CalSTRS Funding: An Update

CalSTRS Funding: An Update MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • MAY 2017 Summary Recent Legislation Aims to Fully Fund CalSTRS by Mid-2040s. Prior to recent state action, the California State Teachers’ Retirement System (CalSTRS) faced large unfunded liabilities with no plan in place to address them. Recent legislation increased state, district, and teacher contributions to CalSTRS with a goal of fully funding the system by the mid-2040s. This legislation was a major state accomplishment. Recent Developments Increase Unfunded Liabilities. The CalSTRS board recently approved changes in a number of the assumptions actuaries use to estimate unfunded liabilities. Combined with a worse-than-expected investment return in 2015-16 and other factors, these changes increase the estimate of CalSTRS’ unfunded liabilities from $76 billion as of 2014-15 to $97 billion as of 2015-16. State Assigned Responsibility for Bulk of Increased Unfunded Liabilities. State law, as implemented by CalSTRS, uses complex calculations to assign responsibility for CalSTRS’ unfunded liabilities. Under this policy, the state is assigned $15 billion of the $21 billion increase, with school and community college districts generally assigned responsibility for the remainder. The state is now responsible for $29 billion of the total unfunded liability, and is expected to be assigned another several billion dollars of unfunded liabilities next year. CalSTRS projects that increases in the state’s contribution rate will not fully phase in for 15 years due to a cap in state law that limits state rate increases. These recent developments do not affect district contribution rates, which will continue to increase through 2020-21 pursuant to a schedule in state law. State Contributions Key to Meeting Funding Goal. CalSTRS projects that the pension fund is still on track for full funding by the mid-2040s target date. To the extent that CalSTRS’ funding situation continues to erode—either through worse-than-assumed investment performance or further changes in actuarial assumptions—the state will largely bear the responsibility for covering the resulting costs (assuming the current funding approach remains in place). Whether CalSTRS is fully funded by the mid-2040s target date will depend largely on whether the state pays enough to CalSTRS. Yet, increases in the state’s contribution rate are capped, which—under some scenarios—could prevent the funding plan from achieving its goal. If the Legislature wants to increase the likelihood that the funding plan is successful within the target time frame, it may need to ramp up state contributions even faster. It could do so by raising the cap on annual state contribution increases, dedicating a portion of required Proposition 2 debt payments, or using some combination of the two. AN LAO BRIEF INTRODUCTION A central tenet of public finance holds that was expected to exhaust its assets in the mid-2040s, expenses should be paid for during the year in an alarming prospect for a pension system. which they are incurred. Applied to pension Chapter 47 of 2014 (AB 1469, Bonta) increases programs, this principle means that benefits should contributions to CalSTRS made by the state, school be funded during employees’ working careers. and community college districts (referred to as Underfunding benefits during employees’ working districts in this report), and teachers. The plan aims years imposes costs on future generations of to fully fund CalSTRS by the mid-2040s. While taxpayers, a practice which should be avoided. fully funding CalSTRS will mean that taxpayers CalSTRS Historically Underfunded. An and teachers will contribute billions more in the unfunded liability exists when the amount of assets next few decades, the plan will lower longer-term a pension program has is insufficient to cover costs and put CalSTRS on a sustainable path. As projected liabilities for pension benefits earned to such, the funding legislation was a major state date. Figure 1 displays CalSTRS’ historical “funded accomplishment. ratio”—a ratio of assets to liabilities. CalSTRS Periodic “Experience Study” Results in has been inadequately funded for almost all of its New Assumptions Used in CalSTRS’ Actuarial 100-plus year history. Valuation. Every four years or so, CalSTRS’ Recent Legislation Aims to Fully Fund actuaries produce a study that assesses the CalSTRS by Mid-2040s. Prior to recent state appropriateness of the system’s assumptions. The action, CalSTRS faced large unfunded liabilities study looks at historical experience as well as with no plan in place to address them. CalSTRS expectations about the future. The CalSTRS board reviewed the actuaries’ most Figure 1 recent experience study at CalSTRS Pension Program Historically Underfunded their February 2017 meeting and voted to change a number Assets as a Percent of Accrued Liabilities of assumptions that are used to estimate CalSTRS’ 120% liabilities. These assumptions 100 also affect how responsibility for CalSTRS’ unfunded 80 liabilities is divided between 60 the state and districts. This report describes how these 40 new assumptions and other factors have increased 20 CalSTRS’ unfunded liabilities and details how these 1976 1981 1986 1991 1996 2001 2006 2011 2016 developments will impact the Note: Years shown are the years in which actuarial valuations were released. Valuations cover the state, districts, and teachers. prior fiscal year. For example, the valuation released in 2015 covered the end of 2013-14. 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF Assumptions Are Long Term in Nature. It users of this report to not only keep in mind is important for observers of pension programs recent experience and near-term expectations to understand that actuarial valuations assess a about actuarial assumptions but also consider how system’s funding status over the very long term. these variables have performed several decades in While the way in which investments and other the past and how they may perform very far into factors play out (what actuaries call “experience”) the future. For example, while annual inflation matters in the near term, the purpose of an rates have been near zero in recent years and are actuarial valuation is to determine whether expected to stay below 2 percent in the near term, contributions from governments and public actuaries also consider in their studies periods of employees will be sufficient to cover the cost of “hyperinflation” during the 1970s and 1980s when providing pension benefits to those employees inflation was at times greater than 10 percent. over the next several decades. We therefore urge UNFUNDED LIABILITIES INCREASE $21 BILLION At its April 2017 board meeting, CalSTRS’ return assumption is sometimes called the actuaries presented the actuarial valuation covering “discount rate.”) Lowering the discount rate the fiscal year ending June 30, 2016. Compared with increases the present value estimate of the liabilities the actuarial valuation for the year prior, the total (and vice versa). Because actuaries project liabilities unfunded liability increased $21 billion, as shown in decades in the future, small changes in the discount Figure 2. Five main factors contributed to the increase: rate result in large changes in the present value new economic assumptions, new demographic estimate of liabilities. In other words, the estimate assumptions, underfunding, investment returns in of future liabilities—and therefore the estimate of 2015-16 falling short of assumptions, and salaries unfunded liabilities—is highly sensitive to changes growing faster than assumed. Figure 3 (see next page) in the investment return assumption. shows how much each of these five factors contributed to the increase in unfunded liability. We describe Figure 2 these factors below. CalSTRS' Unfunded Liabilities Increase $21 Billion Investment Return and (In Billions) Other Economic Assumptions $100 Investment Return Is Most Important Assumption. Actuarial valuations are premised 80 on various assumptions about economic and 60 demographic factors. The most important assumption concerns future investment returns. 40 This is in part because the investment return assumption is used to “discount” the estimate 20 of future benefit payments (liabilities)—in other words, to produce an estimate of the present value 2014-15 2015-16 of future liabilities. (This is why the investment www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO BRIEF return assumption from Figure 3 7.5 percent to 7.25 percent. Increase in Unfunded Liability by Contributing Factor These changes take effect for (In Billions) the 2015-16 valuation, which was released in April 2017. In New Economic total, these new assumptions Assumptions account for nearly $7 billion of the $21 billion increase New Demographic Assumptions in CalSTRS’ unfunded liabilities. (The board also Underfunding voted to further reduce the investment return assumption to 7 percent for the 2017-18 2015-16 Investment Return valuation, which will be released in spring 2018. While that assumption does Salary Growth not affect the estimate of the unfunded liability in the most 2 4 6 $8 recent valuation, it affects rate projections that we describe The investment return assumption has two near the end of this report.) components. First, the assumption incorporates New Mortality and the system’s assumption concerning future annual Other Demographic Assumptions inflation (3 percent). In addition, CalSTRS assumes that it will receive an additional investment Assumptions Concerning Life Expectancy return based on the level of risk in its portfolio. Also Important. Another key actuarial assumption This premium above inflation is assumed to concerns life expectancy. To the extent that be 4.5 percent. In total, the investment return teachers live longer than was expected during their assumption was 7.5 percent for the 2014-15 careers, contributions made by them and their actuarial valuation. employers—combined with investment returns on New Assumptions Increase Unfunded those contributions—will be insufficient to pay for Liabilities by $7 Billion. At the February 2017 their pension benefits for the portion of their lives meeting, the board voted to reduce the inflation that extend beyond their assumed life expectancy. assumption to 2.75 percent. This decision flows If this happens, an unfunded liability results. It is through to assumptions that depend on inflation, therefore important for CalSTRS to reflect recent including the wage growth and investment return trends and future expectations about mortality assumptions. Specifically, the new inflation in their assumptions so that pension benefits are assumption reduces the annual wage growth funded by teachers and their employers during assumption from 3.75 percent to 3.5 percent. The teachers’ working years rather than unfunded inflation decision also reduces the investment liability payments made by future generations of taxpayers. 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF Prior “Static” Assumptions Did Not Capture teachers are already phased in, while higher district Future Improvements in Life Expectancy. contributions will be phased in by 2020-21. While Historically, CalSTRS—like most pension over the next few decades these contributions are systems—has used static assumptions about life projected to be sufficient to fully fund CalSTRS, expectancy. This means that the assumptions did during the phase in period contributions are not change over time to reflect anticipated future insufficient to keep CalSTRS’ unfunded liability improvements in life expectancy. Rather, CalSTRS from growing. An analogy could be credit card would update the assumptions periodically to debt. Each month, an individual with credit card incorporate these improvements. debt incurs an interest charge. The cardholder’s New Approach Increases Unfunded Liabilities monthly payment typically must exceed the interest by Over $6 Billion. CalSTRS’ new mortality charge in order for the principal—or in the case assumptions use a “generational” approach. of CalSTRS, the unfunded liability—to decrease. Essentially, this means that future improvements This underfunding accounts for $4 billion of in life expectancy are incorporated up front in the $21 billion increase in CalSTRS’ unfunded current assumptions. This could be thought of as liabilities. accelerating life expectancy improvements that 2015-16 Investment Return Fell Short of CalSTRS would have otherwise assumed in the Assumption. The value of the system’s investment future into today’s assumptions. The new approach portfolio decreased by about 1.5 percent during aims to ensure that contributions from teachers 2015-16. As of the end of 2015-16, the portfolio and employers made during teachers’ working lives was valued at $7.3 billion below assumptions. are sufficient to cover the costs of their pension CalSTRS uses a “smoothing” policy to reduce benefits, and thus should help avoid unfunded volatility in reported unfunded liabilities and liabilities in the future. In addition, the new contribution rates, such that only one-third of the approach will reduce the need to change mortality variance is reflected this year. This means that only assumptions in the future. Because the generational $2.4 billion of the difference is factored into the approach accelerates future life expectancy $21 billion increase in the unfunded liability, with improvements into current assumptions, the remainder of the difference deferred to future however, it increases the current estimate of the actuarial valuations. unfunded liability. Specifically, the new mortality Salary Growth Outpaced Assumptions. assumptions, along with other, relatively minor Assumptions about salary growth also affect changes in demographic assumptions, account estimates of liabilities. Similar to the investment for over $6 billion of the $21 billion increase in return assumption, the salary growth assumption CalSTRS’ unfunded liabilities. has two components—one tied to inflation that captures cost-of-living adjustments and another Other Factors tied to pay raises that teachers receive as they Current Contributions Insufficient to progress in their careers. (As discussed above, Keep Unfunded Liability From Growing the reduction in the inflation assumption also (Underfunding). The funding legislation phased reduced the overall salary growth assumption from in higher contributions over three years in the 3.75 percent to 3.5 percent.) case of the state and teachers and seven years for Salaries are one input in determining a districts. Higher contributions from the state and teacher’s monthly pension benefit in retirement, www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO BRIEF along with age and number of years of service. lower estimate of projected benefit payments, an Teacher and district contributions made during unfunded liability results for those prior years of a teacher’s career are premised on an assumed service. amount of salary growth. When salaries grow faster CalSTRS’ most recent valuation shows that than assumed there are two main effects. First, salaries grew faster than CalSTRS’ new assumption. because contributions are measured as a percentage As shown earlier in Figure 3, the greater-than- of payroll, CalSTRS receives more contributions. assumed salary growth accounted for $1 billion On the other hand, projected pension benefits of the $21 billion increase in CalSTRS’ unfunded will be higher than previously assumed. In part, liabilities. because earlier contributions were premised on a WHO PAYS FOR INCREASED UNFUNDED LIABILITIES? Funding Plan Assigns Responsibility for unfunded liabilities associated with the benefits CalSTRS’ Unfunded Liabilities. The 2014 funding and contributions that were in place in 1990. This legislation, as implemented by CalSTRS, assigns means that the state’s share of CalSTRS’ unfunded responsibility for CalSTRS’ unfunded liabilities liabilities and its contribution rate are based on an to the state and districts. (The legislation also estimate of what CalSTRS’ funding situation would increased teacher contributions, which help pay be today had the state made different decisions down the district share.) Specifically, the plan about teacher pensions in the past. Generally, the makes the state responsible for unfunded liabilities calculation estimates what CalSTRS’ unfunded associated with the benefit and contribution liabilities would be if (1) the state had not granted structure that was in place as of 1990 (currently teachers more generous pensions in the late 1990s less than one-third of the total). Districts pay for and (2) state and teacher contributions to CalSTRS’ unfunded liabilities associated with changes made main pension fund had not been decreased when after 1990, but only through 2013-14 (currently over CalSTRS was fully funded around 2000. two-thirds of the total). (Responsibility for a small Theoretical Assets Assumed for Calculating amount of CalSTRS’ unfunded liabilities—those State’s Share of Unfunded Liabilities. Had less associated with benefit changes made after 1990 generous benefits been paid to members and had and for years after 2013-14—is not assigned under more contributions been made to the investment the funding plan.) We describe these concepts fund, CalSTRS would have had more assets. below in more detail, and discuss how CalSTRS’ In order to estimate what CalSTRS’ unfunded new actuarial assumptions and the latest actuarial liabilities would have been in this theoretical valuation affects the state, districts, and teachers. situation, the calculation assumes that CalSTRS’ investment portfolio is larger than it actually is State Share of Unfunded Liability today. This is important because when CalSTRS Increases $15 Billion records investment gains in the real world, the Assembly Bill 1469 Assigns State calculation gives the state the benefit of additional, Responsibility for 1990 Benefit Structure. As theoretical gains off the fictional portion of the implemented by CalSTRS, the 2014 funding investment portfolio. For example, if CalSTRS’ real legislation makes the state responsible for world portfolio grows by $10 billion, the calculation 6 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF gives the state the benefit of a roughly $11 billion total CalSTRS assets and liabilities, as well as those gain. Of course, the opposite is true as well. When credited to the state and to districts for purposes CalSTRS records an investment loss—as they did of calculating their respective shares. As described in 2015-16—the loss to the theoretical investment above, the state benefits from a theoretical asset portfolio is larger than the real world loss, making the Figure 4 state share of the unfunded State and District Shares of Unfunded Liabilities liability grow more than the (Surplus) Under Sample of Investment Return Scenarios increase in the real world (In Billions) unfunded liability. District Share Theoretical Assets $200 Makes State Share Relatively Volatile. Because theoretical 100 assets that determine the state’s share of the unfunded liability fluctuate more than -100 real world assets, the state share is relatively sensitive to -200 changes in assets. Figure 4 shows a sample of possible -300 investment return scenarios and resulting state and -400 district shares of CalSTRS’ 2015 2020 2025 2030 2035 2040 2045 unfunded liabilities. The state’s share of future State Share $200 unfunded liabilities is far more volatile and uncertain 100 than the district’s share. (We note that this figure is out of date for a variety of reasons—including new -100 actuarial assumptions and a June 2016 amendment to -200 the actuarial policy—but we offer it because it illustrates -300 the volatility of the state share discussed above.) -400 2015 2020 2025 2030 2035 2040 2045 State Share Also Sensitive to Changes in Liabilities. Note: Displays result of 30 simulations reflecting average investment returns of between Figure 5 (see next page) 5.6 percent and 10.9 percent. When state share drops below $0, surplus used to reduce district share. Adjusted for inflation. shows the breakdown of www.lao.ca.gov Legislative Analyst’s Office 7 AN LAO BRIEF liabilities. Moreover, the Figure 5 weak investment return in Detail on Calculation of Responsibility for 2015-16 decreased assets. CalSTRS’ Unfunded Liabilities The bulk of unfunded 2015-16 (In Billions) liabilities resulting from Total State Districts Unassigned all of these changes are Liabilities $266.7 $218.0 $41.8 $6.8 assigned to the state. Assets 170.0 188.7 -25.1 6.4 Specifically, the state’s share Unfunded Liability $96.7 $29.3 $66.9 $0.5 of the unfunded liability as portfolio ($189 billion) that is greater than the real of the most recent valuation world portfolio ($170 billion). Also, note that the more than doubled from $13.9 billion as of 2014-15 to state is responsible for the bulk of CalSTRS’ liabilities $29.9 billion as of 2015-16. This increase is reflected ($218 billion out of the $267 billion total). (Note in Figure 6. Note that the figure also illustrates the that we are discussing total liabilities, not just the relative volatility in the state’s share of CalSTRS’ unfunded liability—the portion of liabilities not unfunded liabilities. In the first two years following covered by assets.) This is because, had the post-1990 the funding plan, the state’s share dropped from benefit enhancements and contribution decreases not $20 billion to $14 billion, before more than doubling occurred, CalSTRS would still have had the bulk of as of the most recent estimate. In comparison, the the liabilities that it has today. This is important for district share of the unfunded liability has increased determining the state’s share of steadily over the period. the unfunded liability because Figure 6 when CalSTRS changes State Share of CalSTRS' assumptions that increase the Unfunded Liabilities Relatively Volatile estimates of liabilities—like the investment return, mortality, (In Billions) and other assumptions $100 described earlier—most of the State resulting increase is assigned to Districts 80 the state. State Assigned Responsibility for $15 Billion 60 of $21 Billion Unfunded Liability Increase. As 40 described above, the state share of CalSTRS’ unfunded 20 liabilities is sensitive to changes in both assets and liabilities. CalSTRS’ new assumptions 2012-13 2013-14 2014-15 2015-16 about future investment returns, life expectancy, and Note: Figure does not reflect a small portion of unfunded liability for which no party is responsible. This amount totaled about $500 million as of June 30, 2016. other factors have increased 8 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF District Share of Unfunded Liability benefits that employees earn in a given year. The Increases $5 Billion normal cost is expressed as a percentage of payroll. Normal cost payments are different from unfunded Districts Responsible for Cost of Benefit liability payments. Normal cost payments fund the Enhancements and Contribution Decreases. The projected cost of pension benefits earned the year funding legislation, as implemented by CalSTRS, in which the normal cost contribution is made. In makes districts responsible for unfunded liabilities contrast, an unfunded liability is an amount owed associated with the benefit and contribution for pension benefits earned in the past that were not changes that occurred after 1990, but only for fully funded. service through 2013-14. For example, Chapter 74 New Assumptions Increase Estimate of of 2000 (AB 1509, Machado) diverted one-quarter Normal Cost. Changes in the various actuarial (or 2 percentage points) of teachers’ contributions assumptions can have a significant impact on the from the main pension program to a supplemental estimate of normal cost. For example, assuming retirement benefit program. Had this change not that teachers will live longer means that they are been made, CalSTRS estimates that the investment assumed to be paid pension benefits for a longer portfolio would have roughly $10 billion more period. This in turn means that more must be in assets. Districts are responsible for unfunded paid during their working careers to fund their liabilities that resulted from these and other projected benefits in retirement. Likewise, to the changes that were made after 1990. extent that future investment returns are assumed Changes in Actuarial Assumptions Also Affect to pay for less of a teacher’s future pension benefits, District Share. Districts are responsible for a small teachers and districts must pay more in normal cost share of CalSTRS’ liabilities, as shown earlier in during teachers’ working careers. Figure 5. Changes in actuarial assumptions that Teachers Hired After January 1, 2013 Pay increase liabilities will also increase the districts’ Half of Normal Cost. Major pension legislation share of liabilities, albeit by a lesser amount than known as the Public Employees’ Pension Reform the state’s share. For example, like the state’s share Act (PEPRA)—Chapter 296 of 2012 (AB 340, of CalSTRS’ liabilities, the districts’ share is also Furutani)—changed many aspects of public discounted by the investment return assumption employee retirement programs. Among these to arrive at a present value. The action to lower changes was a requirement that public employees the investment return assumption therefore hired on or after January 1, 2013 pay half of the increases liabilities assigned to districts as well. As normal cost of their pension benefit. (We refer to of the latest actuarial valuation, the district share teachers hired after this date as “PEPRA teachers.”) of CalSTRS’ unfunded liability increased from If the normal cost rate increases or decreases by $62 billion to $67 billion. more than 1 percentage point from the initial level Contributions From PEPRA Teachers set in the spring 2013 valuation (15.9 percent of Expected to Increase in July 2018 payroll), the member must pay half of the increase, rounded to the nearest 0.25 percentage point. Explanation of “Normal Cost.” The term Contributions From PEPRA Teachers normal cost refers to the amount actuaries estimate Projected to Increase on July 1, 2018. Figure 7 (see is necessary—combined with assumed future next page) shows estimates of normal cost since investment earnings—to pay the cost of pension www.lao.ca.gov Legislative Analyst’s Office 9 AN LAO BRIEF New Rate Projections Figure 7 District Rates Continue Contribution Rate Increase Expected for PEPRA Teachers in 2018-19 to Increase Pursuant to Statutory Schedule. Figure 8 Estimate of Normal Cost, Percent of Payroll shows near-term projections 19% of state, district, and teacher contribution rates and Increase Required 18 amounts. (The projections reflect the planned decrease 17 in the investment return No Change Required assumption to 7 percent in 16 the spring 2018 actuarial 15 valuation.) Under current law, district contributions Decrease Required 14 are set in statute through 2020-21. Pursuant to that 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 statutory schedule, district Actual Projection contributions increase from Note: PEPRA teachers are teachers hired after January 1, 2013. Years shown are years in which an adjustment 12.6 percent in the current in the teacher contribution rate would be necessary, based on the actuarial valuation for two fiscal years prior. For example, the projected increase shown for 2018-19 would be based on the actuarial valuation for 2016-17. fiscal year to 19.1 percent PEPRA = Public Employees Pension Reform Act. in 2020-21. To begin to pay down the large increase in the first actuarial valuation following the passage the state’s share of CalSTRS’ of PEPRA. The darker band shows the range in unfunded liabilities described earlier, the state’s which changes in teacher contributions are not rate increases by 0.5 percentage points per year necessary, while the two lighter bands show ranges over the period. This is the maximum increase in in which changes would be necessary. As shown in the state contribution rate allowable under current the figure, CalSTRS’ actuaries are projecting that law. Lastly, the rate for PEPRA teachers is projected an increase in the PEPRA teacher contribution to increase by 1 percentage point in 2018-19, as rate will be necessary in 2018-19. This is largely described earlier. due to the planned further reduction in the State Rate Projected to Increase Until 2030. investment return assumption from 7.25 percent Figure 9 shows long-term projections of state, to 7 percent. The projected rate of 17.8 percent is district, and teacher contribution rates. As shown nearly 2 percentage points higher than the initial in the figure, most of the long-term contribution post-PEPRA rate of 15.9 percent. If this projection increases are shouldered by the state. This is holds, the PEPRA teacher contribution rate will be because the state’s share of CalSTRS’ unfunded 1 percentage point higher starting in 2018-19. We liabilities more than doubled in the most recent discuss rate projections for the state, districts, and valuation, and are assumed to increase further in teachers in the section below. next year’s valuation when the investment return is 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF Figure 8 Near-Term Projection of CalSTRS Contribution Rates and Amounts (Dollars in Billions) 2016-17 2017-18 2018-19 2019-20 2020-21 Contribution Rates Districts 12.58% 14.43% 16.28% 18.13% 19.10% Statea 8.58 9.09 9.60 10.11 10.62 Teachers hired before January 1, 2013 10.25 10.25 10.25 10.25 10.25 Teachers hired after January 1, 2013 9.21 9.21 10.21 10.21 10.21 Contribution Amounts Districts $4.0 $4.7 $5.5 $6.4 $7.0 Statea 2.5 2.8 3.0 3.3 3.6 Teachers 3.2 3.3 3.5 3.6 3.7 Totals $9.7 $10.9 $12.1 $13.3 $14.3 a Includes roughly 2.5 percentage points related to a program that protects retired teachers’ pension benefits from the effects of inflation. State rate is based on statewide payroll as measured on a two-year lag. further reduced to 7 percent. Due to the 0.5 percentage Figure 9 point maximum allowable State Contributions to CalSTRS increase per year in the state’s Projected to Increase Steadily for 15 Years contribution rate under Percentage of Payroll current law, state rates are projected to increase for 25% the next 15 years. District rates are expected to decline 20 Districts modestly beginning in 2020-21. The districts’ rates Statea 15 do not increase as the state’s do because the current Teachers 10 funding approach assigns the overwhelming majority of increased unfunded liabilities 5 to the state. Increased contributions from the state 2016-17 2021-22 2026-27 2031-32 2036-37 2041-42 and teachers keep the system on track to full funding, a State contributions based on statewide payroll as measured on a two-year lag. Includes roughly 2.5 percentage points related to a program that protects retired teachers’ pension assuming future experience from the effects of inflation. Note: Assumes future experience matches CalSTRS' actuarial assumptions, including assumption matches assumptions. that investment returns equal 7 percent beginning in 2017-18. www.lao.ca.gov Legislative Analyst’s Office 11 AN LAO BRIEF LAO COMMENTS New Assumptions Are a Good Thing for assets in less than 30 years, the plan represents a Many Reasons. While recent changes have major improvement. increased CalSTRS’ unfunded liabilities notably, State Contributions Key to Funding CalSTRS there are many positive aspects resulting from by Mid-2040s. Earlier in this report, we described the new actuarial assumptions. CalSTRS’ new how the state’s share of CalSTRS’ unfunded mortality assumptions better reflect future liabilities is sensitive to changes in assets and expected improvements in life expectancy. liabilities. This is important because to the extent The new assumptions will increase future state that CalSTRS’ funding situation continues to contributions to address the increases in CalSTRS’ erode—either through worse-than-assumed unfunded liabilities. The decision will also increase investment performance or further changes in the estimate of normal cost, which is expected to actuarial assumptions—the state will largely bear increase contributions from PEPRA teachers. These the responsibility for covering the resulting costs decisions will increase contributions to CalSTRS, (assuming the current funding approach remains reduce the likelihood that unfunded liabilities in place). Yet, increases in the state’s contribution materialize in the future, and keep the funding rate are capped under state law at 0.5 percent per plan on track for full funding. As such, we view year. Under some scenarios, the funding plan may these developments positively. fall short of its key goal of fully funding CalSTRS Concerns About Current Funding Plan by the mid-2040s because this cap could keep state Implementation. In February 2016, we released rates below what is necessary to fund CalSTRS. In a series of online posts titled, A Review of the short, whether the funding plan meets its stated CalSTRS Funding Plan. In our review, we examined goal will depend largely on whether the state pays a number of details about the plan that, in our enough to CalSTRS. view, differed from our earlier understanding Consider Increasing State’s Contributions of legislative intent. For example, we found that Faster. If the Legislature wants to increase the the plan “potentially exposes the state to larger likelihood that the funding plan succeeds in unfunded liabilities than we thought possible when achieving this goal, it probably needs to ramp up the Legislature passed the law.” That scenario seems state contributions faster. While this would mean to be coming to fruition with CalSTRS’ recent state costs for CalSTRS are even higher in the near changes in actuarial assumptions. The state’s share term, it would lower state costs in future decades of the unfunded liability is now about 50 percent and increase the likelihood that CalSTRS is fully greater than it was in 2014. Perhaps more funded by the mid-2040s target date. important is the staggering complexity of CalSTRS’ Options for Increasing State Contributions policy that implements the funding law and the Faster. The Legislature has three options for strange calculations that underpin that policy. We increasing state contributions to CalSTRS. First, the continue to have concerns about this complexity. Legislature could increase the 0.5 percentage point That said, compared to the prior situation in which cap on state rate increases. Each 0.25 percentage responsibility for funding CalSTRS was not defined point increase in the cap would cost around in law and CalSTRS was projected to exhaust its $75 million per year in the near term. Second, 12 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF Proposition 2 (2014) requires the state to pay down on a one-time, periodic, or ongoing basis. Third, a certain amount of debt each year based largely the Legislature could take a hybrid approach in on the amount of capital gains related revenue the which it increases the statutory cap on state rate state receives. The Legislature could dedicate a increases and dedicates a portion of Proposition 2 portion of Proposition 2 debt payments to CalSTRS debt payments to CalSTRS. www.lao.ca.gov Legislative Analyst’s Office 13 AN LAO BRIEF 14 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF www.lao.ca.gov Legislative Analyst’s Office 15 AN LAO B R I E F LAO Publications This brief 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 brief 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. 16 Legislative Analyst’s Office www.lao.ca.gov