Analysis of the 2007-08 Budget Bill: General Government

Retirement Contributions (Control Section 3.60)

This control section specifies the state’s contribution rates for the various retirement classes of state employees in the California Public Employees’ Retirement System (CalPERS). The section also allows the Director of Finance to adjust amounts in any appropriation item as a result of changes in the contribution rates.

The State Constitution gives retirement boards, such as the CalPERS Board of Administration, the exclusive power to undertake actuarial reviews of their pension funds and to administer the funds for the benefit of their members. In order to fund defined monthly benefits for retired public employees, CalPERS uses (1) returns generated from its $224 billion investment portfolio and (2) contributions made by public employees and employers. Employees and retirees of the state and many local governments are enrolled in CalPERS’ programs, with the assets and liabilities of each employer accounted for separately. Of the $26.6 billion unfunded liability for CalPERS’ Public Employees’ Retirement Fund as of June 30, 2005, for example, $14.8 billion represents unfunded liabilities attributable to the state. Local governments and school districts are responsible for the other liabilities. As a whole, the system’s liabilities are 87 percent funded.

State law and collective bargaining agreements define the retirement benefits that state employees earn as part of the compensation provided in exchange for their work. The law and collective bargaining agreements require that employees pay a specified percentage of their salaries—typically about 5 percent or 6 percent—to CalPERS to cover a part of the costs of future pension benefits. The state also makes employer contributions to CalPERS. The employer contributions cover the estimated cost of pension benefits earned by employees in each pay period (normal cost), as well as costs to amortize and eliminate (over time) any unfunded liabilities that exist with regard to employees’ and retirees’ prior service. In defined benefit pension programs, such as those of CalPERS, unfunded liabilities emerge when actuarial assumptions related to annual investment returns, employee pay levels, and demographic factors are not met. Since these trends cannot be predicted with precision, CalPERS contribution rates usually change from year to year—sometimes increasing and sometimes decreasing.

Projected State Contribution Rates Down, Except for Peace Officers and Firefighters

Because of healthy investment returns, the California Public Employees’ Retirement System (CalPERS) projects that required state contribution rates will decline slightly for most state employee groups in 2007-08 after unexpectedly increasing in 2006-07 due to several noninvestment-related actuarial factors. The system’s projection appears reasonable. Nevertheless, we withhold recommendation on 2007-08 contribution rates pending their final determination in May by the CalPERS Board of Administration based on the system’s annual actuarial valuation.

Healthy Investment Returns May Help Reduce Rates for Most Groups. The CalPERS will set 2007-08 rates based on an actuarial valuation of the system’s financial condition as of June 30, 2006. In 2005-06, the investment return of CalPERS’ assets totaled about 12 percent, compared to the system’s normal projected investment return of under 8 percent annually. This healthy investment performance was led by a (1) 38 percent return on the system’s real estate investments, (2) 27 percent return on international stocks, (3) 19 percent return on private equity investments, and (4) the system’s 10 percent investment return on domestic stocks. These investment returns are the principal factors resulting in projected lower contribution rates for most state employee groups in 2007-08, as shown in Figure 1. More than one-half of the state’s total contributions is for “Miscellaneous Tier 1” employees, and another one-fourth is for peace officers (such as correctional officers) and firefighters.

Employer Rates for Correctional Officers and Firefighters May Rise. The system’s projections shown in Figure 1 indicate that the state’s contribution rates for peace officers and firefighters will increase from 24.5 percent of payroll in 2006-07 to 25.6 percent in 2007-08. (This would be the highest state contribution rate for the peace officer and firefighter [POFF] retirement group in its 23-year history.) Enhanced “3 percent at 50” retirement benefits took effect for correctional officers and firefighters on January 1, 2006. Since the upcoming valuation will reflect the system’s financial status as of June 30, 2006, it is the first such review to reflect the costs of the enhanced benefits. For the POFF retirement group, therefore, the increased costs of addressing liabilities related to the enhanced benefits are expected to outweigh the benefits of the favorable investment returns of 2005-06. The system projects that the state will make employer contributions of $755 million in 2007-08 for POFF group members. Most POFF group members work in departments that receive virtually all of their funding from the General Fund. The estimated 2007-08 POFF employer contributions equal about 50 percent of total projected General Fund-supported contributions to CalPERS in 2007-08.

Total State Contributions Should Rise, Due to Larger Payroll. While required employer contribution rates are projected to decline for all of the retirement groups except POFF, the state’s total contributions should increase due to payroll growth. Figure 2 shows recent trends in the state’s total contributions from the General Fund and special funds, including CalPERS’ projections for 2007-08 contributions. Under these projections, total state contributions would grow from $2.7 billion in 2006-07 to $2.8 billion in 2007-08, up 3.6 percent. Over one-half of this amount (an estimated $1.5 billion) would be paid from the General Fund. The 2007-08 Governor’s Budget accommodates virtually all of these costs. Should CalPERS’ current projections hold, we estimate that about $10 million may need to be added to the Governor’s budget in order to address higher General Fund costs than are currently reflected in various line items.

Withhold Recommendation. The projections provided by CalPERS appear reasonable. Nevertheless, we withhold recommendation on the control section pending CalPERS’ final determination of required 2007-08 contribution rates—which is expected to occur in May. The administration should be able to submit any necessary revisions in budgeted amounts related to the new contribution rates in the May Revision or soon thereafter.

Doubtful That $525 Million Will Be Realized From Pension Bonds

The Governor’s budget assumes that pension obligation bonds authorized in 2004 will be sold in 2007-08, yielding $525 million of net General Fund savings. In November 2005, a court found that the legislation authorizing the sale of the bonds was unconstitutional. Even if appellate courts were to overturn the superior court ruling, it is risky to assume that the sale of the bonds could be completed in the budget year.

Chapter 215, Statutes of 2004 (SB 1106, Committee on Budget and Fiscal Review), authorizes the sale of up to $2 billion in pension obligation bonds. (This bill was passed after a similar 2003 law was challenged in court.) Legal rulings also have prevented the sale of the bonds authorized by Chapter 215. The administration now assumes that (1) its efforts to overturn the 2005 superior court ruling in appellate courts will succeed, (2) the case will be finalized—meaning that all appeals by all parties are exhausted—during the budget year, (3) the bonds can be successfully marketed to investors in time to generate a net benefit for the General Fund for the budget year, and (4) the amount of bond proceeds—limited under the law by an arcane formula—will be sufficient to generate $525 million of net General Fund savings. We believe it is unlikely that all four of these assumptions will be met during the budget year, if ever.

Even if the bonds could be sold in 2007-08, we would advise on a policy basis not to proceed with a sale. We have consistently recommended against issuing the bonds since they would incur debt for an annual operating expense. In addition, the proposed issuance of the pension obligation bonds runs counter to the budget’s stated goal of reducing budgetary debt.

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