October 1 reference in this statute may be important for the current issue.)

Chapter 1021, Statutes of 2000 (AB 2700, Lempert), reduced General Fund appropriations to the defined benefit program again, and this law amended Section 22955(b) into largely the form it has in statute today, including an October 1, 2003 start date for the continuous appropriations to fund the 1990 unfunded liability.

Prior Experience With Section 22955(b) Payments. The CalSTRS board adopted the defined benefit program's June 30, 2003 actuarial valuation on July 8, 2004. This valuation identified a $118 million unfunded obligation in the 1990 benefit structure. In that valuation document, actuaries stated that their "interpretation of [Section] 22955(b), supported by [CalSTRS'] legal counsel, is that an additional annual contribution of 0.524 percent will be payable quarterly commencing on October 1, 2004 based on credited compensation from the 2002-03 fiscal year." The state made this payment for one year only. In the next actuarial valuation, actuaries opined that the $118 million unfunded obligation in the 1990 benefits structure had changed into an $804 million actuarial surplus. Accordingly, in 2003-04, the state did not have Section 22955(b) payment obligations, and it has not had to make these payments since then--until now.

CalSTRS' Interpretation of Section 22955(b)

What Is the Start Date for State Payment Obligations in 2011-12? As described above, the Governor's budget assumes a July 2011 start date for the state's Section 22955(b) payment obligations to CalSTRS. Accordingly, the administration assumes four equal quarterly payments of $35.5 million in 2011-12. Yet, based on CalSTRS' recent schedules of approving its actuarial valuations in September, as well as the past precedent of these payments beginning in October, we inquired of the system whether instead only three quarterly payments would be required in 2011-12. Our thinking was that the state's Section 22955(b) payment requirements could not possibly be triggered until after the TRB's formal adoption of the system's annual actuarial valuation.

In responding to our informational request, system officials informed us instead that the next actuarial valuation--concerning the system's funded status as of June 30, 2010--is expected to be formalized at the TRB's April 2011 meetings. Accordingly, it seems certain that by April 2011, CalSTRS will determine that the unfunded obligation in the 1990 benefit structure currently exists. The system's officials also informed us that they interpret Section 22955(b)--we gather, due to the mention of the date of October 1, 2003 as the commencement date for its continuous appropriation--as requiring the state to begin making payments in October 2011. In other words, even though the board is likely to determine an unfunded obligation exists in the 1990 benefit structure in April 2011, the system's interpretation of the law appears to be that no continuously appropriated quarterly payments from the state have to start until October--over five months later.

Implications of the System's Decision. System officials acknowledge--and we agree--that Section 22955(b) is vague as to the start date of 1990 unfunded liability payments in fiscal years after 2003-04. It is worth noting that nowhere in the statute does it say that quarterly payments on the 1990 unfunded liability, once required, begin in October. Nowhere does the statute say that five months may elapse between the board's determination that a 1990 unfunded obligation exists and the commencement of state appropriations related to that liability.

The system's current interpretation of Section 22955(b) seems to rest heavily on the October 1, 2003, date mentioned in the law. The implications of that interpretation are that the $35 million July 1, 2011 payment included in the Governor's budget may not be required under current law. If the Legislature adopts this interpretation and the $35 million payment on July 1 is not made, the system would forego the opportunity to invest and earn money on that $35 million until it is eventually paid by the state (effectively, with over 7 percent annual interest) in a future year.

While there is a risk that an interested party, such as a CalSTRS member or stakeholder group, could sue the state to require the $35 million payment, the odds of that appear to be very low given that system staff indicate that they interpret the law to require the payments to start in October 2011.

Conclusion

Based on CalSTRS officials' interpretation of Section 22955(b), the Legislature may wish to reduce the Governor's estimated budget amount for 2011-12 CalSTRS contributions by $35,478,000 to reflect an understanding that Section 22955(b) payments will commence in October 2011--not July 2011, as the administration assumed.

The Legislature could then use this $35.5 million to reduce other expenditure cuts in its budget or reduce the need for revenue increases.

In the final analysis, the system's unfunded liabilities as of its June 30, 2009 valuation--$40.5 billion--will require far larger additional payments from the state, school districts, and/or teachers than those required by Section 22955(b) in 2011-12 and future years. As of that valuation, actuaries determined that the system needed contributions equal to an additional 13.9 percent of teacher payroll--over $3.8 billion per year--from some source, beginning immediately, to retire its unfunded liabilities over 30 years, thereby preventing additional intergenerational transfers of teachers' compensation costs. (The TRB's decision to lower its assumed average annual rate of investment return to 7.75 percent in December 2010 will affect these calculations in future valuations. In this recent board agenda item, actuaries estimated this would increase the additional funding need from 13.9 percent of payroll to 15.1 percent. At that time, CalSTRS staff had recommended instead a drop in the assumed investment return rate to 7.5 percent, which would have increased the estimate of additional funding need even further to 16.8 percent of payroll.)

Given these grim statistics concerning the fiscal health of CalSTRS, another option for the Legislature would be to voluntarily contribute the $35.5 million to the system at some point in 2011-12, despite the system's contention that no July 2011 payment will be required. This $35.5 million would reduce what would otherwise be the state's future payment obligations--already significant--by a very small amount.