State Teachers' Retirement System (1920)

The Governor's budget proposes shifting the state's contribution for basic teacher retirement to schools. (This includes K-12 school districts, county offices of education, and community colleges.) The budget assumes $469 million in General Fund savings from this reduction in state contributions to the State Teachers' Retirement System (STRS).

In this piece, we:

Describe the retirement plan for teachers, its funding, and its unfunded liability.
Lay out criteria for increasing local control, flexibility, and responsibility for a teacher retirement system.
Describe and evaluate the Governor's proposal to shift contributions to school districts in the context of these goals.

Background

The Basics of the STRS Plan

Defined Benefit Pays 2 Percent at 60. All K-12 and community college teachers in public schools who work at least half-time are required to participate in the state-sponsored retirement plan administered by STRS. This is a "defined benefit" program, which guarantees a certain lifetime monthly pension benefit based on salary, age, and years of service at retirement. The basic defined benefit pension for retired teachers pays 2 percent of salary for each year of service at age 60.

Recent Benefit Enhancements. Beginning in the late 1990s, when STRS investment returns had resulted in full plan funding, the state approved a series of benefit enhancements. Effective in 1999, the state approved higher percent-of-salary formulas to calculate pension benefits for teachers who are above 60 years of age and/or have 30 years of service.

Effective in 2001, the state again enhanced benefits as investments continued to surge. These changes instituted the following:

Highest one-year salary (rather than the standard three-year period) to calculate pensions for teachers with 25 or more years of service.
Additional dollar amounts per month for teachers who retire by the end of 2010 with 30 or more years of service.
Diversion of 25 percent of teacher contributions—2 percent of the total 8 percent—to a new defined benefit supplement (DBS) program. This program includes individual accounts designed to provide extra retirement income above the defined benefit pension. This diversion is in effect through 2010.
The STRS payment of Medicare Part A (hospitalization insurance) premiums for retiring teachers who did not pay Medicare taxes (hired before April 1986) and must, therefore, pay the full Part A premium to participate in the federal program.

In addition, the state also approved:

Allowing retirement credit for accumulated sick leave.
Increasing the inflation protection benefit from 75 percent up to 80 percent. This benefit increases retirees' pensions when inflation erodes their initial allowances to below 80 percent of their original purchasing power.

Three Contribution Sources Finance Benefits. Contributions to STRS are fixed in statute. Teachers contribute 8 percent of salary to STRS, while school districts contribute 8.25 percent. Figure 1 compares employee and employer contribution rates for STRS and related or comparable Public Employees' Retirement System (PERS) plans.

Figure 1 STRS Retirement Contributions Less Than Average PERS Contributions
	STRS	PERS Miscellaneous Tier 1	PERS School Employees
Employees
Pension	8.0%	5.0%a	7.0%
Social Security	—	6.2	6.2
Totals	8.0%	11.2%	13.2%

Employers
Pension	8.25%	12.4%b	7.6%b
Social Security	—	6.2	6.2
Totals	8.25%	18.6%	13.8%
a On amount of monthly salary in excess of $513.
b Varies annually for State Miscellaneous Tier 1 and noncertificated school employees. Amount shown is the 25-year average contribution rate.

In addition to the teacher and school contributions, the state contributes 4.517 percent of teacher payroll to STRS (calculated on payroll data from two fiscal years ago). The state contribution includes:

2.017 percent for the enhanced defined benefit program. This payment would be $469 million in 2005-06, if not for the Governor's proposal to shift the payment to school districts.
2.5 percent to finance purchasing power protection at 80 percent. This payment will contribute $581 million in 2005-06.

Unlike typical defined benefit programs such as those administered by PERS, neither the STRS employer nor the state contribution rate varies annually to make up funding shortfalls or assess credits for actuarial surpluses.

Surcharge Triggered for First Time. The state also pays a surcharge when the teacher and school district contributions noted above are not sufficient to fully fund the pre-enhancement benefits within a 30-year period. Because of the downturn in the stock market, an actuarial valuation as of June 30, 2003 showed a $118 million shortfall in these baseline benefits—one-tenth of 1 percent of accrued liability. Consequently, this surcharge kicked in for the first time in the current year at 0.524 percent for three quarterly payments. This amounts to an additional $92 million from the General Fund in 2004-05.

The Governor's budget assumes this surcharge is discontinued in 2005-06 based on greater-than-assumed investment returns for 2003-04. It will not be known, however, whether the surcharge will continue until a new valuation becomes available in the spring. If it does continue, the 2005-06 General Fund cost for a full year would be between an estimated $120 million and $170 million.

Actuarial Valuation Finds Funding Shortfall

In addition to the small shortfall in pre-enhancement benefits (triggering the current-year surcharge), the recent valuation also showed a substantial $23 billion unfunded liability for the entire system, including enhanced benefits. That is, existing contributions from teachers, school districts, and the state are not sufficient to fully fund retirement benefits. As a result, STRS has just 82 percent of the assets necessary to pay accrued benefits.

As noted above, the pre-enhancement benefit structure has just a fractional shortfall. Consequently, the large systemwide unfunded liability results from the recent benefit enhancements. As described in the nearby box, STRS is currently reviewing options to address this shortfall.

Larger State Teachers' Retirement System (STRS) Funding Issue Looms

Shortfall Amounts to an Extra $1 Billion in Annual Contributions. The Governor's cost-shift proposal comes at a time when STRS faces another significant funding issue—the $23 billion unfunded liability noted in the main text. The STRS estimates that the retirement fund needs the equivalent of an additional 4.438 percent of salary over a 30-year period to retire the unfunded liability. This amounts to additional contributions exceeding $1 billion annually.

Options for Closing the Gap. The STRS has developed a dozen options for the board to consider to address the identified shortfall. Most of these options would require legislative action. The options can be grouped into three categories:

Rescinding Recent Benefit Increases. The majority of the options would roll back benefits provided to teachers in recent years. In most cases, these changes could only be implemented for teachers who begin working after the new changes take effect. (Courts have considered pension plans to be part of the employment contract. Once a teacher begins working, therefore, the pension is not changeable without some offsetting benefit.)
Additional Contributions. The state could increase contributions for teachers, school districts, and/or the state to cover the liability. As with reductions in benefits, the state generally would not be able to increase current teachers' contribution rates.
Refinancing the Unfunded Liability. The STRS typically amortizes unfunded liabilities over a 30-year period. One refinancing option developed by STRS would stretch these payments over 40 years. (This time period would exceed the bounds of what is allowed for private pensions and is outside the norm for the state's practice.) Another option would be the issuance of a pension obligation bond. By issuing a bond at a lower interest rate than STRS' assumed rate of return (currently 8 percent), the state could reduce its interest payments over time. The Legislature would have to determine who is responsible for providing the resources to pay off the bond.

STRS Board Will Weigh Options This Spring. The STRS board has asked constituent groups for their comments, preferences, and recommendations on these options. The board has also requested an updated actuarial valuation as of June 30, 2004, which will be available in the spring. After this process, the board plans to bring proposals to the Legislature to address the unfunded liability. We believe there are three main problems with the current method of providing teacher retirement benefits.

Local Program Has No Local Control or Responsibility

System Problems

We believe there are three main problems with the current method of providing teacher retirement benefits.

Passive State Role in Teacher Compensation, Except for Retirement. As described above, the state is extensively involved in providing teacher retirement benefits and designating funding for this local program. This active role is contrary to the state's passive role in other forms of teacher compensation. The most significant form of compensation—teacher salaries—is left to local school districts and their employees to determine through collective bargaining. Moreover, because the state contributes to the retirement system, local districts do not bear the full costs of retirement plans, unlike teacher salaries.

No Plan Flexibility. In addition, the state-run system limits the choices of both school districts and teachers. With a single benefit structure and required contributions spelled out in statute, districts and teachers have no choices about how best to meet their pension needs. For example, some districts might prefer to use retirement contributions to finance other pension plans that better meet their overall funding needs. Similarly, teacher retirement needs may vary dramatically. Some teachers may prefer to weight their compensation toward present needs. Other teachers may want to forego some current salary for an even more generous retirement allowance than that provided through the STRS program.

State Viewed as Funder of Last Resort. As noted above, all contributing parties—teachers, school districts, and the state—have fixed contributions in statute. Thus, there is no designated responsibility for long-term funding shortfalls, such as the current $23 billion gap. In fact, because the state requires school district participation and designates the rates paid by teachers and school districts, the Legislature may feel compelled to pick up some or all of the unfunded liability despite the local nature of the program. In this way, the current system prevents funding decisions from being viewed as a local responsibility.

Long-Term Solutions

In our view, the long-term solution to these issues is to put decision making and responsibility for school retirement (including nonteaching or noncertificated employees) at the local level with employers (school districts) and employees (teachers). In other words, treat teacher retirement the same as other local government retirement programs. This would include:

Having all costs borne by school districts and/or teachers, rather than the state being responsible for some share of costs.
Allowing local flexibility for schools to choose different retirement plans—for teachers and noncertificated staff—that best meet local needs. This could be through STRS, PERS, or other venues such as joint powers authorities.
Assuring fiscal soundness in that all potential costs are designated to be covered by employers and employees without the necessity of future statutory changes.

It is these criteria that we use to evaluate the long-term impact of the Governor's proposal for teacher retirement. In addition, there are short-term issues the proposal raises as a 2005-06 budget balancing solution.

Governor Proposes Cost Shift to School Districts

Proposal

The budget proposes shifting the state's benefits contribution to school districts. (The state would continue annually paying 2.5 percent of payroll to the inflation protection account.) The proposal would increase districts' contributions by 2 percent of payroll, resulting in a total district payment of 10.25 percent. (The state's contribution of 2.017 percent of payroll from two years ago is equivalent to a district payment of 2 percent at current payroll.) This amounts to roughly $500 million in additional contributions. The Governor's proposal would allow school districts to pass through to employees this additional contribution through collective bargaining. Consequently, teachers could contribute as much as 10 percent of their wages toward retirement.

To maintain take-home pay, however, teachers would also have the option of ending the equivalent diversion—2 percent—of the employee contribution to DBS (described previously). This component of the Governor's proposal is not contingent on school districts passing through the shifted responsibility for the 2 percent benefits contribution. Teachers could elect to stop contributing to DBS and receive that compensation in take-home pay regardless of whether districts or teachers pay the benefits contribution.

The administration proposal to shift the state's benefits contribution to school districts also includes eliminating the statutory provision for the surcharge when there is an unfunded liability in the pre-enhancement benefits.

Administration Asserts State Commitment Fulfilled. The administration asserts that the state fulfilled its 1971 promise—included in Chapter 1305, Statutes of 1971 (AB 543, Barnes)—to contribute a fixed dollar amount to the system for 30 years. This period would have ended in 2001-02, four years after the STRS program reached 100 percent funding.

Short Term: Does the Governor's Proposal Work As a 2005-06 Budget Solution?

We find that the Governor's proposal to shift the state benefits contribution to school districts likely would not achieve the intended savings under current law.

The Governor's proposed budget solution assumes the shift of STRS costs would provide ongoing General Fund relief. As we discuss below, however, these savings may not be achievable.

Shift Could Require Proposition 98 "Rebenching." Retirement contributions for school teachers and administrators are an operating cost schools face, like salaries and other benefits. When the state was implementing Proposition 98, however, it decided which programs to include within the minimum guarantee. At that time, the state decided to keep its STRS contributions outside of the guarantee. While the state can move a funding responsibility from outside of Proposition 98 into the guarantee, state law requires that the minimum guarantee be rebenched to reflect this added responsibility. Thus, the Governor's proposal would likely require a $469 million upward rebenching of the minimum guarantee. If so, the proposal would not result in any General Fund savings.

Long Term: Does the Proposal Move Toward the Goals of Local Control and Responsibility?

The Governor's proposal would not fundamentally reform the State Teachers' Retirement System. To move towards a retirement system that emphasizes local control and responsibility, the Legislature would need to focus on a new approach for new teachers.

Shortcomings in System Would Remain. On a long-term basis, the Governor's proposal would not bring the state significantly closer to a teachers' retirement system which reflects local control and responsibility.

Local Control. The Governor's proposal would shift the costs of a local program to the local level. Yet, the proposal would not fundamentally change the state's role with regard to STRS. First, the state would continue to have an active role in the costs of the program—by contributing to the purchasing protection program. Second, the state would remain actively involved in determining future benefit changes.
Local Flexibility. The Governor's proposal also would not increase flexibility for school districts or teachers. Every school district would continue to offer the same retirement plan for teachers, regardless of local circumstances.
Designated Funding Responsibility. Finally, the proposal would not designate which entity would be responsible for any financial shortfalls. Consequently, the state could continue to be viewed as the funder of last resort, reducing local responsibility for the program.

Limitations on Changing System for Existing Teachers. For these reasons, the Governor's proposed cost shift would not fundamentally reform the existing STRS system. For existing teachers, the Legislature may find it difficult to reach the long-term goals of local control, flexibility, and designated funding responsibility with any proposal. Once in place, retirement systems are difficult to alter. By viewing a retirement program as part of the employer-employee contract, the courts have placed significant limits on the types of changes that can be made to a current employee's retirement program. Additionally, the state will be required to designate a source of funding to pay off the current STRS unfunded liability.

Proposals Regarding New Teachers. For new teachers, however, the Legislature would have significantly more flexibility in designing a system that focused on local control and responsibility. The Governor, for example, has proposed requiring all new state, local government, and school employees in California to participate in defined contribution retirement plans. We discuss his proposal in detail—as well as alternatives—in "Part V" of The 2005-06 Budget: Perspectives and Issues.

Return to Education Table of Contents, 2005-06 Budget Analysis

Analysis of the 2005-06 Budget Bill

Legislative Analyst's Office February 2005

Legislative Analyst's Office
February 2005