A Review of the CalSTRS Funding Plan

Funding Plan May Not Meet Principle of “Shared Responsibility”

This post is the sixth in a series looking at the implementation of the CalSTRS funding plan. Below, we describe how the plan might fall short of meeting the principle of “shared responsibility,” a key goal of the Legislature in passing the plan. Specifically, we explain how the state may not incur higher costs under the funding plan.

Update. As noted on the homepage of this series, the CalSTRS board voted in June 2016—after we published this series—to maintain the state’s contribution at its fully phased-in level until the state’s share of CalSTRS’ unfunded liabilities is eliminated. In other words, this change keeps the “express elevator” described below from eliminating the state’s funding plan contribution until the state’s share of the unfunded liability has been amortized. Over the near term—perhaps the next decade or so—annual state contributions to CalSTRS will be hundreds of millions of dollars higher than the “current projections” shown in Figure 1 and Figure 2 below. Over the longer term, the change produces state savings, offsetting the higher near term costs and reducing state contributions below what they otherwise would have been. Because the amendment mostly changes the timing of state contributions to CalSTRS, it does not fundamentally change our findings described below.

Principle of Shared Responsibility. During the legislative debate on the CalSTRS funding plan, administration officials and some legislators stressed the importance that state, district, and teacher contributions increase to ensure that all three groups would share in the costs to pay down CalSTRS’ unfunded liabilities. For example, in a hearing of the Senate Budget and Fiscal Review Committee, an administration official commented that “everyone will be contributing more.” The administration continues to stress this principle, as the Governor’s January 2016 budget summary describes the funding plan as “based on a model of shared responsibility.” Below, we examine whether the state will incur incremental costs as a result of the funding plan—that is, whether the state’s funding plan contributions will exceed what they would have been under prior law.

Projected State Costs Much Lower Than in May 2014. Figure 1 compares CalSTRS’ May 2014 projections of the state’s funding plan contribution with CalSTRS’ most recent projections. (We have updated the May 2014 projections to reflect the most recent teacher payroll data.) By 2019-20, state contributions are currently projected to be over $1 billion less than expected when the Legislature considered the funding plan in 2014. As we described in our third post, the abstract calculation central to the funding plan implementation gives the state the benefit of theoretical investment gains that do not exist in the real world. These theoretical investment gains have shifted some of the state’s responsibility for CalSTRS to districts, resulting in lower projections of state costs compared to CalSTRS’ May 2014 projections.

Whether State Shares in Responsibility Depends On Future Investment Experience. As we described in our second post, the funding plan—as implemented—makes the state responsible for an estimate of what CalSTRS’ unfunded liabilities would be today if the state had made different decisions about teacher pensions in the past. This is the same responsibility the state had under prior law. The key difference is that—under prior law—the state’s contribution was capped at around 3.5 percent of statewide teacher payroll. Over the long term, the funding plan makes it possible for state contributions to be much higher than this prior law cap if, for example, investments underperform assumptions. Essentially, whether the state incurs incremental costs under the funding plan—that is, whether the state shares in the responsibility of addressing CalSTRS’ unfunded liabilities—depends upon future investment experience.

If Investments Meet or Exceed Assumptions, State Does Not Share in Responsibility. As described above, the abstract calculation central to the funding plan has shifted some of the state’s responsibility for CalSTRS to districts. Compared with estimates from 2014, this means that fewer state contributions are necessary to pay down the state’s share of the unfunded liability. Moreover, it seems that the state’s prior law contributions would have been sufficient to pay down the current estimate of the state’s share. As shown in Figure 2, current projections suggest that the funding plan accelerated what the state would have paid anyway. Specifically, beginning in 2018-19, state contributions under the funding plan are estimated to be lower than they would have been under prior law. This trend would continue through the mid-2040s, making the state’s total funding plan contributions roughly the same as total contributions would have been under prior law. In other words, current projections suggest that the state will not share in the responsibility of addressing CalSTRS’ unfunded liabilities. This does not assume a potential decrease in the key assumption concerning future investment returns, which could increase the current projection of the state’s funding plan contribution by roughly $1 billion in 2017-18.

State May Share in Responsibility Under Other Scenarios. If near-term investment returns fall short of assumptions—and recent stock market performance indicates this will be the case—the state’s share of CalSTRS’ unfunded liabilities will increase and state contributions to CalSTRS may be hundreds of millions of dollars above funding plan levels shown in Figure 2 beginning in 2017-18. The state would share in the responsibility for CalSTRS’ unfunded liabilities under this scenario—at least in the near term. Moreover, if investment returns fall far short of assumptions over the long run, state contributions to CalSTRS could be billions of dollars higher by the 2040s. We described this in greater detail in the fifth post in this series. We note that state contributions could also be much higher than under prior law if CalSTRS lowers its assumption concerning future investment returns.

Near-Term Investment Returns Will Not Settle This Issue. We caution against placing too much emphasis on near-term investment returns because a feature referred to as the “express elevator” can eliminate the state’s supplemental funding plan contribution after a large investment gain. In other words, even if investments fall short of the CalSTRS’ target in the near term, a large investment gain a few years from now could eliminate the state’s share of the unfunded liability and reduce the state’s funding plan supplemental payment to $0. Instead, we suggest that observers focus on long-term investment scenarios. Because the state would not share in the responsibility for CalSTRS if investments meet assumptions, and because CalSTRS considers its investment assumption to be a roughly median return scenario, there is a good chance that the state will incur little or no incremental costs under the funding plan. (We note that the state would continue to make other contributions unaffected by the funding law.)

Administration’s Recent Budget Forecasts Have Failed to Reflect These Developments. Recent administration budget forecasts, including the administration’s January 2016 forecast, have held the state contribution rate in 2017-18 at the 2016-17 level. By failing to show a decrease in state contributions in 2017-18, the administration’s forecast has neglected to show the effects of recent large investment gains—both real and theoretical—on the state’s contribution rate. Accordingly, the administration has arguably overstated General Fund spending in 2017-18 by over $800 million, growing to over $1 billion by 2019-20. One possible explanation could be that the administration assumes a roughly 14 percent investment loss in the current fiscal year—the investment return scenario necessary for the state rate to stay flat in 2017-18. This scenario, however, would be inconsistent with the administration’s economic and revenue forecasts, which generally have assumed continuing stock price growth.

Changes Might Be Necessary to Reflect Legislative Intent. Depending upon how investment and other actuarial experience plays out, changes to the funding plan might be necessary to ensure the funding plan matches legislative intent. Specifically, if investments generally meet CalSTRS’ assumptions, the Legislature may need to increase the state’s contribution to ensure the state shares in the costs of addressing CalSTRS’ unfunded liabilities. We note that higher contributions could be counted toward meeting Proposition 2’s debt payment requirements.