Legislative Analyst's Office

Analysis of the 2002-03 Budget Bill


State Retirement Contributions

Retirement Proposals Have Costly Price Tag

The Governor's budget proposes deferring $2 billion in state retirement contributions, including $1.6 billion from the General Fund, over three fiscal years. Our analysis shows that the fiscal flexibility this proposal provides now would cost the state in excess of $13 billion, including more than $9.7 billion from the General Fund, over more than 30 years. In present value terms, this is equivalent to getting about $2 billion worth of fiscal flexibility at a cost of well over $4 billion.

The state contributes annually to the Public Employees' Retirement System (PERS) and the State Teachers' Retirement System (STRS). Contributions to PERS cover state employees and nonteacher school employees. About 55 percent of the contributions towards state employees' retirement are paid from the General Fund, with the other 45 percent coming from various special funds. Contributions towards nonteacher school employees' and teachers' retirement come entirely from the General Fund.

Proposals to Defer State Retirement Contributions

The budget proposes deferring about $1 billion of the state's General Fund retirement contributions to PERS and STRS in 2002-03 in exchange for administration support of additional retirement benefits.

The Governor's budget proposes to postpone payment of the state's retirement contributions to both PERS and STRS in exchange for the administration's support of increased retirement benefits. The objective of these proposals is to achieve one-time savings, largely in the current year and budget year, to help address the state's General Fund shortfall. The administration has indicated that it will reassess these proposals at the time of the May Revision in light of the state revenue picture at that time.

Figure 1 shows the savings that would result from deferring the state's retirement contributions. Figure 2 shows the costs to pay off the deferrals and to pay for the additional retirement benefits. We discuss the proposals and their costs below.

Figure 1

Savings From Proposed Deferral of
State Retirement Contributions

(In Millions)

 

2001-02

2002-03

2003-04

PERS

 

 

 

  General Funda

$496

$125

  Special funds

408

    Subtotals

$904

$125

STRS

 

 

 

  General Fundb

$96

$412

$441

    Totals

$96

$1,316

$566

a     Includes state contributions for state employees and nonteacher school employees.

b     The General Fund pays the entire amount of the STRS contribution.

 

Deferral of PERS Contribution. In December 2001, the PERS board lowered the contribution rates for state and nonteacher school employees for the current and budget years by recognizing past investment returns more quickly. The rate adjustments reduced the state's contribution amount for the budget year by $1.029 billion, of which $904 million would have been payable in 2002-03 and the remaining $125 million in 2003-04, as shown in Figure 1. (This is because the state pays its General Fund contributions one quarter in arrears, making fourth quarter payments fall into the next fiscal year.) As a result, in the budget year, the state can save $496 million in General Fund outlays, including $371 million for state employees' retirement contribution and $125 million for nonteacher school employees' retirement contribution. Without these rate adjustments now, the state would have realized the savings over a longer period in future years.

In order to compensate for realizing these savings immediately, the state would pay higher contributions over 30 years. As Figure 2 shows, the state would have to pay about $86 million beginning in 2003-04, including $60 million from the General Fund. Over time, the amounts would generally increase with the growth in payroll. Based on information from PERS, we estimate that the state's contribution to make up the deferred amount would total $3.4 billion over a period of about 30 years, assuming an interest rate of 8.25 percent, which is the projected rate of return on PERS investments. The amount includes total General Fund costs of $2 billion and special fund costs of $1.4 billion.

Figure 2

Costs of Retirement Deferral

(In Millions)

 

2003-04

2004-05

2005-06

2006-07

Total Through 2033-34

PERS

 

 

 

 

 

  Payback of deferral

$86

$83

$64

$66

$3,407

  Purchasing power protection

185

6,345

    Totals

$86

$83

$64

$251

$9,752

STRS

 

 

 

 

 

  Payback of deferral

$56

$58

$61

$3,275

  Increased benefit

a

a

a

a

a

    Totals

$0

$56

$58

$61

$3,275

      Grand Totals

$86

$139

$122

$312

$13,027

a     STRS agreement is not yet finalized. Additional benefits are yet to be determined.

 

The PERS Deferral Contingent on Additional Benefits. In exchange for lowering the state's retirement contributions, the administration has agreed to support legislation that would increase payments to retirees, effective January 1, 2005, to ensure that the value of their retirement benefits does not drop below 80 percent of the initial value of their pension amount ("purchasing power protection"). Currently, the inflation protection is set at 75 percent of a retiree's initial pension amount.

Based on information from PERS, we estimate that the 30-year cost of providing this benefit for state and school employees is about $2 billion in present-value terms--$1.4 billion for service already rendered and $0.6 billion to provide the benefit on an ongoing basis. Beginning in 2006-07, we estimate that the state would have to pay about $135 million for the cost of past service and about $50 million for the ongoing cost. These amounts would increase annually with wage growth, with the past-service component paid off after 20 years.

Figure 3 shows the cost of the PERS retirement deferral proposal to the General Fund and special funds. As Figure 3 shows, the cost of the PERS agreement would total about $9.8 billion over 30 years.

Figure 3

Cost of Retirement Deferral by Fund

(In Millions)

 

General Fund

Special funds

Total
Through
2033-34

PERS

$6,422

$3,330

$9,752

STRSa

3,275

3,275

  Totals

$9,697

$3,330

$13,027

a     Figures do not include costs to provide yet-to-be-determined additional benefits.

 

Deferral of STRS Contribution. The provisions of the STRS agreement had not been finalized at the time of this analysis. Under the current tentative agreement, however, the state would defer payment of nine quarters of its contributions for teachers' retirement benefits. This results in current-year and budget-year General Fund savings of $508 million, as shown in Figure 1. Additional savings in 2003-04 are estimated at $441 million. According to STRS, the state would make up these deferred payments by increasing the state's contribution to STRS in the future--about $56 million beginning in 2004-05 and increasing annually with wage growth. Total General Fund costs--including 8 percent interest, which is the assumed rate of return on STRS investments--for deferring $949 million from the current year through 2003-04 would be about $3.3 billion over 30 years, as shown in Figure 2.

In exchange for deferring these contributions, the administration has agreed to support an as-yet-undetermined increase in benefits.

Proposals Are Costly; Costs Stretch Far Into Future

We recommend that the retirement proposals be rejected because they are very costly. These costs would total over $13 billion, be paid over many years, and tie up future state revenues. In present value terms, the proposal is equivalent to getting about $2 billion worth of fiscal flexibility at a cost of well over $4 billion.

Our review shows that for the amount of General Fund flexibility the state gets with the PERS and STRS agreements, the deferral proposals are extremely costly. As Figure 3 shows, these costs as currently structured would total over $13 billion and would last for the next 30 or so years, thereby reducing the state's fiscal flexibility for a long time to come. In present value terms (that is, adjusted for cheaper dollars in the future and foregone investment returns), this is equivalent to getting about $2 billion worth of fiscal flexibility at a cost of well over $4 billion.

The PERS Proposal Has Effective Interest Rate of About 20 Percent; STRS Rate Would Also Be High. The PERS proposal would cost the state about $9.8 billion over 30 years, assuming that the state does not pay back the deferred amount early. Our analysis shows that this is equivalent to the state paying an interest rate of about 20 percent in order to achieve one-time savings of $1.029 billion (including $621 million from the General Fund).

Because the additional benefits to be provided under the STRS agreement are not yet determined, total costs to the state for that proposal cannot be estimated. Consequently, the effective interest rate for the STRS proposal is unknown. Nonetheless, it would undoubtedly be significantly higher than 8 percent.

Interest Rates Higher Than the Market Rate. The interest rates charged to pay off the deferrals--8.25 percent for PERS and 8 percent for STRS--equal the rates of return the retirement systems assume they can achieve from investments. These rates are significantly higher than what the state would have to pay to borrow the funds in the private market, and are higher than the Pooled Money Investment Account (PMIA) rate. Thus, even if the state did not have to provide any additional benefits under either the PERS or the STRS proposal, the state would still be paying a premium to achieve the budget-year savings in state retirement contributions.

Special Funds Would Incur Cost for Unnecessary Deferral. The state's revenue problem principally affects the General Fund. However, the retirement proposals would result in budget-year savings to special funds as well, even though the state does not need to defer costs for these funds. As shown in Figure 3, special fund costs of the PERS proposal would total $3.3 billion over 30 years. While the deferred special fund contributions would not benefit the state's fiscal condition in the budget year, the additional cost that results could necessitate increases in various fees and taxes in the future.

Proposals Tie Up Future Funds. The PERS and STRS proposals would commit General Fund revenues for decades to solve a relatively short-term fiscal problem. As Figure 2 shows, beginning in 2006-07, the state would have to pay a total of $312 million for the proposals. This amount includes about $228 million in General Fund costs. These ongoing costs would reduce the state's fiscal flexibility by hundreds of millions of dollars for many years to come.

Analyst's Recommendation. Given these concerns, we recommend that the Legislature reject the proposed deferral of state retirement contributions to PERS and STRS and the additional retirement benefits as proposed. Instead, the Legislature should investigate other means of freeing up General Fund resources or reducing expenditures in 2002-03 that are less costly or have less impact on future revenues. Our office has made recommendations in this Analysis for the Legislature's consideration and also identified additional expenditure and revenue options in a companion publication.


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