Analysis of the 2005-06 Budget Bill Legislative Analyst's Office February 2005

School District Financial Condition

School districts face a number of difficult financial challenges in 2005-06 and beyond, including falling revenues due to declining enrollment and long-term costs for retiree benefits.

School districts have not been immune to budget cuts during this current fiscal crisis. Midyear cuts reduced funding for categorical programs and mandates in 2002-03. In 2003-04, no cost-of-living adjustments (COLAs) were provided and the state actually reduced district general purpose funding by a small amount. In 2004-05, schools received a COLA and a partial repayment of the cut in general purpose funds. The 2005-06 proposed budget promises another COLA and partial general purpose funding restoration.

During this time, a significant number of districts also began losing students due to demographic changes in the K-12 population. As enrollment fell several years in a row, so did state funding for these districts. Recent data suggest that 40 percent of districts statewide experienced declining enrollment for both 2002-03 and 2003-04. The decline in district enrollments combined with modest increases in state funding over this period translated into flat or declining revenues for many districts.

Looking to 2005-06, school districts face a number of revenue and cost pressures (see Figure 1). Declining enrollment will continue to affect many districts. In fact, our projection of K-12 enrollments shows very little growth during the next five years. These losses reduce district revenues, requiring budget cuts at the local level.

The figure also lists three other types of financial pressures facing districts. Districts must restore, beginning in 2005-06, unrestricted reserves and maintenance spending to levels required by the state. As part of the 2003-04 budget plan, the state allowed districts to reduce general purpose reserve levels, cut spending on maintenance, and transfer available categorical fund balances at the end of 2002-03 into the districts' general fund. In 2005-06, districts must restore reserve levels and maintenance spending to the state-required levels. For districts that used the full flexibility afforded by the state, the cost of restoring reserves and maintenance spending equals about 2.5 percent of local budgets.

Based on our discussions with district and county fiscal officers, districts also are under pressure to get their operating budgets back in balance. In many cases, they have taken one-time actions to help finance spending that is above ongoing revenues. The figure shows some of the more common practices, including borrowing from other district funds (such as self-insurance funds) and using one-time funds for ongoing expenses. All of these practices can be justified as reasonable short-term actions if they are accompanied by a plan for ending the practice. Failure to end them—that is, by aligning ongoing revenues and expenditures and repaying internal borrowing—often results in a bigger problem as time goes on.

Districts also face several significant cost increases in the budget year. Health insurance costs have been increasing at annual rates above 10 percent over the past several years, affecting the cost of current employees and retirees whose health benefits are covered by districts. Salary costs are also a concern; since employee salaries comprise the largest component of local budgets, any increase in wages has a major impact on district finances.

Districts With Financial Problems Increasing. Preliminary information for 2004-05 suggests an increasing number of districts need to take steps to remain financially healthy. The state maintains a fiscal oversight process (known as the AB 1200 process) that makes county offices of education (COEs) responsible for reviewing school district budgets and assisting districts that are experiencing financial difficulties. Twice each year, COEs certify the fiscal condition of districts—that is, they report the likelihood that each district will be able to meet its financial obligations over the next three fiscal years. The first 2004-05 reports were due to the State Department of Education (SDE) on December 15, 2004.

While these first 2004-05 reports were not available at the time this analysis was written, the Fiscal Crisis and Management Assistance Team (FCMAT) projects an increase in the number of districts given a "qualified" or "negative" certification. This team is established in state law to provide fiscal and management assistance to school districts and COEs. A qualified rating means the district may not be able to meet its financial obligations. A negative certification means the district will not be able to meet its obligations in the current or subsequent fiscal year. A negative or qualified certification initiates the development of a plan for addressing the causes of the district's financial instability.

The FCMAT projects the number of negative or qualified districts will increase in 2004-05. It expects 11 districts to receive a negative certification, up from 9 last spring. In addition, it expects 44 districts to receive a qualified certification, an increase from 36 in spring 2004. In addition to these districts, we know of several districts that made midyear reductions in order to avoid a negative or qualified certification. While the number of districts with a negative or qualified certification is still relatively small, the increase reflects the fiscal pressures districts face. We think the pressure is likely to mount in spring 2005, when districts begin their budget planning for next year in earnest.

In the following sections, we recommend the Legislature address two financial pressures faced by districts. The first is the problem of long-term retiree health benefits. Many districts face large liabilities for future retiree health care costs. We think the state needs to begin a process for recognizing these costs and requiring districts to develop plans for addressing long-term liabilities for these benefits.

The second issue is declining enrollment. Because statewide growth in the K-12 population is likely to be stagnant for the next five years, declining enrollment is likely to affect the majority of districts in the state. We suggest the Legislature consider an alternate declining enrollment funding formula that would give districts more time to adjust to the financial impact of fewer students.

Retiree Benefits Pose Long-Term Challenge

We recommend the Legislature require county offices of education and school districts to take steps addressing districts' long-term retiree health benefit liabilities.

In 2004, the Governmental Accounting Standards Board (GASB) issued a new policy describing how state and local governments (including schools and community colleges) must account for nonpension retirement benefits such as health insurance. For K-12 and community college districts, the GASB policy requires each district to include its long-term liabilities for post-retirement benefits in its annual financial statement. One component of this new liability statement is an identification of the amount that, if paid on an ongoing basis, would provide sufficient funds to pay for benefits as they come due.

In other words, GASB requires districts to account for health and other retirement benefits similarly to the way they account for pension costs. For retirement, an amount is contributed to a fund each year for each employee. Over the years, these payments are set at a level sufficient to pay for the full cost of retirement benefits for the average employee. In effect, the retirement benefits are "prefunded"—that is, their costs are provided for over the working life of the employee. (Also, contributions are set aside in a special "trust" fund so they cannot be used for any other purpose.) The new GASB policy encourages districts to pay for retiree health benefits in the same way, thereby avoiding the accumulation of large unfunded liabilities for future benefits. The GASB policy, however, does not require such annual payments or public agencies to act on any past liabilities—it only requires the reporting of such liabilities. We are not aware of any school district that has prefunded its retiree health benefits. Instead, these costs are paid out of districts' operating budgets as they are incurred by retirees.

Some District Liabilities Are Huge

The liabilities some districts face are very large—so large they potentially threaten the district's ability to operate in the future. For instance, Los Angeles Unified School District (LAUSD) estimates its current "actuarial liability" for retiree health benefits at $5 billion. This figure is the amount the district would need to place in an interest-bearing account in 2005 to pay for these benefits over time. To provide a sense of the size of this liability, the $5 billion estimate for LAUSD is the equivalent of about 80 percent of the district's general purpose annual operating budget. Other districts face a similar problem. Fresno Unified estimates its liability at $1.1 billion—almost twice its annual budget. The cost for both districts is very high because each provides lifetime health benefits to retirees.

While these costs are not yet at a stage that will seriously erode the district's ability to function, both districts are experiencing rapidly increasing annual costs for these benefits. In Los Angeles, for instance, the district budget includes about $170 million for retiree health benefits in 2004-05. The district estimates the annual cost of these benefits will grow to about $265 million by 2010 and $360 million by 2015. The district would have to add $500 million to the budget—about 8 percent of its overall budget—starting next year and continuing for the next 30 years to pay off its unfunded liabilities and prefund future retiree health benefits.

Weak District Incentives to Face Liabilities. Districts do not have much incentive to address this problem. In the short run, the need to set aside funds for this obligation would only complicate budgeting as it would reduce funding available for other local priorities. Furthermore, any financial crisis resulting from these liabilities may be years or decades away. For these reasons—and especially given the number of financial pressures districts currently face—districts will be reluctant to take the needed steps to address this problem. There is one way, however, that the new GASB policy may prod districts to address these liabilities. Large liabilities could affect a district's bond rating and increase the costs of borrowing. Pressure from credit agencies, therefore, represents one of the few short-term incentives for addressing retiree costs that will result from the new policy.

Liabilities Could Be Even Larger. Districts may also have an incentive to understate their actual liabilities. The GASB policy left many details of the actuarial calculation of liabilities to local agencies. While this makes sense given the range of state and local agencies affected by this policy, it also allows local agencies the ability to make assumptions that minimize their apparent liability. Small changes in the underlying assumptions used in these studies have a major impact on the results. For instance, the LAUSD's actuarial study determined a $5 billion actuarial liability using "best estimate" assumptions. This figure increased to $7 billion if all current and retired employees were included in the calculation instead of retirees plus those employees whose health retirement benefits are vested. Moreover, the figure grew to $11 billion if the long-term interest rate the district would earn on its annual contributions was reduced from 6 percent to 4 percent. Thus, we think it is in the state's interest to ensure districts use reasonable assumptions in their actuarial studies.

Require District Plans for Addressing Liabilities

The size of retiree health benefit liabilities is so large that unless steps are soon taken to address the issue, it seems likely that districts will eventually seek financial assistance from the state. As a first step, we think the Legislature needs to establish a process for ensuring that districts identify and address the liabilities created by post-retirement benefits. Currently, there is no state or local process for collecting information on the financial liabilities districts presently face or whether districts have a plan for addressing these liabilities. In addition, the long-term liabilities of retiree benefits are not part of the AB 1200 district fiscal review process. As a result, COEs are not always aware of which districts provide retiree benefits or the magnitude of the costs for those benefits.

About 150 districts present the most serious problem. Of these, 70 districts provide lifetime health benefits to retirees and represent the districts that probably have the most serious fiscal problem. Another 80 districts provide health benefits from the time an employee retirees to a specific age—most commonly age 70. These districts also may face significant fiscal challenges.

To address this problem we recommend the Legislature enact legislation to achieve the following:

Require districts to provide COEs by October 1, 2005, with a copy of any actuarial study of its retiree benefits liability. Until the GASB issued its new policy, the state required districts to assess their outstanding liabilities for certain post-retirement benefits every three years. The COEs should receive a copy of these studies so they are informed of the size of any existing liabilities.

Require districts to provide COEs by June 30, 2006, with a plan for addressing retiree benefits liabilities. The GASB policy requires large local agencies to make public data on retiree benefit liabilities beginning in 2007. Because of the prior state requirement and the new GASB policy, most districts with significant liabilities are aware of the problem. We think encouraging districts to develop a plan for addressing these long-term liabilities as soon as possible is in the districts' and state's interest. These plans could address district liabilities in several ways including prefunding benefits, restructuring or eliminating benefits for new employees, and partial prefunding that protects districts during years when benefit costs are high.

Modify AB 1200 to require COEs to review whether districts' funding of long-term liabilities adequately cover likely costs. This change would have two elements. First, COEs would assess whether districts are following their plan for addressing the long-term liabilities for retiree benefits. This review would occur each time districts revise their actuarial estimate of liability. Second, SDE would add to existing AB 1200 regulations new guidelines for the development of future actuarial studies of retiree benefits. This would ensure that district studies used reasonable assumptions in their assessment of local liability.

Require SDE to report to the fiscal committees by December 15, 2005 on the size of retiree health liabilities in the 150 districts that provide the most extensive benefits. This would inform the Legislature's discussion about any future steps that may be needed to deal with this problem.

Create a New Declining Enrollment Option

We recommend the Legislature adopt legislation to establish an alternate declining enrollment formula that would give districts more time to adjust to the financial impact of fewer students. Our recommendation would create no additional state costs in 2005-06 but would probably result in a 2006-07 cost of $80 million to $100 million. This cost would grow modestly over time until districts reach their equalization targets.

Each district is assigned a unique revenue limit, or per-pupil funding rate. Revenue limits are comprised of two main parts. First, each district receives a base revenue limit, which accounts for 95 percent of the amount of revenue limit funds provided to districts. Base revenue limits are determined largely by historical factors, including a district's spending levels at the time Proposition 13 was approved by voters in 1978. Since then, the Legislature has added "equalization" funding to revenue limits several times to reduce differences among districts in base revenue limits.

Second, the other 5 percent of revenue limit funding is for ten "add-on" programs. These add-ons, for instance, include funding for minimum teacher salary incentive programs, the Unemployment Insurance program, and longer school day and year incentives. Since districts receive significantly different amounts from these adjustments, the add-on programs introduce a second factor contributing to differences in district revenue limits among districts.

In our past reports on K-12 finance, we have recommended the Legislature address these two problems. In our view, most of the differences in revenue limit funding levels among districts have no analytical basis. Instead, most of the variation stems from decisions made during the 1970s and 1980s that have little policy relevance today. To correct these problems, we have recommended the Legislature make progress in equalizing revenue limits. We have also recommended consolidating most of the add-on funding into base revenue limits so that the Legislature could equalize the amount of general purpose funds districts actually receive, not just the amounts represented by base revenue limits.

Recently, the Legislature made revenue limit equalization a funding priority. The 2004-05 Budget Act provides $110 million for this purpose, setting the goal of equalization at the 90^th percentile of all districts within each size and type. The 2005-06 budget proposal does not include any new funds to continue progress towards more uniform base funding levels.

Declining Enrollment Affects Many Districts

Another feature of the revenue limit system is known as the "declining enrollment adjustment." This adjustment gives districts a one-year reprieve from funding reductions caused by declining attendance. Technically, the adjustment allows districts to claim the higher of the current or prior year's average daily attendance (ADA). Since, in declining enrollment districts, the prior-year total exceeds the current-year ADA, the adjustment maintains a district's previous year's funding level (increased by a COLA).

A fall in the number of elementary school age students in California is creating declining enrollment in many school districts. In 2003-04, elementary and unified districts reported that 13,800 fewer students were enrolled in grades K-6 than in the previous year. This net decline is relatively small—only a 0.4 percent reduction in enrollment. However, the net figure masks the fact that the losses are not uniform across the state.

Forty Percent of Districts Are Declining. The most recent data available show that 412 districts (or 42 percent) experienced declining enrollments in 2003-04. The data suggest that attendance in most of these districts fell in both 2002-03 and 2003-04. The declining enrollment adjustment cost the state about $130 million in 2003-04.

The typical declining enrollment district lost 1.7 percent of its previous year's ADA. About one-fifth of districts reporting declines, however, lost more than 5 percent of their students. Districts of all sizes are experiencing falling enrollment. Most are small—about half enroll fewer than 1,000 students. Thirty-nine of the declining districts, however, are large, enrolling more than 10,000 students.

Declining revenues associated with falling enrollments create difficult fiscal issues for districts. Falling enrollments mean that districts need fewer teachers. As districts stop hiring new teachers, the average teacher salary grows (simply because districts have more experienced, higher wage staff whose salaries are not offset by newer, lower-wage staff), which requires additional cost reductions. If the decline is large or continues over an extended period of time, districts typically need to close schools.

School fiscal experts advise that districts should accommodate declining enrollment by making cost adjustments before the decline actually occurs. Often, enrollment trends are known in advance. In some cases, however, falling enrollments can occur relatively quickly. Enrollment increases in one year may be followed by sharp declines in the next—with no transition year in between. In these instances, or when districts fail to adequately plan for sustained reductions in enrollment, the financial consequences can be severe.

Our fall 2004 estimate of future K-12 attendance growth projected a continuing decline in the growth rate of the student population. By 2008-09, we estimate no growth in ADA statewide. As a result, we expect declining enrollment will play an important role in district finance for several years. Many districts that are currently declining will continue to lose students. A portion of districts that are still growing will become declining enrollment districts in the near future.

Option: Permanently Increase Revenue Limits

For districts that face significant long-term reductions in ADA, the existing declining enrollment adjustment may not provide a sufficient amount of time for districts to adjust to the fiscal consequences of falling enrollments. In the first year of decline, the adjustment maintains the prior-year funding level (plus a COLA). Beginning in the second year of ADA reductions, however, districts lose revenue limit funding commensurate with the size of the ADA decline in the previous year. While the declining enrollment adjustment actually provides a series of one-time financial benefits to districts in this situation, the current formula still requires districts to ratchet down their annual spending as enrollment falls.

There are two basic ways the Legislature could help districts facing multiyear enrollment declines. First, it could expand the existing temporary protection, such as extending the funding adjustment to two years. This would provide districts with an additional year of constant funding before the impact of falling attendance reduced total revenue limit funding.

The second way is to provide a more lasting adjustment. We propose an option that increases revenue limits by an amount sufficient to offset the enrollment decline. This option would allow a district to maintain its prior-year level of funding over time. By allowing this option to be used only by districts which are below the state's equalization target, it would have the dual benefit of helping the state make progress toward its equalization goal.

How Would This Option Work? Figure 2 illustrates the difference in the impact of the current adjustment and our alternative adjustment in a hypothetical district that experiences falling attendance over many years. The dark line shows how total revenue limit funding would decline without any funding adjustment; revenues would fall with enrollment. The existing declining enrollment adjustment is shown as a parallel line to the "no adjustment" scenario. The current adjustment delays the revenue reduction of falling attendance by one year. As a result, after one year of holding the district harmless from the effect of falling enrollment, the district experiences annual cuts in revenues equal to the previous year's reduction in attendance.

Our proposed declining enrollment adjustment would operate quite differently. As the figure illustrates, total revenues for the hypothetical district would stay constant for several years. During this time, the district's per-pupil revenue limit would be increased annually to offset the fall in attendance and keep total funding constant. In year five, however, the revenue limit increases cause the district to reach the state's equalization target. After that point, the district no longer qualifies for our proposed adjustment, and further enrollment declines reduce district revenues.

Proposal Helps Districts, Makes Progress Towards Equal Funding. Our proposed revenue limit increase has two main advantages over the current declining enrollment formula. First, it provides a higher level of funding protection for most districts that are losing students. This increase in a district's per-pupil revenue limit would be permanent—it would not revert back to its previous level the next year as the current ADA adjustment does. Per-pupil revenue limit adjustments would continue only until the district reaches the state's equalization target. Since almost all districts are within about 10 percent of the state's equalization target, districts experiencing significant, sustained, declines would reach the 90^th percentile funding level relatively quickly.

The second advantage of our proposal is that increasing district revenue limits to the state's equalization target makes progress on another state priority—a system of uniform revenue limits. Currently, districts are required to reduce spending due to declining enrollment regardless of whether they receive less per pupil than other similar districts. By holding total funding constant from year to year, the state can make progress towards its goal of reducing these differences.

Another advantage of our proposal is that the revenue limit adjustment would occur automatically. Like the existing adjustment, our proposal would automatically increase district revenue limits to compensate for declining enrollments. The Legislature would not be required to make a specific appropriation in the budget. Funds would flow to districts as part of the existing statutory appropriation. In this way, the state would make annual progress towards a more equal system of revenue limits.

It is important to recognize our alternate adjustment has a long-term cost. Since our proposal would generate the same amount of revenue limit funding to districts in the first year as the existing adjustment, our formula would not create any additional cost in 2005-06. Beginning in 2006-07, however, our formula would provide these districts a higher level of funding. Data are not available to allow us to make a precise estimate of the cost of this formula. Depending on the number of districts in decline and the size of the declines, the cost could total between $80 million and $100 million in 2006-07. This cost probably would increase modestly each year until districts reach their equalization targets. The total possible cost of the formula, however, cannot exceed the amount of funds needed to equalize revenue limits to the 90^th percentile for all districts. We calculate this amount to be about $300 million.

Add a Declining Enrollment Revenue Limit Adjustment

We recommend the Legislature adopt legislation to create a new declining enrollment revenue limit adjustment that would begin in 2005-06. As discussed earlier in this section, we are concerned by the size and number of financial pressures districts currently face. We also see enrollment declines as a statewide problem that probably will continue for some time. Based on our K-12 enrollment projections, the financial pressures associated with declining enrollment will continue for at least the next five years. Our proposal is not intended to prevent declining districts from making cost reductions warranted by a long-term fall in ADA. Instead, our formula would give districts a longer period for adjusting to the financial pressures created by falling attendance.

Our analysis also suggests another way the Legislature could help declining enrollment districts and make progress towards a more uniform funding system—providing additional equalization funding for all districts. Equalization funding would help both declining and growing districts with revenue limits below the state's equalization targets.

We also recommend two additional steps that we think should accompany this new formula, as follows.

Limit Increases to 5 Percent. As discussed above, about one-fifth of the current declining enrollment districts experienced reductions of more than 5 percent in 2002-03. Districts that sustain such large declines in student attendance need to make immediate efforts to bring costs into line with revenues. Therefore, we recommend the Legislature limit annual revenue limit increases to 5 percent. Under our proposal, a district that lost 10 percent of its ADA would be able to choose between our formula (which would provide an ongoing 5 percent increase) and the existing adjustment (which would provide a one-time 10 percent increase).

Consolidate "Add-On" Funding Into Revenue Limits. The state's equalization targets focus on differences in district base revenue limits. As noted above, however, the revenue limit add-on funds alter the distribution of revenue limit funding. As a consequence, successfully bringing all district base revenue limits to the state's equalization targets would not eliminate funding disparities introduced by the add-ons. As part of our alternate declining enrollment formula, therefore, we recommend the Legislature merge most of the add-on funds into base revenue limits and reset the equalization targets based on the consolidated amounts.