Addressing California's Key Liabilities

Addressing California’s Key Liabilities MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • MAY 7, 2014 AN LAO REPORT Cover Photo: The image on the cover shows the headquarters of CalSTRS, on the Sacramento River in West Sacramento. 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT EXECUTIVE SUMMARY Key Liabilities Total $340 Billion. A central tenet of public finance holds that expenses should be paid for during the year that they are incurred. In some cases, however, the state has taken actions that allowed it to provide services without at the same time paying for their full costs, creating a liability that must later be addressed. This report provides an overview of $340 billion of the state’s key liabilities— that is, debt, deferred payments, and other liabilities that will affect the state’s financial health in the future. Over $140 Billion of Liabilities Being Addressed. Of the state’s key liabilities, changes to current law and policy are not needed for over $140 billion of liabilities to be eliminated in a reasonable manner. For example, recent actions taken by the California Public Employees’ Retirement System (CalPERS) board are intended to address the unfunded liability for state employee pension benefits in about 30 years. On the other hand, about $200 billion in liabilities are at least in part not being addressed and merit further legislative attention. For example, absent corrective action, the California State Teachers’ Retirement System (CalSTRS) pension program is expected to deplete its assets during the 2040s. Prioritizing Key Liabilities. Because the state does not have the resources to immediately address all liabilities that merit further attention, the state must set priorities about which liabilities to repay. In general, we suggest priority be given to paying down those liabilities that result in the greatest benefits. We assess these benefits by looking at characteristics of the liabilities—including (1) the rate at which they grow and (2) whether addressing them also benefits groups or entities other than the state government. Make CalSTRS Top Priority. Due to its massive unfunded liability and relatively fast growth rate, we recommend that the Legislature make the CalSTRS pension program a top priority in addressing the state’s key liabilities. We recommend that the Legislature aim to fully fund the system in about 30 years. Doing so will be difficult. Depending on the funding arrangement, the additional contributions from the state, teachers, and districts combined could total over $5 billion per year by the early 2020s. Addressing this difficult challenge, however, only grows more costly the longer we wait, meaning that the most important action the state can take to minimize costs is to act quickly to increase contributions to CalSTRS. Prefunding Retiree Health. Among the state’s other key liabilities, retiree health liabilities for state employees present a difficult challenge. Committing to a plan to prefund retiree health benefits for state employees over 30 years would have cost an additional $1.8 billion in 2013-14. While this is a significant sum, using investment returns to pay for these benefits would dramatically reduce state costs over the long run. For this reason, we recommend making retiree health a key priority after CalSTRS. Approach Could Mean Fewer Resources for Addressing “Wall of Debt.” Addressing the CalSTRS liability and some or all of the retiree health unfunded liabilities would mitigate two of the greatest long-term risks to the state budget. In the near term, addressing CalSTRS and retiree health liabilities could mean fewer resources available for other priorities—including building budget reserves and paying down the rest of the Governor’s wall of debt. Because CalSTRS and retiree health liabilities tend to have higher interest rates than the items on the wall of debt, failing to prioritize CalSTRS and retiree health will increase the state’s budgetary risk in the longer run. www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO REPORT 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT INTRODUCTION Fundamental Principle of Public Finance. A responsible for paying at least part of the cost of a central tenet of public finance holds that expenses liability or indirectly responsible—meaning that if should be paid for during the year that they are another funding source were incapable of paying for incurred. In the case of annual operating expenses, a liability the General Fund could become responsible this means that deferrals and other accounting in part or in whole. In addition, the report lists two maneuvers that delay costs should be avoided. In liabilities—pension and retiree health benefits for the case of pension and other retirement benefits, University of California (UC) employees—for which this means that costs should be paid for during the the General Fund does not have a legal responsibility. employees’ working years. Waiting until employees Because growing costs associated with these liabilities retire to pay these expenses not only increases the could result in pressure for the state to provide future total costs of providing benefits but also imposes General Fund augmentations to UC, the liabilities these costs on future generations. have an indirect relationship with the General Fund Graphic Sign Off Purpose of Report. In some cases, the state has and are included in this report. Appendix 1 provides taken actions that allowed it to provide services some additional detail on the scope of this report. Secretary without at the same time paying for their full costs, Three Major Categories of Liabilities. Analyst creating a liability that must later be addressed. This California’s liabilities fit into three broad MPA report provides an overview of these key liabilities— categories—retirement, infrastructure, and Deputy that is, debt, deferred payments, and other liabilities budgetary. As shown in Figure 1, the state’s key that will affect the state’s financial health in the liabilities total about $340 billion. State retirement future. First, we categorize and provide information liabilities—for pension and retiree health benefits— about California’s key liabilities. Next, we develop make up the bulk of that amount. a framework for the Legislature to consider in prioritizing how state funds could most Figure 1 Retirement Benefits Make Up the effectively be used to pay down these liabilities. Bulk of California’s Key Liabilities Finally, we make recommendations on which liabilities to pay down first and comment on how (In Billionsa) the state should address these costs in the future. Determining Scope of Report Requires Budgetary Significant Judgment. California has many retirement, infrastructure, and budgetary liabilities, and there is no single correct way to Infrastructure itemize them. We have used our best judgment in providing the Legislature with our take on Retirementb the state’s key liabilities. In general, the state has not paid for the liabilities in this report as costs accrued. The liabilities detailed in this $50 100 150 200 250 report have some relationship with the General a Generally, reflects most recent estimate for each liability. b Based on each pension systems’ valuations of liabilities. Fund—the state’s main operating account. Specifically, the General Fund must be directly www.lao.ca.gov Legislative Analyst’s Office 5 Template_LAOReport_mid.ait ARTWORK #140209 AN LAO REPORT • Retirement. These liabilities include operations—such as the value of state unfunded liabilities for pension and retiree worker vacation balances—that have not health benefits for state employees, as well as been funded over time. for pension benefits for the state’s teachers Some Key Liabilities Already Being Addressed. and school administrative personnel. (For Within these three categories, changes to current the purposes of this report, the term “state law and policy are not needed in order for some employees” includes judges and California liabilities to be eliminated in a reasonable manner. State University [CSU] employees but not For example, recent actions taken by the CalPERS UC employees. UC employees are addressed board are expected to increase future employer in this report separately from state contributions to the system and aim to eliminate employees.) the unfunded liability for its pension prGogrraamph oivcer Sign Off about 30 years—a reasonable amount of time in • Infrastructure. These liabilities include the Secretary our view. On the other hand, some liabilities are at principal amount of outstanding general Analyst least in part not being addressed and merit further obligation and lease revenue bonds issued by MPA legislative attention. For example, absent corrective the state to finance capital infrastructure. Deputy action, the CalSTRS pension program is expected • Budgetary. These liabilities include those to deplete its assets during the 2040s. Additional that the state incurred in recent years to actions are therefore needed to address this address its budget problems, as well as unfunded liability, as well as certain other liabilities. liabilities arising from typical government As shown in Figures 2 and 3, most of the state’s key Figure 2 Most Liabilities Merit Further Legislative Attention (In Billions) $90 Merit Further Attention Being Addressed 80 70 60 50 40 30 20 10 CalSTRS State Budgetary Other Infrastructureb CalPERSc Budgetary Retiree Healtha Retirement a Unfunded liability for retiree health benefits for state employees. Unfunded liability for retiree health benefits for UC employees included in “Other Retirement.” b General obligation and lease revenue bonds. c Includes $41 million unfunded liability for Judges’ Retirement System II. 6 Legislative Analyst’s Office www.lao.ca.gov Template_LAOReport_large.ait ARTWORK #140209 AN LAO REPORT liabilities merit further Figure 3 action in our view. Most Key Liabilities How Much Is Merit Further Legislative Attentiona $340 Billion? The state’s (In Billions) key liabilities listed in Liabilities That Merit Further Legislative Attention Amount Figures 1 through 3 total Retirement around $340 billion, a CalSTRS pension program $73.7 substantial sum. To put Retiree health benefits for state employees 64.6 that figure in perspective, it UC pension program 13.8 Retiree health benefits for UC employees 12.5 is nearly two-and-one-half Judges’ Retirement System I pension program 3.3 times the amount of state Subtotal ($167.9) General Fund and special Budgetary School and community college obligationsb $10.0 fund spending in 2013-14. Special fund loans to the General Fund 4.5 If divided among the state’s State worker leave 4.1 residents, the amount of Workers’ compensation obligations 3.5 Deferred Medi-Cal costs 2.0 these key liabilities would Mandate reimbursements to cities, counties, and special districts 1.9 represent over $8,500 per Salton Sea mitigation and other pollution remediation 1.8 person. The state’s key State payroll deferral 1.6 Proposition 98 settle-up 1.5 liabilities represent nearly Unclaimed property 0.9 one-fifth of California CalPERS quarterly payment deferral 0.4 personal income in 2013 (a Unemployment insurance loan from federal governmentc — Subtotal ($32.1) commonly cited measure Total $200.0 of the size of the state’s Liabilities That the State Is Addressing economy). Retirement General Fund CalPERS pension program for state employees $49.9 Judges’ Retirement System II pension program 0.0d Not Only Source for Subtotal ($50.0) Addressing Key Liabilities. Infrastructure Figure 4 (see next page) General obligation bonds $75.1 Lease revenue bonds 10.2 displays the sources of Subtotal ($85.3) funding that may be used Budgetary to address the state’s key Economic recovery bonds $4.6 Quality Education Investment Act obligation 0.4 liabilities. As shown in the Transportation Investment Fund borrowing 0.3 figure, the state’s General Paterno settlement 0.1 Fund will incur all of the Subtotal ($5.3) costs of addressing some Total $140.6 liabilities. In other cases, Grand Total $340.7 a however, other state funds Generally, reflects most recent estimate for each liability. b Includes payment deferrals ($6.2 billion), mandate reimbursements ($4.8 billion), and Emergency Repair and even external sources Program obligation ($462 million). Assumes $1.5 billion Proposition 98 settle-up obligation used to repay school and community college obligations. may share in a portion of c Under current law, employers in California are expected to repay the principal on this loan through increased revenues related to the federal unemployment insurance tax. the costs. For example, d Judges’ Retirement System II unfunded liability totals $41 million. depending on how the www.lao.ca.gov Legislative Analyst’s Office 7 AN LAO REPORT Figure 4 Key Liabilities Paid From State General Fund and Other Sources (Dollars in Billions) State Other State Other Possible Liability General Fund Fundsa Sources of Funding Liabilities That Merit Further Legislative Attention Retirement CalSTRS pension program $73.7 Unk. — School districts, teachers Retiree health benefits for state employees 64.6 59% 41% State employees UC pension program 13.8 Unk. — UC, UC employees Retiree health benefits for UC employees 12.5 Unk. — UC, UC employees Judges’ Retirement System I pension program 3.3 100 — — Budgetary School and community college obligationsb 10.0 100c — — Special fund loans to the General Fund 4.5 100 — — State worker leave 4.1 49 51 — Workers’ compensation obligations 3.5 65 35 — Deferred Medi-Cal costs 2.0 100 — Mandate reimbursements to cities, counties, and special 1.9 100 — — districts Salton Sea mitigation and other pollution remediation 1.8 Unk. Unk. — State payroll deferral 1.6 46 54 — Proposition 98 settle-up 1.5 100 — — Unclaimed propertyd 0.9 — 100 — CalPERS quarterly payment deferral 0.4 100 — — Unemployment insurance loan from federal governmente — — — Employers, benefit changes Total $200.0 Liabilities That the State Is Addressing Retirement CalPERS pension program for state employees $49.9 58% 42% — Judges’ Retirement System II pension program 0.0f 100 — — Infrastructure General obligation bonds 75.1 83 17 — Lease revenue bonds 10.2 74 26 — Budgetary Economic recovery bonds 4.6 — 100g — Quality Education Investment Act obligation 0.4 100 — — Transportation Investment Fund borrowing 0.3 100 — — Paterno settlement 0.1 100 — — Total $140.6 Grand Total $340.7 a Includes federal reimbursements to state special funds. b Includes payment deferrals ($6.2 billion), mandate reimbursements ($4.8 billion), and Emergency Repair Program obligation ($462 million). Assumes $1.5 billion Proposition 98 settle-up obligation used to repay school and community college obligations. c School and community college obligations can be repaid within growth in the Proposition 98 minimum guarantee. d Claims will be paid from the Unclaimed Property Fund. Indirectly, claim payments will result in decreased General Fund revenues. e Under current law, employers in California are expected to repay the principal on this loan through increased revenues related to the federal unemployment insurance tax. f Judges’ Retirement System II unfunded liability totals $41 million. g Until the economic recovery bonds are repaid, a state special fund makes payments on principal and interest. The General Fund compensates schools and community colleges for amounts equal to those payments for their lost revenues resulting from the financing mechanism used to repay the bonds. Unk. = unknown and/or dependent on future decisions by the state and other entities. 8 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Legislature and Governor assign responsibility for pay a share of the costs. In this and similar cases, the the $73.7 billion CalSTRS unfunded liability, school full costs of key liabilities described in this report and community college districts and teachers may may not be borne entirely by the state. LIABILITIES THAT MERIT FURTHER LEGISLATIVE ATTENTION This section of the report details liabilities actuarial valuations such that changes in estimates that are not being addressed (at least in part) and of unfunded liabilities and normal costs produce therefore merit further legislative attention. changes in employer contributions required to fund these systems. R etiRement $6 Billion in Contributions to CalSTRS For background information on pension and in 2012-13. In 2012-13, employees contributed retiree health benefits—including a description 8 percent of their pay ($2.3 billion), districts Graphic Sign Off of unfunded liabilities, constitutional protections contributed 8.25 percent of payroll ($2.3 billion), Secretary of vested benefits, and actuarial practices—see and the state contributed about 5 percent of payroll Analyst Appendix 2 at the end of this report. ($1.4 billion, as measured on a two-year lag). MPA $73.7 Billion Unfunded Liability. CalSTRS CalSTRS Deputy has not been appropriately funded for most Second Largest Pension System in U.S. of its 101-year history. The program was fully Established in 1913, CalSTRS administers retirement funded for a brief period in the late 1990s, as programs for 868,000 members—equivalent to shown in Figure 5. Around that time, the state about 2 percent of California’s population. CalSTRS members are Figure 5 current, former, and retired teachers CalSTRS Pension Program and administrators, as well as their Fully Funded for Brief Period in Late 1990s beneficiaries. Assets as Percent of Accrued Liabilities State Sets Contribution Rates 120% in Statute. A key distinction between CalSTRS and other active 100 pension systems in California is that the Legislature and the Governor 80 set contribution rates for CalSTRS 60 in state statutes. In other pension systems, including CalPERS and the 40 Judges’ Retirement System (JRS) II, the retirement system’s governing 20 board has the authority to change employer contribution rates. 1975 1980 1985 1990 1995 2000 2005 2010 These rates are generally based on www.lao.ca.gov Legislative Analyst’s Office 9 ARTWORK #140209 Template_LAOReport_mid.ait AN LAO REPORT increased member benefits and reduced the state’s over-$5 billion estimate could prove too high or too contributions to CalSTRS. These actions, combined low, depending on the details of the funding plan, with weak investment returns in the early 2000s, investment returns, and other actuarial factors. produced a $23 billion unfunded liability by 2003. CalSTRS Unfunded Liability May Be State’s The unfunded liability increased significantly as Most Difficult Fiscal Challenge. Assuming a the system recorded large investment losses during gradual ramp-up of additional contributions, the the late 2000s economic downturn and adjusted amounts necessary to fully fund the CalSTRS downward its estimates of future system investment pension program over a 30-year period would be returns. The unfunded liability is estimated to be about the same as the amount of state General $73.7 billion as of June 30, 2013. Fund spending on the UC and CSU combined. Unfunded Liability Continues to Grow Despite As some of these contributions may come from Strong Investment Returns. Over the past three teachers and districts, addressing the CalSTRS years, CalSTRS’ annual investment returns have unfunded liability likely will have a significant averaged over 12 percent. Despite these strong effect on state and district budgeting. As such, this gains, the unfunded liability has grown 14 percent may be the state’s most difficult fiscal challenge. (from $64.5 billion to $73.7 billion) over the same Retiree Health Benefits for State Employees period, largely due to the underfunding of the system. State Covers 277,000 Retirees and Projected to Deplete Assets in About 30 Years. Dependents. California provides health and dental According to its latest actuarial valuation, absent benefits to 277,000 retired state employees and their additional contributions to its pension program, dependents. The state also provides health benefits CalSTRS estimates that it will exhaust its assets in to active employees, most of whom would be 2046. If assets are depleted, CalSTRS benefits could eligible for health benefits in retirement assuming only be paid on a pay-as-you-go basis—meaning they finish their careers with the state. that benefits would have to be paid for after the For Most State Employees, Eligibility employees retire rather than funded during their Dependent on Years of Service. State employees service years. This would be significantly more hired prior to 1985 receive 100 percent of average costly because the program could no longer use state health premium costs at retirement. Most investment returns to pay a portion of the benefits. state employees hired since 1985, however, must To prevent this worst-case scenario, additional work a certain number of years before the state will funding would need to be provided to CalSTRS in pay 100 percent of the average health premium in the coming few decades. retirement. (CSU retirees are one exception—the Over $5 Billion in Additional Annual state will pay 100 percent of average premium costs Contributions Likely Needed. To fully fund the provided they are eligible for health benefits at system over a 30-year period, annual contributions retirement.) For state employees hired after 1989, from the state, teachers, and districts will likely the state pays 50 percent of average premiums at need to increase by more than $5 billion. This retirement provided they have ten years of service. amount assumes a gradual ramp-up of additional With each additional year of service at retirement, contributions starting in 2015-16. This also the state will pay an additional 5 percent of the assumes that the system achieves its 7.5 percent premium, such that if an employee has 20 or more average annual investment return target. The years of service the state will pay 100 percent of 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT average premium costs. (At 20 or more years of they accrue. Because investment returns would pay service, the state also pays 90 percent of dependent for a much greater share of the cost for providing costs.) future retiree health benefits, the accounting California Governments Generally Do Not guidelines would then allow a higher assumption Prefund Retiree Health Benefits. Most pension about investment returns, significantly reducing systems invest contributions and use the resulting the estimate of the unfunded liability. Specifically, investment returns to partially fund future costs. under a scenario in which the state commits to Generally, governments in California do not fully fund retiree health benefits over 30 years, the prefund retiree health benefits in this way. Rather, unfunded liability would fall to $42.5 billion. retiree health benefits are funded on a pay-as-you Additional $1.8 Billion Needed Annually go basis, a significantly more expensive method of Under Full Funding Scenario. The state will spend paying benefits. This means that governments pay $1.8 billion on retiree health benefits in 2013-14. for the costs of benefits when the employees retire To fully fund retiree health benefits in 30 years, rather than as costs accrue during the employees’ state spending would have to be twice that amount service years. These costs therefore are routinely ($3.6 billion). deferred to future generations. UC Retirement Liabilities Retiree Health Partially Prefunded for Three Bargaining Units. In 2010, the Legislature ratified UC Pension Program Covers 254,000 labor agreements with three bargaining units— Members. The UC Regents created the UC Unit 5 (California Highway Patrol [CHP] officers), Retirement Plan (UCRP) in 1961. In 2013-14, the Unit 12 (craft and maintenance workers), and Unit UCRP covered 254,000 current, former, and retired 16 (physicians, dentists, and podiatrists)—to begin faculty and other UC employees, as well as their prefunding retiree health benefits. Employees in beneficiaries. these units contribute at least 0.5 percent of their UCRP Historically Well-Funded. . . Figure 6 pay and, in the case of Unit 5, the state makes (see next page) displays historical funding ratios additional contributions. Despite these modest for the UCRP. Unlike most pension systems in efforts, however, California’s retiree health liability California, the UC pension plan was “superfunded” remains virtually unfunded. Specifically, the state for about 20 years starting in the late 1980s. This has assets sufficient to pay for less than one-tenth means that the system had over 100 percent of the of one percent of its $64.6 billion retiree health assets needed to pay future benefits. At its peak liability. around 2000, for example, the UCRP had assets $64.6 Billion Unfunded Retiree Health totaling 154 percent of the amount needed to pay Liability. The state’s unfunded liability for retiree the cost of future benefits earned as of that date. health benefits was estimated to be $64.6 billion Due to UCRP’s exceptional funding status, the UC as of June 30, 2013 under current public-sector Regents allowed a “funding holiday” for nearly two accounting guidelines. This accounting estimate decades during which neither UC nor its employees of these unfunded liabilities would be much lower, were required to contribute to the retirement plan. however, if the state committed to prefund retiree (The funding holiday also resulted in the state health benefits. This would involve eliminating the discontinuing funding to UC for retirement costs unfunded liability over a few decades while at the for instructional and certain other staff.) same time paying for the full cost of the benefits as www.lao.ca.gov Legislative Analyst’s Office 11 Graphic Sign Off Secretary Analyst MPA Deputy AN LAO REPORT upon retirement. Similar to Figure 6 the state, UC provides retiree UC Retirement Plan Was Superfunded for Many Years health benefits on a pay-as- Assets as Percent of Accrued Liabilities you-go basis. As of July 1, 180% 2013, the UC’s unfunded 160 liability for retiree health 140 120 benefits was $12.5 billion. 100 General Fund Has No 80 Direct Responsibility for UC 60 Retirement Liabilities. The 40 20 state does not have a legal obligation to provide funding 1990 1995 2000 2005 2010 to the UC specifically to pay Source: University of California. for its retirement liabilities. As these retirement liabilities . . .But Funding Holiday Led to $13.8 Billion consume a larger share of Unfunded Liability. The 2009 valuation revealed UC’s budget, however, there may be pressure on the first unfunded liability for the plan in over the state to provide General Fund augmentations two decades. As of July 1, 2013, the system had a to UC, as these rising costs will affect university $13.8 billion unfunded liability, with 76 percent of operations. For example, in the 2012-13 budget, the asTseemts pnelaetdee_dL tAo OpaRye bpeonretfi_tms eiadr.anietd aAs oRf TthWatO RK #140209 the state provided $90 million for UCRP. UC’s date. retirement liabilities therefore could affect the Contributions to UCRP Reinstated in 2009. state’s future financial health, and that is why they Effective July 1, 2009, the UC Regents adopted a are discussed alongside the other liabilities in this funding policy to reinstate contributions to the report. UCRP. Under UC’s funding policy, contributions to the plan have been gradually ramped up. JRS I In 2014-15, total funding for the plan will be System Covers 2,300 Members. Administered 22 percent of pay—8 percent from employees by CalPERS, JRS I provides benefits for judges who and 14 percent from the UC (up from 6.5 percent serve or served on the state Supreme, Appellate, and 10 percent in 2013-14, respectively). While Superior, and Municipal Courts, as well as their contributions from employees and the UC beneficiaries. Chapter 879, Statutes of 1994 (SB 65, combined will exceed estimated normal costs in McCorquodale), closed JRS I to members elected or 2014-15, contributions of around 30 percent of pay appointed after November 9, 1994. As of June 30, are required to address the unfunded liability in 2013, only 328 members in JRS I were active—that 30 years. For this reason, the UC Regents will need is, they were still working as of that date. to take further actions to increase contributions JRS I Historically Underfunded. For years, and finish implementing the funding policy. JRS I had a severe normal cost deficit—that is, $12.5 Billion Unfunded Liability for UC contributions from employees and the state were Retiree Health Benefits. The UC provides a choice insufficient to pay the future cost of those members’ of health and dental benefits to eligible employees benefits. The system provided relatively generous 12 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT benefits—75 percent of a judge’s final salary at age payment deferrals achieve a one-time savings by 60 with only 20 years of service (65 percent with delaying spending into a future fiscal year. The fewer than 20 years of service). By 1993-94, due state, however, also took actions on the revenue side to insufficient funds in the Judges’ Retirement of the state budget to address its budget problems. Fund, the system received a General Fund subsidy For example, the state accelerated taxpayer of $52.5 million to pay benefits. At that time, the payments from future fiscal years to produce a amount of the subsidy was expected to grow to one-time increase in revenues. While these revenue over $200 million by 2001-02. The state General actions are not liabilities, we think that they are Fund pays JRS I benefits on a pay-as-you-go basis similar to payment deferrals and other items on the because employer and employee contributions for Governor’s wall of debt. The box on the next page the remaining employees in JRS I are far below details these revenue actions. amounts needed to pay current benefits. The state $10 Billion in School and Community College essentially has chosen to fund JRS I on a pay-as- Obligations. Beginning in the early 2000s, the you-go basis now and in the future. As of June 30, state adopted various actions to delay or suspend 2013, JRS I had an unfunded liability of $3.3 billion, payments to schools in order to achieve state with under 2 percent of the system’s liabilities General Fund savings. By the end of 2012-13, the funded. state had $11.5 billion in these obligations. When the state repays the $1.5 billion in Proposition 98 B udgetaRy “settle-up” obligation discussed later in this Below, we discuss (1) liabilities arising from report, those funds can be used to pay down typical government operations—such as the value these obligations. For that reason, we only list of state worker vacation balances—that have not Figure 7 been funded over time Items in Governor’s “Wall of Debt” and (2) liabilities resulting Included in Our List of Budgetary Liabilitiesa from actions that the (In Billions) state took in recent years to address its budget School and community college obligationsb $10.0 Economic recovery bonds 4.6 problems. In general, these Special fund loans to the General Fund 4.5 latter budgetary liabilities Deferred Medi-Cal costs 2.0 are similar to those in the Mandate reimbursements to cities, counties, and special districtsc 1.9 State payroll deferrald 1.6 Governor’s wall of debt. Proposition 98 settle-upe 1.5 Figure 7 displays the items CalPERS quarterly payment deferral 0.4 in the Governor’s wall Quality Education Investment Act obligatione 0.4 Transportation Investment Fund borrowing 0.3 of debt that also appear Total $27.1 in our list of budgetary a Generally, reflects most recent estimate for each liability. liabilities. b Includes payment deferrals ($6.2 billion), mandate reimbursements ($4.8 billion), and Emergency Repair Program obligation ($462 million). Our estimate assumes that the $1.5 billion Proposition 98 settle-up Budgetary liabilities obligation is used to repay school and community college obligations. Emergency Repair Program obligation included in “underfunding of Proposition 98” in wall of debt. are almost all on the c Amount listed in wall of debt includes only local government claims for state reimbursable mandates prior to 2004-05. Our estimate also includes local government claims after 2004-05. spending side of the state d Amount listed in wall of debt includes only General Fund amounts. e budget. For example, Included in “underfunding of Proposition 98” in wall of debt. www.lao.ca.gov Legislative Analyst’s Office 13 AN LAO REPORT $10 billion for this item to avoid double counting. allowed the state to push payments back In addition, the state can count spending to repay a few weeks into the following fiscal certain education liabilities toward meeting the year—generating a one-time savings for Proposition 98 minimum guarantee for funding the General Fund—while not affecting schools and community colleges. This means that the amount of programmatic spending as the amount required to be spent on schools and in schools. (The deferrals, however, community colleges grows in the future, the state increased the need for some schools to can allocate some of that growth to repaying these borrow for cash-flow purposes.) Over liabilities without committing additional General four years beginning in 2008-09, the Fund dollars. For example, the 2014-15 Governor’s state deferred additional payments to Budget proposes to allocate some of the growth in schools and community colleges, with the Proposition 98 funding to eliminate all remaining total reaching $10.4 billion by the end of payment deferrals and pay down $188 million of 2011-12. The 2013-14 budget pays down a the Emergency Repair Program (ERP) obligation. total of $4.2 billion, bringing the total to The following obligations can be repaid within $6.2 billion as of the end of 2013-14. (The future growth in the minimum guarantee. Governor’s 2014-15 budget plan proposes to eliminate the remaining deferrals.) • $6.2 Billion in Payment Deferrals. From 2001-02 through 2003-04, the • $4.8 Billion in Mandate Reimbursements state deferred a total of $1.3 billion in to Schools and Community Colleges. payments to schools and community Proposition 4 (1979) requires the state to colleges. These payment deferrals Revenue Actions Also Produced Budgetary Savings Several Billion Dollars in Tax Accelerations. In the late 2000s, the state changed tax policy to accelerate revenues from future years into earlier years. While these actions provided one-time revenue gains for the General Fund and helped the state balance budgets at that time, they amount to multi-month interest-free loans from taxpayers to the state that now recur annually because they remain a part of state law. For example, the 2009-10 spending plan increased amounts withheld from many public- and private-sector workers’ paychecks primarily to capture $1.6 billion in additional personal income tax (PIT) revenues in 2009-10. In addition, changes in the state’s estimated payment schedule around this time accelerated PIT and corporation tax revenues from the second half of the calendar year to the first half, increasing General Fund revenues by over $2 billion in 2008-09, 2009-10, and 2010-11 combined. These tax payment “accelerations” continue to this day. We estimate that reversing these changes to withholding and estimated payments would have a one-time cost of between $4 billion and $5 billion at the present time. Recommend Reversal of These Tax Accelerations in the Future. As we discussed in a March 2014 analysis, these tax accelerations were adopted for short-term budget benefit and, in our view, have little or no independent policy rationale supporting them. We recommend that the Legislature reverse these tax accelerations at some point in the future. 14 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT reimburse local governments—including General Fund is required to repay special funds schools and community colleges—for when needed to ensure the special fund meets the new programs or services that the state objects for which it was created. Courts have given requires them to provide. The state began the Legislature latitude in making determinations to defer its reimbursement of these costs as about when to repay special funds under this it addressed significant budget shortfalls standard. in the early 2000s. Reimbursements owed $4.1 Billion for State Worker Leave Liabilities. to schools and community colleges grew When state employees retire or otherwise leave in later years, and total $4.8 billion as of state service, they are able to cash out accrued April 2013. vacation, annual leave, and other types of paid leave. The state does not set aside funds to pay for • $462 Million ERP Obligation. Williams state worker leave as employees earn time off. The v. California was a class-action lawsuit total amount of accrued leave grew significantly in filed on behalf of public school students. recent years, as the state used furloughs—unpaid Plaintiffs argued that instructional time off work—to reduce employee compensation materials, facility conditions, and the costs. Specifically, these policies resulted in state number of teachers were inadequate in employees using most of their additional furlough many of the state’s schools. As part of a days and less of their normal leave days than 2004 settlement, the state agreed to provide would have otherwise been the case. Because of $800 million to address repair needs at this, some of the savings resulting from furlough schools. The administration estimates policies will result in costs when employees cash $462 million of the ERP was outstanding out their banked leave when they either retire as of the end of 2012-13. (The Governor’s or otherwise leave state service. (For additional 2014-15 budget plan proposes to pay down information regarding the effect of the state’s recent $188 million of the ERP obligation.) furlough policies, see our March 2013 report, After $4.5 Billion in Special Fund Loans to the Furloughs: State Workers’ Leave Balances.) As of the General Fund. Since the early 2000s, loans from end of 2012-13, the total amount of accrued leave special funds helped close General Fund budget was estimated to be $4.1 billion. (State employees’ shortfalls, generating one-time savings that avoided unused sick leave can be converted to CalPERS spending cuts or revenue increases of an amount service credit, payments for which the state makes equal to the loans. The amount of special fund through its routine pension contributions.) loans outstanding reached $2.4 billion in 2004-05, $3.5 Billion in Workers’ Compensation but fell to roughly $750 million in 2007-08. Claims. The state generally self-insures against Borrowing from special funds increased sharply workers’ compensation claims. In other words, as the state struggled with huge budget shortfalls the state generally pays for claims as they are due during the recent economic downturn. As of the rather than setting aside funds to cover the cost end of 2013, the state General Fund owed special of future claims by either purchasing insurance funds $4.5 billion. (Because special fund loans or prefunding the liability. This is not unusual, as represent amounts owed from one state fund to many other large organizations self-insure against another, it could be said that the amount of state these types of claims, but this pay-as-you-go debt for special fund loans nets to zero.) The approach means that the state does not pay for all www.lao.ca.gov Legislative Analyst’s Office 15 AN LAO REPORT workers’ compensation costs as injuries occur. The thereby providing a one-time savings for the state’s Comprehensive Annual Financial Report General Fund of $930 million. As of the end of (CAFR) includes an actuarial estimate of the cost 2012-13, the administration estimates that it would of future payments to state workers for injuries cost $2 billion to revert to the accrual basis of that have already been incurred. (We discuss the accounting for the Medi-Cal Program. CAFR in the nearby box.) As of the end of 2012-13 $1.9 Billion for Mandate Reimbursements the state’s workers’ compensation liability was to Cities, Counties, and Special Districts. As estimated to be $3.5 billion. (Around 40 percent of described earlier, Proposition 4 requires the the liability is for estimated injury costs that have state to reimburse local governments for new been incurred but not yet reported.) programs or services that the state requires $2 Billion Deferral of Medi-Cal Costs. them to provide. In the early 2000s, the state Another action the state took to mitigate its began deferring its reimbursement of these costs significant budget problems during the 2000s due to budget problems and, by 2004, the state was to change the accounting basis for the owed cities, counties, and special districts about Medi-Cal Program from an accrual basis to a $1 billion. Proposition 1A (2004) requires the state cash basis. An accrual basis of accounting records to either (1) pay local governments the costs of all expenses as they are incurred whereas cash basis outstanding claims for a mandate or (2) suspend accounting records expenses when payments are or repeal the mandate. (This prompt repayment made. Moving the Medi-Cal Program to a cash requirement does not apply to certain employee basis therefore allowed the state to use payment relations mandates and obligations incurred before deferrals for one-time budgetary savings. For 2004.) As a result, the state has suspended or example, as part of the 2003-04 budget package, repealed many mandates to avoid having to pay the state delayed payments to Medi-Cal providers these costs. Despite these suspensions and repeals, for a few weeks into the following fiscal year, the state owed $1.9 billion to cities, counties, and State Financial Reporting Comprehensive Annual Financial Report (CAFR). Each year, the State Controller’s Office works with departments to produce the CAFR. The CAFR generally displays the state’s finances in compliance with generally accepted accounting principles (GAAP) for state and local governments in the United States. The Governmental Accounting Standards Board (GASB)—a nonprofit entity—has a key role in establishing GAAP for state and local governments. The State Auditor’s Office audits the CAFR, and the report is released each spring. The CAFR is the source for a few of the estimates of liabilities listed in this report—including liabilities for state worker leave, workers’ compensation, unclaimed property, and pollution remediation. The CAFR includes other liabilities described in this report, but we instead reflect more up-to-date information from another source. (For example, the State Treasurer’s Office releases data monthly concerning the state’s outstanding general obligation and lease revenue bonds.) In other cases, the CAFR and our report reflect different liabilities, such as in cases where GASB standards differ from common pension valuation practices. 16 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT special districts for mandate claims as of April This accounting action did not affect when 2013. paychecks were issued to state employees, but $1.8 Billion for Salton Sea Mitigation and represents costs that the state does not recognize Other Pollution Remediation. Public-sector as they accrue. Undoing the payroll deferral accounting rules require the state to list in its would also not affect the timing or amount of CAFR the future remediation costs of existing state worker paychecks. Based on administration pollution. As of the end of 2012-13, the CAFR estimates, reversing the deferral would cost lists $974 million in known future remediation $732 million from the General Fund and costs. Because the state only records costs when a $866 million from other state funds. reasonable estimate can be made, future costs likely $1.5 Billion Proposition 98 Settle-Up will exceed current estimates. For example, the Obligation. The Proposition 98 minimum 2011-12 CAFR mentioned two remediation sites—a guarantee for any given fiscal year is based on mine and a landfill—that will result in future costs numerous factors, including General Fund tax but for which remediation costs were unknown. revenue and per capita personal income. Estimates In addition, state law and an agreement with local of these factors often change after the level of governments and other entities requires the state to Proposition 98 funding is set in the budget. conduct mitigation activities related to the Salton Sometimes the actual guarantee turns out to Sea, with the bulk of expenditures occurring after be larger than the amount that was included in 2017. Based on a 2006 Natural Resources Agency the budget, meaning the state sometimes owes estimate (and after adjusting for amounts agreed additional amounts to satisfy past Proposition 98 to be paid by local water agencies), a portion of requirements. This funding shortfall is referred to the mitigation costs for the Salton Sea could total as a settle-up obligation. The state owed $1.5 billion roughly $800 million. Similar to the pollution in Proposition 98 settle-up as of the end of 2012-13. remediation costs reflected in the CAFR, as the When the state repays this obligation, the funds state’s mitigation responsibilities become more can be used to pay down school and community clear over time, total costs may exceed this amount. college obligations, as described earlier. The costs for restoration of the Salton Sea—which $853 Million Unclaimed Property Liability. are more discretionary than mitigation costs— Since 1959, banks and other companies (“holders”) could be much greater. Estimates for restoration have been required by law to remit unclaimed activities range from $2.3 billion to $8.9 billion— property to the state. The most common types of the latter estimate reflecting the Natural Resources unclaimed property are bank accounts, safe deposit Agency’s preferred alternative as of 2007—and box contents, stocks, and proceeds of insurance would be conducted over a period of up to 75 years. policies. Most property is deemed unclaimed While future Salton Sea costs would be paid by the when an account has remained dormant for three state over many years, it is clear that—at the high years and efforts to locate the owner have been end of such cost estimates—restoring the sea could unsuccessful. The State Controller’s Office reports rank in the upper tier of the state’s liabilities. that the state’s potential liability for unclaimed $1.6 Billion State Worker Pay Deferral. The property is $6.9 billion in properties belonging to 2009-10 budget package included an ongoing 24.9 million owners. To comply with public-sector one-month deferral of June state payroll to early accounting rules, the state’s CAFR estimates the July, providing a one-time savings for the state. amount owners will reclaim in the future. That www.lao.ca.gov Legislative Analyst’s Office 17 AN LAO REPORT liability is estimated to be $853 million as of the year, with the resulting revenues applied to the end of 2012-13. outstanding loan balance. Because under current $431 Million Deferral to CalPERS. The state law employers will repay the $9.7 billion principal, routinely defers its fourth-quarter contributions it is not reflected in our earlier figures. to CalPERS to the subsequent fiscal year. This In our November report, The 2014-15 Budget: means that the state does not incur each year’s costs California’s Fiscal Outlook, we projected that until the following fiscal year. The administration the state would make interest payments totaling estimates that reversing that deferral would have over $900 million between 2013-14 and 2019-20, cost $431 million as of the end of 2012-13. when we estimate the loan to be repaid. While the Federal Unemployment Insurance (UI) Loan. condition of the UI fund has improved in recent The UI program provides weekly payments to years due to growth in the economy, ideally the workers who are unemployed through no fault of loan would be repaid much sooner, allowing the their own. In January 2009, the UI fund became UI fund to build a significant reserve prior to insolvent, meaning that unemployment taxes paid the next recession. (A recession prior to 2020 is by employers were insufficient to fund UI benefits quite possible given that the current economic at that time. California—like 32 other states expansion has lasted about five years—the same around that time—obtained loans from the federal as the average economic expansion since World government to continue providing unemployment War II.) Should a recession occur before the fund benefits. As of the end of 2013, the state owes the is able to build a significant reserve, an increased federal government nearly $9.7 billion on these unemployment rate could quickly return the fund loans. While the state General Fund pays interest to insolvency. For this reason, we continue to each year on the loan, under current law the think that tax and benefit changes are necessary principal will be repaid in the coming years by to improve the condition of the UI fund. We employers. (This arrangement is unique among discuss these possible changes in our October 2010 the liabilities discussed in this report.) Specifically, publication, California’s Other Budget Deficit: The since 2012 federal unemployment tax rates paid Unemployment Insurance Fund Insolvency. by employers have increased incrementally each LIABILITIES BEING ADDRESSED While the state did not pay for the full costs of R etiRement retirement and budgetary liabilities listed in this section as they accrued, the state is taking actions CalPERS each year that are expected to address the liabilities in Largest Public Pension System in U.S. With a reasonable manner over time. In other words, costs assets totaling over $275 billion, CalPERS is the to address these liabilities already are reflected in nation’s largest public pension fund. CalPERS the state budget each year. Similarly, the state makes administers retirement programs for over 3,000 payments each year to service its infrastructure debt. state and local employers. This report, however, We think it is reasonable for the state to finance concerns retirement programs that CalPERS infrastructure over the life of an asset. administers on behalf of the state. Specifically, 18 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT CalPERS administers benefits for 589,000 current, Peace Officers and Firefighters and CHP groups— former, and retired state employees, as well as their 36.8 percent and 43.5 percent, respectively. These beneficiaries. These include CSU employees. rates include additional contributions the state has Employer Contributions Determined by opted to make to offset recently increased employee CalPERS Board. In contrast to CalSTRS (the contributions and pay off unfunded liabilities.) The contributions to which are set in statute by the new practices aim to fully fund the system—thus Legislature and Governor), employer contributions eliminating the unfunded liability—in about 30 to CalPERS are set by the CalPERS board. years. In our view, this is a reasonable amount Specifically, each year the CalPERS board adopts of time over which to address unfunded pension contribution rates based on its most recent liabilities. actuarial study. The Legislature and Governor have State Unfunded Liability Totals $49.9 Billion. no direct control over the employer contributions As of the end of 2012-13, the state’s unfunded to CalPERS. liability for state employee pension benefits was $5.1 Billion in Contributions. Based on $49.9 billion, with 66 percent of the assets needed CalPERS valuation estimates, in 2013-14 the to pay benefits earned as of that date. Figure 8 state and its employees will contribute a total displays the historical funded status of the CalPERS Graphic Sign Off of $3.8 billion and $1.3 billion to CalPERS, pension program. While the CalPERS and CalSTRS Secretary respectively. The state contribution is funded from pension programs had similar funded ratios as of Analyst both the General Fund and other state funds. In the end of 2012-13, an important distinction is that MPA 2014-15, the administration estimates that the CalPERS aims to address its unfunded liabilities Deputy General Fund will pay 58 percent of the state over the coming few decades, whereas current contribution, while other state funds will provide law provides no means for CalSTRS to address its the remaining 42 percent. unfunded liabilities. Recent Changes Expected to Improve Funding Status Over Time. Recently, the CalPERS board voted to Figure 8 change its actuarial practices, Historical Funded Ratio Reported by CalPERS resulting in increased employer Assets as Percent of Accrued Liabilities contributions. Specifically, employer rates are expected to 140% increase significantly over the next several years. Employer 120 rates differ for various groups 100 of state employees, but for State Miscellaneous Tier 1 80 employees—a group that represents the majority of 60 state employees—the rate was set for 24.3 percent of pay for 40 1990 1995 2000 2005 2010 2014-15. (The 2014-15 rate Note: Figure excludes assets and liabilities for pension benefits for local government employees. is much higher for the State www.lao.ca.gov Legislative Analyst’s Office 19 Template_LAOReport_mid.ait ARTWORK #140209 AN LAO REPORT JRS II liability. As of June 30, 2013, the JRS II unfunded liability was only $41 million, with 95 percent of System Covers 1,400 Members. Similar to assets needed to meet liabilities already on deposit JRS I, JRS II is administered by CalPERS and with CalPERS. provides benefits to judges and beneficiaries. Nearly all of the system’s 1,400 members were active judges i nfRastRuctuRe as of June 30, 2013. Actuarially Sound Pension Program. As General Obligation and Lease Revenue Bonds described in the previous section of this report, Most Infrastructure in California Financed contributions to JRS I were insufficient to pay Using Bonds. Decades ago, the state funded many benefits. Chapter 879 closed JRS I to new members of its infrastructure projects on a pay-as-you-go and created JRS II, an actuarially sound system basis. This meant that taxes and fees were used to in which members are required to work until pay for infrastructure when it was built, rather than a later age to receive the same level of benefits. financing construction costs over many years. Over The major difference between the two systems, time, bonds became the state’s predominant tool however, is that the employer contribution to JRS I is 8 percent of pay whereas the contribution to with which to financGe rinafprahstircu cStuigren. B Oy tfhfe 2000s, California issued bonds to finance about two-thirds JRS II is based on actuarial estimates and changes Secretary of its infrastructure spending. (The other third was every year. That rate was set at 24.6 percent for Analyst funded on a pay-as-you-go basis, mostly funded the 2014-15 fiscal year. The actuarially determined MPA by transportation revenues deposited into special state contribution is a key factor in the relative funds.) Deputy health of the JRS II system shown in Figure 9, Two Types of Bonds Used. California issues and is the reason that no additional actions are two main types of infrastructure bonds—general required to eliminate the small JRS II unfunded obligation bonds and lease revenue bonds. Investors buy Figure 9 these bonds, and the state Judges’ Retirement System II Relatively Well-Funded uses the proceeds to finance Assets as Percent of Accrued Liabilities infrastructure projects, including highways, bridges, 110% higher education facilities, water infrastructure, prisons, 100 health care facilities, and government buildings. The 90 state pays principal and interest payments to investors 80 in most cases over a period of around 30 years, meaning 70 that the Legislature and the Governor do not need to 60 2000 2005 2010 take additional actions for the bonds to be addressed 20 Legislative Analyst’s Office www.lao.ca.gov Template_LAOReport_mid.ait ARTWORK #140209 AN LAO REPORT (though they could choose to accelerate repayment that were authorized by voters in 2006 and 2008. of the bonds). The General Fund and, to a much When these bonds are sold they will increase the lesser extent, special funds incur costs each year to state’s liability for general obligation and lease service these debts. revenue bonds reflected in our earlier figures. $75.1 Billion in General Obligation Bonds. Growing Backlog of Deferred Maintenance The state pledges its “full faith and credit” to Could Increase Demand for Bonds in Future. repayment of general obligation bonds. General Shortly after the release of the 2014-15 Governor’s obligation bonds are placed on the ballot either Budget, the Governor released the first five-year through the initiative process or by the Legislature infrastructure plan since 2008. In the plan, the with a two-thirds vote and must be approved by administration estimates that the state has deferred a majority of the state’s voters. General obligation maintenance equal to $64.6 billion, over 90 percent bonds make up most of the state’s bond debt. As of which is for the state’s highways. Defining which of April 1, 2014, $75.1 billion in general obligation projects are categorized as deferred maintenance bonds were outstanding. is difficult, however, and reasonable estimates of $10.2 Billion in Lease Revenue Bonds. Lease the state’s deferred maintenance backlog can vary revenue bonds are repaid by the state department significantly. The reason that deferred maintenance that uses the facility for which the bonds are issued. is related to the state’s liabilities is that it represents One-third of lease revenue bonds outstanding routine and scheduled maintenance that was today finance facilities at the Department of deferred to the future. The state would not have Corrections and Rehabilitation, and another deferred maintenance if it spent the amounts 10 percent are for CSU facilities. The annual necessary each year to keep its assets in good debt-service payments come from the departments’ condition. Over the years, however, the state has operating budgets, most of which are funded from not fully funded its necessary maintenance needs the General Fund. Unlike general obligation bonds, each year, contributing to a growing deferred lease revenue bonds are not backed by the state’s maintenance backlog. full faith and credit. For this reason, lease revenue Delaying maintenance on the state’s bonds tend to have slightly higher interest and infrastructure can result in higher maintenance issuance costs, meaning they are a more expensive or replacement costs in the future. Deferring way to borrow money. They are also a much smaller maintenance therefore increases future component of the state’s infrastructure debt—as of maintenance costs and—in the worst cases— April 1, 2014, $10.2 billion in lease revenue bonds reduces the useful life of the asset. In these latter were outstanding. Lease revenue bonds do not cases, deferring maintenance increases the demand require voter approval and can be approved by a for infrastructure bonds or other costs in the majority vote of the Legislature. future. Bonds Authorized but Not Yet Sold. The B udgetaRy amount of currently outstanding bonds does not include about $31 billion in general obligation and $4.6 Billion of Economic Recovery Bonds lease revenue bonds that have been authorized but (ERBs). Proposition 57 (2004) authorized the state not yet issued, meaning the state has not yet sold to sell up to $15 billion in bonds to finance past the bonds to investors. A large share of this—about budget deficits. Roughly three-quarters of these $23 billion—is from the nearly $54 billion in bonds bonds were issued in 2004, and some were issued in www.lao.ca.gov Legislative Analyst’s Office 21 AN LAO REPORT 2008, for a total of nearly $15 billion. Proposition 57 $251 Million in Transportation Investment created a complex financing mechanism—known Fund (TIF) Borrowing. Proposition 42 (2002) as the “triple flip”—that dedicated a part of the required the state to transfer revenue from the sales local sales tax to repay the ERBs. That mechanism tax on gasoline to the TIF. The state was allowed to will remain in effect until the bonds are repaid, suspend these transfers and use the funds for other meaning that no additional action is needed from budgetary purposes. The 2003-04 and 2004-05 the Governor and the Legislature to service these budgets suspended $2.1 billion in such transfers. bonds. The 2014-15 Governor’s Budget, however, The 2006-07 budget repaid roughly two-thirds of proposed to deposit 3 percent of General Fund that balance. Shortly thereafter, Proposition 1A revenues into the state’s rainy-day reserve. The State (2006) required that the remaining balance Constitution requires half of that deposit be used to ($754 million) be repaid by the end of 2015-16. accelerate payments on the ERBs. Under that plan, The state has been making annual payments the administration expects the ERBs to be repaid in of $83 million since 2007-08. As of the end of 2015. There is no provision in law that would allow 2012-13, $251 million was owed to the TIF. The similar bonds to be issued in the future. administration expects the balance to be repaid by $410 Million Quality Education Investment 2015-16. Act (QEIA) Obligation. In response to the $86 Million Paterno Settlement Obligation. 2004-05 suspension of the Proposition 98 In 1986, a levee in Yuba County breached, flooding minimum guarantee and a related settle-up homes and businesses. About 2,600 affected obligation in 2005-06, the California Teachers parties filed suit against the state, and in 2003 a Association (CTA) sued the state, claiming the state appellate court found the state liable. The state underfunded K-14 education by $2.8 billion state eventually reached a $464 million settlement in those years. In 2006, the administration reached with the plaintiffs. The 2005-06 spending plan a settlement with CTA, agreeing to provide used a ten-year financial arrangement (similar $2.8 billion to schools and community colleges to a “judgment bond”) to finance the Paterno under the QEIA over seven years beginning in settlement. This action achieved $361 million in 2007-08. (Because the settlement related to the General Fund savings at the time, but resulted in underfunding of Proposition 98, amounts provided the state paying more than this amount over the under QEIA are from the General Fund and are in ensuing ten-year period. As of the end of 2012-13, addition to Proposition 98 requirements.) As of the the state owes $85.6 million in principal under this end of 2012-13, the state owed $410 million, with transaction, with the last payment scheduled for the balance expected to be repaid in 2014-15. June 2015. HOW TO PRIORITIZE KEY LIABILITIES: A FRAMEWORK This section develops a framework for the to address the liabilities in this report at some Legislature to consider in prioritizing how state point in the future. Because the state does not have funds could be used to most effectively pay down the resources to immediately address all of them, key liabilities. In our view, it is in the state’s interest however, the state must set priorities about which 22 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT liabilities to repay. In general, we suggest priority very different rates. Left unaddressed, retirement be given to paying down those liabilities that result liabilities tend to grow—over the long run—at a in the greatest benefits. We assess these benefits rate similar to their assumption for investment by looking at characteristics of the liabilities— returns. This is because each year the state delays including (1) the rate at which they grow and action on unfunded retirement liabilities, the state (2) whether addressing them also benefits groups or loses another year of investment returns under the entities other than the state government. actuarial assumptions, an amount that compounds Some Liabilities Excluded From Framework. over time. On the other hand, most budgetary Liabilities that are already being addressed merit liabilities are either fixed or grow at comparatively little additional legislative attention. In addition, low interest rates. as the amount required to be spent on schools Left Unaddressed, Retirement Liabilities and community colleges under Proposition 98 Present Long-Term Risk to Budget. In general, grows in the future, the state can allocate some of retirement liabilities grow much faster than that growth to pay down school and community budgetary liabilities. Delaying action to address the college liabilities, including payment deferrals, state’s retirement liabilities means that overall costs mandate reimbursements, and the ERP obligation. will be much greater when the state ultimately takes The Governor, for instance, proposes paying down action. For this reason, retirement liabilities present school payment deferrals in his 2014-15 budget significant long-term risks to the state budget—the plan in this manner. Because future decisions longer they remain unaddressed, significantly fewer about how to repay these items will depend budgetary resources will be available for other on available resources in the Proposition 98 purposes in the future. Because of these long-term budget, the state’s elected leaders will have a risks, growth rates are in our view an important separate conversation about these liabilities. For a factor for the Legislature to consider when discussion of the relative trade-offs of paying down prioritizing the pay down of key liabilities. school and community college liabilities, see the Benefits to Employers, Individuals, “Wall of Debt Plan” section of our February 2014 and Local Governments report, The 2014-15 Budget: Proposition 98 Education Analysis. Addressing Most Key Liabilities Results in Benefits to These Groups. Paying down most of the Growth Rates of Key Liabilities state government’s liabilities benefits other entities Growth Rates. In Figure 10 (see next page), and groups, including local governments (including we make some rough estimates about how much schools and community colleges) and individuals. liabilities will tend to grow over time. In effect, Because some liabilities have similar growth rates, these rates reflect the interest—or carrying—cost evaluating the benefits that accrue to these groups associated with these liabilities. The growth rates from paying down key liabilities can be a secondary reflected in Figure 10 apply to amounts outstanding factor to consider in determining how to prioritize at a certain point in time and do not attempt to liabilities. predict how future actions could change those Mandates, Proposition 98 Settle-Up Benefit amounts. Local Governments. Paying down the mandate Liabilities Grow at Very Different Rates. As backlog and Proposition 98 settle-up obligations shown in the figure, these liabilities tend to grow at would result in one-time revenue for local www.lao.ca.gov Legislative Analyst’s Office 23 AN LAO REPORT governments, including schools and community Repaying Certain Special Fund Loans Results colleges. These actions would increase budgetary in Greater Benefit Than Others. Repaying a flexibility for local governments, and could result in special fund loan increases the balance available in one-time spending or tax relief, which would then that fund. In some cases, those balances could be benefit others. spent—increasing services to groups for which the fund was created—or used Figure 10 to reduce fees and charges, Rough Estimate of Growth Rates for Key Liabilitiesa thereby helping to ensure that fee payers are not (Dollars in Billions) overcharged. Liability Growth Rates Amount Funding Retirement Retirementb Liabilities Decreases CalSTRS pension program 7.5% $73.7 Retiree health benefits for state employees 4.3 64.6 Risk to Public Sector UC pension program 7.5 13.8 Employees and Retirees. UC retiree health benefits 5.5 12.5 Making additional Judges’ Retirement System I pension program 4.3 3.3 Subtotal ($167.9) contributions to Budgetary retirement systems results Special fund loans to the General Fund 0.7%c $4.5 in more secure retirement State worker leave Growth of state 4.1 worker payd funding (either pensions Workers’ compensation obligations 3.5 3.5 or retiree health benefits) Deferred Medi-Cal costs —e 2.0 Mandate reimbursements to cities, counties, and 0.3 1.9 for program participants special districts and beneficiaries. Salton Sea mitigation and other pollution 0.0 1.8 The state and other remediation State payroll deferral Growth of state 1.6 governmental entities worker payd often have contractual Proposition 98 settle-up 0.0 1.5 Unclaimed property 0.0 0.9 commitments to ensure CalPERS quarterly payment deferral Growth of state 0.4 that pension funds are worker payd soundly funded over the Unemployment insurance loan from federal —g — governmentf long term. Subtotal ($22.1) Other Liabilities Total $190.0 Have Little Effect on a Generally, reflects most recent estimate for each liability. b Over the long run, retirement programs grow at a rate similar to the assumed rate of return on Other Groups. Repaying investments, holding other factors constant. c some other key liabilities Rate shown is growth in interest costs if all loans were repaid in 2014-15 versus all loans being repaid in 2013-14. Interest rates on special fund loans are based on the Pooled Money Investment Account rate in would produce little to no effect when each loan was executed and vary from about 0.2 percent to roughly 3 percent. d For these liabilities, growth in state worker pay includes step increases, promotions, and general salary tangible benefit for other increases already agreed to at the bargaining table. Additional general salary increases and growth in the size of the state workforce would also contribute to growth but would depend on future decisions by groups. For example, the Legislature and Governor. e Amount expected to shrink somewhat over time as more program participants are moved from fee-for- reversing the state payroll service care to managed care. f deferral would not result Under current law, employers in California are expected to repay the principal through increased revenues related to the federal unemployment insurance (UI) tax. in any change to the g While employers pay the principal, the state pays interest on the UI loan. That interest is calculated by the U.S. Department of the Treasury and has varied from about 2.4 percent to 4.75 percent since timing or amount of state January 2009. (The rate was 2.4 percent as of December 31, 2013.) employee paychecks. 24 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Other Considerations Governor’s 2014-15 budget proposal would address other liabilities, such as school payment deferrals Public Confidence in Government. In general, and the state’s ERBs. the liabilities listed in this report reflect cases where the state did not pay for its costs as they accrued. Figure 11 These liabilities diminish Suggested Approach on State’s Key Liabilities public confidence in Implement Key Liability Provisions of Governor’s 2014-15 Budget Proposal government—for example, 9 some recent cost deferrals These include the Governor’s proposed paydown of school and were seen by some to be community college payment deferrals in his 2014-15 budget proposal. 9 accounting gimmicks. The state’s economic recovery bonds and some special fund loans also Consequently, addressing are repaid in the Governor’s 2014-15 budget proposal. the items listed in this Address CalSTRS as a Top Priority report may improve public 9 confidence in government. Fully funding the CalSTRS pension program over about 30 years is crucial. In addition, getting the • Will require significant ongoing annual funding. state’s fiscal house in Then Address Other Liabilities order would likely be seen 9 by bond investors and State retiree health benefits involve large costs that should be paid rating agencies as positive. (prefunded) as workers accrue benefits during their careers. • Would require ongoing annual funding. This could result in an 9 improvement to the state’s Prioritize other budgetary liabilities with high growth rates or that produce benefits for other entities or groups. In some cases, these could be paid credit rating and therefore from one-time state revenues. could reduce future state • Mandate reimbursements. borrowing costs slightly. • Proposition 98 settle-up. • Certain special fund loans. Suggested Approach • Salton Sea mitigation. • Unemployment insurance tax and benefit changes. Figure 11 summarizes 9 Consider state’s role in addressing UC retirement liabilities. our suggested approach 9 for prioritizing repayment Establish longer-term goal of prefunding budgetary liabilities where of the state’s key liabilities possible. • State worker leave. and how the state should • Workers’ compensation. address these costs in • Unclaimed property. the future. As noted • Other pollution remediation. throughout this report, How to Address Liabilities in the Future some liabilities—such as 9 the state’s infrastructure Going forward, key goal of state budgeting to pay for costs as they accrue. and CalPERS liabilities— 9 are already being Address key liabilities without intent to incur them again. Building budget reserves when times are good is key method to make this goal more addressed. Moreover, as realistic. noted in Figure 11, the www.lao.ca.gov Legislative Analyst’s Office 25 AN LAO REPORT Make CalSTRS Top Priority. Due to its over the long run. For this reason, we recommend massive unfunded liability and relatively fast making retiree health a key priority after CalSTRS growth rate, we recommend that the Legislature from ongoing revenues that are available to address make the CalSTRS pension program a top these liabilities. priority in addressing the state’s key liabilities. Approach Could Mean Fewer Resources We recommend that the Legislature aim to for Addressing Wall of Debt. Addressing the fully fund the system in about 30 years. Doing CalSTRS liability and some or all of the retiree so will be difficult. Depending on the funding health unfunded liabilities would mitigate two of arrangement, the additional contributions from the greatest long-term risks to the state budget. In the state, teachers, and districts combined could the near term, however, addressing both of these total over $5 billion per year by the early 2020s, liabilities would mean fewer resources available similar to the amount of current state funding for for other priorities—including building budget the two university systems combined. For each reserves and paying down the rest of the Governor’s year of delay in implementing a funding plan, wall of debt. Because CalSTRS and retiree health CalSTRS loses another year of investment returns, liabilities tend to have higher interest rates than which compound over time, making addressing the items on the wall of debt, failing to prioritize the funding shortfall more costly the longer we CalSTRS and retiree health would increase wait. The most important action the state can take budgetary risk in the longer run, as addressing to minimize costs is to act quickly to increase these retirement liabilities would become contributions. As we noted in our January 2014 significantly more costly in the future. Similarly, publication, The 2014-15 Budget: Overview of the UC’s pension and retiree health liabilities could Governor’s Budget, it would be smart to set aside pressure the university’s finances—and potentially money during the 2014-15 budget process in the state budget—if they persist. As the Legislature anticipation of higher state costs under a long-term considers which budgetary liabilities to repay, CalSTRS funding plan. we suggest prioritizing remaining resources for Prefunding Retiree Health Benefits for State addressing certain liabilities, as described below. Employees. Among the state’s other key liabilities, Prioritize Budgetary Liabilities With High retiree health liabilities for state employees present Growth Rates or That Benefit Others. Budgetary a difficult challenge. Despite modest efforts in liabilities often involve no ongoing commitment recent years to begin prefunding retiree health of state funds. This means that they can be repaid benefits for state workers, the state has virtually no from one-time influxes of state revenues. Among assets on hand to pay for $64.6 billion of estimated budgetary liabilities, our sense is that addressing unfunded liabilities. Committing to a plan to mandate reimbursements, Proposition 98 settle-up, prefund retiree health benefits for state employees and some special fund loans would be the best use over 30 years would cost an additional $1.8 billion of budgetary resources in the near term. While annually. (About $1.1 billion of this amount mandate and Proposition 98 settle-up liabilities would be paid from the General Fund, with other do not grow quickly, repaying these items would state funds paying for the rest.) While this is a increase budgetary flexibility for local governments. significant sum, using investment returns to pay for Addressing the significant environmental problems these benefits would dramatically reduce state costs facing the Salton Sea would benefit nearby residents 26 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT and local governments. Finally, among special state’s retiree health liabilities would result in the fund loans, we advise the Legislature to be selective estimate of the unfunded liability for those benefits in choosing which loans it repays first. Naturally, decreasing from $64.6 billion to $42.5 billion. any special fund facing budgetary problems must The amount of savings would vary depending be repaid to ensure the fund has sufficient cash on the liability. (In general, because of the on hand. Aside from that constraint, we suggest long-term nature of retirement liabilities, the state repaying loans with higher interest rates or where could probably use investment returns to pay for the special fund proceeds could be directed more of a retirement liability than a budgetary toward legislative priorities (for example, reducing liability.) But, prefunding these liabilities could a backlog in a department’s safety inspection significantly reduce long-term costs. For this workload). reason, we think that the idea of prefunding UI Loan Also Merits Attention. While additional liabilities—including state worker leave, under current law the principal on the UI loan workers’ compensation, unclaimed property, and will be repaid in the coming years by employers pollution remediation liabilities—merits legislative through increased revenues related to the federal consideration. For some of these liabilities, there unemployment tax credit, the state incurs may be administrative challenges that would substantial interest costs related to the loan. (As make prefunding difficult or impractical, but the discussed earlier, in our November 2013 report, potential savings may outweigh these challenges. The 2014-15 Budget: California’s Fiscal Outlook, Going Forward, Pay for Operating Costs as we forecasted that state interest payments on the They Accrue. In the future, we suggest establishing UI loan would total over $900 million between a goal of paying for all operating costs as they 2013-14 and 2019-20.) Addressing the UI fund accrue. This means avoiding questionable actions insolvency—through a combination of tax and used in the past to address budget shortfalls, such benefit changes—could produce a greater interest as payment deferrals and accounting maneuvers. savings than addressing budgetary liabilities with This also means funding retirement benefits slower growth rates. as employees earn them, rather than deferring Prefunding Could Reduce State Costs Over the costs for pension and retiree health benefits to Long Run. Historically, the state’s efforts to prefund future generations. And it means funding normal liabilities has been focused on pension and retiree maintenance costs each year to avoid any further health programs. Prefunding other liabilities, build-up of deferred maintenance. however, would allow the state to use investment Address Key Liabilities Without Intent to returns to partially pay the costs. To illustrate, Incur Them Again. In our November 2013 report, according to CalSTRS, 58 percent of resources The 2014-15 Budget: California’s Fiscal Outlook, used to pay benefits from 1984-85 through 2011-12 we projected continued improvement in the state’s were generated from investment returns. Absent budgetary condition. While that improvement is those returns, teachers, districts, and the state dependent on a continued economic expansion might have had to contribute more than twice what and restraint in making ongoing spending they contributed during those years to provide commitments, we believe the state has an the same level of benefits. This is also the reason opportunity now and perhaps in the next few years why committing to a full funding plan for the to make significant progress in addressing the www.lao.ca.gov Legislative Analyst’s Office 27 AN LAO REPORT liabilities detailed in this report. Doing so would avoid creating similar budgetary liabilities again. result in a significant improvement in the long-term By building budget reserves when times are good, fiscal health of the state. Inevitably, the state will the state can place itself in a position where this face another economic or budgetary downturn. goal is more realistic. When such a downturn occurs, the state should 28 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT APPENDIX 1: SCOPE OF REPORT In general, the state has not paid for the liabil- • Revenue Bonds. This report excludes ities in this report as costs accrued. In addition, revenue bonds because they are generally these liabilities have a relationship with the General repaid from non-General Fund revenue Fund. As such, the following types of liabilities are sources. For example, general obligation excluded from this report. bonds issued under the veterans’ home loan program are repaid using monthly • Near-Term Liabilities. This report payments from veterans. Because these excludes “current” liabilities that can payments have always been sufficient to be characterized as normal operating service the bonds—meaning that the state expenses paid for in the year in which has never incurred costs for the bonds—we they accrue. For example, amounts owed exclude them from this report. Similarly, to utilities for phone, Internet, or other we exclude revenue bonds issued by the services are excluded. University of California and California • Local Government Liabilities. The State University because—in general— purpose of this report is to provide dedicated revenue streams at the univer- background on the state’s key liabilities. As sities repay these bonds. such, this report excludes local government • Interest and Similar Costs Not Included. liabilities. For example, we exclude the This report does not attempt to quantify portion of the California Public Employees’ what the state will eventually pay to retire Retirement System unfunded liability these liabilities. Instead, amounts listed in attributable to local governments for their this report reflect point-in-time estimates pension programs. of amounts owed. This is the standard way • Leases and Other Contracts. The state has that liabilities are discussed in accounting. over 900 leases for 13 million square feet of For example, this report reflects the state office space. In addition, the state has principal owed on general obligation bonds entered into contracts with various entities but does not calculate future interest costs to provide services. Because of incomplete the state will incur to service the bonds. data concerning the state’s leases and Similarly, amounts listed for retirement contracts, we have excluded these items liabilities reflect estimated amounts that from this report. If an amount were listed, would be necessary to eliminate unfunded however, it would appear in the “Liabilities liabilities all at once, right now. Over Being Addressed” section of this report the long term, therefore, total amounts because the state generally pays these costs to address these liabilities often will be as they accrue. multiple times the estimates listed in this report. www.lao.ca.gov Legislative Analyst’s Office 29 AN LAO REPORT 30 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT APPENDIX 2: BACKGROUND ON RETIREMENT LIABILITIES The California Public Employees’ Retirement Pension Benefits Protected Under U.S. and System (CalPERS), a unit of state government, California Constitutions. California courts have administers retirement programs—including ruled for decades that pension benefits for current pension and retiree health benefits—for state and past public employees are protected under employees and judges. The California State the Contract Clauses of the U.S. and California Teachers’ Retirement System (CalSTRS), another Constitutions. As a result, these benefits can only state entity, administers pension benefits and be reduced in rare circumstances. Even then, other retirement programs for teachers and school employers are generally required to provide an administrative personnel. The University of offsetting advantage that tends to negate the California (UC) administers pension and retiree savings of the benefit reduction. While local health programs for UC employees. governments may be able to alter contracts during bankruptcy proceedings, Chapter 9 bankruptcy Background is unavailable to state governments and therefore Defined Benefit (DB) Pension Programs. A generally is not thought to apply to the retirement DB pension program (1) receives contributions liabilities listed in this report. from employees and employers, (2) invests those Benefits May Be Altered for Future contributions, and (3) uses the contributions plus Employees. While pension benefits for current and investment returns to provide a specific monthly past public employees are protected under the U.S. pension benefit to retirees and their beneficiaries. and California Constitutions, future employees (Some members designate beneficiaries that receive have not yet been offered benefits and therefore benefits from the member’s retirement account do not have this contractual right. For this reason, after the member is deceased.) governments can change benefits for future How Pension Payments Are Calculated. employees without limitation. Employees earn—or accrue—their pension benefits Retiree Health Benefits. The state and UC at a specified rate per year of public service. When provide medical, prescription drug, and dental an employee retires, their accrual is multiplied by benefits to retired employees. These benefits their final pay to determine the amount of their are often referred to as other post-employment pension payment. (In some cases, that final pay benefits, or OPEB, but they are generally known as may be based on the highest pay over 12 months “retiree health benefits.” of service, in other cases the highest pay over three Systems Use Actuaries to Assess System years of service.) For example, an employee in a Financial Health. CalPERS, CalSTRS, and the “2 percent at 60” pension plan accrues 2 percentage UC Regents—like other pension systems—employ points per year of service at age 60 to be multiplied actuaries to assess the financial condition of their by their final salary at retirement. If that employee retirement programs. An actuarial valuation retired at age 60 with 25 years of service and estimates the present value of a system’s liabilities a salary of $80,000, their payment would be and compares those with the value of assets on 50 percent of $80,000, or $40,000 per year. hand. In the course of producing a valuation, www.lao.ca.gov Legislative Analyst’s Office 31 AN LAO REPORT actuaries make many assumptions about benefits are increased retroactively, as occurred various economic and demographic factors, in California about 15 years ago, this creates a including investment returns, mortality, future situation in which past contributions were not compensation, inflation, years of service, and enough to have paid for these benefits. A second retirement age. (The CalPERS and CalSTRS way that unfunded liabilities arise is when future boards—along with the UC Regents—establish events differ from prior actuarial assumptions—for what assumptions will be used in their valuations.) example, if retirees live longer than was expected Unfunded Liabilities. In producing an estimate during their service years or if investment returns about the present value of a system’s assets and do not meet assumptions. liabilities, an actuarial valuation determines Funded Ratios. A system’s unfunded liability whether a system has an unfunded liability. An estimate alone provides insufficient information unfunded liability exists when a system does not about the condition of a pension system. Another have enough assets to fund all or part of a future estimate to consider is its funded ratio—the ratio of Graphic Sign Off obligation to provide benefits to its members. Taken system assets to accrued benefit liabilities—because Secretary another way, an unfunded liability is the amount it provides additional context. Appendix Figure 1 Analyst that would have to be set aside as of the date of displays historical funded ratios reported by the actuarial valuation and invested by the system CalPERS and CalSTRS. (A system with a funded MPA to cover the future costs of all promised benefits ratio of 80 percent, for example, has enough assets Deputy earned by members as of the valuation date. for 80 percent of promised benefits. A system has Causes of Unfunded Liabilities. Unfunded an unfunded liability if its assets are less than liabilities generally arise in two ways. First, they 100 percent of its liabilities.) While one system result when contributions to the system were less than the Appendix Figure 1 estimated cost of a promised Historical Funded Ratios Reported by CalPERS and CalSTRS benefit in a given year. This Assets as Percent of Accrued Liabilities is referred to as a “normal cost deficit.” (The term 140% CalPERSb “normal cost” refers to the 130 amount actuaries estimate is 120 necessary—combined with 110 assumed future investment 100 earnings—to pay the cost 90 of pension benefits that 80 CalSTRSa employees earn in a given 70 year.) In these situations, 60 the entities contributing to 50 the pension program are not 1990 1995 2000 2005 2010 paying for the benefits as they a Reflects funded ratio for CalSTRS pension program. are earned, instead passing b Reflects funded ratio for CalPERS pension program. Excludes assets and liabilities for pension benefits for local government employees. those costs on to future Note: CalPERS assets reflected on market value basis while CalSTRS assets reflected on generations. When pension actuarial value basis. 32 Legislative Analyst’s Office www.lao.ca.gov Template_LAOReport_mid.ait ARTWORK #140209 AN LAO REPORT may appear to be in a worse financial position than Importance of Investment Assumptions. another because it has a larger unfunded liability In producing a valuation, actuaries make many (in dollar terms), it could be better funded if it assumptions about a host of economic and has a higher ratio of assets to liabilities. Pension demographic factors, including future investment systems are very complex, however, and cannot be returns. Because investments compound over fully assessed by any one measure. For example, time—that is, returns are reinvested, allowing the as shown in Appendix Figure 1, the DB programs earnings to also generate investment returns— managed by CalPERS (for state employees) and changing the discount rate significantly affects the CalSTRS had similar funded ratios as of the size of the unfunded liability. Appendix Figure 2 end of 2012-13. Because of recent actions taken demonstrates the effect of reducing the investment by the CalPERS board, the system aims to set return assumption on an initial investment of contribution rates that will address its unfunded $1,000 from 7.5 percent to 5.5 percent. By year liability in around 30 years—that is, its funded 20, assets under the 5.5 percent assumption are ratio will reach 100 percent in 30 years if future around one-third less than under the 7.5 percent Graphic Sign Off events reflect actuarial assumptions. In contrast, assumption. By year 30, assets are reduced by over the same time period, CalSTRS is expected nearly one-half. Reducing the discount rate from Secretary to deplete its assets—that is, its funded ratio will 7.5 percent to 5.5 percent would significantly Analyst reach zero absent increased contributions from the affect the pension fund’s discounted estimates of MPA state, districts, and teachers. Of the two systems, their liabilities, and by extension their unfunded Deputy CalSTRS is clearly in the worse position. liabilities. The discount rate is therefore one of the Unfunded Liabilities Would Change Using most important assumptions made in an actuarial Different Assumptions. Actuarial estimates depend valuation. heavily on assumptions. If future events deviate from these assumptions, actual liabilities will differ from Appendix Figure 2 estimates in the valuation. For Effect of Different Investment Return Assumption on a $1,000 Investment example, if retirees live longer (or shorter) than is assumed, unfunded liabilities would $10,000 increase (or decrease) in future 9,000 valuations, holding other 8,000 factors constant. Probably 7,000 the most debated actuarial 6,000 7.5% assumption concerns future 5,000 investment returns, often 4,000 3,000 referred to as the “discount 5.5% 2,000 rate.” Both CalPERS and 1,000 CalSTRS currently assume a future rate of return of 5 10 15 20 25 30 7.5 percent annually on their Years investments. www.lao.ca.gov Legislative Analyst’s Office 33 Template_LAOReport_mid.ait ARTWORK #140209 AN LAO REPORT Discount Rate Subject to Much Debate. lowering the discount rate would increase estimates CalPERS and CalSTRS both assume that the of additional contributions necessary to fund that future rate of return on their investments will system.) be 7.5 percent. This means that their investment Our Estimates Reflect Systems’ Valuations portfolio growth would average 7.5 percent per of Liabilities. The estimates we use in this report year. In practice, investment returns will be much generally are the estimates produced by the greater than this in some years and much less systems’ actuaries. This is principally because (or even negative) in others, and that the returns investment return assumptions of 7.5 percent for from “good” investment years will have to pay the CalPERS and CalSTRS DB programs discount for returns from “bad” investment years. Some rate appear in line with historical trends. For observers contend that the assumed discount example, CalSTRS reports that its investment rate is optimistic and therefore should be lower. returns over the past 20 years have, on average, Because employer contributions to CalPERS are met their current assumption of 7.5 percent. That affected by the actuarial valuation, lowering the volatile period in asset markets, however, includes discount rate would not only increase the estimate both the “dot-com bubble” of the late 1990s and the of the unfunded liability, it would also increase the severe economic downturn of the late 2000s. In the amount that the state would be required to pay for future, asset markets may behave quite differently providing employees with pension benefits. (For than they have in the past, making this an issue example, reducing CalPERS’ discount rate from that could affect public finances in the future. 7.5 percent to 6.5 percent would have resulted in Recent Changes to Public Employee the unfunded liability as of the end of 2011-12 Retirement Benefits. Chapter 296, Statutes of 2012 increasing from $45.5 billion to $62.5 billion. This (AB 340, Furutani), changed many aspects of public would have also increased employer rates from employee retirement programs. Taken as a whole, 21.1 percent of payroll to 31.3 percent of payroll these actions reduced future state costs of providing in 2013-14.) Because CalPERS uses what critics DB pensions. In the case of the changes that affect characterize as an unreasonably high discount employees who started service prior to January 1, rate, these critics argue that the state does not pay 2013, the savings from the law have already begun the full cost of providing pension benefits to its to be reflected in actuarial valuations. Savings will employees. (In the case of CalSTRS, contributions materialize over several decades as post-2013 hires to the system are set in statute and not directly make up a larger share of the public workforce. influenced by the actuarial valuation, though 34 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT www.lao.ca.gov Legislative Analyst’s Office 35 AN LAO REPORT LAO Publications This report was prepared by Ryan Miller and reviewed by Jason Sisney. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 36 Legislative Analyst’s Office www.lao.ca.gov