Analysis of the 2006-07 Budget Bill Legislative Analyst's Office February 2006

Retirement Contributions (Control Section 3.60)

This control section specifies the state’s contribution rates for the various retirement classes of state employees in the California Public Employees’ Retirement System (CalPERS). The State Constitution gives public retirement boards, such as CalPERS’ Board of Administration, the exclusive power to undertake actuarial reviews of the financial soundness of their retirement funds and to administer the funds so that members and beneficiaries receive the benefits to which they are entitled by law.

The control section also authorizes the Department of Finance to adjust any appropriation in the budget bill as required to conform with changes in the state’s retirement contribution rates. In addition, the section requires the State Controller to offset retirement contributions with any surplus funds in the employer accounts of the retirement trust fund.

Retirement System’s New Policy Should Reduce Rate Volatility

The retirement contribution rates set by CalPERS for the state and many local governments were volatile in the late 1990s and the early part of this decade. Governments had difficulty predicting annual contributions during their budgeting process. In 2005, CalPERS adopted a comprehensive rate stabilization policy. We believe the new policy promises more stability in contribution rates for the state and other public entities.

How Does CalPERS Calculate Required Contribution Rates? Annual employer contributions to CalPERS and most other retirement systems consist of two parts-the normal cost and costs related to any unfunded liabilities. These costs are determined using the results of actuarial studies that CalPERS updates annually.

The normal cost is the average annual cost of retirement benefits earned by an employee in a given year of service. In other words, it is the amount (usually expressed as a percentage of payroll) the plan needs to invest, earning the assumed returns over time, to accumulate enough assets to pay the retirement benefits when the employee retires.

For several reasons, the normal cost collected over time and invested can be insufficient to pay future retirement benefits. This shortfall is known as an unfunded liability. Unfunded liabilities can arise when investment returns fall short of expectations, benefit enhancements are applied retroactively, or the demographics of retirees do not conform to past assumptions. Retirement contribution rates set by CalPERS include a component to pay off this unfunded liability over a specified number of years. In order to moderate fluctuation in retirement contribution rates, CalPERS and other pension systems spread out-or “smooth”-the recognition of investment and other types of gains and losses over multiple years.

A Recent History of Volatile Contribution Rates. In The 2005-06 Budget: Perspectives and Issues (P&I), we discussed the issue of public pension benefits and costs. Among the issues discussed was the volatility of rates that public employers have been required to contribute to retirement systems, despite policies described above to reduce such fluctuations. After the bull market of the 1990s greatly improved the funding of pension systems, many systems reduced required employer contributions substantially. Figure 1 illustrates how the state’s required contributions to CalPERS’ dropped to minimal amounts in 1999-00 and 2000-01. Other pension systems-throughout California and the nation-also reduced required contribution rates for public employers. At about the same time, the state and many local governments increased retirement benefits, which used up surplus assets and increased the annual normal cost of pension funding. When the stock markets declined, plans experienced consecutive years of less-than-expected investment returns. This double whammy-major asset losses and higher benefit costs-led to rapid increases in required employer contribution rates. Figure 1 shows how state contributions to CalPERS dramatically increased between 2001 and 2004.

New CalPERS Rate Stabilization Policy. In the spring of 2005, CalPERS actuarial staff analyzed 34 possible methods to reduce fluctuations in contribution rates and presented a recommendation to the system’s board. In April 2005, the board adopted an approach recommended by its chief actuary. The rate stabilization policy applies to all CalPERS pension plans, including those for the state.

Perhaps the most important part of the new policy is a rule that gains and losses in the value of CalPERS assets will be built into the actuarial calculation of the plans’ asset value over 15 years instead of three years (the previous policy). These calculations are important because they go into CalPERS’ annual assessment of the plans’ unfunded liabilities. The new policy means that, when the stock markets experience periods of large declines (like they did beginning in 2001), the unfunded liability that drives a part of employers’ annual CalPERS contribution will grow much more slowly than it did in the past. Conversely, when the markets increase in value rapidly (as they did in the 1990s), unfunded liabilities will drop much more slowly than they did previously. For these reasons, employer contribution rates will be much more stable.

The new policy also provides for a minimum employer contribution rate set equal to the employer normal cost less the value of any system surplus (which can be created after periods of large gains in the stock market) spread out over 30 years. This policy reduces the possibility of contribution rates dropping to zero or near zero, as they did for many California public employers several years ago.

Plan Should Provide Stability. The CalPERS staff conducted extensive quantitative analysis of the possible impacts of a rate stabilization policy. The plan adopted by CalPERS was estimated to cut prospective volatility in employer rates by one-half. By reducing the responsiveness of employer contribution rates to sudden changes in the stock market, the new policy should address this major problem with the pension funding system that we discussed in the 2005-06 P&I. There is little reason for state contributions to ramp up or down in a rapid rush to compensate for what could be temporary changes in the stock market. Therefore, we believe that the new approach of gradually moving employer contribution rates is an appropriate way for CalPERS to meet its funding obligations.

Policy Does Not Eliminate All Risk on Retirement Rates. This new policy does not eliminate all risks of pension rate increases. Extended periods of declining investment returns or changed demographic assumptions about state retirees could affect future rates. In addition, any future legislative action to enhance retirement benefits can still result in increased contribution rates. (The state’s employer contribution rates, for example, may increase when the effects of new retirement benefits adopted in 2002 for correctional officers and firefighters are incorporated in CalPERS rates in 2007.) The Legislature, therefore, will still need to consider carefully the possible long-term costs of any future proposed enhancement of retirement benefits.

Projected State Contribution Rates Down Slightly

Because of healthy investment returns, CalPERS projects that required state contribution rates will decline slightly in 2006-07. This projection appears reasonable, but we withhold recommendation on 2006-07 contribution rates for retirement benefits pending their final determination by the CalPERS board based on the system’s annual actuarial valuation.

CalPERS first utilized its new rate stabilization policy in setting 2005-06 rates. CalPERS staff estimate that required state retirement contribution rates will decline slightly in 2006-07 for all retirement categories, as shown in Figure 2. More than one-half of the state’s contribution is for “Miscellaneous Tier 1” employees, and another one-fourth is for peace officers and firefighters.

Healthy Investment Returns Help Reduce Rates. The CalPERS sets rates based on actuarial valuations of the system’s condition two fiscal years ago, so that 2006-07 rates will be based principally on the retirement system’s financial condition, as of June 30, 2005. In 2004-05, CalPERS assets grew in value by 13 percent, compared to the system’s normal projected investment return of under 8 percent annually. This healthy investment performance was led by the nearly 38 percent return on the system’s real estate investments. These investment returns are the principal factor resulting in projected lower contribution rates for 2006-07.

Total State Contributions Should Rise, Due to Larger Payroll. While required contribution rates are projected to decline slightly, the state’s total contributions should increase slightly, as shown in Figure 1. This is because the state payroll is growing. The system’s standard actuarial assumption is that state payroll grows by 3.25 percent annually. Utilizing this assumption, CalPERS projects that total state contributions will grow from $2.4 billion in 2005-06 to $2.5 billion in 2006-07, up 2.2 percent. Over one-half of this amount (an estimated $1.4 billion) will be paid from the General Fund.

Withhold Recommendation. The projections in the 2006-07 Governor’s Budget appear reasonable, but we withhold recommendation on the control section pending final consideration of required contribution rates by the CalPERS board this spring.

No Pension Obligation Bonds Are Assumed in Budget

In November 2005, a court found that the legislation authorizing the sale of pension obligation bonds was unconstitutional. The Governor’s budget assumes that no pension obligation bonds will be issued in the current or budget years.

In 2004, the Legislature enacted a law authorizing the sale of up to $2 billion in pension obligation bonds to fund the state’s obligations to CalPERS. The 2005-06 budget package assumed that the bonds would be issued in 2005-06, with a net benefit to the state’s General Fund of $525 million. In November 2005, a Sacramento County Superior Court judge found that the legislation authorizing the bonds was unconstitutional because it had not been approved by voters. The state intends to appeal the decision, but the Governor’s budget assumes that no pension obligation bonds will be issued in 2005-06 or 2006-07.