LAO 2006 Budget Analysis: School District Financial Condition

In our Analysis of the 2005-06 Budget Bill, we discussed the range of fiscal issues facing school districts. These included low general purpose reserves, internal borrowing from self-insurance funds, and falling state revenues due to declining enrollment. We also discussed the long-term challenge created by new accounting requirements on retiree health benefits. The financial health of districts has not improved significantly, and may have even worsened somewhat, over the past year.

In this section, we deepen our discussion of the impact of the new accounting requirements on K-12 school districts and reiterate our recommendations for ensuring that districts address retiree health liabilities. We also provide the Legislature with an option to help improve district financial conditions through a fiscal solvency block grant, which would give districts flexible funds to address the broad range of fiscal problems encountered locally.

Retiree Health Benefit Liabilities

In 2004, the national Governmental Accounting Standards Board (GASB) issued a new policy requiring state and local governments, including local educational agencies, to account for retiree health benefits in a manner similar to other pension costs. This new policy, which will be implemented over the next three years, will highlight a major new fiscal challenge for many school districts and county offices of education. In this section, we recommend several steps the Legislature could take to encourage districts to address this challenge. We also discuss how the new GASB policy affects the state’s retirement costs and the costs of local governments in The 2006-07 Budget: Perspectives and Issues (P&I).

GASB Policy Treats Retiree Health Benefits More Like Pension Benefits. The new GASB policy encourages districts to budget for retiree health care costs in a manner similar to the way pension systems operate. The pension systems calculate the normal cost of pension benefits, or the average annual amount that must be deposited in the pension fund during an employee’s working life to fully cover the cost of pensions during the employee’s retirement. The estimate can change over time based on several factors, including higher or lower returns on the funds’ investments and changes in life expectancies.

The new GASB rule attempts to treat retiree health benefits in a similar fashion. It would require districts to identify the normal cost of the retirement benefits to current employees. Because schools generally have not set aside funds for these benefits in past years, the new rule also requires districts to identify the total unfunded liability for retiree health benefits that the district has promised to current employees and retirees for service in previous years. In other words, this liability represents employee benefits already earned, but which have not been paid for.

California Department of Education (CDE) Survey Incomplete, But Reveals Large Liabilities

In our 2005-06 Analysis, we discussed the large liabilities of two districts in California that had completed an actuarial study of retiree health benefit costs. Los Angeles Unified School District (LAUSD) estimated its liability for likely future costs over 30 years at $5 billion. Fresno Unified School District pegged its liability at $1.1 billion. Both districts have identified the significant fiscal threat posed by these liabilities. For instance, LAUSD would have to add $500 million in annual outlays-or about 8 percent of its overall budget-for the next 30 years to pay off its unfunded liabilities and adequately budget for the normal cost of benefits to current employees.

Statewide data on the extent of the problem were not available last year. The CDE, however, agreed to ask districts to report their estimated liability as part of a fall 2005 survey of employee benefits. Unfortunately, the data collected by CDE are incomplete. About 20 percent of districts did not respond to the CDE survey and, of those that did report, most could not identify an estimate of current liabilities. Therefore, the results do not allow a comprehensive assessment of district liabilities in this area.

The survey does provide additional insight into the financial challenge posed by retiree health benefits. Of all districts in the state, about 60 percent (623) responded that some amount of retiree health benefits are provided. Of these, 102 districts reported cumulative liabilities of $3 billion (LAUSD did not report its estimate). The other 521 districts did not include an estimate of the district’s liability for the benefits.

Figure 1 displays selected data from the CDE survey. For this figure, we converted district’s reported unfunded liabilities into per-pupil figures to allow a comparison among districts of the financial burden districts face. Districts that provide lifetime health benefits generally have the highest liabilities. Fresno Unified reported $13,624 per student in benefit liabilities, the highest per-pupil liability reported by any district. While the liability for this group averages $4,075 per pupil, only about one-half of the 76 districts that provide lifetime benefits reported their estimated liability.


Figure 1 Estimated K-12 Retiree Health Benefits Unfunded Liabilities
(Dollars Per Student Enrollment)
Benefit	Number of Districts	Per-Pupil Liabilitiesa
Benefit	Number of Districts	High	Average	Low

Lifetime	76	$13,624	$4,075	$84
Over age 65, not lifetime	116	5,144	1,706	61
Up to age 65	431	5,061	2,668	5

a These estimates are based on a subset of districts that provide the given benefit.

The per-pupil liabilities for districts in the other two categories-districts that provide retiree health benefits up to age 65 and districts that end benefits at some point above age 65-are significantly lower. The group that ends benefits to retirees at some point above age 65 has a lower average cost than those that stop benefits at 65. This surprising result may be the result of the survey’s under-reporting problem, which is especially severe for districts in the up to 65 group.

Another interesting finding of the survey is the relatively large number of districts reporting relatively small liabilities for retiree health benefits. As Figure 1 shows, the “low” districts in all three categories report per-pupil liabilities of less than $100. Among the 42 districts that reported their liability for lifetime benefits, 11 districts estimated costs at less than $500 per student. There are at least three situations where this is possible. These districts could have set-aside a portion of the funds needed to pay for future retiree costs, developed agreements with local employee unions to share the cost of these benefits, or recently granted these benefits to employees (giving little time for unfunded benefits to build into a large liability). From what we have learned about retiree benefits in school districts, it seems unlikely however, that these situations exist in many districts.

The survey data suggests that district unfunded liabilities for retiree health care costs differ substantially. The majority of districts offer some form of subsidized retiree health care. Districts with the most substantial benefits face the largest outstanding liabilities. A large number report small liabilities for these benefits. The data provide a first glimpse of the liabilities over a broad range of districts, yet they also raise questions about the reliability of the figures. While it is possible that a closer examination would validate these estimates, the low cost estimates for these generally expensive benefits makes us concerned about the accuracy of the district figures.

Why Retiree Benefits Is an Important State Issue

For districts with large unfunded liabilities, retiree health benefits pose a major financial threat. Not only do many districts have large unfunded liabilities, but their failure to pay annual normal costs means these liabilities are growing. In the long run, this problem may become so severe that districts eventually will seek financial assistance from the state. Some districts may even require emergency loans due to this problem.

As we discuss in more detail in the P&I piece, we believe public entities should begin prefunding benefits. This means moving from a “pay-as-you-go” approach to paying for retiree health benefits as they are earned. Prefunding involves payment of normal costs each year plus an annual amount necessary to pay off any unfunded liability over a given number of years. For districts with significant liabilities, full prefunding would require a significant redirection of internal resources. The average district that provides lifetime benefits currently faces liabilities for retiree health benefits of about $4,000 per student. To fund this amount over 30 years, a district would have to set aside roughly $400 per student each year. This represents about 8 percent of general purpose funds districts receive in state funds and local property taxes. Fully funding both the normal cost and a share of unfunded liabilities by redirecting existing district revenues would significantly affect the quality of education offered by districts.

Continuing to operate on a pay-as-you-go basis, however, would only make the problem more difficult to address in the future. Figure 2 displays the estimated per-pupil cost of retiree health benefits for LAUSD over the next 15 years. Under the LAUSD estimate, the costs for retiree health benefits on a pay-as-you-go basis will more than double in the next ten years, increasing from $275 per student to $575 per pupil. By 2020, the district’s estimate shows costs reaching $755 per student.

These costs, however, could be even higher. The LAUSD estimate assumes long-term medical inflation of 6 percent a year, which is a reasonable projection of health care inflation. Actual premiums for health care, however, have tended to increase faster than health care inflation because the quality of health care-and the amount of health care services consumed-also increases each year. To illustrate the sensitivity of these projections to different assumptions, we estimated LAUSD’s costs for health care assuming 8 percent growth (see Figure 2). Under this alternative, district out-of-pocket costs reach $680 per student in 2015, more than $100 per student more than the district’s projection and about $400 per student more than it currently spends. By 2020, our projection pegs the annual cost at almost $1,000 per student-an increase of 250 percent from its current level of spending.

Under this alternative scenario, retiree health benefits could absorb roughly 30 percent of all new general purpose funds received by the district over the next 15 years.

Districts Need to Address Liabilities

We recommend enactment of legislation to require county offices of education and school districts to develop a plan for addressing long-term liabilities for retiree health benefits.

Districts do not currently have strong incentives to address the retiree health benefit funding problem. The increase in out-of-pocket costs from year-to-year does not signal an immediate fiscal crisis in most districts. Setting aside funds for prefunding retiree benefits would only make balancing local spending priorities more difficult in the near term. The new GASB policy may prod districts to address the problem-either through public pressure or possible negative impacts on a district’s bond rating and costs of borrowing.

The state, however, has an incentive to encourage districts to focus on this problem because, at some point, districts are likely to seek financial assistance for these costs from the state-perhaps at the same time it is addressing its own liabilities for state employees and retirees. Early attention may allow some districts to avoid serious future financial problems. Therefore, we recommend the Legislature take two steps to address this problem. Below, we recommend establishing a “fiscal solvency” block grant that would provide a source of funds to assist districts in meeting current fiscal challenges, including retiree health benefits. Before providing financial assistance to districts, however, it is essential that the state require districts to develop a plan for addressing the issues presented by the new GASB policy. Specifically, we reiterate the recommendations from our 2005-06 Analysis (see page E-47) that would require districts providing retiree health benefits to develop a long-term financing plan for these costs. The plan has three elements:

Negotiate a Plan to Use Federal Funds for Retiree Costs

We recommend enactment of the trailer bill language to direct the California Department of Education to work with the federal government to develop a template that would guide district development of comprehensive plans for addressing unfunded retiree health benefits. We also recommend the Legislature enact trailer bill language to allow districts to use state categorical program funds as part of a comprehensive plan for addressing retiree health liabilities.

It is our understanding that most school districts are paying for the cost of retiree benefits entirely with their own general purpose funds. Federal regulations permit local governments to use federal funds to pay for a share of the cost of those benefits, including past unfunded liabilities. While details on these regulations are not available, it appears that districts, as part of a comprehensive plan for addressing retiree liabilities, could charge current federal programs for the portion of the liabilities for employees who were paid from federal funds in the past. This would be another tool to help districts address unfunded retiree health liabilities.

The Legislature can help districts take advantage of this flexibility. Specifically, we recommend that the Legislature direct CDE to negotiate with the federal government a “template” that outlines the specific requirements districts would have to meet to use current federal funds for the unfunded retiree health liabilities of employees paid with federal funds in the past. Rather than require each district to negotiate separately with the federal government, establishing a template for the required comprehensive plan would help districts take advantage of this flexibility. There are several critical elements of a template that would be of concern to both the federal government and districts, including the length of the plan, limits on the proportion of federal funds that may be used to pay for benefits earned in past years, and documentation requirements for determining the proportion of a district’s unfunded liability that may be paid for with federal funds. While the federal government may insist on approving each district plan, a template would facilitate the development of district plans that conform with the federal requirements, and help districts use this tool for addressing unfunded liabilities for retiree health benefits.

The Legislature also could extend the same type of flexibility created in federal regulations to apply to state categorical programs. It is not clear that state law allows the same flexibility with state categorical funds as the federal regulations provide. This can result in districts using their general purpose dollars to pay for the unfunded retiree liabilities of employees supported by categorical state funds.

Adopt Trailer Bill Language. To give districts additional tools for addressing unfunded retiree health benefits, we recommend the Legislature adopt trailer bill language directing CDE to work with the federal government to develop a template that would guide district development of comprehensive plans for addressing unfunded retiree health benefits. We also recommend the that this language allow districts to use state categorical program funds as part of a comprehensive plan for addressing these unfunded liabilities. As part of this trailer bill language, we recommend requiring CDE to adopt regulations before districts would be permitted to use this flexibility. This would allow public review of the new flexibility provisions and afford an opportunity to assess their impact on state categorical programs.

Create a Fiscal Solvency Block Grant

We recommend the Legislature redirect $411.7 million in Proposition 98 funds to a block grant that would provide districts and county offices of education with a source of funding to address the fiscal challenges they currently face.

In our 2005-06 Analysis we discussed a number of fiscal threats districts face. During the first part of the decade, state funding cuts created hard financial choices for districts. In response, many districts employed financial practices such as spending their general fund reserves, borrowing from self-insurance funds, and using one-time funds for ongoing expenses. While these practices may have helped districts weather short-run funding shortfalls, over the long run, it is important to eliminate internal borrowing and deficit spending, and restore fund balances to appropriate levels.

District Financial Woes Continue

Since last year, however, the fiscal status of districts has not improved significantly. In fact, district finances may even have deteriorated somewhat. The number of districts identified in fiscal trouble, for instance, increased in 2004-05. Under the AB 1200 process, county offices certify the financial condition of districts each year. Districts certified in “negative” financial condition are those that currently cannot meet their financial obligations over the next three years. A “qualified” certification signals significant financial concerns that may cause a district to be unable to meet its financial obligations in the future. In spring 2003-04, 45 districts were certified as negative (9 districts) or qualified (36 districts). In spring 2004-05, that figure jumped to 61 districts (14 negative and 47 qualified).

According to the state’s Fiscal Crisis and Management Assistance Team (FCMAT), the increase results from the lingering fiscal consequences of the recent recession combined with declining enrollment. Because most state funding is allocated based on attendance, declines in the number of students enrolled in districts reduces district revenues. As discussed later in this chapter, the number of districts experiencing declining enrollment increased each year from 2001-02 through 2004-05, affecting more than 40 percent of all K-12 districts in 2004-05.

The Department of Finance’s (DOF) long-term enrollment projections suggest this trend will continue. Over the period from 2005-06 through 2009-10, DOF projections show total statewide enrollment gains of less than 1 percent, and declines in 30 of the state’s 58 counties, including Los Angeles, San Francisco, Alameda, and Orange. Because this forecast is based on county-level demographic changes, DOF does not issue district-level projections. The implication for K-12 education, however, is that the fiscal pressures created by declining enrollment represent a continuing challenge for the future.

Looming on the horizon is the threat posed by retiree health benefits. As discussed above, 60 percent of districts report providing these benefits for some period of their employees’ retirement. Survey data on this issue shows that a significant number of districts face accrued liabilities for these benefits of more than $4,000 a student. Given the weak district financial condition and other fiscal demands on districts, such as higher utility costs and employee wage increases, it seems unlikely that most districts will have the fiscal flexibility to make serious inroads towards resolving the retiree health issue in the near term.

Improve Incentives, Insist on Local Solutions

In the past, we have been reluctant to suggest that the Legislature address financial issues that, at their roots, result from local policy, administrative, or fiscal practices. Instead, we have counseled the Legislature to address the incentives that cause local problems that are not in the long-term interests of students, the overall health of the K-12 system, or the state. Once the incentive problems are fixed, we think districts are in a better position than the state to find good solutions to locally created problems.

We think this perspective applies to the financial issues facing districts. For the most part, past district action (or inaction) created current problems, and the state should not attempt to craft specific solutions to those problems. Districts differ in the extent to which they have been willing to address these issues. The FCMAT reports that most districts are making the hard choices to make ends meet. Thus, in general, we think the state should avoid trying to “fine tune” state law in response to local fiscal problems.

The issue of retiree benefits, however, presents a new challenge for the majority of districts. As noted above, districts lack a strong incentive for resolving this issue. Therefore, the question facing the state is how to encourage all districts to address their financial problems without the state becoming so involved in the solution that it assumes responsibility for the problem in the long run.

For retiree health benefits, the first step is to require districts to develop long-term plans for reducing liabilities for current and past benefits granted to employees as we recommend above. This recommendation is designed to balance the state’s interest in ensuring districts begin addressing this issue while maintaining local accountability for solutions.

If the Legislature adopts our recommendation on retiree health benefits, the need for further state intervention boils down to a question of whether districts have the financial flexibility to address these issues. The answer to this question requires a judgment about whether, given all the demands placed on local administrators and school boards, districts realistically can address all of the fiscal threats facing them. In general, we think they can-and most districts do. On the issue of retiree benefits, however, the size of the problem is simply too large to expect districts to resolve this issue without additional state action.

We are also wary of developing a state response that penalizes those districts that have made the hard choices needed to resolve their fiscal problems. Many districts are closing schools as a response to declining enrollment, for example. While closing schools upsets parents and community members, the action demonstrates that districts recognize the need to realign district operations-and reduce base spending-in line with the decline in enrollment. Thus, any state action to help districts with their financial problems should not penalize districts that have already addressed these issues.

A Solution That Rewards Good Financial Practices

Earlier in the chapter, we recommend the Legislature reject the Governor’s proposals for new programs on the basis that the state faces many of the same fiscal issues as school districts. If the Legislature chooses to fund schools at the level of Proposition 98 funds identified in the 2006-07 Governor’s Budget, however, we recommend the Legislature use the $411.7 million proposed for new programs and other augmentations to the base budget instead to establish a new fiscal solvency block grant.

The block grant would provide flexible funding that would be available to address the variety of fiscal challenges facing districts. Under our proposal, block grant funds would be provided on a per-pupil basis to districts and county offices. Districts would submit plans for the use of these funds to the county office of education, which would review and approve plans that meet the specific requirements of the block grant. County offices would submit similar plans to CDE for approval. For districts or counties that face none of the challenges discussed above, the block grant funds would be free of any restrictions. Recognizing that, in the long run, districts and county offices would need predictability of funding in order to address long-term financial issues, our proposal would add the block grant funds into revenue limits after five years.

Our plan also contains specific priorities over the use of the block grant funds:

Internal Borrowing and the “Normal” Cost of Retiree Benefits. Our proposal would first require districts to use block grant funds to restore internal fund balances (such as self-insurance funds for workers’ compensation) and set aside funds for the normal cost of retiree health costs of current employees. Self-insurance funds provide a source of funding that adequately supports the costs of anticipated claims that, if left unbudgeted, have to be paid from a district’s general purpose reserve. Borrowing from these internal funds is a way districts can circumvent the state’s AB 1200 guidelines for general purpose reserve balances. Therefore, requiring districts to use block grant funds to repay internal fund borrowing would place districts on a sounder financial footing and reinforce the importance of adequate district general purpose reserves.

Setting aside funding equal to the normal cost of retiree health benefits would begin the process of appropriately budgeting for these benefits. The normal cost of these benefits is the amount that should be set aside each year to pay for the future benefits of current employees when they retire. Under existing practice, district liabilities grow each year when they do not set aside the normal cost of these benefits. Using block grant funds for this purpose is designed to cap unfunded liabilities at their current level.

Declining Enrollment. For districts with large unfunded benefit liabilities, setting aside funds for the normal cost of benefits probably would consume the entire block grant. Districts with smaller liabilities may have block grant funds left over. Under our proposal, one-half of any remaining funds could be used for short-term costs of declining enrollment. In general, districts need to restructure district operations in line with enrollment declines. Recognizing that declining enrollment will affect districts for at least the next five years, our proposal would permit districts to use a portion of the block grant funds to smooth the transition to a lower enrollment environment over that time. In general, we suggest that districts use these funds for short-term transitional costs, rather than to offset the need for permanent operational changes. Indeed, we would hope that districts would develop long-term plans for addressing the issues presented by declining enrollment in order to use the flexibility provided by the block grant most strategically.

Accrued Liability for Retiree Health Benefits. The remaining block grant funds would be used to address unfunded retiree health liabilities.

For districts that do not offer retiree health benefits or have adjusted to the impacts of declining enrollment, our plan would allow districts to use the block grant for any general purpose. We would also suggest one final feature for the block grant, which would allow districts to waive the fiscal solvency block grant priorities during a fiscal emergency, with the approval of the county office of education and the Superintendent of Public Instruction. We think the Legislature should provide some flexibility for districts who find themselves in dire fiscal straights. We would suggest limiting this option to a district that is unable to meet its financial obligations in the next year and likely to seek a loan from the state under AB 1200. With these limitations and a close review by the county office and the SPI, we think the block grant could provide some needed flexibility in exceptional situations.

The block grant would give districts a five-year period to address pressing fiscal issues while also keeping responsibility at the local level for specific solutions. By using the flexibility provided in the proposed block grant strategically, we think most districts could fill existing budgetary holes, address declining enrollment, and begin setting aside funds for past retiree health care obligations. Our proposal also rewards districts that have dealt with these fiscal issues, as the block grant in these districts could be used for any local priority. While our proposal represents a significant investment of state funds, we think the block grant would pay dividends for many years in the future.

Analysis of the 2006-07 Budget Bill

Legislative Analyst's Office
February 2006

School District Financial Condition