February 2, 2016

A Review of the CalSTRS Funding Plan

CalSTRS Funding Plan Relies on Abstract Calculation

This post is the second of a series looking at the implementation of the CalSTRS funding plan. Below, we critique the complex calculation central to the funding plan.

Plan Seemed Relatively Simple to Us. When the Legislature passed the funding plan in 2014, we understood it to be a relatively simple approach. The total $74 billion unfunded liability would be divided up between school and community college districts ($47 billion), the state ($20 billion), and teachers ($8 billion). As we understood the plan, districts and the state would share in investment gains and losses roughly in proportion to the amounts they owe. In other words, when CalSTRS records a large investment gain, we thought most of the gain would be used to reduce the district share of unfunded liabilities with the rest reducing the state share.

Funding Plan Instead Relies on Abstract Calculation. Instead of the simple proportional approach described above, CalSTRS is interpreting the law so that state and district shares of the unfunded liability will change annually based on the outcome of an “alternate universe” calculation. The calculation estimates what CalSTRS’ funding situation would be today had the state made different decisions about teacher pensions in the past. Specifically, the calculation estimates what CalSTRS’ unfunded liabilities would be if (1) the state never granted teachers more generous pensions in the late 1990s and (2) contributions to CalSTRS’ main pension fund had not been decreased when CalSTRS was fully funded around 2000. (The calculation also excludes the effects of pension change legislation passed in 2012 known as “PEPRA.”)

If the state had made these different decisions in the past, the calculation shows that CalSTRS’ unfunded liability would be smaller today. In general, the state will pay for these smaller theoretical unfunded liabilities—as determined by the calculation—while districts will pay the difference between total real world unfunded liabilities and the state’s share. Because districts pay for the balance, the district share will increase when the state share decreases and vice versa. Unlike our earlier understanding of the plan, the state will generally receive exclusive benefit of asset gains and, by the same token, would shoulder essentially all unfunded liabilities resulting from investments underperforming assumptions.

Alternative Universe Calculations Subjective. The funding plan’s central calculation is subjective. Applying different assumptions in administering the calculation would result in different outcomes for the state and districts. For example, had no changes been made to CalSTRS’ main pension program since 1990, teachers would have earned less generous pension benefits beginning in the late 1990s. If teachers were receiving lower overall compensation, districts would have faced pressure to pay teachers higher salaries. In administering the calculation, however, CalSTRS does not assume that higher salaries would have been paid to teachers.

Because teachers and districts contribute a fixed percentage of payroll, a different choice to assume that teachers would have earned higher salaries would have resulted in more teacher and district contributions to CalSTRS. Because pension benefits are based on salaries, these higher salaries would have in turn led to more generous benefits, offsetting the effects of the higher contributions to some degree. Nevertheless, compared to the way in which CalSTRS is currently administering the calculation, this different choice would seemingly result in a different state share of CalSTRS’ unfunded liabilities and a correspondingly different district share.

Problematic to Base CalSTRS Funding on These Calculations. There is no good option to adjust this calculation to fix this or other issues. Any adjustments to “improve” the calculation would be mostly subjective. We offer the example above to show how the calculation fails to reach meaningful results. Because the outcome of this calculation lacks meaning (and will be even more subjective and strange years from now), in our view it would be deeply problematic to base CalSTRS funding on this alternative universe calculation for decades to come.

Complexity Weakens Oversight. In November 2014, CalSTRS’ consulting actuary introduced the details of the proposed funding policy to the CalSTRS board as follows: “This is probably the most difficult thing I’ve had to explain to a board in my entire career.” Pensions are very complex. But the staggering complexity of this funding plan as it has unfolded makes it harder for the Legislature, the Governor, the CalSTRS board, teachers, and the public to understand how teacher pensions are funded. This weakens oversight of the funding plan, adds complexity to an already complex program, and will cause confusion about teacher pensions.