The California State Teachers’ Retirement System (CalSTRS) has released the proposed June 30, 2010 actuarial valuation of its defined benefit pension program for teachers and administrators of school and community college districts. This item discusses the defined benefit program valuation, thereby updating prior analysis items on our website related to this retirement system.

Background

What Are Unfunded Pension Liabilities? This item will discuss CalSTRS’ unfunded liabilities. For pension systems, the unfunded actuarial accrued liability (UAAL) or unfunded actuarial obligation (UAO), as CalSTRS describes it, is an estimate of the portion of future benefits already earned by current and past workers that are not funded from available system assets. Put another way, the UAAL represents an estimate of the additional amount of money that employers, employees, and/or the state would have to contribute in one lump sum today in order to generate enough investment returns to fund all future pension benefits already earned by current and past workers.

Not Due Immediately…But Delay Tends to Increase Costs. Unfunded liabilities do not have to be paid immediately. Typically, public employers are required by pension contracts to fund and fully amortize UAALs over roughly a 30-year period. It is important to note, however, that delaying full amortization of UAALs tends to increase—sometimes substantially—the eventual cost for providing a given set of pension benefits. This is because delay reduces the amount of time that a pension system has to generate investment earnings off of each dollar of contribution. Put another way, $1 contributed to CalSTRS today has 30 years to generate investment earnings before paying benefits to a community college instructor who retires in 2041. By contrast, $1 contributed to CalSTRS in 2016 for that same instructor has only 25 years to generate investment earnings before paying a benefit in 2041.

CalSTRS Unlike Other Systems—No Current-Law Payments to Pay Down Liabilities. CalSTRS differs dramatically from nearly all other major public pension systems in that it has virtually no ability to independently set rates in order to ensure that UAALs are amortized within a reasonable time frame. Instead, state law generally sets the rates paid each year by CalSTRS members, districts (which employ teachers), and the state. For this reason, in recent years, CalSTRS actuaries have determined repeatedly that based on the defined benefit program’s assets, future current-law contributions, and assumed future demographic and other trends concerning California’s teachers, the system’s UAAL “will not be amortized over any future period” (emphasis added). This means that if current-law contributions to the system are unchanged, the system will eventually be unable to fund promised benefits. CalSTRS actuaries have estimated that this point would arrive in the early 2040s if current-law contributions are unchanged. Pension systems have extraordinarily long-lived liabilities—in some cases, promised benefits required to be paid out 50, 75, or 100 years from now—and therefore, indications of funding stress within just two or three decades are of significant concern.

In Recent Decades, Policy to Fully Fund CalSTRS Liabilities. Despite the unusual features described above concerning CalSTRS’ generally fixed contribution sources, the state has embarked upon a concerted effort in recent decades to improve CalSTRS’ financial health. In 1972, the Legislature enacted the E. Richard Barnes Act to begin prefunding CalSTRS’ liabilities. During the 1970s and 1980s, the system’s funded ratio (an actuarial calculation of the system’s assets divided by its liabilities) grew from below 40 percent to nearly 80 percent. In 1990, the Legislature enacted the Elder State Teachers’ Retirement Full Funding Act, which contributed (along with robust investment returns during the 1990s) to the system reaching a 100 percent funded status in the late 1990s. Thereafter, the system’s funded status (summarized below) has declined due to weak investment returns in several years, benefit enhancements in 1999 and 2000, and other factors.

Policies established through voter-approved measures also have supported efforts to move CalSTRS and other pension systems toward full funding. In 1970, Proposition 6 led to CalSTRS being able to invest in stocks on a limited basis in order to increase investment returns of the pension fund. In 1984, Proposition 21 deleted the remaining constitutional provisions on stock investments, replacing it instead with a "prudent person" investment requirement for California's public pension systems. In 1992, unions and retiree groups led the effort to pass Proposition 162, which limited the ability of the state and other public employers to interfere with actuarial and investment activities of public pension funds.

There are a variety of reasons that the state has moved toward fully funding CalSTRS’ liabilities in recent decades. Moving toward full funding lessens the amount of costs to compensate today’s teachers that are passed on to tomorrow’s taxpayers. It gives the system the broadest possible opportunity to maximize investment returns that generally serve to minimize public employer and employee costs. Moreover, trying to keep the system at or very close to full funding lessens financial pressures on public employers to reduce future employee compensation costs to try to preserve the financial health of the pension system. In other words, full funding lessens the risk that policy makers will have to reduce pay, pensions, or other benefits for future employees in order to pay accrued pension costs related to past employees.

CalSTRS’ New Valuation

System Reports That Its Unfunded Liabilities Have Grown. Like most pension systems, CalSTRS recognizes investment gains and losses in its actuarial valuations over a multi-year period. Due to the near-collapse of world financial markets in 2008, CalSTRS and other pension systems sustained heavy losses, and the continued recognition of those losses is the major driver of the system’s growing UAAL/UAO reports. The new valuation indicates the system’s UAO grew from $40.5 billion as of the 2009 valuation to just over $56 billion as of June 30, 2010. This means that CalSTRS’ reported funded ratio dropped from 78 percent as of the 2009 valuation to 71 percent in the new June 30, 2010 valuation.

The unfunded liability figures above use the standard method of pension reporting relied upon by CalSTRS and virtually all other public pension systems, in which investment gains and losses are recognized over several years (known as the actuarial value of assets [AVA] method). By contrast, the California Public Employees’ Retirement System measures its funded ratio based on the market value of assets (MVA), thereby recognizing investment gains and losses all at once. If CalSTRS had used this MVA method, its assets actually would have grown since the last valuation—from $113.2 billion as of June 2009 to $123.2 billion as of June 2010.   Under the MVA method, CalSTRS’ funded ratio would have been 58 percent as of June 2009 and 63 percent as of June 2010, according to page 23 of the proposed new valuation. This reflects recent investment market gains. Yet, as the valuation discloses (see page 18), the system has yet to recognize over $23 billion of prior years' investment losses. As these investment losses are recognized in the future, they will influence the reported UAO of the system negatively.

Report Reflects Recently Lowered Investment Return Assumption. In December 2010, the CalSTRS board changed the system’s actuarially assumed rate of future investment return—reducing it from 8.0 percent per year to 7.75 percent. This lower assumed rate of investment return is reflected in this proposed new valuation. At the December 2010 meeting, the CalSTRS board rejected a staff recommendation to lower the investment return assumption even further—to 7.5 percent per year for the defined benefit program. In the December 2010 board agenda item, staff indicated that the lower investment return rate would have increased the system’s UAO by about an additional $5 billion. Lower investment return assumptions affect the discounting of system liabilities—resulting in more money needing to be invested now and in the future to fully cover future pension obligations.

About $3.9 Billion More Per Year Needed to Retire Liabilities Over 30 Years. Three decades “is the funding period normally used by the (CalSTRS) board to determine the adequacy of resources for benefits,” according to the board agenda item that includes the proposed new valuation. By amortizing unfunded liabilities over about 30 years, most public pension systems seek to minimize systematic transfers of compensation costs for today’s public employees to future generations of taxpayers and employees.

The new valuation estimates that current law contributions from teachers, districts, and the state to CalSTRS’ defined benefit program will equal 19.3 percent of teachers’ earned salaries. The new valuation estimates that CalSTRS needs additional contributions—from some source, above contributions required in current law—equal to 14.2 percent of teachers’ earned salaries to fully retire the system’s UAO over the next thirty years. In 2009-10, CalSTRS has reported that teacher compensation totaled $27.1 billion. Accordingly, additional contributions from some source of about $3.9 billion per year (in current dollars) for 30 years would be required—beginning immediately—to pay off the system’s existing unfunded liabilities over the next three decades.

Incremental Funding Increases Possible…But Will Increase Long-Term Costs Further. The current financial condition of the state and school districts certainly would seem to preclude an immediate increase in CalSTRS contributions of this amount. As system staff and actuaries described to the CalSTRS board in February 2011, a more likely option for increasing the system’s funding will be an incremental annual increase in state or district contributions to the pension program. All scenarios that involve delays in building up to full funding, however, will tend to increase the eventual annual contribution increases needed to fully fund CalSTRS benefits. For example, in the February 2011 board agenda item, staff discussed a possible scenario in which additional contributions would be made to CalSTRS beginning in 2016-17 in order to cause the system to reach an 85 percent funded ratio in 2046. This particular scenario involved incremental annual increases in CalSTRS contributions of 1.5 percent of teacher payroll beginning in 2016-17. In other words, this scenario assumes that an additional amount equal to 1.5 percent of teacher pay would be provided to CalSTRS in 2016-17 and then in 2017-18, an additional 1.5 percent—for a total of 3.0 percent of teacher payroll above current-law contribution requirements—would be provided to CalSTRS.  The extra 1.5 percent of teacher pay would be added to district or state contributions to CalSTRS each year for 14 years in this scenario, such that by year 14 (2029-30), additional contributions of 21 percent of teacher pay were flowing to CalSTRS. These additional contributions--above those required in current law by an amount equal to 21 percent of teacher payroll—would then have to continue flowing to CalSTRS for the remainder of the 30-year period until 2046. If this scenario occurred, the eventual additional annual funding needed just to reach 85 percent funding in 2046 would be about 50 percent higher than the additional funding needed immediately to bring the system to 100 percent funding at the same time. In fact, the February 2011 board agenda item listed a scenario in which total contributions to CalSTRS’ defined benefit program would eventually have to grow to over 45 percent of teacher payroll—above those required in current law by an amount equal to about 26 percent of teacher payroll. In current dollars, 26 percent of teacher payroll equals over $7 billion.

In short, delay in providing funding for a given set of benefits can increase the eventual annual contribution increases needed by a substantial amount. For pension systems—more perhaps than for some other parts of public budgeting—time is money.

Under Current-Law Contributions, Very Negative Cash Flow Trend for System. Page 17 of the new valuation discloses that CalSTRS’ net cash flow (contributions less benefits and expenses) “continues to be increasingly negative.” In 2008-09, as shown on page 20 of the new valuation, net cash flow was -$3.4 billion; in 2009-10, this net cash flow became more negative, coming in at -$4.3 billion. As the actuaries describe, “this is a typical pattern for a mature retirement system where it is expected that contributions will be less than benefits and that the system will begin drawing on the fund that has been built up over prior years.” This trend will continue, the valuation notes, “absent a significant increase in contributions.” Over the medium term and long term, without a significant increase in contributions, these negative cash flows could require changes in the system’s asset allocation (to preserve and stabilize liquidity), which might tend to reduce annual investment returns. Such reductions—coupled with concern by many that system investment assumptions are already too optimstic—could result in substantial future increases in system funding requirements above those already estimated.

Current Law Requires Relatively Small Increase in State Payments Beginning in 2011-12. As we described in a prior analysis item, it has long been expected that the results of this new valuation would trigger a requirement already in law for an increase in state contributions to CalSTRS beginning in 2011-12. The proposed new valuation does trigger that requirement, although--contrary to prior, explicit assurances from system officials--the text of the valuation suggests that the higher state contributions will be triggered beginning July 1, 2011, rather than on October 1, 2011. We expect that system staff will clarify with the CalSTRS board that an October 1 start date is required, consistent with their prior assurances. Senate Bill 69 (the enrolled conference version of the 2011-12 Budget Bill that has passed both houses of the Legislature but has not yet been transmitted to the Governor) reflects an October 1 start date for these supplemental contributions. The proposed new valuation's estimate of needed additional contributions in the future already appears to reflect this supplemental state funding.

Conclusion

CalSTRS Soon Will Require a New Funding Strategy. CalSTRS’ current fiscal model is unsustainable. Its own actuarial valuation clearly slows this. There is no realistic way for CalSTRS to “grow its way” out of this problem through favorable investment returns over the long term, as the system’s own officials have acknowledged clearly. Previously, our office has suggested that the Legislature make several changes for CalSTRS, including ending the state contribution role for future teachers' benefits, providing increased contributions from the state or other sources to address the system's unfunded liabilities, and perhaps changing defined benefit pensions for future teachers.

Fundamentally, there are only two broad strategies to rebuild CalSTRS' fiscal health: (1) building more assets through more contributions from the state, districts, and/or employees and/or (2) reducing the accumulation of future system liabilities, which most likely would have to occur through reduction of the benefits for teachers hired in the future. Only the legislative branch of state government can amend the Teachers’ Retirement Law to create such a new fiscal model for CalSTRS.

The Longer the Wait, the Greater the Costs. The fiscal conditions of the state and school and community college districts are such that substantially increased contributions do not appear likely in the immediate future. Nevertheless, the longer that the state waits to put in a place a new fiscal model or other changes for CalSTRS, the more costly or drastic that such changes will eventually have to be. Waiting to provide more funding will tend to increase the eventual annual costs of a solution. Waiting to reduce future teachers’ benefits means that future teachers might have to be asked to take even sharper reductions in their pension benefits or other compensation. These are all very difficult choices.