The 2019-20 Budget: Structuring the Budget: Reserves, Debt and Liabilities

The 2019-20 Budget: Structuring the Budget: Reserves, Debt and Liabilities GABRIEL PETEK LEGISLATIVE ANALYST FEBRUARY 5, 2019 analysis full gutter 2019-20 BUDGET LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET Executive Summary After many consecutive years of economic growth, California’s budget continues to be on strong footing. The $21 billion surplus available in the Governor’s January budget proposal reflects the strong fiscal position of the state. This gives the Legislature a unique opportunity to address a variety of statewide issues and further prepare the state for a recession or other crisis. Governor’s Proposals Put the State on Better Fiscal Footing. The Governor’s plan to improve the budget’s fiscal position largely is based on a roughly $11 billion plan to pay down retirement liabilities and budgetary borrowing. In addition, the Governor builds more reserves, devotes most of his new spending proposals to one-time commitments, and adds roughly $3 billion in ongoing spending to the budget. We think the Governor’s focus on paying down debt is commendable and that the budget’s overall structure puts the budget on better footing. That said, we have several suggestions for improving the Governor’s plan—alternatives that would likely save the state more money and would put the state in an even better fiscal position. Building More Reserves Than Proposed by the Governor Would Be Prudent. If the Legislature concurs with the Governor’s approach to make roughly $3 billion in new ongoing commitments, but wants to minimize potential reductions to ongoing programs in a recession, we suggest the Legislature consider building more reserves than the Governor proposes. We offer a variety of options for achieving this goal, including building more cash reserves or prepaying retirement liabilities. Because we also agree with the Governor’s approach to use a significant portion of discretionary resources to pay down debt, increasing reserves above the level proposed by the Governor could require reducing one-time programmatic proposals. Options to Improve the Debt Repayment Plan. We have a variety of suggestions for the Legislature to consider that could improve the Governor’s debt repayment package and are likely to save the state more money. These options fall into two areas: (1) paying down retirement liabilities and (2) modifying the Governor’s proposals to address budgetary borrowing. Paying Down Retirement Liabilities to Maximize State Savings. The Governor proposes using more than $6 billion General Fund to make supplemental payments to reduce the unfunded liability associated with state employee pensions (CalPERS) and teachers (CalSTRS). Of this total, about $4.1 billion would address the state’s share of these systems’ liabilities. On these proposals, we suggest the Legislature: • Consider Goal of Supplemental Payments. Our understanding is that a supplemental payment to the state’s CalSTRS unfunded liability likely would yield a lower savings rate over the next few decades than a payment of the same magnitude to CalPERS. This raises a trade-off for the Legislature. If it would prefer to maximize state savings, then funding CalPERS rather than CalSTRS would be preferable. If, instead, its goal is to address the unfunded liability at both systems, then the Governor’s approach is reasonable. • Maximize General Fund Savings When Using General Fund Resources. The Governor’s plan to make a supplemental payment to CalPERS relies exclusively on General Fund money, but achieves savings for both the General Fund and other funds. We offer two options that would maximize the General Fund benefit: (1) devote the entire supplemental www.lao.ca.gov 1 analysis full gutter 2019-20 BUDGET payment to one CalPERS plan which is nearly entirely paid for by the General Fund (Peace Officers and Fire Fighters) or (2) distribute the payment to all state plans and require other funds that benefit from the General Fund payment to repay the General Fund. Under the second option, the benefit to other funds likely would exceed the cost of repaying the General Fund. Modifying the Governor’s Proposals to Address Budgetary Borrowing. The Governor also uses $4.5 billion to address budgetary borrowing, including to repay all outstanding special fund loans, undo two budgetary deferrals, and repay all outstanding settle up owed to schools and community colleges. On these proposals, we have two recommendations. First, we recommend the Legislature reject the Governor’s proposal to undo two payment deferrals and consider instead using those resources ($1.7 billion) to build more reserves. Second, we recommend the Legislature pay down high-interest liabilities, like retirement liabilities, instead of using $2.1 billion to repay outstanding special fund loans. For example, the Legislature could maintain the state’s current plan to repay these loans over the next few years and use the funds to pay additional amounts toward CalPERS. This would save the state hundreds of millions of dollars relative to the Governor’s current plan. 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET INTRODUCTION After many consecutive years of economic to continue the state’s recent progress in preparing growth, California’s budget continues to be on for an economic downturn or other crisis. strong footing. The nearly $21 billion surplus This report considers the overall structure of available in the Governor’s January budget proposal the Governor’s budget to evaluate how well it reflects the strong fiscal position of the state. By prepares the state to address a future budget historical standards, this surplus is very significant. problem. We begin with background to explain The Governor introduces a wide range of policy the state budget structure, budget problems, and proposals to achieve a variety of objectives. options for addressing budget problems. We also First, the Governor proposes allocating roughly provide background on the state’s existing reserves $11 billion to pay down state debts and liabilities. and debts and liabilities. We then present some The Governor also proposes the state continue key considerations as the Legislature considers recent efforts to build more reserves and devotes its overall budget structure. Finally, we present most of his new spending proposals to one-time and assess each of the Governor’s major budget commitments. Together, these actions are intended reserve and debt and liability proposals and offer some alternatives for legislative consideration. THE STATE BUDGET STRUCTURE This section provides background information on corporation tax. While some revenue sources, the budget’s structure. like the sales tax, grow relatively steadily from Each Year, the Legislature Must Pass a one year to the next, the PIT is quite volatile— Balanced Budget. The State Constitution requires in most years growing by billions of dollars the Legislature to pass a balanced budget each and in some years shrinking by billions of year. Specifically, Article IV prohibits the Legislature dollars. The PIT makes up over 70 percent of from enacting a budget bill that would appropriate General Fund revenues. more in General Fund expenditures than are • Reserves. Budget reserves are monies set available in resources. The General Fund is the aside for future use, like a household’s savings state’s main operating account, but the state also account. In a year the state makes a reserve has hundreds of other separate funds (including, for deposit, it reduces revenues available. In example, special funds). Each of these individual a year the state makes a withdrawal from funds receives revenues (often from fees or bonds), a reserve account, it increases available makes expenditures (including for employee revenues. salaries and retirement benefits), and has its own There are three major components of anticipated reserve level. expenditures: Major Features of the General Fund Budget. To ensure the General Fund is balanced, anticipated • Constitutional Spending for Schools expenditures must not exceed resources available. and Community Colleges. Proposition 98 There are two main components of available (1988) establishes a constitutional minimum resources: spending requirement for schools and community colleges. The requirement changes • Revenues. Revenues from taxes and fees are each year based upon various factors, the major sources of available resources. The including General Fund revenue, per capita three largest sources of state revenues are personal income, and student attendance. the personal income tax (PIT), sales tax, and The state meets the requirement through a www.lao.ca.gov 3 2019-20 BUDGET combination of state General Fund revenue General Fund). The Legislature can allocate and local property tax revenue. In most years, spending on a one-time basis (that is, for only spending on schools and community colleges one year), a temporary basis (for a set period comprises about 40 percent of the General of years), or an ongoing basis (indefinitely). Fund budget making it the single largest Once made, ongoing expenditures will General Fund expenditure. continue unless the Legislature takes action to • Spending on Debt and Liabilities. The end them. annual state budget commits billions of State’s Budget Position and Cash Position dollars each year to repaying state debts Differ. The state budget process aligns General and liabilities. As described later, the state’s Fund revenues with expenditures on an annual largest liabilities are related to pensions and basis. This budgetary position is different than other retirement benefits. The Legislature the General Fund’s cash position—a daily or has very little discretion over some debt point-in-time estimate of whether the fund has repayments (such as bond debt service and sufficient cash on hand to make expenditures. contributions to state employee pension Although state expenditures are distributed fairly benefits), but considerably more flexibility evenly throughout the fiscal year, the state receives about how and when to repay other debts. most revenues in a few key months (most notably, • Other Spending. The annual state budget April, June, and January). As a result, even though also appropriates billions of dollars to the budget is balanced on an annual basis, in a other programs and purposes. After single week or month the General Fund can expend K-14 education, the largest area of state more revenues than it receives, creating a cash expenditures is health and human services deficit. These cyclical cash fluctuations are normal. programs (representing about one-third of the BUDGET PROBLEMS In some years, state revenues exceed spending Figure 1 under current law resulting in additional resources available to allocate (a “surplus”). In other years, Budget Can Face a revenues are insufficient to cover current law Surplus or Budget Problem expenditures and the state faces a budget problem (a “deficit”). Figure 1 illustrates these different situations. The surplus (or deficit) in any given year differs from the budget’s operating surplus (or operating deficit), which is the ongoing amount by which revenue growth is expected to exceed spending growth (or, in the case of an operating deficit, the amount by which spending growth exceeds revenue growth). In this section, we discuss two main drivers of budget problems—recessions and unexpected crises. We then discuss the tools the state can a The cost of currently authorized programs before policy changes. use to prepare for a budget problem and actions the state must take to address a budget problem if its level of preparation is insufficient to cover the entirety of the budget problem. 4 LEGISLATIVE ANALYST’S OFFICE seuneveR detcejorP aserutidnepxe detapicitnA seuneveR detcejorP aserutidnepxe detapicitnA analysis full gutter Discretionary resources available (a “surplus”) Budget problem (a “deficit”) analysis full gutter 2019-20 BUDGET Sources of Budget Problems spending, schools are sharing in the budget problem and the size of the state’s budget problem Large Budget Problems Emerge During is reduced accordingly. (As shown in the figure, the Recessions. In a recession, revenues decline state opted not to reduce school spending down to due to reduced economic activity. Despite this the minimum requirement in 2001-02.) economic slowdown, absent policy changes, much Unexpected Crises Can Significantly Increase of the state’s expenditure base grows relatively Expenditures, Creating a Budget Problem. constantly. This creates a budget problem in the Although historically much less costly than tens of billions of dollars over the period of multiple recessions, unexpected expenses related to natural years. (During the Great Recession, the federal disasters and other crises can significantly increase government provided significant assistance to the the demand on available resources and also cause state through increased federal spending. In a more a budget problem. (In the case of major disasters, moderate recession, such assistance may not be the federal government reimburses the state for the available.) majority of certain related expenditures, but these In a Recession, School Spending reimbursements do not cover the full cost of the Requirement Can Reduce the Size of Budget disaster.) Some examples of past events that have Problem. Typically, when revenues decline year caused significant unanticipated costs for the state over year, required constitutional spending on include: schools and community colleges also goes down. The state has historically responded to • Loma Prieta Earthquake. In 1989, an these reductions in the minimum requirement by earthquake in Northern California resulted also lowering spending, as Figure 2 shows. By in severe damage to infrastructure in cities the guarantee dropping and the state lowering across the region, including the partial Figure 2 School and Community College Spending Drops in a Recession Percent Change Over Prior Year 25% 15 Actual State Spending (if Higher) 5 -5 Minimum Spending Requirement -15 1989-90 1992-93 1995-96 1998-99 2001-02 2004-05 2007-08 2010-11 2013-14 2016-17 www.lao.ca.gov 5 analysis full gutter 2019-20 BUDGET collapse of the San Francisco-Oakland Bay line. First, making a deposit, rather than increasing Bridge. In response to the earthquake, the ongoing spending, lowers the rate of growth of the state increased the sales tax by a quarter cent state’s spending base, shrinking the size of any to raise $800 million ($1.6 billion in today’s future budget problem. Second, making a deposit dollars) for disaster relief. increases the resources available to address a • Energy Crisis in Early 2000s. When the future budget problem. state’s two largest utilities faced serious Illustration of How Reserves Work. Figure 3 financial problems in the early 2000s, the shows a hypothetical example of how reserves state Department of Water Resources began work. The left side of the figure shows spending purchasing electricity on behalf of the utilities’ from year to year without budget reserves, while customers. The state used proceeds from the right side shows a budget with reserves. the sale of long-term electricity bonds to Without reserves, the state must significantly drop finance $11.2 billion in these costs. (Electricity spending from year to year during a recession ratepayers, rather than the General Fund, (when revenues decline). With reserves, the state repaid these bonds financed by a surcharge sets aside money during an expansion (lowering on electricity bills.) In addition, in response to spending in those years), but then can use those the crisis, the state spent $1 billion (roughly funds in a recession to reduce the need for budget $1.5 billion in today’s dollars) on various cuts. conservation and rebate programs in the State Has Other Tools to Prepare for a 2001-02 budget. Budget Problem • 2018 California Wildfires. In November 2018, the Camp, Woolsey, and Hill fires collectively In addition to reserves, there are other tools the resulted in the most destructive fire season Legislature can use before a recession that help in state history in terms of loss of life and (1) address and/or (2) minimize the size of a future property damage. While the state costs budget problem. Some of these tools have both of associated with these events are still evolving, these reserve benefits, while others have only one initial estimates suggest these fires will result of the two benefits. Specifically, the Legislature can: in additional state General Fund costs of over $900 million for disaster response and • Prepay Debt. The Legislature can prepay debris removal (after federal reimbursements). future debts, most notably retirement The Governor also has proposed the state liabilities. For example, in some cases, the spend some additional funds to assist local state can transfer funds to a pension system governments with their associated costs. early so that, at a later date, the state can reduce its annual required contribution to that system. In this case, the pension system Reserves Are the Main Tool to holds this deposit in trust, and the state can Prepare for a Budget Problem use the deposit later in lieu of a future required Budget reserves are monies set aside for future payment. Prepaying debts has both benefits use, like a household’s savings account that is of reserves. dedicated to emergencies. Reserves help insulate • Pay Down Debt. A different tool available the budget from temporary shortfalls, delaying or to the Legislature is paying down future mitigating the need for the Legislature to make debts, including retirement liabilities (called difficult choices, including spending reductions and supplemental payments). In this case, the tax increases. state transfers additional funds to a pension Setting Aside Reserves Has Two Major system to reduce costs over the long-term, Benefits. Making reserve deposits has two key saving money on an ongoing basis. Paying features that help improve the budget’s bottom down debts has one benefit of reserves 6 LEGISLATIVE ANALYST’S OFFICE 2019-20 BUDGET Figure 3 Illustration of How Reserves Work Hypothetical Spending Hypothetical Spending Without Budget Reserves With Budget Reserves The state now saves some Historically, the state spent nearly . . . which led to large of its revenue during the expansion . . . . . . which can be used all its revenue in expansion years . . . budget cuts when to reduce the need revenues dropped off for budget cuts in the in a recession. next recession. (it addresses future spending obligations, as state reserves. In the case of prepaying debt, thereby reducing the size of a future budget this benefit is only temporary during the years the problem), but not the other benefit of reserves pension systems hold onto the funds (before the (holding money available to spend on state applies the funds toward a future payment programs in the future). obligation). • Spend on a One-Time Basis. One-time When a Budget Problem Persists, programmatic spending also benefits the State Must Take Other Actions budget in the event of a budget problem. One-time spending has one of the benefits If reserves and other tools are insufficient to of reserves (it reduces the size of a future cover the entire budget problem, the Legislature budget problem) but not the other benefit of finds other solutions to address the remaining reserves (holding money available to spend on problem. There are three broad categories of these programs in the future). actions: spending reductions, revenue increases, and cost shifts. For example, to address budget Some Tools Have Additional Benefits. problems in the past, the state has increased taxes; Prepaying and paying down debt can have an reduced programmatic spending; and shifted costs additional benefit that setting aside funds for to local governments, school districts, and future reserves does not. Specifically, if the state transfers years. these funds to a pension system, the system’s board can invest the funds, likely earning a higher rate of return than the funds would earn invested www.lao.ca.gov 7 serutidnepxE launnA serutidnepxE launnA analysis full gutter Recession Recession Reserves Reserves set-aside used to address budget problem analysis full gutter 2019-20 BUDGET STATE BUDGET RESERVES This section describes the state’s General Fund Safety Net Reserve. The 2018-19 budget reserves. created the Safety Net Reserve to set aside funds Budget Stabilization Account (BSA). The BSA for future costs of two programs—California is the state’s general purpose constitutional reserve Work Opportunity and Responsibility to Kids and it is governed by the rules of Proposition 2 and Medi-Cal—in the event of a recession. (2014). A set of complicated constitutional formulas Absent policy changes, these programs typically requires deposits into the BSA each year until experience increased expenditures during a deposits reach 10 percent of the fund’s balance. recession when unemployment increases and their In addition to required deposits, the state has caseloads rise. twice made additional, optional deposits into the School Stabilization Account. In addition to account. The constitution limits the Legislature’s creating new rules for depositing funds into the access to funds deposited into the BSA. BSA, Proposition 2 established a specific statewide Special Fund for Economic Uncertainties school reserve account (the Public School System (SFEU). The state’s other primary general purpose Stabilization Account). This school account is reserve account is the SFEU. Unlike the BSA, which governed by a separate set of formulas. To date, has restrictions on withdrawals, the Legislature these formulas have not required any deposits. has wide discretion to use the funds in the SFEU. Therefore schools do not have any dedicated Under statutory language that recently expired, state-level reserves available for a recession. As the administration also has had authorization to described in the nearby box, however, individual use funds allocated in the SFEU to respond to school districts have built up reserves at the local disasters. Specifically, the administration could level. transfer funds from the SFEU to a disaster-specific Budget Deficit Savings Account (BDSA). The subaccount and then expend those funds for 2018-19 budget package also created the BDSA response and recovery activities. as an additional savings account. This account has similar restrictions on withdrawals as the BSA, although these rules are statutory. STATE DEBTS AND LIABILITIES This section describes California’s major • Bond Debt. These liabilities include the outstanding debts and liabilities and discusses how principal and interest amount of outstanding the state has been addressing them. general obligation and lease revenue bonds Three Primary Types of Debts and Liabilities. issued by the state to finance capital California’s debts and liabilities fit into three broad infrastructure. categories: • Budgetary Borrowing. For the purposes of this report, these are the debts the state • Retirement Liabilities. As discussed below, has incurred in the past to address its California has unfunded liabilities associated budget problems. These include loans from with pension benefits for judges and state other state funds to the General Fund and employees, retiree health benefits, and the outstanding obligations to other entities, like state’s share of pension benefits for the state’s cities, counties, and school and community teachers and school administrators. college districts. 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET Retirement Liabilities aside to prefund benefits that have been earned to date—or investment returns have been lower Public employees earn retirement benefits than expected—an unfunded liability exists. In this (typically pension and Other Post-Employment section, we discuss four major state retirement Benefits [OPEB, most commonly retiree health liabilities. benefits]) over the course of their careers and then State Employees’ Pensions. Depending receive the benefits in retirement. The value of the on their job, state employees earn pension benefits earned by employees constitutes a liability benefits under one of five state pension plans to the employer. In some cases, a substantial (Miscellaneous, Industrial, Safety, Peace Officer/ share of the liabilities accrued to date has been Firefighter, and Highway Patrol) administered by the prefunded through employer and/or employee California Public Employees’ Retirement System contributions that have been invested over the (CalPERS). The state and employees make regular course of employees’ careers. These investments contributions toward these benefits. The state’s earn an annual rate of return. In other cases, contributions to CalPERS are made from the retirement benefits are paid on a pay-as-you-go General Fund and other funds. As Figure 4 (see basis where employers instead pay the cost of the next page) shows, the General Fund’s share of the benefits as they are received by retired employees. state’s contribution to each pension plan varies. To the extent that insufficient assets have been set Overview of Local School Reserves School and Community College Districts Have Local Reserves. While the state has not set aside any reserves specifically for schools, school and community college districts have the option to build their local reserves. District reserves can be restricted or unrestricted. Restricted reserves can legally be spent only for specific programs (such as special education), whereas unrestricted reserves can be spent for any purpose. Local reserves can help districts respond to drops in state funding, address unexpected costs, manage cash flow, and save for large purchases. Some State Policies Promote, Others Discourage, Local Reserves. To promote fiscal stability, the state requires school districts to maintain a minimum level of unrestricted reserves. For an average district, these minimums equal 3 percent of annual expenditures. However, if a district wants to maintain reserves that are more than twice the minimum, it must adopt an annual statement justifying any reserves exceeding that threshold. State law also caps district reserves at 10 percent of expenditures once the balance of the state school reserve reaches a specified threshold. (These caps have never been operative because the state has made no deposits into the state school reserve. Additionally, small school districts are exempt from the cap.) The state does not have any specific policies regarding minimum or maximum reserve levels for community colleges. School and Community College Reserves Have Been Growing Throughout Economic Expansion. The most recently available data show that school districts’ unrestricted reserves totaled $11.7 billion (18 percent of expenditures) in 2016-17, up from $7.6 billion (15 percent) in 2013-14. (Most school districts adopt annual statements justifying their reserve levels.) For community colleges, unrestricted reserves totaled $1.6 billion (21 percent) in 2016-17, up from $1.1 billion (18 percent) in 2013-14. During this period of growing reserves, both school and community college districts were experiencing significant overall funding increases. (Despite these statewide trends, available data show that about 30 school districts and one community college hold reserves of less than 6 percent.) www.lao.ca.gov 9 analysis full gutter 2019-20 BUDGET Figure 4 State CalPERS Plans (Dollars in Billions) General Fund Other Funds’ Total State 2019-20 Share of Share of Unfunded Funded Plan Contributiona Contribution Contribution Liability Ratio Miscellaneous $3.7 48% 52% $34.8 68% Industrial 0.2 70 30 1.0 76 Safety 0.5 45 55 2.9 76 Peace Officer/Firefighter 1.8 98 2 15.2 66 Highway Patrol 0.5 — 100 4.9 60 a Includes both normal cost and payments toward the plans’ unfunded liabilities. For example, whereas nearly all of the state’s are paid from the General Fund. School districts contributions to the Peace Officer/Firefighter plan use their own general purpose funds to pay these come from the General Fund, no General Fund costs. dollars go towards the Highway Patrol plan. In total, Judges’ Pensions. Supreme and Appellate the unfunded liability associated with the state’s Court justices and Superior Court judges who CalPERS pension benefits is about $59 billion. were appointed or elected before November 9, Retired State Employees’ Health and Dental 1994 earn pension benefits under Judges Benefits. Eligible state employees receive health Retirement System I (JRSI). Pensions under JRSI benefits in retirement from the state. Although are paid by the state on a pay-as-you-go basis. The the state adopted a plan in 2015-16 to begin total unfunded liability of JRSI—assuming the state prefunding these benefits for current employees, continues to pay for this benefit on a pay-as-you-go the state pays for current retirees’ health benefits basis—is estimated to be $3.3 billion. on a pay-as-you-go basis. The state has an Bond Debt unfunded liability associated with the benefit of about $91 billion. State Has Two Main Types of Bond Debt. Teachers’ Pensions. California teachers earn California issues bonds to finance most of its pension benefits administered by the California infrastructure spending. Two main types of bonds State Teachers’ Retirement System (CalSTRS). issued by the state are general obligation bonds Although the state is not the employer for teachers, and lease revenue bonds. General obligation it contributes money to the pension system and bonds must be approved by voters. Lease revenue determines the system’s funding policy and benefit bonds are issued for state facilities and are repaid levels. (The University of California also administers by the state departments that use those facilities. its own pension and retiree health benefit systems; The state repays bonds with interest to investors however, the Legislature does not play a direct who purchase them. The state currently has about role in establishing these benefit-related levels or $84 billion in outstanding General Fund-supported funding policies.) In 2014, the state adopted a plan bond debt and repays a portion of this debt each to fully fund CalSTRS by 2046. Under the funding year. plan, the state, school districts (the employers), and Budgetary Borrowing teachers make regular contributions to CalSTRS. Further, through a complex calculation, the state State Has $9.3 Billion in Outstanding and school districts share responsibility to pay Budgetary Borrowing Remaining. Before down the $104 billion CalSTRS unfunded liability. accounting for the Governor’s debt repayment The state’s share of the unfunded liability is about proposals in the January budget, we estimate the $35 billion. The state’s contributions to CalSTRS state has $9.3 billion in outstanding budgetary 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET borrowing (generally reflecting the most recent fund can meet the objectives for which it was estimate available). As shown in Figure 5, the state created. Courts have given the Legislature has made significant progress in addressing these latitude in making determinations about when debts in recent years—significantly reduced from to repay special funds under this standard. an estimated $31 billion in 2014. The remaining • Settle Up. Settle up includes past due budgetary borrowing amounts fall into four amounts to schools and community categories: colleges from years in which the estimated constitutional spending requirement turned • Deferrals. To address budgetary shortfalls, at out to be larger than the amount that was various points, the state made adjustments initially included in the budget. Settle up to expenditure accounting to push costs into existing as of July 1, 2014 is eligible to be different fiscal years, providing a temporary paid from Proposition 2. budgetary benefit. The state made three such major changes that are still outstanding: Addressing Debt and Liabilities (1) the state converted the Medi-Cal program from an accrual basis to cash, (2) the state Different Debts Carry Different Effective deferred employee payroll by dating June Interest Rates. Liabilities tend to grow in cost payroll checks July 1st, and (3) the state over time, reflecting an interest or “carrying” cost. deferred the fourth quarter General Fund Different types of liabilities grow at very different payment to CalPERS due in June to July. • Outstanding Mandates. Proposition 4 (1979) requires Figure 5 the state to reimburse local State Has Made Significant Progress in governments—including Addressing Budgetary Borrowing cities, counties, special (In Billions) districts, schools, and community colleges—for Outstanding Budgetary Borrowing 2014 2019 new programs or services Deferrals of State Spending that the state requires Medi-Cala $2.0 $2.0 them to provide. The state State payrollb 1.0 1.0 deferred its reimbursement of CalPERS quarterly payment 0.4 0.7 Subtotals ($3.5) ($3.7) these costs as it addressed significant budget shortfalls Outstanding Mandates in the early 2000s. The Schools and community colleges $11.5 $0.7 Cities, counties, and special districts 1.9 0.7 state has been repaying Subtotals ($13.4) ($1.5) past due mandates, but still Special Fund Loans $6.7 $2.1 owes about $1.5 billion in Settle Up 1.5 0.7 outstanding mandates. • Special Fund Loans. As one Budgetary Borrowing Fully Repaid 2014 2019 of many actions it took in the Economic recovery bonds $4.6 — 2000s to address its budget Transportation Investment Fund borrowing 0.3 — problems, the state loaned Quality Education Investment Act obligation 0.4 — amounts to the General Fund Subtotals ($5.2) (—) from other state accounts, Totals $30.2 $7.9 a particularly special funds. Our most recent estimate available to undo Medi-Cal related deferrals is from 2016-17, consequently the cost today is likely higher than this amount. The General Fund is required b Includes only General Fund payment proposed for 2019-20. to repay special funds when Note: Figure shows most recent estimate available of outstanding budgetary borrowing before Governor’s proposals for 2019-20. Excludes amounts that arise from typical government needed to ensure the special operations—such as the value of state worker balances. www.lao.ca.gov 11 analysis full gutter 2019-20 BUDGET rates. Left unaddressed, retirement liabilities tend Figure 6 to grow—over the long run—at a rate similar to General Fund Paid Down $17 Billion in their assumption for investment returns—currently 7 percent for both CalPERS and CalSTRS. On Debts and Liabilities in 2018-19 the other hand, most budgetary liabilities are (In Billions) either fixed or grow at comparatively low interest Retirement Liabilitiesa rates (for example, 1 percent or 2 percent). With State employee pensions $3.6 respect to bond debt, the state can “refund” many Teachers’ pensions 3.1 outstanding bonds for a lower interest rate when Judges’ pensionsb 0.3 the prevailing rates in the market decline (similar to Retiree health and dental 2.2 the way a household would refinance a mortgage). Bond Debt Service Because interest rates have been low for many General obligation $5.3 years, much of the state’s outstanding bond debt Lease revenue 0.7 carries a relatively low interest rate. Budgetary Budgetary Borrowing borrowing often carries the lowest interest rates of Special fund loans $0.8 these three types. As such, among the three major Mandates 0.5 types of state liabilities, retirement liabilities carry Other 0.1 the highest interest costs. Total $16.6 a State Budget Pays Down Billions of Dollars Excludes normal cost except for teachers’ pensions. b Pay-as-you-go benefit payments to current retirees. in Debt Each Year. The annual budget pays down several billion dollars of liabilities each year. These borrowing—most notably, special fund loans—and include costs to pay down pension unfunded to pay down state retirement liabilities (that is, liabilities, debt service on bonds, and budgetary payments above what is required under law). Bond borrowing. For example, as shown in Figure 6, the debt and some types of budgetary borrowing—like 2018-19 Budget Act allocated about $17 billion deferrals—are not eligible for repayment under to pay down state debts and liabilities, including Proposition 2. (Some of the amounts listed in nearly $4 billion to CalPERS to pay down the Figure 6 are attributed to annual Proposition 2 debt unfunded liability for state employee pensions and payments.) over $5 billion for debt service on general obligation bonds. That said, the state also generates new State Has Focused Proposition 2 Payments debts and liabilities each year, for example, when on Budgetary Liabilities. Figure 7 shows how the voters authorize new bond sales or financial market state has allocated required debt payments under losses increase the value of the state’s unfunded Proposition 2 since its passage at the end of 2014. liabilities. Specifically, the state has primarily focused these requirements on repaying budgetary borrowing. Proposition 2 Requires Annual Since the 2015-16 budget, the state has repaid Payments Toward Certain Eligible Debts. $3.7 billion in special fund loans using Proposition 2 Proposition 2 requires the state to set aside certain (this represents over half of the cumulative required amounts of General Fund spending each year payments since 2015-16). In the most recent to pay down specific eligible debts. (As with the fiscal year, the state used a greater proportion reserve requirement, these amounts are determined of Proposition 2 funding to focus on retirement by a set of formulas.) Only some of the debts liabilities. listed in this section are eligible for repayment under Proposition 2. Specifically, Proposition 2 can be used to pay down a subset of budgetary 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET Figure 7 The State Has Focused Required Debt Payments on Budgetary Borrowing (In Billions) $2.0 Other Retirement Liabilitiesa 1.8 State Retirement Liabilitiesb 1.6 Budgetary Borrowing 1.4 1.2 1.0 0.8 0.6 0.4 0.2 2015-16 2016-17 2017-18 2018-19 a University of California Retirement Plan. b In 2018-19 this is primarily to repay the CalPERS borrowing plan. KEY CONSIDERATIONS IN STRUCTURING THE BUDGET As discussed earlier, in some years the state either be a spending increase—either for programs faces a budget problem (a deficit) and in other or to repay debts—or revenue reduction.) This years it has additional discretionary resources section provides considerations for the Legislature available (a surplus). In years a surplus exists, as it determines the distribution of resources the Legislature must determine how to allocate across these three structural components. Figure 8 the resources among reserves and one-time and summarizes these considerations. ongoing commitments. (A budget commitment can Figure 8 Key Considerations in Structuring the Budget Determining a Target Level of Reserves • What is the size of the recession for which the Legislature would like to prepare? • What are the current levels of one-time and ongoing commitments in the budget? • How willing is the Legislature to take other actions during a recession? • Would the Legislature like to mitigate reductions to both school and nonschool programs? Allocating One-Time Spending Between Debt Repayments and Program Commitments • Would the Legislature prefer to address the state’s immediate needs or save money to address more future needs? • Would the Legislature prefer to address state debts or debts of other entities first? Setting the Level of Ongoing Commitments • How quickly are revenues expected to grow under various economic conditions? • How quickly are existing spending commitments expected to grow under various economic conditions? www.lao.ca.gov 13 analysis full gutter 2019-20 BUDGET Determining a Target Level of is more willing to take these actions, less Reserves reserves are needed. On the other hand, if the Legislature would prefer to cover most or all We often recommend that the Legislature of a future budget problem with reserves, then first consider its target level of reserves. There more reserves would be needed. is no single “right” level of reserves. Rather, an • Whether to Mitigate Reductions to Both appropriate level of reserves in any year’s budget School and Nonschool Programs. As depends on a number of factors: discussed earlier, the state historically • The Size and Length of Future Recession. has reduced funding for schools and The first consideration in determining a community colleges when state revenues target for total reserves is the size of the have declined, corresponding with declines next recession—and associated budget in the constitutionally required funding level. problem—for which the Legislature would If the Legislature instead wishes to use state like to prepare. No one can predict when reserves to mitigate reductions to school the next recession will occur or how long or spending levels, additional reserves would be deep it will be. Nonetheless, in determining required to cover larger deficits. a reserve target, the Legislature must first assess what it expects economic trends to Allocating One-Time Commitments be in the future and the extent to which it is Between Debt and Programs optimistic or cautious about the economic After determining an appropriate level of outlook. In general, a larger reserve increases reserves, we recommend that the Legislature the likelihood that the state can weather a determine how it wishes to allocate one-time more severe recession without the Legislature commitments between debt repayment or needing to take corrective action (such as programmatic purposes. As we discuss in this increasing revenues, reducing spending, or section, there are a number of factors to consider shifting costs). when determining the appropriate balance between • Current Level of Ongoing and One-Time these two types. Commitments in the Budget. The next factor Balancing Immediate Needs Against Future to consider when determining a target level Needs of the State. Paying down additional of reserves is the budget’s current level of debt in the budget reduces the amount of money one-time and ongoing commitments, including available today for programmatic purposes. That how ongoing commitments are expected said, paying down more debt today means the to grow. For example, with more one-time budget has more funds available in the future for spending, the Legislature needs less reserves any purpose including programs. Because most because one-time spending does not carry debts carry an interest cost, spending $1 today to through to the next fiscal year—reducing the pay down debt saves the budget more than $1 over size of a potential budget problem. In general, time. The Legislature may nevertheless have a the state needs more reserves if (1) a higher preference to address some programmatic needs proportion of the state’s budgetary spending immediately. As such, choosing between paying is ongoing or (2) the state expects significant down debt and one-time programmatic spending is growth in ongoing spending. often a balance between the state’s current needs • Willingness to Take Other Actions During and expected future needs. a Recession. We noted earlier that the Weighing State Debts Against Debts of Other Legislature has three possible responses to Entities (Including Schools). As it determines address a budget problem if reserves are the amount to pay toward debt, the Legislature insufficient to cover the shortfall. Namely, the can choose to pay state-level liabilities or the Legislature can increase revenues, reduce liabilities of other nonstate entities, like schools and spending, or shift costs. If the Legislature 14 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET community colleges. Similarly, the Legislature can and human services programs), but others choose to allocate General Fund resources to repay grow more slowly. Programmatic growth only debts incurred by the General Fund or it can also can depend on a variety of factors, like use these monies to benefit a broader array of state demographic trends and economic conditions. funds. If the Legislature expects existing programs to grow faster than revenues, then no funding Setting the Level of Ongoing is available for new ongoing spending absent Commitments other policy changes. If existing programs are growing more slowly, the budget likely has The third major consideration in the structure of more capacity for new ongoing commitments. the budget is its level of ongoing commitments. The level of ongoing spending that can be supported by If revenues are expected to grow faster than available revenues over a multiyear period is equal currently authorized spending, an operating surplus to the difference between: exists and the budget likely has the capacity to take on additional commitments. If, however, anticipated • Anticipated Growth of Revenues. The resources are not adequate to cover spending budget’s capacity for new ongoing spending commitments, then the budget might not have depends on assumptions about how revenues capacity for new ongoing spending. will grow. For example, the health of the job Both Factors Depend on Future Economic market, performance of the financial markets, Conditions. Both revenue and spending growth and growth rate of wages will have important depend, to a large degree, on how the economy implications for how quickly or slowly PIT will perform over the next few years. In the most grows. If the Legislature expects revenues basic sense, the economy can take one of two to keep growing at a healthy pace, more paths: either keep growing or enter a recession. resources would be available on an ongoing Within these two paths, however, there are many basis. If revenue growth is expected to different sets of economic conditions that have weaken, then less new funding is available on significant budgetary implications. For example, an ongoing basis. the level of and growth in employment, wages, • Growth of Currently Authorized Spending. the financial market, housing prices, consumer The next important consideration is the growth confidence, and many other economic factors can rate of existing programmatic commitments. all play a role in how revenues will grow and the Some programs within the budget grow budget’s multiyear condition. relatively quickly (for example, several health STRUCTURING THE 2019-20 BUDGET This section considers the Governor’s overall down debt and focusing spending proposals on budget structure, reserve proposals, and debt and one-time purposes. In this section, we also offer liability reduction proposals to evaluate how well some alternatives for the Legislature to consider— they prepare the state to address a future budget alternatives that are likely to save the state more problem. (Other forthcoming LAO publications money or better prepare the budget for a future will address the Governor’s many one-time and recession. Figure 9 (see next page) provides a ongoing spending and revenue proposals.) Overall, summary of our options and recommendations we find the Governor’s proposed budget puts outlined in this section. the state on better fiscal footing by devoting a significant portion of available resources to paying www.lao.ca.gov 15 analysis full gutter 2019-20 BUDGET Figure 9 of economic growth is slowing. Home sales in the last quarter of Summary of LAO Options and Recommendations on 2018 were 12 percent lower than Governor’s Reserves and Debt and Liability Proposals the same period in 2017. Similarly, Building Reserves housing construction slowed at Building more reserves than proposed by the Governor would be prudent. the end of 2018 with fewer permits Options for building more reserves: issued in the last few months of the • Build more cash reserves. year than those same months the • Prepay CalPERS pension costs. prior year. Unemployment claims Paying Down Retirement Liabilities also ticked up at the end of 2018, Consider goal of supplemental payments. If Legislature wishes to maximize however, job growth remained savings, concentrate payments on CalPERS. strong through December. Maximize state General Fund savings when using General Fund resources. Governor’s 2019-20 Budget Options that maximize General Fund savings: • Devote entire supplemental payment to POFF plan. Structure. The Governor’s budget • Require other funds to repay General Fund for their shares of the structure for 2019-20 includes four supplemental payment. major components: Addressing Budgetary Borrowing • Increases Reserves by Recommend rejecting proposal to undo deferrals. $2.1 Billion. Under the Governor’s Recommend rejecting special fund repayment proposal and instead use $2.1 billion to pay high-interest liabilities, like pensions. proposed budget and revenue POFF = Peace Officers and Firefighters. estimates, 2019-20 would end with $18 billion in reserves—about OVERALL BUDGET STRUCTURE $2.1 billion higher than the level enacted in 2018-19. This would represent Our Office and the Governor’s Budget about 12.6 percent of General Fund revenues Estimated Large Surplus for 2019-20 . . . and transfers, somewhat higher than the Our November Fiscal Outlook estimated the enacted 2018-19 level of nearly 12 percent. General Fund would have $14.8 billion in • Pays Down $10.8 Billion in Debts and available discretionary resources to allocate Liabilities. Including constitutionally required in the 2019-20 budget process. Based on the debt payments, the Governor proposes administration’s January proposals, we estimated repaying $10.8 billion in debts and liabilities the Governor’s available surplus was $20.6 billion. in 2019-20. (This total includes required (The difference between these two estimates Proposition 2 debt payments.) These planned is largely due to lower than expected Medi-Cal repayments include $4.1 billion for the state’s spending under the Governor’s budget.) By CalPERS and CalSTRS unfunded liabilities, historical standards, these surplus estimates are as well as $2.3 billion on behalf of districts extraordinary. for their share of the CalSTRS unfunded . . . But There Are Some Early Signs liability. The Governor also proposes repaying Revenues Could Be Weaker Than These $4.4 billion in budgetary borrowing. Estimates. Revenues in January are roughly • Provides $5.1 Billion in Discretionary $2 billion below estimates for the month under One-Time Spending. After satisfying the Governor’s budget. This shortfall is almost constitutional requirements and funding entirely due to lower than expected estimated current law policies, we estimate the Governor payments, which could in part reflect the decline in allocated $5.1 billion in available discretionary the financial market at the end of 2018. (There are resources on a one-time or temporary basis other factors—including recent changes to federal for a variety of programmatic expansions. tax policy—that could explain part of this shortfall.) • Provides $2.7 Billion in Discretionary Final payments in April could make up some of Ongoing Spending. The Governor’s this shortfall, however, there are signs the pace 16 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET discretionary spending proposals also include required under the formulas must be spent on $2.7 billion in ongoing spending. Because infrastructure. The 2018-19 budget package some of these ongoing proposals are phased made an optional deposit into the BSA so that in over a multiyear period, we estimate the it would reach this constitutional threshold cost at full implementation of all of these at the end of the year. The Governor takes ongoing proposals is $3.5 billion. a new interpretation of these rules, under which optional deposits do not count toward the threshold. Under this new interpretation, RESERVES the state is required to make a $1.8 billion deposit into the BSA and has no infrastructure This section considers the Governor’s proposed spending requirement. reserve level for the 2019-20 budget. First, we describe the major components of the Governor’s • Governor Increases Discretionary Reserves overall level of proposed reserves for the end of by $546 Million. In addition to the required 2019-20. Then, we discuss some considerations BSA deposit, the Governor increases for the Legislature as it looks ahead to the May discretionary reserves (relative to the 2018-19 Revision and June budget act—in particular, Budget Act) by $546 million. This plan lowers noting some reasons to believe the overall level of the balance of the SFEU from just under reserves could end up lower. Then, we describe $2 billion (enacted in 2018-19) to $1.8 billion some reasons why the Legislature might prefer a (proposed for the end of 2019-20). However, higher level of reserves than currently proposed by the administration proposes depositing an the Governor. We conclude with some options for additional $700 million into the Safety Net legislative consideration that would help build more Reserve, which we describe in detail in the reserves—and reserve-like benefits—than currently box on page 18. proposed. Governor Sets Aside Funds for Disasters Within General Purpose Reserves. The Governor Governor’s Reserve Proposals further proposes using funding for unexpected Proposes Total Reserves of $18 Billion. costs related to disasters within the state’s The Governor proposes a total reserve level of discretionary reserve, the SFEU. In the past, $18 billion for the end of 2019-20. As shown in statutory language has designated a fund for Figure 10, this total reserve would include three disasters as a subaccount within the SFEU. This components: $15.3 billion in the BSA, $1.8 billion statutory language, which expired at the end of in the SFEU, and $900 million in the Safety Net 2018, also gave the administration the authority Reserve. (Due to an accounting error, the SFEU to transfer funds between these accounts as balance is actually about $500 million lower than needed to respond to disasters. The administration the administration estimated in mid-January.) Under proposes reauthorizing this language as part of an the Governor’s budget assumptions, there would early action package in the current year. be no balance in either the schools’ reserve or the BDSA at the end of Figure 10 2019-20. We describe the details of Total Reserves in Governor’s Budget these reserve proposals below. Proposed for the End of 2019-20 • Governor Takes a (In Millions) New Interpretation of Budget Stabilization Account $15,302 Proposition 2. Under the Special Fund for Economic Uncertainties 1,808 rules of Proposition 2, when Safety Net Reserve 900 the BSA reaches a threshold School Stabilization Account — of 10 percent of General Budget Deficit Savings Account — Fund taxes, additional funds Total $18,010 www.lao.ca.gov 17 analysis full gutter 2019-20 BUDGET Required BSA Deposit 2018-19 budget package anticipated the BSA Might Be Lower in May would reach its constitutional threshold of 10 percent of General Fund taxes, triggering BSA Deposit Will Be Lower if . . . Under the required spending on infrastructure. Budget trailer administration’s estimates and assumptions, the language appropriated these future, anticipated state is required to deposit $1.8 billion into the BSA spending requirements to three purposes: this year. This required deposit could fall, however, (1) state infrastructure, (2) rail infrastructure, under two circumstances (explained below). If this and (3) multifamily housing. The Governor’s BSA deposit is lower, total reserves would also be interpretation of Proposition 2 eliminates this lower (absent other policy choices). required infrastructure spending and instead funds . . . Revenues Are Lower. As mentioned earlier, additional reserves. If the Legislature maintains there are some reasons to believe that revenues its previous interpretation of Proposition 2, could be weaker at the time of May Revision infrastructure spending would be higher and the relative to the Governor’s January estimates. Lower BSA reserve balance would be lower. revenues, particularly those from capital gains, in Depending on Legislative Priorities, 2019-20 would mean the required BSA deposit will be lower. For example, if capital gains revenues More Reserves Likely Needed are lower by roughly $1 billion in 2019-20, the Reserve Targets Assuming No Other Actions. required BSA deposit in that year would fall by a Our past budget publications have estimated few hundred millions of dollars. ranges of reserves that would be needed for the . . . Legislature Maintains Previous state to weather various types of recessions with Interpretation of Proposition 2. The minimal reductions to ongoing programs. Based on Safety Net Reserve Governor Proposes to Deposit $700 Million Into Newly Created Safety Net Reserve. In addition to creating the Safety Net Reserve, the 2018-19 budget plan deposited $200 million into a California Work Opportunity and Responsibility to Kids (CalWORKs) subaccount within the reserve. The Governor’s 2019-20 budget proposes depositing $700 million more into the reserve and changing its rules so that funds could be used for either CalWORKs or Medi-Cal. Underlying CalWORKs Costs Increased During Great Recession, Prompting Programmatic Reductions. We estimate that during the Great Recession, baseline costs for the CalWORKs program increased by about $1.6 billion annually by 2010-11 (compared to pre-recession levels). In response to these growing costs and lower revenues, the state enacted several programmatic reductions—including, among other actions, a 12 percent monthly grant reduction—that reduced expenditures in the program by nearly $1 billion per year. This past experience may prove helpful in assisting the Legislature as it evaluates the Governor’s proposed Safety Net Reserve deposit. Although a recession as severe as the Great Recession is unlikely, CalWORKs costs (as well as costs for other safety net programs) would nevertheless increase significantly during an economic downturn. Consider Desired Level of Protection for These Programs. In crafting the 2019-20 budget, the Legislature will want to consider its target level of reserves overall and for the Safety Net Reserve specifically. One key consideration will be whether the Legislature intends to avoid any, or only some, program reductions in CalWORKs, Medi-Cal, and other safety net programs in the event of a budget problem. If the Legislature would like to minimize changes to eligibility or benefits during the next recession, more reserves would be needed. 18 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET the experience of recent recessions, we estimate If the Legislature Intends to Use General the state would need about $20 billion in reserves Purpose Reserves for Schools, State’s Reserve to cover a budget problem associated with a mild Needs Are Higher. The above estimate of reserves recession and $40 billion to cover a moderate needed is based on an assumption that the state recession. In last year’s Fiscal Outlook publication, would fund schools and community colleges at we estimated $25 billion would be sufficient their minimum level. More explicitly, this means that to cover the budget problem associated with in a recession scenario, General Fund spending Moody’s Analytics “moderate” recession scenario. on K-14 education would decline even as the This scenario is not based on a recent historical state maintains other programmatic spending example, but rather a model of one possible using reserves. As such, if the Legislature wanted recession scenario that Moody’s believes could to mitigate reductions to schools and community materialize in the coming years. colleges by using statewide reserves, more Our Recent Economic Scenarios Suggested reserves would be needed. $3 Billion Could Be Available for Ongoing If the Legislature Intends to Use General Commitments. The budget’s target level of Purpose Reserves for Disasters, State’s reserves should depend, in part, on the amount Reserve Needs Are Higher. When discussing the of ongoing spending currently authorized by the overall level of state reserves, our office typically budget. Our Fiscal Outlook report from November considers the amount needed in the event of a included the results from two scenarios: economic recession. In recent years, however, reserves also growth and recession. In both scenarios about have been needed to address costs associated $3 billion in ongoing spending was feasible over with disasters, particularly wildfires. (While a the multiyear period. Under the economic growth significant portion of these costs are reimbursed scenario, this was the amount that nearly depleted by the federal government, some costs are not the budget’s operating surplus in the last year of reimbursed. For example, the administration our analysis. In the recession scenario, the budget estimates the state will incur around $1 billion in could cover these commitments before depleting costs, after reimbursements, for the 2018 wildfires.) available reserves in the last year of the outlook. The administration proposes to continue to use (The two scenarios produced in our Fiscal Outlook the SFEU to address disasters in 2019-20. Were are among the many different paths the economy a major disaster to occur simultaneously with a and state budget could take in coming years. recession, reserves would be needed to address While our growth scenario reflected the consensus both the disaster and the budget problem. Given among professional economists at the time, it the severity and frequency of recent disasters, should not be viewed as predictive of what will more reserves may be necessary to prepare for this occur.) possibility. Building More Reserves Now Would Reduce LAO Options the Need for Programmatic Cuts in the Future. Importantly, our recession scenario from November Build More Reserves. If the Legislature concurs found $3 billion in ongoing commitments were with our assessment that more reserves may be supportable in a recession scenario, assuming needed, it has other options for building more the state entered the recession with $25 billion reserves beyond those proposed by the Governor. in reserves—more than the $18 billion now For example, to build cash reserves, the Legislature proposed by the Governor. If the Legislature would could make a deposit into one of the state’s several like to make around $3 billion in new ongoing reserve accounts. commitments and wants to minimize reductions Prepay CalPERS Retirement Contribution . . . to ongoing programs in a recession, building more Alternatively, to achieve the same benefits reserves than proposed by the Governor would be of reserves, the state could prepay CalPERS prudent. retirement liabilities using a “Section 115 Trust.” CalPERS expects it will offer governmental www.lao.ca.gov 19 analysis full gutter 2019-20 BUDGET employers a Section 115 trust option by July 1, • $3 Billion Supplemental Payment to 2019 under the California Employers’ Pension State Employee CalPERS Liabilities. The Prefunding Trust (CEPPT) Fund. The state could administration proposes making a $3 billion use CEPPT to set money aside that could be used supplemental payment to CalPERS in July of to make future payments to CalPERS, offsetting a 2019, attributed to expenditures in 2018-19. future requirement. The administration proposes that the $3 billion . . . Though Prepaying CalPERS Involves payment be distributed across the pension Trade-Off. The option to prepay a retirement plans in a way that is proportionate to each liability has a potential additional benefit that plan’s share of the state’s General Fund building cash reserves does not have. Over time, contribution to CalPERS. (The payment by CalPERS could earn a higher rate of return on the plan is shown in Figure 12 see page 22.) money held in the CEPPT than the state would • $2.3 Billion Supplemental Payment earn by holding it in reserves (which are invested Towards Districts’ Share of CalSTRS in low-risk assets that earn a low return). With Unfunded Liability. To reduce school higher returns comes more risk, however. In districts’ share of the CalSTRS unfunded the event of a recession, funds available in the liability, the Governor proposes the state pay CEPPT could decline thereby lowering the amount CalSTRS an additional $2.3 billion General available for pension payments at that time. Fund. This proposal means the state would (Once financial markets recover, so too would the pay a larger share of the unfunded liability amount available in the CEPPT.) Consequently, if than assigned to it under the 2014 CalSTRS the Legislature wishes to use such an option, we funding plan. (As discussed in the nearby box, would recommend it carefully consider the role this the administration also proposes transferring transfer would play in the context of the state’s $700 million to CalSTRS to provide school overall reserve level and level of risk it wished to districts with rate relief in 2019-20 and take on for assets held in the CEPPT. 2020-21; however, this would not reduce the CalSTRS unfunded liability.) DEBTS AND LIABILITIES • $1.1 Billion Supplemental Payment Toward State’s Share of CalSTRS Unfunded This section addresses the Governor’s proposals Liability. The Governor also proposes that the to pay down various debts and liabilities. Figure 11 state pay $1.1 billion General Fund toward summarizes all of the debt and liability proposals in the Governor’s budget. They fall into two Figure 11 categories: paying down retirement liabilities with Debt and Liability Proposals in the supplemental payments and addressing budgetary 2019-20 Governor’s Budget borrowing. In the remainder of this section, we describe each of these proposals in detail and (In Millions) provide our comments and some alternatives for Debt Repayment Amount legislative consideration. Retirement Liabilities Governor’s Proposal to CalPERS $3,000 CalSTRS (districts) 2,300 Pay Down Retirement Liabilities CalSTRS (state)a 1,117 Additional State Payments to Pension Budgetary Borrowing Systems’ Unfunded Liabilities. The administration Special fund loans $2,051 proposes that the state make supplemental June-to-July payroll deferral 973 CalPERS 4th quarter deferral 707 payments totaling more than $6 billion to reduce Settle up 687 CalPERS’ and CalSTRS’ unfunded liabilities. Total $10,835 Specifically, the Governor proposes: a Counts toward state’s Proposition 2 debt payment requirement. 20 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET the state’s share of the CalSTRS unfunded possible savings associated with each of these liability. This money would be counted payments. The first estimate is an actuarial model, toward Proposition 2 debt repayments. In which is based on one scenario where precise addition, the Governor proposes that future actuarial assumptions (including investment returns) Proposition 2 debt repayment obligations materialize over the next 30 years. For illustrative be used to pay down the state’s CalSTRS purposes, such a model would assume a pension unfunded liability further. (The administration system achieves exactly a 7 percent rate of return estimates an additional $1.8 billion would be in every year for decades and produces one paid to CalSTRS over the next three years estimate of savings. Because this does not reflect with these payments.) real world experience with the financial market and investment returns, the second method—called a Potential Savings From Supplemental stochastic analysis—examines a range of possible outcomes based on many scenarios. As a result, a Payments stochastic model yields many estimates of savings. Two Different Models for Examining Savings. We look to the median estimate from this analysis There are two different ways to estimate the for what savings could be. District Rate Relief Budget Provides $700 Million for District Rate Relief. Separate from his proposals to pay down the California State Teachers’ Retirement System (CalSTRS) unfunded liability, the Governor proposes providing roughly $700 million over the next two years (roughly $350 million per year) to provide school and community college districts immediate budget relief. Specifically, the payments would reduce districts’ CalSTRS rates in 2019-20 and 2020-21—freeing up resources for other parts of districts’ operating budgets. Under current law, district rates are scheduled to grow from 16.3 percent of pay in 2018-19 to 18.1 percent in 2019-20 and 19.1 percent in 2020-21. The administration estimates that under its proposal, district rates over the next two years instead would grow to 17.1 percent of pay and 18.1 percent, respectively. The state would make the $700 million payment from General Fund revenues outside of the Proposition 98 minimum requirement. Administration Proposes District Rate Relief When School Funding Is at Historically High Level and Growing. Most districts identify rising pension costs as one of their most significant fiscal challenges. School funding, however, has grown by nearly $22 billion (37 percent) over the past six years, significantly outpacing growth in pension costs. Adjusted for inflation, school and community college funding per student is at its highest level since the passage of Proposition 98. Under the Governor’s 2019-20 budget, school and community college funding continues to grow, increasing a projected 3.6 percent. Though districts view rising pension costs as difficult to manage today, these difficulties will be much more pronounced if the state were to enter a recession and Proposition 98 funding were to drop. Consider Setting Aside Funding for Future Rate Relief. Rather than providing districts with budget relief over the next two years, the state could modify the Governor’s proposal to provide rate relief during the next economic downturn. Under this alternative, the state would set aside funds for school district retirement costs, but not immediately adjust district contribution rates. Later, during a downturn, the Legislature could choose when to apply the additional funds and reduce district rates. Such an approach is beneficial because it mitigates the need for pension rate increases at a time when districts would have less funding and be facing even more difficult budget choices. www.lao.ca.gov 21 analysis full gutter 2019-20 BUDGET CalPERS Contribution Generates General . . . Meaning the State Might Not Achieve Fund and Special Fund Benefit. Figure 12 shows Savings From Contribution to CalSTRS Before the results of the CalPERS stochastic model 2046. CalSTRS’ limited rate setting authority by plan. Under the median scenario, CalPERS dampens the expected savings to the state estimates the state’s $3 billion supplemental compared to what the administration initially payment to CalPERS would save, in total and on asserted. Using actuarial assumptions about net, $6.3 billion. This is considerably higher than investment returns, CalSTRS estimates that the the expected savings under the actuarial model proposed $1.1 billion payment to the state’s share ($4.2 billion). Although the General Fund would pay of the unfunded liability would result in $2 billion the entire amount of the supplemental payment, it net savings through 2046. While we do not have would not realize this entire benefit. Assuming the stochastic analysis for this particular payment, General Fund share of these savings is roughly in we understand there is a roughly 15 percent and line with the fund’s share of payroll costs by plan, 20 percent probability it would show that the state the General Fund savings associated with this will achieve no savings before 2046. In these payment would be roughly $4.4 billion and other scenarios without savings by 2046, CalSTRS funds would accrue the remainder ($1.9 billion). actuaries indicate that savings would materialize (The actual shares of savings could deviate from after 2046. In addition, the average savings ratio these rough estimates somewhat.) under the stochastic analysis is lower than the CalSTRS Has Limited Authority to Set actuarial estimate. Rates . . . The 2014 CalSTRS funding plan Consider Options With Greatest established a long-term plan to fully fund the Budgetary Benefit CalSTRS pension system by 2046. Under this plan, the CalSTRS board has limited authority to The Governor proposes using General Fund increase contribution rates—limiting the increase resources to make supplemental payments to in contribution rates in any given year and the CalPERS and CalSTRS. As we discuss below, total contribution rates—for the state and school we think that using these funds differently than districts until 2046 (at which point contribution proposed by the Governor could have greater rates return to the much lower rates in place before budgetary benefits for the state. (We also suggest the funding plan). Because of the limitations on the the Legislature consider the timing of the transfers board’s rate-setting authority, CalSTRS has less to CalPERS and CalSTRS, as discussed in the box flexibility than CalPERS to increase contribution on pages 24 and 25.) rates in response to investment losses. This Consider Goal of Supplemental Payments. contributes to the state savings ratio from the The state’s supplemental payments to CalSTRS proposed payments to CalSTRS being lower than a might not result in savings for the state before payment to CalPERS over the next few decades. 2046. Before the Legislature approves the Governor’s proposed Figure 12 state supplemental payments Anticipated Savings by CalPERS Plan to CalSTRS, we suggest it Under Stochastic Model consider the primary objective of the supplemental payments. (In Billions) One objective could be to make Plan Total Contribution Net Savings steps toward addressing the Miscellaneous $1.4 $2.9 liability without regard to the level Industrial 0.1 0.2 of savings to the state. Another Safety 0.2 0.4 objective could be to maximize Peace Officer/Firefighter 1.4 2.7 state savings within the next few Highway Patrol — — decades. Maximizing state savings Total $3.0 $6.3 creates greater flexibility for the 22 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET state to address budgetary problems in the future. plan’s unfunded liability—but require other The proposed state contribution to CalSTRS would funds that benefit from the supplemental make progress toward addressing the system’s payment repay the General Fund. Other funds unfunded liability, but might not achieve as much would still receive a net benefit because state savings as other options. The Legislature they would only need to use a portion of the might want to consider maximizing state savings as savings they receive in contribution reductions the highest priority when considering how to make to pay back the General Fund. In addition supplemental payments to retirement benefits. One to distributing the cost of the supplemental option for maximizing state savings would be to payment across the state’s funds, this concentrate pension supplemental payments on approach also has the benefit of distributing behalf of the state to CalPERS. We discuss ways the benefit across all of the state’s five to maximize the General Fund benefit of those pension plans. payments below. Maximize General Fund Saving. The Governor Governor’s Proposals to Address proposes using General Fund money to make the Budgetary Borrowing supplemental payments to CalPERS—generating Repays $2.1 Billion in Special Fund Loans. both General Fund and special fund benefit. We In addition to the proposals related to retirement suggest that the Legislature consider prioritizing liabilities, the Governor proposes fully repaying General Fund savings when using General Fund all remaining special fund loans in 2019-20. The resources. Overall, we estimate (based on the largest of these loan repayments is $768 million CalPERS stochastic model) that under the to repay “weight fee loans,” which are loans to the Governor’s proposal the General Fund would only General Fund from a fund receiving transportation receive $4.4 billion of the $6.3 billion in net savings weight fee revenues that—upon repayment—are from a supplemental payment to CalPERS. If the used for transportation bond debt service. The Legislature would prefer to maximize General Fund Governor’s plan also includes $236 million to repay savings on this General Fund payment, we suggest a loan from the Transportation Congestion Relief it consider: Fund and $200 million to repay a loan from the • Making Contributions to the Peace Officers Greenhouse Gas Reduction Fund. (For a variety of and Firefighters (POFF) Plan. Nearly all reasons, borrowing from some of these funds may (about 98 percent) of the state’s contributions not be available in the future.) to POFF are from the General Fund. The POFF Governor Undoes Two Budgetary Deferrals. plan currently has an unfunded liability of The Governor proposes undoing two budgetary $15 billion and a funded ratio of 66 percent. payment deferrals with the understanding the The state could make a supplemental state could take these actions again in the future. payment to the POFF plan that substantially (This could function similar to a reserve because reduces that plan’s unfunded liability and the state would spend money now and could take produces savings that almost entirely action again in the future to achieve savings.) benefits the General Fund. Although there Specifically the Governor proposes reversing the: is substantial General Fund benefit from this approach, making such a large contribution to • June-July Payroll Deferral. The one pension plan could raise questions about 2009-10 budget package included an ongoing what the state is doing for other pension one-month deferral of June state payroll to plans. early July, providing savings for the state. This accounting action did not affect when • Requiring Other Funds to Repay General paychecks were issued to state employees. Fund. Alternatively, the state could make Because payroll costs grow over time, the supplemental payments to all five CalPERS deferral continues to provide ongoing savings pension plans—apportioned based on each for the state General Fund. For example, www.lao.ca.gov 23 analysis full gutter 2019-20 BUDGET in 2016-17, the associated General Fund in 2016-17, this General Fund benefit benefit was $65 million (savings vary from was $56 million (savings vary from year to year to year depending on how payroll year depending on how pension costs are costs are growing). Undoing this deferral growing). Undoing the deferral would eliminate would eliminate this annual benefit. The these savings. The administration estimates administration estimates the cost to undo the cost to undo this action is $707 million this action will be $973 million for the General General Fund (other funds’ fourth quarter Fund. (The state never recognized the deferral CalPERS payments are not deferred). in other funds’ budgetary statements and, as Governor Repays $687 Million in Settle a result, undoing it would only have budgetary Up. The Governor proposes the state repay implications for the General Fund.) $687 million in settle up obligations to schools and • Fourth Quarter CalPERS Payment Deferral. community colleges. While most of this obligation The state routinely defers its fourth-quarter is eligible for Proposition 2 debt requirements, the contributions to CalPERS to the subsequent Governor does not propose attributing any of it to fiscal year. Because pension costs grow Proposition 2. over time, this deferral provides ongoing savings for the General Fund. For example, Provide Flexibility by Changing Timing of Debt Repayments State’s Cash Position Varies Throughout the Fiscal Year. Cash flows in the General Fund can swing widely throughout the year. In particular, the state usually faces seasonal cash deficits during the early months of the state fiscal year. Cash surpluses are more common during the second half of the fiscal year. This is because state tax collections are concentrated in the second half of the fiscal year, especially in April (the annual income tax payment deadline), January, and June. Resources Available Based on Projections. The current estimate of the surplus available to allocate for the upcoming fiscal year is largely based on projections of revenues for the next 16 months. (Some of this surplus is attributable to actual revenues received through the end of 2018.) These estimates are inherently uncertain. Actual revenues over the next year could be lower or higher than current projections by billions of dollars. Governor Proposes Debt Repayments Early in Fiscal Year, Limiting Flexibility. As the figure shows, the Governor proposes making some key debt repayments in the first month of the 2019-20 fiscal year (although the payments would be attributed to 2018-19). Notably, the Governor proposes transferring $7.1 to California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS) in July 2019. When an employer—including the state—makes a contribution to a pension fund, the employer has no legal right to withdraw the funds at a future date. This means that, once transferred in July 2019, the state would no longer be able to revisit these transfers, even if revenues in 2019-20 end up being significantly below expectations. In this case, the Legislature would only have the option to make adjustments to other parts of the budget (such as by lowering programmatic expenditures). Recommend Making Transfers to CalPERS and CalSTRS Later in the Fiscal Year. To maintain legislative and budgetary flexibility, we recommend the Legislature schedule any transfers to CalPERS and CalSTRS for later in the fiscal year. While we do not have a reason to believe revenues will fall significantly short of the administration’s projections, there is 24 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET Governor Restructures Multiyear of these payments will vary substantially based on Proposition 2 Debt Repayment Plan. The prior economic and financial market conditions. administration had a multiyear plan to repay all Recommend Rejecting Proposal to remaining special fund loans using Proposition 2 debt payment requirements (in the case of one of Undo Deferrals these loans, this multiyear plan also is reflected in The Governor proposes undoing two deferrals statute). The new administration proposes repaying with the aim of achieving a reserve-like benefit. all remaining special fund loans this year and does In both cases, the deferral provides annual not attribute them to Proposition 2. Using the budgetary savings. Both of these deferrals involve additional capacity freed up with this action, the administrative work to implement. Given these administration plans to make additional payments limitations—and the stated intent to reuse these to CalSTRS for the state’s share of the system’s tools in the future—we recommend the Legislature unfunded liability. In particular, over the next few reject the Governor’s proposal to undo these years, under the administration’s estimates and deferrals. Instead, the Legislature could use these proposals, the state would transfer to CalSTRS resources to build additional reserves. $802 million in 2020-21, $615 million in 2021-22, and $345 million in 2022-23. The actual amounts always inherent uncertainty in revenue projections. By scheduling these transfers to occur later in the fiscal year, the Legislature would have the opportunity to observe cash trends in key revenue months and, if needed, make a midyear adjustment to repayments and other planned expenditures. That said, transferring these funds later in the fiscal year does reduce the associated savings somewhat because it forgoes the rate of return the pension systems can earn on the funds in the interim. Administration Proposes Making Major Debt Repayments Early in the Fiscal Year State’s cash (surplus or deficit) Timing of Some Major Jun Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Planned Transfers 2019 2019 2019 2019 2019 2019 2019 2020 2020 2020 2020 2020 2020 Safety Net Reserve Deposit $700 CalPERS 4th Quarter Deferral $707 Transfer to CalPERSa $3,000 Transfer to CalSTRSa $4,117 Special Fund Loan Repayments $768 $236 $1,047 a Once transfer is made, state cannot retrieve the funds. www.lao.ca.gov 25 analysis full gutter 2019-20 BUDGET Recommend Prioritizing Figure 13 shows the Governor’s proposed special High-Interest Liabilities fund repayments for 2019-20, the amount of reserves that each fund is projected to hold before Governor’s Multiyear Plan Prioritizes these repayments (at the beginning of 2019-20), Lower-Interest Debts. The Governor’s plan and the amount that reserve levels represent as to restructure the multiyear Proposition 2 debt a percent of expenditures. As the figure shows, repayment schedule uses money today to several of these funds currently have significant prioritize low-interest debt (special fund loans) reserve balances, in several cases exceeding and uses future revenues to pay high-interest 100 percent of their annual expenditures. debt (the CalSTRS unfunded liability). Moreover, Recommend the Legislature Prioritize Proposition 2 debt payment requirements are Retirement Liabilities Over Budgetary somewhat uncertain and can be higher or lower by Borrowing. If the Legislature instead prioritizes several hundreds of millions of dollars each year. higher-interest debts over lower-interest debts, the If the state enters a recession or the stock market state would save more money over the long term. is lower than anticipated, Proposition 2 payments For example, rather than repaying special fund to CalSTRS will be much lower than currently loans, the Legislature could use $2.1 billion to pay anticipated. down additional CalPERS liabilities today, saving Governor Repays Some Special Fund the state at least hundreds of millions of dollars Loans With Significant Balances. Every state over the long term. As such, we recommend the fund faces a unique situation. Some funds have Legislature maintain its former multiyear plan for significant reserve balances, while others face Proposition 2 to repay budgetary borrowing over structural deficits. The repayments of all remaining the next few years and instead dedicate those freed outstanding special fund loans would generally up funds toward retirement liabilities. repay loans to funds that have significant balances. Figure 13 Governor Proposes Repaying Some Special Funds With Significant Reserve Balances (Dollars in Thousands) Proposed Beginning Reserve Reserves as Percent of Fund 2019-20 Repayments 2019-20 Expenditures Greenhouse Gas Reduction Fund $200,000 $1,327,411 55% Vehicle Inspection Repair Fund 90,000 99,669 68 Immediate and Critical Needs Account 90,000 222,483 98 Occupancy Compliance Monitoring Account 57,000 26,533 469 Tax Credit Allocation Fee Account 35,000 43,237 1,071 Gambling Control Fund 29,000 62,263 365 Fingerprint Fees Account 24,000 56,160 58 State Board of Barbering and Cosmetology Fund 21,000 19,304 86 State Corporations Fund 18,500 87,730 139 Hospital Building Fund 15,000 146,826 209 Real Estate Fund 10,900 32,793 57 Firearms Safety and Enforcement Special Fund 4,900 12,408 110 Psychology Fund 3,700 5,197 92 Drinking Water Operator Certification Special Account 1,600 3,688 196 Osteopathic Medical Board of California Contingent Fund 1,500 2,373 74 Physician Assistant Fund 1,500 1,918 87 Acupuncture Fund 1,000 2,971 82 Note: Excludes nongovernmental cost funds and the oil spill response trust fund. 26 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET CONCLUSION The Governor’s Budget Puts Forward a Governor’s Debt Repayment Efforts Are Variety of Policy Proposals. The Governor’s Commendable, but Improvements Could Be budget includes a variety of policy proposals, Made. We think the Governor’s approach to devote seeking to achieve a range of policy outcomes. By a significant portion of available discretionary doing so in January, the Legislature can engage in resources to paying down debt is commendable. a robust conversation about key choices that will That said, we have several suggestions for influence the state’s budget structure into future improving the Governor’s plan—alternatives that years. are likely to save the state more money and would Governor’s Proposals Put the Budget on put the state in an even better fiscal position. These Better Footing. The Governor proposes using a suggestions fall into two areas: significant portion of discretionary resources to • Paying Down Retirement Liabilities. pay down state debts and liabilities. Further, he With respect to the Governor’s proposals proposes the state build additional reserves and on retirement liabilities, we suggest the focuses new spending commitments on one-time Legislature (1) consider focusing state purposes. These proposals put the budget on contributions on CalPERS, rather than better footing to withstand a future budget problem CalSTRS, unfunded liability and (2) maximize as a result of a recession or another crisis. As the General Fund savings when using General Governor has put it, these proposals improve the Fund resources. budget’s resilience. • Addressing Budgetary Borrowing. We Building More Reserves Than Proposed have two recommendations regarding the by the Governor Would Be Prudent. If the Governor’s plan to address budgetary Legislature makes roughly $3 billion in new ongoing borrowing. First, we recommend the commitments, but wants to minimize potential Legislature reject the Governor’s proposal reductions to ongoing programs in a recession, to undo two payment deferrals and consider building more reserves now would be prudent. We instead using these resources to build more offer a variety of options for achieving this goal, cash reserves. Second, we recommend the including building more cash reserves or prepaying Legislature pay down high-interest liabilities, retirement liabilities. Because we also agree with like retirement liabilities, instead of using the Governor’s approach to use a significant $2.1 billion to repay outstanding special fund portion of discretionary resources to pay down loans. debt, increasing reserves above the level proposed by the Governor would require reducing proposed one-time programmatic spending. www.lao.ca.gov 27 analysis full gutter 2019-20 BUDGET 28 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET www.lao.ca.gov 29 analysis full gutter 2019-20 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead and Nick Schroeder, and reviewed by Carolyn Chu. 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. 30 LEGISLATIVE ANALYST’S OFFICE