Strengthening the CalSTRS Funding Plan

Strengthening the CalSTRS Funding Plan GABRIEL PETEK LEGISLATIVE ANALYST MARCH 2021 AN LAO REPORT Executive Summary CalSTRS Funding Plan Marks State Accomplishment... Prior to the passage of the funding plan for the California State Teachers’ Retirement System (CalSTRS) (Chapter 46 of 2014 [AB 1469, Bonta]), actuaries projected the system’s assets would be depleted within a few decades. With the aim of fully eliminating the Defined Benefit Program’s unfunded actuarial obligation (UAO) by 2046, the funding plan divides responsibility for UAO between the state and employers, and increases CalSTRS’ authority to adjust required contribution rates to meet the plan’s goal. To date, the plan has set CalSTRS on track to pay down almost all UAO by 2046. The existence of the funding plan represents a significant accomplishment for the state and has put CalSTRS on a much more sustainable path toward securing the fiscal health of the Defined Benefit Program for current and future members. …But Certain Aspects of the Plan May Impede Its Success. Now that the funding plan has been in place for several years, some of its implementation complexities and challenges have become more apparent. Specifically: (1) CalSTRS uses highly complex, theoretical formulas to assign responsibility for UAO to the state and employers; (2) the state’s share of UAO is sensitive to volatility while CalSTRS holds only limited authority to adjust the state’s contribution rate in response; (3) volatility results in relatively minor, but counterintuitive, impacts on employers’ contribution rate; and (4) CalSTRS’ ability to address UAO becomes increasingly difficult over time, and essentially ends when the funding plan provisions expire in 2046. These challenges and complexities risk impeding CalSTRS’ ability to achieve full funding by 2046 and to continue securing the Defined Benefit Program’s fiscal health beyond the duration of the plan. The plan’s complexities also make legislative oversight of the funding plan’s progress challenging. Recent Economic Uncertainty and Budget Actions Underscore Challenge of CalSTRS’ Limited Rate-Setting Authority. Due to extreme market volatility in 2019-20 caused by the coronavirus disease 2019 pandemic, CalSTRS did not meet its investment return assumption for the year (the system experienced an actuarial loss of 3.1 percent). This loss means CalSTRS will need to continue to increase the state’s contribution rate by the maximum amount allowed in future years to pay down accrued UAO. At the same time, to help address the state’s projected budget problem in 2020-21, the 2020-21 Budget Act suspended CalSTRS’ authority to increase the state’s contribution rate for one year. This budget action resulted in one-time savings for the state, but creates an ongoing gap between the state’s contribution rate and what it would have been in absence of the suspension, potentially making it more difficult for the state to pay down its share of UAO by 2046. The administration has proposed one-time supplemental payments to offset this gap for one year, but the ongoing gap remains unaddressed. Moreover, CalSTRS’ inability to increase the state’s rate quickly enough results in more UAO accruing, and the state paying more over time to address it. Recommend Legislature Consider a “Catch-Up” Mechanism in the Near Term. To address this ongoing disparity, the Legislature could consider allowing CalSTRS to increase the state’s rate more quickly—either beginning in 2021-22 or in a future year once the state has addressed current pandemic-related challenges. This increased authority could be in place for a limited time while the state’s rate and contributions catch up to what they would have been absent any suspension. www.lao.ca.gov 1 AN LAO REPORT In the Longer Term, Recommend Legislature Consider Addressing the Plan’s Underlying Challenges. To increase transparency and oversight, increase the likelihood that the state will be able to fully pay down its share of CalSTRS UAO by 2046, potentially help the state achieve significant long-term savings, and allow CalSTRS to effectively address future losses and UAO, we recommend that the Legislature consider addressing some of the underlying challenges to the plan. Specifically, we recommend that the Legislature consider the following changes: (1) allow CalSTRS to increase the state’s contribution rate by more than is currently allowed; (2) eliminate the complex theoretical calculations currently used to determine assets and obligations assigned to the state and employers in favor of a fixed proportional division of UAO; and (3) make the provisions of the funding plan ongoing, allowing CalSTRS to develop an amortization policy to address future losses in line with industry best practices. 2 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT INTRODUCTION For several years, the state and school its implementation complexities have become more employers have significantly increased their apparent. contributions to the California State Teachers’ In this report, we: (1) provide background on Retirement System’s (CalSTRS’) Defined Benefit CalSTRS and the funding plan, (2) lay out some Program as a result of the 2014 CalSTRS Funding aspects of the funding plan that may impact its Plan, which aims to fully fund the program by ultimate success, (3) put these risks into context 2046. Prior to the passage of this legislative plan, given recent economic volatility as well as recent the Defined Benefit Program was headed toward state budget actions, (4) describe the Governor’s insolvency. To date, the plan has set CalSTRS 2021-22 proposals for supplemental payments funding on a more sustainable path. However, to CalSTRS, and (5) offer the Legislature some recent economic volatility and state budget immediate and longer-term considerations. actions have underscored some risks to the plan’s Additionally, we include a glossary that defines key longer-term success. Additionally, since the plan pension fund terms used throughout this report has been in place for several years now, some of (refer to the Appendix). BACKGROUND In this section, we provide background on the CalSTRS Benefits Are Legally Protected. CalSTRS system, Defined Benefit Program, and Both the U.S. and California Constitutions 2014 funding plan. contain a clause—known as the Contract Clause—that prohibits the state or its voters CalSTRS Defined Benefit Program from impairing contractual obligations. In the CalSTRS Is World’s Largest Educator-Only context of pension benefits, California courts Pension System. Established in 1913, have ruled for many decades that the Contract CalSTRS is the nation’s second largest pension Clause generally prohibits reductions to pension system (the largest is the California Public benefits accrued by governmental employees for Employees’ Retirement System), and the largest work already performed. In addition, the courts educator-only pension system in the world. have determined that these benefits generally CalSTRS administers benefits programs for more are promised to employees on the day they are than 975,000 members—equivalent to roughly hired. In the case of both past and future pension 2.5 percent of California’s population—whose benefit accruals, pension benefits for current service as educators is not eligible for federal governmental employees can be reduced only in Social Security participation. Members are rare circumstances—generally, when governmental prekindergarten through community college public employers provide a benefit that is comparable and educators, including current, former, and retired offsets the pension contract that is being impaired teachers and administrators, as well as their or when employers previously have reserved beneficiaries. CalSTRS’ largest program is the the right to modify pension arrangements. As Defined Benefit Program, which provides members such, CalSTRS benefits generally are considered with retirement, disability, and survivor benefits, guaranteed for current members, and the fiscal with individuals’ benefits determined based on age, health of the CalSTRS system is essential to the service credit, and final compensation. state’s ability to provide those benefits. www.lao.ca.gov 3 AN LAO REPORT Teachers’ Retirement Fund Receives Program (and that deterioration was exacerbated Contributions and Generates Returns. The by the 2001 and 2008 recessions, along with Teachers’ Retirement Fund is a special trust changes in CalSTRS’ actuarial assumptions). At the fund that receives contributions from CalSTRS time of the funding plan development, actuaries members, school employers, and the state, and projected the program would be fully depleted of additionally generates significant returns over time assets by the mid-2040s. through investment in diverse assets. Investment …Until Funding Plan Established a More returns comprise the majority of funding for Sustainable Path Forward. In response to this CalSTRS benefits payments, covering around alarming projection, in 2014, the Legislature 61 percent of total benefits payments currently. As passed the CalSTRS Funding Plan (Chapter 47 of December 2020, the market value of CalSTRS’ of 2014 [AB 1469, Bonta]) with the goal of fully investment portfolio totaled nearly $280 billion. funding the Defined Benefit Program by 2046. To CalSTRS Board Oversees the Fund. fully fund the Defined Benefit Program, the plan The 12-member Teachers’ Retirement Board had to address the unfunded actuarial obligation administers the Teachers’ Retirement Fund. (UAO)—or the difference between the program’s California’s Constitution entrusts state pension assets and the assets required to pay benefits— boards with overseeing their systems’ investment that had accrued since the early 2000s. To reach policies and ensuring that benefit payments are this goal, the funding plan phased in significantly made on time and according to law. Importantly, higher contribution rates from employers and the the Teachers’ Retirement Board is responsible state over several years. (Members’ contributions for establishing the state’s and employers’ annual also increased, but less significantly.) Under contribution rates, based on actuarial requirements. the funding plan, the state and employers each (The board’s contribution rate-setting authority is pay a fixed base contribution rate, in addition to limited by the law, which we describe in more detail a supplemental rate that the board may adjust later on in this report.) annually (with limitations, which we describe in more detail later in this report) to eliminate UAO CalSTRS Funding Plan by 2046. Since its passage, the funding plan has Defined Benefit Program Was Headed set the Defined Benefit Program on a much more Toward Insolvency... Prior to 2014, contribution sustainable path and has allowed CalSTRS to rates for CalSTRS’ Defined Benefit Program were make progress toward the goal of fully funding set in statute, and the board had virtually no the program. According to CalSTRS’ most recent authority to adjust those rates. Accordingly, even as actuarial valuation, for the period ending June actuarially required contribution rates changed over 30, 2019, the program has reached 66 percent the years in response to investment performance, funded status and actuaries project achieving shifts in the teacher and retiree population, and 99.9 percent funded status by 2046. The funding other changes, CalSTRS rates remained essentially plan is in effect through June 30, 2046, after which static. While the Defined Benefit Program briefly point the pre-funding plan provisions would return. exceeded fully funded status as a result of the Figure 1 on the next page summarizes the changes historically strong stock market in the 1990s, the to contribution rates and the board’s rate-setting program’s funding condition began to deteriorate authority made by the funding plan, and Figure 2 in the early 2000s due to decisions made in the illustrates the Defined Benefit Program’s historical late 1990s and early 2000s to increase benefits and projected funded status. and decrease contributions to the Defined Benefit 4 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Figure 1 Funding Plan Changes to Defined Benefit Program Contribution Rates and Board Authority All Percentages Refer to Percent of Creditable Compensation Entity Prior to Funding Plan Funding Plan Changes State • Base contribution rate: 2.017 percent. • Base contribution rate: 2.017 percent. • Supplemental contribution rate: On top of the • Supplemental contribution rate increased over time, reaching base rate, the board could levy limited additional 4.311 percent in 2016-17. funds from the state. The board could increase • Beginning July 1, 2017, board may increase supplemental rate by up these required add-on funds by up to 0.25 percent to 0.5 percent of creditable compensation annually. No limit on annual annually, and add-on funds were capped at decrease. No cap on total rate. 1.505 percent. • Supplemental contribution rate as of July 1, 2020: 5.811 percent.a • Maximum possible total rate • Total rate (base + supplemental) as of July 1, 2020: 7.828 percent. (base + maximum supplemental): 3.522 percent. Employers • Base contribution rate: 8.25 percent • Base contribution rate: 8.25 percent. (had not increased since 1986). • Supplemental contribution rate increased over time, reaching • Supplemental contribution rate: None. 10.85 percent in 2020-21. • Beginning July 1, 2021, board may adjust supplemental rate by up to 1 percent of creditable compensation annually. Total (base plus supplemental) rate may not exceed 20.25 percent. • Supplemental rate as of July 1, 2020: 10.85 percent.b • Total rate (base + supplemental) as of July 1, 2020: 19.1 percent.b Members • Contribution rate: 8 percent • Initial increases phased in through 2016-17. (had not increased since 1972). • For 2 percent at 60 members (members not subject to the Public Employees’ Pension Reform Act [PEPRA]), rate is set in statute at 10.25 percent. • For 2 percent at 62 members (members subject to PEPRA), rate is now 10.205 percent. May be increased or decreased in future years based on the normal cost of benefits. a The 2020-21 budget suspends CalSTRS’ ability to increase state’s rate for the 2020-21 fiscal year. In absence of this suspension, the state’s rate would have increased by 0.5 percent effective July 1, 2020. b Employers’ supplemental rate does not reflect supplanting payments made by the state as part of the 2019 and 2020 budgets, which effectively lower the rate that employers pay for 2019-20, 2020-21, and 2021-22 due to payments made by the state on behalf of employers. Figure 2 Historical and Projected Funded Status of CalSTRS Defined Benefit Program As of June 2019, Based on the Actuarial Value of Assets 120% 100 Historical Funded Status Current Funded Status Trajectory 80 60 40 Funded Status Trajectory Without the Funding Plan 20 1970 1981 1986 1991 1996 2001 2006 2011 2016 2021 2026 2031 2036 2041 2046 Source: CalSTRs. www.lao.ca.gov 5 AN LAO REPORT CERTAIN ASPECTS OF THE FUNDING PLAN MAY IMPEDE ITS LIKELIHOOD OF SUCCESS In this section, we describe some key formal division of responsibility for paying down components of the CalSTRS funding plan and UAO. To implement the funding plan, CalSTRS’ explain why certain components risk impeding actuaries annually calculate assets and obligations CalSTRS’ ability to achieve full funding of the for the state and employers based on theoretical Defined Benefit Program by the end of the plan. “alternate universes,” determining what CalSTRS’ Figure 13 at the end of this section (on page 14) assets and obligations hypothetically would be summarizes the plan’s complexities and challenges, had the state made different decisions in the past. which we describe in detail below. Theoretical assets and obligations are calculated for the state based on what is referred to as the Theoretical Assets and Obligations “1990 benefit structure,” while those calculated Exceedingly Complex Formulas Assign for employers are based on the “post-1990 benefit Responsibility for UAO to the State and structure.” (We describe these structures more Employers… In addition to significantly increasing fully in Figure 3.) Based upon these theoretical the state’s and employers’ contribution rates and calculations, the state and employers each are broadening the board’s authority to adjust rates assigned an amount of UAO they are responsible in order to eliminate the program’s UAO by 2046, for paying down. The state’s and employers’ the funding plan stipulates that responsibility for amounts do not necessarily sum to CalSTRS’ total paying down UAO be shared between the state and UAO; a small portion of CalSTRS’ UAO remains employers. Prior to the funding plan, there was no unallocated under the funding plan. Figure 3 Structures CalSTRS Uses to Calculate and Assign Responsibility for Assets, Obligations, and UAO Responsible Entity Structure Used State • 1990 benefit structure refers to benefits that were in effect as of June 30, 1990. • To calculate assets and obligations based on the 1990 benefit structure, CalSTRS’ actuaries determine what assets and obligations the Defined Benefit Program would have today if no changes had been made to benefits since June 30, 1990. Specifically, this structure reflects how CalSTRS’ assets and obligations would be different today if: (1) teachers had not been granted more generous pension benefits in the late 1990s, and (2) contributions to the Defined Benefit Program had not been decreased when the system was fully funded around 2000. The theoretical assets and obligations resulting from these complex calculations are assigned to the state, and the resulting UAO is the state’s responsibility to pay down. Employers • Post-1990 benefit structure refers to benefit changes that occurred beginning on July 1, 1990. • To calculate assets and obligations based on the post-1990 benefit structure, CalSTRS’ actuaries determine what assets and obligations have resulted from changes in benefits and contributions that have been made since July 1, 1990. However, the calculations account only for members’ service accrued (meaning the work done and benefits earned) before July 1, 2014. The theoretical assets and obligations resulting from this set of complex calculations are assigned to employers, and the resulting UAO is employers’ responsibility to pay down. Unallocated • For service accrued July 1, 2014 and later, and falling within the post-1990 benefit structure, neither the state nor employers are responsible. The funding plan does not address who should pay for this unallocated portion of UAO. UAO = unfunded actuarial obligation. 6 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Each year, these structures become increasingly In parallel, volatility in investment returns results complex as CalSTRS accounts for an additional in a smaller but opposite impact on employers’ year of data and hypothetical difference between contribution rate. This counterintuitive effect is real experience and the theoretical structures. due to employers’ theoretically negative assets As of the actuarial valuation for the period ending calculated based on the post-1990 benefit June 30, 2019, CalSTRS’ total UAO is $105.7 billion. structure. Specifically, employers’ actuarially Based on the 1990 benefit structure, $33.1 billion required contribution rate increases slightly in UAO is assigned to the state (representing about response to higher-than-assumed investment one-third of total UAO), while based on the returns, and decreases slightly in response to post-1990 benefit structure, $72.4 billion UAO lower-than-assumed investment returns. (Again, we is assigned to employers (representing about explain this outcome in more detail in the box below two-thirds of total UAO). In addition, actuaries and illustrate assets and obligations in Figure 5.) calculated a small portion of the total UAO as the In other words, employers benefit somewhat—due responsibility of neither the state nor employers. to a slightly lower actuarially required contribution Figure 4 illustrates the current division of UAO. rate—when CalSTRS’ investments perform below …Resulting in Complicated and the actuarially assumed level. As long as the Counterintuitive Effects on Contribution Rates. theoretical assets assigned to employers remain Although the state’s share of UAO (as determined a negative value, this counterintuitive relationship by the 1990 benefit structure) currently is only between investment returns and employers’ about half the size of the employers’ share (as contribution rate will persist. determined by the post-1990 benefit structure), the Figure 5 illustrates the amounts and relative state’s contribution rate is much more sensitive sizes of the Defined Benefit Program’s actual and to volatility in investment returns compared to theoretical assets, obligations, and UAO, as of employers’ contribution rate. (The state’s rate CalSTRS’ actuarial valuation for the period ending is currently about five times more sensitive than June 30, 2019. employers’ rate.) This sensitivity is due to the 1990 benefit structure—which the state is responsible Figure 4 for—having theoretical assets that exceed the UAO Totals $105.7 Billion Defined Benefit Program’s current, real assets. As of June 30, 2019, Based on the Actuarial Specifically, when CalSTRS experiences investment Value of Assets (Dollars in Billions) returns that are greater than (or less than) the assumed rate of return (currently 7 percent), Unallocated UAO, $0.2 the actuarial gains (or losses) are larger for the theoretical asset value assigned to the state, relative to the actual gains (or losses) experienced by the system’s true assets. Therefore, the state’s actuarially required contribution rate based on the State's Share, $33.1 1990 benefit structure decreases more in response to higher-than-assumed investment returns—and increases more in response to lower-than-assumed investment returns—relative to what changes Employers' Share, $72.4 would be required if the state’s rate were based on the Defined Benefit Program’s actual assets. We explain this outcome in more detail in the box and illustrate assets and obligations in Figure 5 on the next page. UAO = unfunded actuarial obligation. Source: CalSTRS. www.lao.ca.gov 7 AN LAO REPORT Outcomes of CalSTRS’ Theoretical Calculations Why Are the Theoretical Assets Calculated Via the 1990 Benefit Structure Greater Than the Program’s Actual Assets? During the 1990s, the Defined Benefit Program experienced a brief surplus resulting from historic stock market growth. In response to that windfall, the state cut required contributions to the program and simultaneously increased members’ pension benefits. If these changes had not been made, the Defined Benefit program today would be better funded because: (1) required benefits payments would be lower and (2) more contributions would have been made to the program. Accordingly, under the 1990 benefit structure, the value of assets that the California State Teachers’ Retirement System (CalSTRS) theoretically would have is higher, while obligations theoretically would be lower. Why Do the Theoretical Assets Calculated Via the Post-1990 Benefit Structure Currently Result in a Negative Amount? As described above, the state increased CalSTRS’ members’ benefits while decreasing contributions to the Defined Benefit Program in the 1990s. The changes essentially decreased the system’s funding health—specifically by reducing the extent to which the assets could pay benefits—relative to what it would have been in absence of the changes. This effective loss is the responsibility of employers, given that it occurs under the post-1990 benefit structure. Eventually—likely in 20 years or so—the post-1990 benefit structure assets will result in a positive value. Figure 5 Defined Benefit Program Assets and Obligations Based on June 2019 Actuarial Values (In Billions) $350 Real Obligations Real Assets 300 Theoretical Obligations Theoretical Assets $105.7 250 UAO $33.1 200 150 100 50 $72.4 $0.24 Defined Benefit Theoretical Assets Unallocated Assets Program's Real and Obligations and Obligations Assets and Assigned to State Theoretical Assets -50 Obligations (Based on 1990 and Obligations Benefit Structure) Assigned to Employers (Based on Post-1990 UAO = unfunded actuarial obligation. Benefit Structure) 8 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Complexity Makes Funding Plan Difficult small actuarial losses and keep the funding plan on to Track. The structures described above result track. Addressing larger losses must be done over in changes to the proportional division of UAO multiple years, however, meaning more UAO may each year when CalSTRS’ actuaries update their accrue over time. projections. Due to these annual fluctuations, Given the volatile nature of the state’s actuarially as well as the sheer complexity of the structures required contribution rate based on the 1990 and calculations themselves, the funding plan’s benefit structure, the board’s current limited progress can be difficult for the state, employers, authority poses challenges only related to the and other stakeholders to understand and track. state’s rate. Specifically, CalSTRS cannot increase Funding Plan Does Not Include Provisions to the state’s rate quickly enough to compensate Pay Down Unallocated UAO. As described above, for lower-than-assumed investment returns when the theoretical assets and obligations assigned to those actuarial losses exceed approximately the state and employers do not precisely match 1 percentage point in a given year (in other CalSTRS’ total UAO. This portion of UAO left over— words, when CalSTRS’ real investment returns assigned neither to the state nor employers—may are 6 percent or lower). Figure 6 provides some grow over time. There is no plan in place to address illustrative examples of actuarial investment losses this unallocated UAO. and impacts on the state’s contribution rate. Limited Authority Also Results in State Board’s Limited Authority to Adjust Paying More Over Time. As described above, State’s Contribution Rate CalSTRS addresses unfunded liabilities by increasing rates, and the limitations on the board’s Limited Authority Results in More Increases rate-setting authority mean accrued UAO must Over a Longer Period to Pay Down UAO. As be addressed over a longer period of time. When described previously, the funding plan sets the goal CalSTRS cannot increase the state’s rate as quickly of fully funding the Defined Benefit Program by as needed, the underfunded amount compounds 2046, and provides CalSTRS with limited authority and accrues UAO, which CalSTRS addresses by to adjust the state’s and employers’ contribution continuing to increase the state’s contribution rate rates to reach that goal. Within the confines of this over time. Every additional year that the state’s limited authority—allowing the board to increase rate is actuarially required to increase equates to the state’s contribution rate by no more than a higher dollar amount that the state must pay. 0.5 percent of creditable compensation each For example, if the state’s rate were actuarially year and employers’ contribution rate by no more required to increase by 0.5 percent of creditable than 1 percent of creditable compensation each compensation every year throughout the entirety year—in any given year, CalSTRS can make up for Figure 6 Illustrative Hypothetical Loss Scenarios (Dollars in Millions) Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Assumed return 7.0% 7.0% 7.0% 7.0% 7.0% Actuarial experience 6.0 5.0 4.0 3.0 2.0 Actuarial loss 1.0 2.0 3.0 4.0 5.0 Implication for change in state’s rate 0.5 1.0 1.5 2.0 2.5 Number of years of maximum increase required to make up for loss 1 2 3 4 5 Underfunding amount accrued in intervening years — $175 $525 $1,050 $1,750 Notes: Each scenario represents a hypothetical loss in a single year. All percentages represent percentage of CalSTRS creditable compensation. Underfunding amount represents the difference between current policy and full rate setting authority, assuming CalSTRS would adjust rates to make up for loss in the following year. Assumes creditable compensation remains around $35 billion each year. www.lao.ca.gov 9 AN LAO REPORT of the funding plan, the state’s contribution rate in Figure 7, along with Figures 8 through 11 on 2046 would be more than 20 percent. pages 11 through 13, demonstrate how allowing the Alternatively, if CalSTRS were able to increase state’s contribution rate to increase more quickly the state’s rate more quickly to address UAO could result in savings over time. Specifically, more immediately, the state could owe more in Figure 7 lays out four hypothetical loss scenarios the near-term relative to what it would owe under and the differences in the state’s contribution rates a 0.5 percentage point annual increase. However, and amounts given an annual rate increase of up to the state could avoid compounding losses, and the 0.5 percent compared to an annual increase of up state’s rate likely would peak at a lower level and to 1 percent. Figures 8 through 11 illustrate these would require less significant ongoing increases four scenarios, depicting the long-term savings the through 2046—resulting in significant overall state would achieve if CalSTRS could increase the savings to the state. state’s rate by up to 1 percent annually. The nearby box explains in more detail how to read those The impact is similar to the effects of a figures. homeowner paying principal and interest on a mortgage: when a homeowner pays a lower Ultimately, Limited Authority Makes Meeting principal amount, interest on the outstanding Funding Plan Goal of Paying Down State’s balance compounds over time, and the homeowner Share of UAO Less Likely. CalSTRS actuaries pays more in totality. If the homeowner paid down estimate that, within the terms of the funding plan, the principal balance more quickly, ultimately, they the system has some capacity to absorb some would accrue less interest and achieve savings over additional years of loss while allowing the state to the life of the mortgage. successfully pay down its share of UAO by 2046. Figure 7 Savings Achieved by Allowing State’s Rate to Increase by Up to 1 Percent Annually, Compared to 0.5 Percent Annual Increase Illustrative Investment Loss Scenarios Scenario 1 Scenario 2 Scenario 3 Scenario 4a Investment return experience 4.5% 5.5% 6.25% 6.0% Period of loss 3 years 5 years 10 years 10 years 0.5 Percent Annual Increase Allowed (Current Law) State’s contribution rate in 2045-46 20.328% 20.328% 18.488% 20.328% Total amount contributed by state through 2045-46 $208.2 billion $208.2 billion $204.7 billion $208.2 billion State’s remaining UAO at end of funding plan — — — $24.7 billion 1 Percent Annual Increase Allowed (Alternative to Current Law) State’s contribution rate in 2045-46 14.915% 15.024% 15.792% 17.409% Total amount contributed by state through 2045-46 $194.5 billion $194.3 billion $195.9 billion $211.9 billion State’s remaining UAO at end of funding plan — — — — Savings Achieved by Alternative Overall Savings in Terms of State Contributions Through 2045-46 $13.7 billion $13.8 billion $8.8 billion -$3.7 billion Savings Plus Remaining UAO $13.7 billion $13.8 billion $8.8 billion $21.0 billion a Under scenario 4, nearly $25 billion UAO would remain unaddressed at the conclusion of the funding plan given a maximum annual increase of 0.5 percent of payroll. If the state’s rate could increase by up to 1 percent of payroll, the state would pay more through 2046 in order to successfully pay down this UAO. Notes: Data provided by CalSTRS. State’s contribution rate reflects percent of creditable compensation. Assumes teacher payroll would grow by 3.5 percent annually, in line with CalSTRS’ actuarial assumption. UAO = unfunded actuarial obligation. 10 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT How to Interpret Figures 7 Through 11 Each scenario represents a deviation between the California State Teachers’ Retirement System’s (CalSTRS’) actuarial assumption for investment returns—that CalSTRS’ assets will return 7 percent annually—and a hypothetical market experience. In all four scenarios, we assume the hypothetical lower-than-assumed rate of return would begin in 2020-21 and would continue for the period shown in Figure 7. Beyond that period, we assume CalSTRS would achieve 7 percent investment returns through the end of the funding plan. In Figures 8 through 11, the blue lines show how the state’s rate would need to increase through 2046 to pay down accrued unfunded actuarial obligation under current law, which allows CalSTRS to increase the state’s rate by up to 0.5 percent of creditable compensation each year. The red lines depict how the state’s rate would differ over time if CalSTRS were able to increase it by up to 1 percent of creditable compensation each year. In all four scenarios, the red lines increase more quickly but then level off, while the blue lines continue to increase steadily into the 2040s. The areas of the graphs where the red lines are above the blue lines represent periods when the state would pay more in a given year if a 1 percent annual increase were allowed. Conversely, areas of the graphs where the blue lines are above the red lines represent periods when the state would pay less in a given year if a 1 percent annual increase were allowed. As shown, under all four scenarios, a 1 percent annual increase would result in the state paying more up front—for at least a decade or so—but by the end of the funding plan would result in the state savings billions of dollars each year. Figure 8 Loss Scenario 1: Comparing 0.5 Percent Increase to 1 Percent Increase State's Contribution Rate 25% However, in these years, the state would achieve savings of nearly $23 billion. 20 Up to 0.5 percent annual increase allowed. 15 Up to 1 percent annual increase allowed. 10 Allowing the state's rate to increase by up to 1 percent annually would result in the state paying more during these 5 years by about $9.3 billion. 2020-21 2025-26 2030-31 2035-36 2040-41 2045-46 www.lao.ca.gov 11 AN LAO REPORT Figure 9 Loss Scenario 2: Comparing 0.5 Percent Increase to 1 Percent Increase State's Contribution Rate 25% However, in these years, the state would achieve savings of around $22.3 billion. 20 Up to 0.5 percent annual increase allowed. 15 Up to 1 percent annual increase allowed. 10 Allowing the state's rate to increase by up to 1 percent annually would result in the state paying more during these years by about $8.5 billion. 5 2020-21 2025-26 2030-31 2035-36 2040-41 2045-46 Figure 10 Loss Scenario 3: Comparing 0.5 Percent Increase to 1 Percent Increase State's Contribution Rate 25% However, in these years, the state would achieve savings of more than $14 billion. 20 Up to 0.5 percent annual increase allowed. 15 Up to 1 percent annual increase allowed. 10 Allowing the state's rate to increase by up to 1 percent annually would result in the state paying more during these years by about $5.3 billion. 5 2020-21 2025-26 2030-31 2035-36 2040-41 2045-46 12 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Figure 11 Loss Scenario 4: Comparing 0.5 Percent Increase to 1 Percent Increase State's Contribution Rate 25% However, in these years, the state would achieve savings of around $8 billion. Moreover, under this scenario, the state would not be able to fully pay down UAO given a 0.5 percent annual 20 increase, but it would successfully eliminate UAO given a 1 percent annual increase. Up to 1 percent annual 15 increase allowed. Up to 0.5 percent annual increase allowed. 10 Allowing the state's rate to increase by up to 1 percent annually would result in the state paying more during these 5 years by about $11.7 billion. 2020-21 2025-26 2030-31 2035-36 2040-41 2045-46 UAO = unfunded actuarial obligation. However, larger losses, or losses over a longer time horizon over which CalSTRS can pay down period or occurring closer to 2046, could mean UAO, including addressing any new actuarial that—even if the state’s rate continues to increase losses, decreases each year. For example, if by the maximum allowed each year through the the system does not meet its investment return end of the funding plan—the state might not be assumption in 2021-22, the board has 25 years able to pay down its share of UAO by the end of the over which it can increase contribution rates (the funding plan period. (This would be the case under actual time period needed would depend on the loss scenario 4, shown in Figures 7 and 11 above.) size of the loss). However, if the system experiences Figure 12 on the next page lays out a few potential a loss in the early 2040s, it has only a few years loss scenarios that CalSTRS could withstand and to increase contribution rates in response to that still be able to eliminate the state’s share of UAO loss. Depending on the size of the loss, the system under the current provisions of the funding plan— may not be able to fully pay down accrued UAO but that would require the state’s rate to continue prior to the end of the plan period, at which point increasing through 2046 and assumes that for contribution rates would default to pre-funding plan all other years CalSTRS would meet all actuarial levels. assumptions. Summary Funding Plan Set to End in 2046 Summary of Funding Plan Complexities and Plan Expiration Date Also May Make It More Challenges. Although the 2014 funding plan has Difficult to Achieve Goal. Because the provisions facilitated significant progress in terms of CalSTRS’ of the funding plan are set to expire in 2046, the ability to address UAO, after several years of the www.lao.ca.gov 13 AN LAO REPORT funding plan being in place, some key challenges also may result in challenges for stakeholders to have been revealed. A few aspects of the funding oversee the plan’s progress. Figure 13 summarizes plan may impede the likelihood of its success, and the funding plan’s complexities and key challenges. Figure 12 System Capacity to Absorb Loss: State’s Share of UAO Illustrative Investment Loss Scenarios That Could Occur While Allowing State to Pay Down Its Share of UAO by 2046 Frequency Investment Return State’s Rate Must Total Amount State’s of Loss in a Experience Continue to Increase State’s Contributed by Remaining Given Year Beginning in Period by the Maximum Rate in State Through UAO at End of Over Past 2020-21 of Loss Through Year 2045-46 2045-46 Funding Plan 25 Yearsa Scenario 1 4.50% 3 years 2045-46 20.328% $208.2 billion — 32% Scenario 2 5.50 5 years 2045-46 20.328 $208.2 billion — 36 Scenario 3 6.25 10 years 2041-42b 18.488 $204.7 billion — 36 a Reflects how often a loss of similar magnitude or greater has occurred in any one year over the past 25 years. b Under scenario 3, the state’s rate would increase by the maximum allowed each year through 2041-42, then continue increasing by less than the maximum each year through 2045-46. Note: Data provided by CalSTRS. UAO = unfunded actuarial obligation. Figure 13 Summary of Funding Plan Complexities and Challenges 9 Highly Complex, Theoretical Formulas. Complex formulas—that become increasingly complex over time— result in an ever-changing proportional division of total UAO between the state and employers, and leave some UAO unallocated. 9 Limited Rate-Setting Authority Paired With State Rate Sensitivity. The state’s contribution rate is sensitive to volatility in investment returns, while CalSTRS’ board has only limited authority to adjust the state’s rate, meaning: (1) CalSTRS cannot always adjust the state’s rate as needed in a given year to prevent the accrual of UAO, and (2) the state owes higher contribution amounts over time. 9 Counterintuitive, but Relatively Minor, Rate Outcomes for Employers. Employers’ contribution rate reacts to investment return volatility in a counterintuitive way—decreasing slightly when returns fall below actuarial assumptions—due to employers’ currently negative theoretical assets. 9 Ultimate Expiration of Funding Plan. Funding plan provisions are set to expire in 2046, meaning accrued UAO and future losses become increasingly difficult to address as CalSTRS’ time horizon to do so decreases. UAO = unfunded actuarial obligation. 14 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT RISKS TO FUNDING PLAN RECENTLY HAVE BECOME MORE APPARENT In this section, we describe how recent estimated the state faced a significant budget economic volatility, coupled with a state budget problem that required reductions in many areas action in 2020-21, underscores the risks to the across state government. In response to the budget ultimate success of CalSTRS’ funding plan. problem, one of the actions taken as part of the CalSTRS Actuaries Recommended Increasing 2020-21 Budget Act was to suspend the CalSTRS State Rate for 2020-21. In May 2020, the CalSTRS board’s authority to increase the state’s Defined board voted to increase the state’s contribution Benefit Program contribution rate in 2020-21 (in rate in 2020-21 by the maximum allowed amount other words, the board’s vote to increase the state’s (0.5 percent of creditable compensation) to ensure rate did not go into effect). This action resulted the state remained on track to meet the funding in estimated one-time General Fund savings of plan goal of eliminating its share of CalSTRS’ $169 million in 2020-21. UAO by 2046. Additionally, actuaries projected 2020-21 Budget Action Underscores at that time it would be necessary for the board Challenge Imposed by CalSTRS’ Limited to continue increasing the state’s rate by the Rate-Setting Authority. Given CalSTRS’ limited maximum allowed amount for two to three more authority to increase the state’s contribution rate, years to continue accounting for accrued UAO. in addition to the pre-existing actuarial need to CalSTRS Experienced Actuarial Loss for increase the state’s rate for several years, the 2019-20. Due to extreme market volatility in 2020-21 suspension may make it more difficult 2019-20 caused by the coronavirus disease 2019 for the state to reach the goal of fully funding the pandemic, CalSTRS did not meet its investment Defined Benefit Program by 2046. Specifically, return assumption for the year. Specifically, because of the 2020-21 suspension, the state’s CalSTRS investments returned 3.9 percent in contribution rate beginning July 1, 2020 is 2019-20, compared to the assumed 7 percent rate, 0.5 percentage points lower than it would have meaning CalSTRS experienced an actuarial loss of been in absence of the suspension. (We note that 3.1 percentage points. As noted in the preceding the administration took one-time action in 2020-21 paragraph, the state’s rate already was scheduled to offset this action and proposes additional to increase by the maximum allowed amount in one-time action for 2021-22. We describe these 2020-21 and for the following two to three years. measures in more detail in the next section.) To The loss CalSTRS experienced in 2019-20 means the extent that the system continues to accrue the state’s rate likely will continue to be actuarially UAO, this lower rate increases the risk that the required to increase beyond that period, probably funding plan may not meet its goal. In other words, for an additional three years or so. the budget action magnifies the risk that—even if CalSTRS’ board is able to increase the state’s rate 2020-21 Returns Remain Unclear. At this point by the maximum of 0.5 percentage points every in time, given ongoing market volatility, CalSTRS’ year through 2046—the state’s contributions would 2020-21 investment returns are unknown. However, be insufficient to completely pay down its share of year-to-date returns are positive and CalSTRS likely UAO by the end of the funding plan. Additionally, would meet or exceed its 7 percent assumption the state may need to pay more to CalSTRS over should current trends continue. CalSTRS’ long-term time. investment return expectation remains 7 percent. 2020-21 Budget Suspended Board’s Ability to Increase State’s Contribution Rate. At the time of the 2020-21 May Revision, the administration www.lao.ca.gov 15 AN LAO REPORT RECENT BUDGET ACTIONS AND PROPOSALS TO ADDRESS STATE’S SHARE OF UAO This section outlines the state’s recent supplemental payments of $1.1 billion in supplemental payments for the state’s share of 2019-20 and $297 million in 2020-21 toward CalSTRS’ UAO, as well as the administration’s the state’s share of CalSTRS’ UAO. The related proposal for 2021-22. 2021-22 Governor’s Budget proposes to use Similar to Past Actions, the Governor’s approximately $410 million of required debt 2021-22 Budget Proposes Some Steps to Help payment funding for the same purpose. We Funding Plan Stay on Track. Since 2019-20, the note that the 2021-22 proposed payment is state has made supplemental payments that help in line with our previous recommendations pay down the state’s share of CalSTRS’ UAO. The for allocating Proposition 2 debt payments. administration proposes similar actions in 2021-22. More information about our previous Past actions and proposed actions include: recommendations can be found in our March 2020 Proposition 2 analysis here. • 2021-22 Budget Proposes to Use • 2021-22 Includes a Proposal to Make Required Debt Payment Funding for One-Time State General Fund Payment. CalSTRS. In 2019-20 and 2020-21, the state The administration also proposes to allocate allocated part of its required debt payment $173 million General Fund in 2021-22 as a funding (pursuant to Proposition 2 [2014]) one-time additional payment to CalSTRS. to CalSTRS. Specifically, the state made LAO COMMENTS AND RECOMMENDATIONS 2021-22 Budget one-time payments would not address ongoing issues. In future years, the state’s rate will continue Proposed Supplemental Payment to CalSTRS to be 0.5 percentage points lower relative to what in 2021-22 Merits Consideration, but Would it would have been. Furthermore, the underlying Not Address Underlying Challenges. In light long-term risks to CalSTRS’ funding plan remain. of the 2020-21 budget action, which holds the Suggest Legislature Also Consider state’s contribution rate flat in the current year, the “Catch-Up” Mechanism. Considering the various administration’s proposed additional state General challenges facing the CalSTRS funding plan Fund payment of $173 million to CalSTRS in described in this report, the Legislature may wish 2021-22 makes sense as a way to offset the lower to consider implementing a catch-up mechanism, state rate for one year. The proposed amount— either in addition to or instead of the Governor’s equivalent to 0.5 percent of estimated creditable proposed one-time $173 million General Fund compensation—effectively would make up for the payment. Specifically, the Legislature could fact that the state’s rate will be 0.5 percentage consider allowing CalSTRS to increase the state’s points lower in 2021-22 than it would have been in rate more quickly—either beginning in 2021-22 or in absence of the 2020-21 rate increase suspension. a future year once the state has addressed current (Additionally, the administration’s proposal to pandemic-related challenges. For example, the allocate some required Proposition 2 debt payment Legislature could consider allowing CalSTRS’ board funding to CalSTRS would prevent added UAO to increase the state’s rate by up to 0.75 percent from accruing in 2021-22 and is consistent with or 1 percent of creditable compensation annually our past recommendation.) However, the proposed 16 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT (or some other amount greater than the currently legislative oversight of the plan’s progress. To allowed 0.5 percent) for a limited time while the eliminate these complexities, the Legislature state’s rate and contributions catch up to what they could consider directing CalSTRS to would have been absent any suspension. determine a fixed proportional split of total UAO between the state and employers (this Longer-Term Considerations split could be based on benefits that were In the Longer Term, Consider Addressing in place as of 1990, or based on some other Risks to Funding Plan Permanently. While the calculation). Simplifying these aspects of the recommendations above would help relieve some funding plan could help improve legislative pressures on the funding plan in the short term, the oversight, lessen the volatile effects of underlying structural aspects of the funding plan investment returns on the state’s actuarially that could impede its likelihood of success in the required contribution rate, and align impacts longer term would remain unchanged. To ensure of investment returns across the state’s and that the fiscal health of the pension system for employers’ actuarially required contribution California’s educators remains secure in the long rates. In addition, a fixed proportional split term, the Legislature could consider some changes would result in more predictable changes to to the provisions of the CalSTRS funding plan. both the state’s and employers’ contribution rates in response to future actuarial gains and • Allow CalSTRS to Increase State’s Rate by losses. More than 0.5 Percent Annually. Due to the • Make Provisions of Funding Plan Ongoing. 1990 benefit structure, the most significant Finally, part of the risk to the funding plan’s risk to the funding plan currently is that the success stems from its expiration in 2046. state will not be able to pay down its assigned Under funding plan provisions, CalSTRS’ time UAO by 2046 given the board’s limited horizon to address accrued UAO decreases authority to increase the state’s contribution each year and makes it very unlikely that rate. To address this challenge, the Legislature CalSTRS will be able to offset losses that could amend the funding plan provisions to occur near the current plan end date. The allow the state’s rate to increase by more Legislature could consider amending the than 0.5 percent of creditable compensation funding plan to make provisions ongoing (we annually. While this change would mean the note this could apply to current provisions state could pay more to CalSTRS in the near or the modified provisions we note for term, it also would strengthen CalSTRS’ ability consideration above). Given an indefinite time to pay down UAO by 2046 and ultimately horizon, rather than a constantly shrinking could generate savings in the long term. one, CalSTRS could adopt a standardized • Eliminate the Complex Theoretical amortization period (for example, a 20-year Calculations. The exceedingly complex time line) to address accrued UAO. For any theoretical calculations employed by CalSTRS new losses, liabilities could be isolated and result in an ever-changing proportional eliminated over a separate fixed period. division of UAO between the state and These approaches would better align with employers, extra sensitivity to investment industry best practices for paying down UAO, returns in terms of the state’s contribution and strengthen CalSTRS’ ability to continue rate, and counterintuitive (but less significant) ensuring the fiscal health of the pension impacts on employers’ contribution rate. system for the state’s educators in the long Combined, the complexities of the funding term, beyond 2046. plan may pose challenges to effective www.lao.ca.gov 17 AN LAO REPORT CONCLUSION The 2014 CalSTRS funding plan divides few years, these challenges to the funding plan responsibility for the Defined Benefit Program’s have become more apparent, and the state has UAO between the state and employers and aims to taken one-time actions to help keep the funding eliminate that UAO by 2046. To date, the plan has plan on track. We recommend the Legislature significantly increased contributions from the state continue to take action in 2021-22 to help ensure and employers to achieve this goal, and is on track the plan’s success. In the longer term, to increase to pay down most UAO over the next few decades. transparency and oversight, increase the likelihood The existence of the funding plan represents a that the state will be able to fully pay down its share significant accomplishment for the state and has of CalSTRS accrued UAO by 2046, potentially help put CalSTRS on a much more sustainable path. the state achieve significant long-term savings, and However, certain aspects of the funding plan allow CalSTRS to effectively address future losses impact its likelihood of success—most notably and UAO, we recommend that the Legislature CalSTRS’ limited authority to increase the state’s consider addressing some of the underlying contribution rate, which is particularly sensitive challenges to the plan. to volatility in investment returns. Over the past 18 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT APPENDIX GLOSSARY OF KEY TERMS Amortization Period. The time horizon over which the system makes up for losses (by RELATED TO PENSION FUNDS increasing contributions). Because the provisions of Throughout this report, we refer to terms the current CalSTRS funding plan will end in 2046, commonly used when describing pension funds. essentially, CalSTRS’ maximum amortization period We define those key terms here, in reference to decreases each year. the California State Teachers’ Retirement System Pension Fund Assets. The accumulated (CalSTRS). contributions of the state, employers, and Creditable Compensation. Amount of public members, in addition to investment returns, educator payroll that counts toward CalSTRS’ that can be used to pay benefits. Assets can be benefits calculations. Creditable compensation measured in terms of their actuarially determined includes educators’ salaries, as well as other value or their market value. eligible pay, such as pay earned for teaching a Pension Fund Obligations. Obligations, or summer school class. liabilities, represent the cost of benefits that the Contribution Rates. The amounts that the state, system owes based on accrued service for active employers, and members are required—by law and and retired members. given board authority—to contribute to CalSTRS, Unfunded Actuarial Obligation (UAO). When calculated annually as a percentage of creditable pension fund obligations exceed assets, the system compensation. has an unfunded actuarial obligation, also called an Actuarial Assumptions. Assumptions that unfunded actuarial accrued liability. actuaries make related to investment returns, Funded Status. An expression of the size membership and payroll growth, age of retirement of the system’s assets relative to obligations, and life expectancy for retirees, and other aspects often conveyed as a percentage. For example, that impact CalSTRS’ projected benefits payments, CalSTRS is 66 percent funded as of its most recent contributions, and revenues. For example, CalSTRS actuarial valuation. This means the system’s assets currently assumes that investments will generate an can cover approximately two-thirds of its total annual return of 7 percent, and that teacher payroll obligations. will grow by 3.5 percent each year. Public Employees’ Pension Reform Act Actuarial Losses. Occur when the system (PEPRA). PEPRA of 2013 (Chapter 296 of 2012 fails to meet actuarial assumptions. For example, [AB 340, Furutani]) made changes to pension when CalSTRS’ investments fail to return 7 percent benefits structures for public employees, including in a given year (for example, actual returns are teachers. As a result, CalSTRS’ benefits for 6 percent), CalSTRS experiences an actuarial loss. members hired prior to when PEPRA took effect Normal Cost of Benefits. For CalSTRS, (January 1, 2013) are different from benefits for the normal cost of a member’s Defined Benefit those hired after PEPRA took effect (January 1, Program benefits is the annual cost applied to each 2013 and later). CalSTRS members who are not year of the member’s service that is necessary to subject to PEPRA are also referred to as “2% at 60” adequately fund the benefits over time. members, while those subject to PEPRA are also referred to as “2% at 62” members. Actuarially Required Contribution Rates. Based on actuarial assumptions, the system’s actuaries determine how much contributors must pay to cover the normal cost of benefits and to pay down any UAO, often over a certain amortization period. www.lao.ca.gov 19 AN LAO REPORT LAO PUBLICATIONS This report was prepared by Angela Short, and 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. 20 LEGISLATIVE ANALYST’S OFFICE