The 2020-21 Budget: Proposition 2 Debt Payment Proposals

The 2020-21 Budget: Proposition 2 Debt Payment Proposals Summary Proposition 2 Represents a Unique Opportunity for State Over Next Decade. Under the provisions of Proposition 2 (2014), the state is required to dedicate annual amounts to accelerate the pay down of state debts. These annual payments will represent a substantial sum of money—$12 billion to $21 billion—over the next ten years and must be dedicated to a limited set of uses, namely to pay down the state’s unfunded liabilities related to retirement. As such, Proposition 2 represents a key and unique opportunity for the state. This report presents our recommendations for how the state can use Proposition 2 debt payments most strategically over the next decade. Teachers’ Pensions and Retiree Health Both Have New Funding Plans. In 2014, the state adopted a plan to fully fund the teachers’ pension program in response to projections suggesting the system would fully deplete its assets by the mid-2040s. Also, in 2015, the state began implementing a plan to prefund retiree health benefits—that is, setting aside money today to fund benefits in the future. Both of these plans represent a significant step forward. These plans position the state to address both outstanding retirement liabilities over the next few decades, however, they also face limitations that could prevent them from staying on track. Agree With Governor’s Strategy on Teachers’ Pensions… The Governor’s 2020-21 budget proposal offers one strategy to prioritize Proposition 2 funds in 2020-21 and over a multiyear period. One notable feature of the plan is the Governor’s proposal to address a portion of the state’s share of the unfunded liability for teachers’ pensions. Under the Governor’s plan, the state would provide nearly $3 billion to this purpose over a multiyear period. We agree that focusing Proposition 2 debt payments on this purpose makes sense. …But Not Specific Choices. The amounts the Governor proposes dedicating to teachers’ pensions both in 2020-21 and in future years are not connected to the specific actuarial needs of the system, however. As such, these additional contributions could fall short of the amounts the system will actually need to stay on track. In this report, we present a method that the Legislature could use to tie additional supplemental contributions to the system’s actuarial needs. In addition, while the Governor does not propose dedicating additional amounts to retiree health, we think some payments could be warranted. In particular, if—after addressing teachers’ pensions—additional Proposition 2 capacity remains in future years, we think it makes sense to use this funding for the state’s retiree health program. Recommend Closer Monitoring—and Tailoring Proposition 2 Funding—to Keep Funding Strategies on Track. While this report outlines a general approach for addressing possible future costs, the amounts needed to accomplish these goals are not yet known. As such, to implement this approach, we recommend the Legislature adopt trailer bill language directing the administration to report, at the time of its January budget proposal each year, on a few different aspects of the teacher pension and retiree health funding plans. This reporting language would allow the state to: (1) better monitor progress on the funding plans and (2) target funding to reduce the risk that those plans get off track over the next decades. GABRIEL PETEK LEGISLATIVE ANALYST MARCH 2020 analysis full gutter 2020-21 BUDGET INTRODUCTION Proposition 2 was added to the November The remaining eligible uses of Proposition 2 debt 2014 ballot in a special legislative session under payments mainly are related to retirement liabilities. ACAX2 1 (Pérez) and subsequently was approved While California has hundreds of billions of dollars by voters. The measure made significant changes in unfunded retirement liabilities, the state also has to the state constitution concerning budgeting several plans in place to address those liabilities practices. In particular, in addition to requiring over the next few decades. Some of those plans, annual deposits into the state’s rainy day fund, however, are still relatively new and there is a it requires the state to make additional debt chance they could fall short of meeting their goals. payments each year until 2030. The intent of Meanwhile, the Proposition 2 debt requirements, Proposition 2 was to improve the state’s fiscal while wholly insufficient to address the state’s total situation—for example, by “repay[ing] state debts retirement liabilities, will represent a substantial and protect[ing] the state from the negative effects sum of money—$12 billion to $21 billion over the of economic downturns.” next ten years. As we discuss in this analysis, Until last year, most of the state’s Proposition 2 these funds—and the requirement to spend them debt-related payments were directed toward paying on certain limited uses— represent a key and off loans the state took out to address its past unique opportunity for the state. The Governor’s budget problems. However, additional payments 2020-21 budget proposal has one plan for how made as a part of the 2019-20 budget essentially to allocate the funds. This report presents our eliminated these types of debts. As such, the recommendations for how the state can adjust this Legislature now has an opportunity to rethink its plan to most strategically deploy this Proposition 2 long-term strategy for Proposition 2 debt payments. funding. BACKGROUND This section provides background on how the other half to increase the level of the rainy day Proposition 2 debt payment requirements are fund (the Budget Stabilization Account). Because estimated and on the state’s major retirement capital gains revenues can vary significantly liabilities—the remaining eligible uses of those from year to year, the annual amount of the payments. Proposition 2 required debt payment has varied by hundreds of millions of dollars each year. DEBT PAYMENTS REQUIRED Dedicates Annual Payments—Even During THROUGH 2029‑30 Downturns—Toward Eligible Debts Until 2030. Proposition 2 debt payments are required through Proposition 2 Required Debt Payments 2029-30. Thereafter, these debt payments become Vary Significantly From Year to Year. optional, but amounts not spent on debt must be Proposition 2 contains a formula that requires the deposited into the rainy day reserve. Unlike reserve state to spend a minimum amount each year to requirements, which the Governor and Legislature pay down specified debts. The formula has two may reduce during a budget emergency, the state parts. First, the state must set aside 1.5 percent cannot reduce required debt payments before 2030 of General Fund revenues. Second, the state for any reason. must set aside a portion of capital gains revenues Over the Next Decade, State Will Make that exceed a specified threshold. The state Between $12 Billion and $21 Billion in Additional combines these two amounts and then allocates Debt Payments. Debt payment requirements half of the total to pay down eligible debts and will vary depending on revenue performance. 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET For example, in a recessionary year when the loans from other state funds to the General stock market declines substantially over several Fund; (3) reimbursements for pre-2004 mandate months, the annual requirement could be as claims from cities, counties, and special low as $900 million. In other years, when capital districts; (4) unfunded liabilities for pensions; gains revenues are more significant, the annual and (5) prefunding and unfunded liabilities requirement could reach well over $2 billion. We associated with retiree health benefits. As of the estimate that, over the next ten years, the state will 2019-20 budget, the state has repaid the first three make $12 billion to $21 billion in additional debt types of eligible Proposition 2 debts (that is, settle payments under Proposition 2. (In addition to these up, special fund loans, and mandate claims). requirements, outside of Proposition 2, the state makes several billions of dollars in annual debt REMAINING ELIGIBLE USES OF payments under a number of other state policies. PROPOSITION 2 DEBT PAYMENTS These are described in more detail in the nearby box.) The remaining eligible uses of Proposition 2 mainly No State Policy for All Proposition 2 Debt are related to unfunded liabilities for pensions and Payments Beyond 2019‑20. The state has retiree health benefits. Figure 1 summarizes those generally approached annual debt payments eligible uses that are the sole responsibility of the on a year-by-year basis, meaning there is no state. While these amounts are large, the state has formal multiyear policy on how these payments plans in place to address these liabilities over the will be distributed over the next decade. The next few decades. The remainder of this section administration, however, maintains its own describes each of the eligible uses and provides multiyear plan for Proposition 2 debt payments detail on how these plans would work. that it updates with each budget proposal. The administration’s current Proposition 2 debt payment plan, which is reflected in the Figure 1 Governor’s 2020-21 budget proposal, extends Outstanding State-Only Eligible Uses of through 2023-24. While the administration’s Proposition 2 budget proposal makes assumptions about future Debt or Liability (In Billions) Proposition 2 payments, the Legislature may choose to use these funds differently. Retiree health $85.6 Last Year’s Budget Paid Down Most of State and CSU employee pensions 59.7 State’s Remaining Budgetary Debt. At the time Teachers’ pensionsa 33.4 Judges’ pensions 3.3 the measure was passed, there were five types of Pooled Money Investment Account loanb 2.5 debts eligible for payments under Proposition 2. a State’s share of the unfunded liability. These were: (1) “settle up” or certain amounts b General Fund’s share of the remaining repayments. Total outstanding the state owed to schools; (2) special fund repayments owed are $5.1 billion, including interest. Proposition 2 Is One Part of the State’s Debt Approach Beyond Proposition 2’s (2014) requirements, the annual budget pays down several billion dollars of liabilities each year. These include costs to pay down pension unfunded liabilities and debt service on bonds. For example, in addition to $1.9 billion in Proposition 2 debt payments, the 2018-19 budget allocated about $4 billion to pay down the unfunded liability for state and California State University employee pension benefits and $6.2 billion for debt service on general obligation bonds. www.lao.ca.gov 3 analysis full gutter 2020-21 BUDGET State Retiree Health liability is created that will be paid off by the state over a couple of decades. The state’s unfunded The state provides health benefits to retired state liabilities at CalPERS total about $63 billion, which employees. Prior to 2015, the state essentially includes about $60 billion associated with state put no money aside to pay for this benefit while and California State University (CSU) employee the eventual retiree was still working. As a result, pension benefits and about $3 billion associated the state accrued a significant unfunded liability with pension benefits for judges first appointed or associated with retiree health. (An unfunded liability elected before 1994. occurs when the assets that have been set aside CalPERS Has Full Rate Setting Authority. A during a retiree’s working years are insufficient to pension system has “full rate setting authority” pay their future benefits—in this case, there were when its board has the authority to require no assets set aside for these workers for decades.) employers to contribute an amount of money that In 2015-16, the state began a policy to prefund the board determines is necessary to fund the this benefit by setting aside funds annually. (Over system. With full rate setting authority, contribution the last few years, the state’s General Fund costs requirements might change year over year in of prefunding have been paid using Proposition 2.) response to actuarial changes. For example, The state retiree health unfunded liability is contribution requirements might increase if retirees estimated to be $86 billion as of the most recent live longer in the future than expected or decrease actuarial valuation. if investment returns are higher than actuaries State and Employees Recently Began Making assumed. This rate setting authority is important Regular Contributions Based on Normal Cost. because it allows the system to (1) make up for Under the new policy to prefund retiree health, losses that occur when actuaries determine that the state and employees each pay a percent of more funds are necessary to pay for benefits pay intended to equal one-half of the normal cost than what has already been set aside (that is, so that the entire normal cost is paid each year. to address an unfunded liability over time) and (Normal cost is the amount that actuaries estimate (2) not charge employers more than is necessary is necessary to be invested today to pay for the for the system to become fully funded. Under benefit in the future.) Actuarial valuations provided the California Constitution, CalPERS has full rate to the Legislature at the time the state adopted the setting authority. funding plan indicated that, using this strategy, the benefit would be fully funded by the mid-2040s Teachers’ Pensions under the plan. This projection is based on a number The California State Teachers’ Retirement of assumptions about the future, including: benefit System (CalSTRS) administers pension and other design and assumptions about investment returns, retirement programs for current, former, and health care inflation, and demographic trends. retired K-12 and community college teachers State and CSU Employee Pensions and administrators, as well as their beneficiaries. According to CalSTRS’ most recent actuarial The California Public Employees’ Retirement valuation, total unfunded liabilities for its defined System (CalPERS) administers pension benefits benefit program are $107 billion. Under state law, for state employees, state judges, certain elected currently about one-third of these liabilities are state officials, and employees of local governments the responsibility of the state ($33 billion) and that contract with CalPERS (and their beneficiaries). about two-thirds are the responsibility of school Unfunded liabilities emerge at CalPERS when districts. (Figure 1 displays only the state’s share of actuaries determine that there are insufficient the unfunded liability, but the districts’ share also assets invested today to make benefit payments arguably is eligible for Proposition 2 payments.) in the future for earned benefits. For example, Prior to 2014, CalSTRS Was on Path to when investment returns on assets are lower than Fully Deplete Assets by Mid‑2040s. Benefits for actuaries assumed in a particular year, an unfunded CalSTRS members are funded from a combination 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET of investment returns, contributions from employers account that is like the state’s checking account— (which we refer to as “districts”), employees to make a one-time supplemental payment to (teachers), and the state. Prior to 2014, base CalPERS. The General Fund and all other funds contribution rates paid by districts, teachers, that make CalPERS payments on behalf of and the state were established in statute, and employees will save money from the supplemental the CalSTRS board had limited authority to set payment. This is because supplemental payments a supplemental contribution rate for the state. reduce the system’s unfunded liability, resulting in Like other pension systems, CalSTRS incurred lower employer contributions over time. Because significant investment losses during the 2008 all funds that contribute to CalPERS will experience financial crisis. However, unlike other pension savings, they are all expected to contribute toward systems, given its constraints, CalSTRS projected the repayment of the loan. The General Fund’s those losses would result in the system running out share of the remaining outstanding loan balance is of assets in the mid-2040s. $2.5 billion. 2014 Funding Plan Aims for System to Be University of California (UC) Pension Fully Funded by 2046. In 2014, the Legislature Liabilities Also Eligible. In addition to the approved a plan (Chapter 47 [AB 1469, Bonta]) retirement liabilities described earlier, unfunded to fully fund the CalSTRS defined benefit program liabilities of the UC Retirement Plan (UCRP) also by 2046 (we refer to this as the “funding plan”). are eligible for Proposition 2 payments. Unlike most To reach that goal, the funding plan statutorily pension systems in California, the UC pension assigned existing unfunded liabilities to districts plan was “superfunded” for many years, meaning and the state. The funding plan also scheduled the system had more than enough assets to pay increases to the contribution rates paid by districts, future benefits. In response to this status, the UC teachers, and the state to the system for several Regents (which serves as the pension board of years and—after that point—granted the CalSTRS UCRP) allowed a “funding holiday” for nearly two board limited rate setting authority. decades during which neither UC nor its employees CalSTRS Board Has Limited Rate Setting made pension contributions. This funding holiday Authority. Unlike CalPERS, the CalSTRS board eventually resulted in an unfunded liability. In 2009, has limited—not full—rate setting authority under the UC Regents adopted a funding plan to reinstate the funding plan. Specifically, the funding plan contributions to UCRP. As of the most recent phased in increases to the state’s contribution actuarial valuation, UCRP’s unfunded liability is rates until 2016-17, after which the funding plan estimated to be $16.6 billion. gave the CalSTRS board limited authority to State Has Used Proposition 2 to Pay for adjust those rates. In particular, the board may UCRP in the Past. In three years since 2014, increase the state’s rate by 0.5 percent of pay the state made contributions to UCRP using each year. Figure 2 shows current and expected Proposition 2 funds. The state does not have a future contribution rates under CalSTRS’ current projections. Under these projections, the state’s Figure 2 rate is expected to continue to increase over the CalSTRS Expected Future State next few years in response to recent actuarial losses (for example, years in which CalSTRS’ Contribution Rates investments have earned less than the actuarially Fiscal Year State Ratea assumed 7 percent). 2019-20 10.3% Other Eligible Uses 2020-21 10.8 2021-22 11.3 General Fund Repayments to PMIA Loan. 2022-23 11.8 The 2017-18 budget package authorized a plan 2023-24 11.6 a to borrow $6 billion from the state’s share of the Includes the required contribution to the Supplemental Benefit Maintenance Account. Pooled Money Investment Account (PMIA)—an www.lao.ca.gov 5 analysis full gutter 2020-21 BUDGET direct legal obligation to provide funding to the UC up a larger share of UC’s budget, however, there specifically to pay for its retirement liabilities. (As could be pressure on the state to provide General a result, we do not display UCRP in Figure 1.) As Fund augmentations to UC. contributions to pay down retirement liabilities take GOVERNOR’S PROPOSITION 2 PROPOSAL This section describes the Governor’s proposal $1.1 billion to CalSTRS in 2019-20 using the for allocating the required Proposition 2 debt Proposition 2 debt payment requirement. payments in 2020-21 and over a multiyear period. Governor’s Multiyear Plan Governor’s Proposal for 2020‑21 The Governor’s current multiyear plan for Total Requirement of $2 Billion. The Proposition 2 debt payments extends through administration estimates that required debt 2023-24. payments will total $2 billion in 2020-21. These Estimates of Multiyear Requirements. requirements are based on the administration’s The administration’s estimates of multiyear January 2020 estimates for 2020-21 General Fund Proposition 2 debt payment requirements are revenues and tax proceeds, personal income based on the administration’s multiyear revenue taxes derived from capital gains, and the share of estimates. These estimates assume the economy excess capital gains that the Constitution requires continues to grow and that the stock market grows the state to spend on education. The estimates slowly. These assumptions result in moderate of these amounts—and therefore of required debt Proposition 2 requirements each year—ranging payments—will change when the administration from $1.5 billion to $1.8 billion over the out-year releases its revised budget plan in May 2020. period. The actual requirements will differ from Proposed Allocation. The Governor proposes the administration’s estimates in any given year, allocating the $2 billion requirement to three depending primarily on the performance of the purposes in 2020-21: stock market. Multiyear Plan. The Governor’s multiyear • Retiree Health Prefunding. The Governor plan for allocating those estimated requirements first uses $340 million of this requirement for has a few parts. First, the Governor proposes to the General Fund cost of prefunding retiree continue using Proposition 2 to prefund retiree health benefits. The state has been using health benefits. Second, he proposes fully paying Proposition 2 to cover these costs since the down the General Fund’s share of the outstanding retiree health prefunding policy was adopted PMIA loan by 2022-23. Next, the Governor in 2015-16. proposes continuing to make supplemental • PMIA Loan Repayments. Next, the payments to CalSTRS until the total amount of administration dedicates $817 million of the Proposition 2 supplemental payments reach nearly total to continue repaying the General Fund’s $3 billion in 2022-23. Finally, after the PMIA loan share of the PMIA loan. This payment would is fully paid off in 2022-23, he proposes directing reduce the outstanding balance owed by the the freed up Proposition 2 capacity to make a General Fund on this loan to $1.7 billion. supplemental payment to CalPERS in 2023-24. • CalSTRS Supplemental Payment. Finally, the Figure 3 summarizes the plan. Because the administration proposes using $802 million to Proposition 2 requirements will differ in amounts in make a supplemental payment to the state’s future years, how the Governor actually proposes share of CalSTRS’ unfunded liability. The to use those funds will likely differ from what is state also made a supplemental payment of included in the current multiyear plan. 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET Figure 3 Administration’s Multiyear Proposition 2 Plan (In Millions) 2020-21 2021-22 2022-23 2023-24 Retiree health prefunding $340 $350 $365 $375 Pooled Money Investment Account loan repayments 817 791 871 — Supplemental payments to CalSTRS 802 615 345 — Supplemental payments to CalPERS — — — 1,123 Totals $1,959 $1,756 $1,581 $1,498 Savings Assumed in Mulityear. In addition CalSTRS payments beginning in 2022-23. Since to reducing unfunded liabilities, another goal the administration put together these estimates, of supplemental payments is to generate state however, the CalSTRS board has adopted some savings. Savings occur when the state pays down changes to assumptions that result in increases to an unfunded liability and that payment lowers the state’s rate. This likely means that, when the contribution rates relative to what otherwise would administration releases a revised budget at the be the case over the next few decades. The time of May Revision, it likely will assume a couple administration’s January multiyear budget plan hundred millions of dollars in higher CalSTRS costs assumes savings associated with the supplemental in the last years of the multiyear budget plan. FINDINGS AND RECOMMENDATION This section provides our assessment of the particular, the state has until 2029-30 to repay the Governor’s Proposition 2 proposal. In the first PMIA loan. The Legislature could choose to spread section, we provide our overall comments on out the payments over a longer period, making more the plan, in particular the multiyear strategy for room for other priorities over the next few years. Proposition 2. In the second section, we present Agree With Governor’s Approach to Focus on two ways to improve the Governor’s multiyear CalSTRS… If the Legislature wants the CalSTRS plan for Proposition 2. We conclude with a funding plan to stay on track to meet its goal of recommendation to the Legislature outlining an full funding by 2046, given CalSTRS’ limited rate approach to implement our improvements. setting authority, the state might need to ramp Agree With Governor’s Approach to Maintain up contributions faster than currently scheduled. Current Commitments. We agree with the The Governor’s multiyear plan for Proposition 2 Governor’s approach to maintain the state’s addresses this need by devoting nearly $3 billion in commitments to prefunding retiree health and additional funds to CalSTRS over a few years. repaying the PMIA loan using Proposition 2. With …But Suggest Connecting Those Amounts regard to retiree health, now that prefunding costs to Specific Actuarial Need. The Governor has are being shared through collective bargaining, targeted multiyear supplemental payments of the General Fund generally is obligated to cover nearly $3 billion to CalSTRS. (We understand that them whether or not the state uses Proposition 2. the underlying rationale for this amount is that it is Likewise, now that the PMIA loan has been made, close to the amount the 2019-20 budget dedicated the state is obligated to repay it whether or not to CalPERS for the same purpose.) While we agree Proposition 2 is used. That said, these payments with the Governor’s emphasis on CalSTRS over could be reduced somewhat over the next few the multiyear period, the amounts proposed by the years, relative to the Governor’s proposal. In Governor are not connected to a specific actuarial www.lao.ca.gov 7 analysis full gutter 2020-21 BUDGET need. Although making these payments would materialize, the funding plan will bring the CalSTRS reduce CalSTRS’ unfunded liability and put the plan system to fully funded status in the mid-2040s. on better footing, because they are not estimated However, future actuarial losses could create based on the actuarial needs of the system, they substantial risk to CalSTRS’ ability to achieve full might fall short of the amounts the system will need funding by 2046. (“Actuarial losses” occur when to stay on track. experience deviates from what actuaries assume Recommend Improvements to the Multiyear in a way that creates unfunded liabilities—for Plan to Keep Funding Strategies on Track. example, lower-than-assumed investment returns.) The Constitution requires the state to make CalSTRS actuaries have reported that although Proposition 2 debt payments each year for the the system likely will be better funded than it is next decade. At the same time, the state has today, there is about a 50 percent chance that the relatively new plans in place to address unfunded system will not be fully funded by 2046. This risk liabilities for CalSTRS and state retiree health primarily stems from the limitations on the CalSTRS benefits that might not succeed in fully addressing board’s rate setting authority. Because the board the unfunded liabilities over the next few decades. can only increase the state’s contribution rate by (We describe why these plans might not fully up to 0.5 percent of pay in any given year, actuarial address the unfunded liabilities in more detail later.) losses can create future unfunded liabilities for the As such, Proposition 2 presents an opportunity state that would not be addressed by 2046. for the state to assist in keeping these plans on Example of Shortcoming in Limited Rate track. In the remainder of this section, we outline Setting Authority. There are many scenarios in a recommendation that would: (1) allow the state which the limitations on CalSTRS’ rate setting to better monitor progress on the funding plans authority constrain the system’s ability to and (2) target funding to reduce the risk that those compensate for actuarial losses. For example, plans get off track over the next decade. CalSTRS estimates that an investment return of 5 percent (which is less than the assumed rate of USE PROPOSITION 2 PAYMENTS TO 7 percent) would necessitate an ongoing increase in the state’s contribution rate by 1 percent of pay. KEEP FUNDING PLANS ON TRACK (Based on current payroll estimates, a 1 percent of pay increase in the state’s rate is equivalent CalSTRS to about $350 million.) However, the board can Funding Plan Is Still Relatively New, but only increase the state’s rate by 0.5 percent of Represents Significant Step Forward for the pay each year. So, in the first year following the State. Under current actuarial and demographic 5 percent return, the state’s rate would increase assumptions—despite the limitations on CalSTRS’ by 0.5 percent of pay and then an additional rate setting authority—the system’s unfunded 0.5 percent pay in the next year. Figure 4 liabilities likely will be reduced by 2046-47. As summarizes the effects on state contribution rates we have said in the past, the resulting from a few lower-than-assumed investment funding plan represents a major accomplishment for the state Figure 4 and puts CalSTRS on a much Examples of CalSTRS Investment Loss Scenarios more sustainable path. However, CalSTRS’ Number of the funding plan—which is three Investment Hypothetical Implication for Years Needed to decades long—is still in the initial Return Investment Actuarial Increase in the Fully Phase-In years of implementation. Assumption Experience Loss State Rate Rate Change Limitation in CalSTRS Rate 7% 6% 1% 0.5% 1 Setting Authority Creates a Risk 7 5 2 1.0 2 for the Funding Plan. If actuarial 7 4 3 1.5 3 7 3 4 2.0 4 assumptions regarding the future 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET scenarios. The limitations on the board’s ability to future Proposition 2 payments to CalSTRS would increase the state’s contribution rate in response be higher—or lower—depending on how much the to actuarial losses under the funding plan mean system actually needed to reach full funding. that the state’s contribution rate might increase at How This Approach Could Work. Figure 5 a slower pace than would be the case if the board shows how our recommendation could work. had full rate setting authority. Sustained actuarial For example, suppose in some year CalSTRS losses over several years could create a risk that the experiences an annual return of 3 percent—which system will not be fully funded by 2046. is lower than the assumed rate of 7 percent. To Use Proposition 2 to Keep the CalSTRS make up for this actuarial loss, the board would Funding Plan On Track. Proposition 2 presents the need to increase the state’s rate by approximately Legislature with a unique opportunity to determine 2 percent of pay, but under law could only raise how best to use funds that it is required to spend. the rate by 0.5 percent of pay each year over four We recommend the Legislature use Proposition 2 to years. In those intervening years, there would be a increase state contributions to CalSTRS to address difference between the rate the state is paying and actuarial losses in future years (should they occur). the rate the state would pay if the CalSTRS board In particular, in years when the board cannot had full rate setting authority. In dollar terms, this increase rates sufficiently to address changes in the difference would very roughly equal $525 million in state’s unfunded liability, we recommend that the the first year, $350 million in the second year, and state direct Proposition 2 requirements to cover the $175 million in the third year. Proposition 2 debt difference. More specifically, Proposition 2 could be payments could be used to make up this difference. used to cover the cost of the difference between This means, under our recommendation, the state CalSTRS rates under law and what those rates would contribute nearly $1 billion over the three would be if CalSTRS had full rate setting authority. years using Proposition 2 to make up for the loss. This differs from the Governor’s approach in that Figure 5 How Our Alternative CalSTRS Approach Would Work The state experiences an actuarial loss of 4 percent in this year. 12.5% 12.0 Under our proposal, the state would use Proposition 2 debt payments to "fill this gap," essentially taking 1 1 1 0 1 1 . . . 0 5 5 U 2 n p d C e e a r r l c f S u e T ll n R r t a S a t g e w e s o e p u t o l t d in i n s g t e s a t u h th t i h e g o h r r a e it t y r e . , o r s e h n p a t r d h e e e s d e p n r a t e e y B g m d i u i n o t e c b n u r n y . e n t a s t d h s e e e r t t h h e e r f a u t n e d b in y g 0 p .5 la n p , e C rc a e lS n T t R ag S e c a p n o i o n n t l s y per year. 10.0 9.5 9.0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 CalSTRS = California State Teachers’ Retirement System. www.lao.ca.gov 9 analysis full gutter 2020-21 BUDGET Retiree Health relatively low in the next few years—because there are so few assets invested that even significantly New Unfunded Retiree Health Liability Could lower-than-assumed investment returns would Arise in the Future. The state and employees each result in a small dollar amount of unfunded liability. contribute a percentage of pay to retiree health that These costs will increase over time, however, as the roughly is equivalent to one-half of the normal cost. state sets aside more prefunded assets. This system creates two risks that might result in new unfunded liability in the future. First, normal Recommendation cost for retiree health benefits—unlike pension In this report, we have discussed two different benefits—grows over time at a rate that is unrelated ways to use Proposition 2 debt payment to salary growth. This means that the percent requirements to keep the CalSTRS and retiree of pay that constitutes half of the normal cost in health funding plans on track. That said, the future one year might not be sufficient in future years. amounts needed to accomplish this goal are still Second, new unfunded liabilities would emerge if unknown. As such, to implement this approach, experience deviates from the actuarial assumptions we recommend the Legislature adopt trailer bill used to determine normal cost. For example, this language directing the administration to report, at would occur if health costs increase faster, retirees the time of its January budget proposal each year, live longer, or investment returns are lower than on a few different aspects of these funding plans. actuaries had assumed when they calculated Specifically the report would include reporting normal cost. These estimates also tend to be language on: subject to a greater range of uncertainty compared to pension benefits, for example, because health • CalSTRS. In the case of CalSTRS, this report care costs can grow unpredictably. could include: (1) the annual difference between Some Risk That This New Unfunded Liability CalSTRS rates under law and what those Would Mean the Retiree Health Plan Gets Off rates would be if CalSTRS had full rate setting Track. New unfunded liabilities will occur in any authority; (2) the annual cost, in dollar terms, year in which the full normal cost is not paid or in of that difference; and (3) how much capacity which actuarial losses occur. Unlike the CalPERS Proposition 2 has to take on that difference. pension system with full rate setting authority or the • Retiree Health. For retiree health, this report CalSTRS system with limited rate setting authority, could include: (1) the annual contribution there is no automatic mechanism to increase requirement necessary to address any new contribution rates to retiree health benefits when unfunded liabilities resulting from actuarial new unfunded liabilities are created. This creates losses over the amortization period assumed by a risk that the retiree health benefit will not stay on actuaries in the most recent actuarial valuation; track be fully funded by the mid-2040s. (2) the total amount, in dollar terms, of that new Use Proposition 2 to Keep the Retiree unfunded liability; and (3) how much capacity Health Prefunding Plan on Track. The state Proposition 2 has to address that total. could use Proposition 2 to address future, new Given that CalSTRS payments are more likely unfunded liabilities should they emerge for retiree to yield savings for the state over the next few health. For example, suppose in a particular year decades and there is more uncertainty inherent investment returns on prefunded assets fail to in future health costs, we further recommend the meet expectations. This would result in a new Legislature use this trailer bill language to direct unfunded liability and would reduce the likelihood the administration to prioritize CalSTRS payments. that the retiree health benefit is fully funded by the In this case, capacity for retiree health would only mid-2040s. (If the system exceeded its investment occur after CalSTRS is addressed. This report target in a subsequent year the unfunded would allow the Legislature to determine how to liability could be reduced or eliminated.) Using allocate Proposition 2 in future years to keep both Proposition 2 to make up for these investment plans on track while allowing more time to pass to losses would keep the plan on track. The costs of assess how the plans are functioning. addressing these new unfunded liabilities would be 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET CONCLUSION In a report to the Legislature last year—The for CalSTRS and retiree health on track. While the 2019‑20 Budget: Structuring the Budget: Reserves, administration’s multiyear plan for Proposition 2 Debt and Liabilities—we analyzed the Governor’s also would direct additional funds toward proposals to make several large supplemental CalSTRS—which we think makes sense—the pension payments. Those supplemental payments proposed amounts are not connected to a specific were part of the Governor’s budget resilience actuarial need. We suggest the Legislature ask the package, which aimed to improve the budget’s administration to track progress on CalSTRS and multiyear condition by paying down state debt. retiree health more explicitly, and then use that Those proposals departed from recent state information to direct additional payments to the practice to deposit more money into reserves systems based on those determined needs. as the primary method for putting the budget on Further, our recommendations related to annual better footing. We analyzed those proposals from reporting would allow the state to monitor the that perspective, concluding that, if the state’s progress of the state’s relatively new plans to goal was to achieve more savings and improve the address CalSTRS and retiree health liabilities. budget’s multiyear condition, making payments to Over the next few years, it could mean the state CalPERS—not CalSTRS—would be best choice. directs more funding to CalSTRS and retiree health, This report takes a different perspective. In this but only to the extent that funding is actuarially report, we consider the very long-term benefits needed. Over the next decade, this could help of supplemental payments to improve existing keep both plans on track and give Legislature state plans to pay down state retirement liabilities. more information about how the funding plans are To that end, we recommend that the state use working. Proposition 2 payments to keep the state’s plans www.lao.ca.gov 11 analysis full gutter 2020-21 BUDGET AUTHORS Ann Hollingshead Proposition 2 916-319-8305 Ann.Hollingshead@lao.ca.gov Nick Schroeder CalPERS 916-319-8314 Nick.Schroeder@lao.ca.gov Retiree Health Angela Short CalSTRS 916-319-8309 Angela.Short@lao.ca.gov LAO PUBLICATIONS This report was reviewed by Ginni Bella Navarre and 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. 12 LEGISLATIVE ANALYST’S OFFICE