Higher Pension Contributions Challenge California Schools

The Bond Buyer, 4/21/16

PHOENIX – Legislation to put California’s teacher pension fund on a more sustainable track could prove to be bitter medicine for some school districts and even the state itself, analysts and other experts said.

Standard & Poor’s reviewed the impact of Assembly Bill 1469 in an April 12 report by analyst Gabriel Petek.

California approved the law in 2014 with the goal of eliminating the California State Teachers’ Retirement System’s unfunded pension liability by 2046, mainly by mandating increased contributions from the state, districts, and employees and also introducing an actuarial component to the contribution formula over the long term.

The legislation’s impact is generally favorable, Petek wrote, because CalSTRS was on an unsustainable path. But it the increased contributions it requires of districts are large enough to impact their credit over time, he found.

“Funding the higher contributions could strain the state’s budget—or those of the local school districts,” Petek wrote. “We can envision plausible circumstances in which the added fiscal pressure caused by the higher contributions could weaken credit quality.”

CalSTRS’ situation has changed significantly under AB 1469. By fiscal 2021, combined annual contributions from school districts and the state will have increased to nearly $8.4 billion from about $2.9 billion when the law was passed. CalSTRS was about 110% funded at the height of the dot-com bubble in 2000, according to S&P, and annual contributions equaled 183% of the annual required contribution.

But the state enacted legislation that increased certain pension benefits and cut the state’s contribution rate by more than half, and by fiscal 2013 contributions to the defined benefit program from the state and districts had fallen to just 44% of the ARC.

The chronic underfunding put CalSTRS’ long-term solvency into jeopardy, Petek wrote.

“Actuarial projections at the time showed that CalSTRS was at risk of exhausting its assets in 30 years,” he wrote. “The higher contribution rate schedules established through AB 1469 have helped stabilize the long-term funding outlook for CalSTRS.”

The plan remains far from full funding. Earlier this month CalSTRS released the actuarial valuation of the defined benefit Program as of June 30, 2015, showing that the current funding gap of $76.2 billion has increased by $3.5 billion since the previous valuation. That is, however, below the projected $85.1 billion figure outlined when the long-term funding plan was developed in 2013-14, according to CalSTRS’ actuarial consultant.

“The truth of the matter is that CalSTRS is moving steadily forward on the path to full funding, thanks to the actions of Governor (Jerry) Brown and the Legislature in 2014 to enact a 32-year funding plan for the system,” CalSTRS chief executive officer Jack Ehnes said in a statement. “That plan of shared responsibility by CalSTRS members, employers and the state ensures the financial future of the nearly 900,000 California educators and their families who depend on the modest retirement benefit CalSTRS administers.”

CalSTRS believes that future revenue from contributions will be enough to finance its future obligations if it meets its long-term assumed annual investment return of 7.5%. It has reported an average investment return of 8.2% over the past 25 years, as of the end of calendar year 2015. CalSTRS has lowered its return assumptions over the past few years, though some critics still charge that the assumptions could be overly optimistic and have questioned CalSTRS descriptions of its positions.

David Crane, a lecturer in public policy at Stanford University and president of the legislative advocacy group Govern For California, has criticized CalSTRS and its CEO for unrealistic return assumptions that Crane believes will create an even more difficult to manage problem down the road.

“It’s not a question of whether STRS is on a more sustainable footing but rather whether school districts are on sustainable footing,” Crane said. “STRS itself has no liabilities. It just manages assets set aside to meet liabilities owed by school districts. AB 1469 established a new and larger contribution schedule. As a result, district pension costs are going up sharply over the next five years. But even that sharp increase won’t be enough because the scheduled increase is based on an unreasonable investment return assumption. Put another way, they really needed to jack up contributions more like 80%, and since they didn’t, even greater increases will be required later. But just the scheduled increase is going to clobber districts.”

Ehnes said the latest valuation is proof of CalSTRS’ sound position.

“This valuation proves the fund is sound, despite naysayers’ attempts to use unrealistic investment assumptions and short-term focused investment theories to create unsubstantiated blog posts and headlines,” Ehnes said in an April 7 statement when its latest valuation was released. “The long-term financial stability of the fund is a top priority for CalSTRS, and it’s especially significant for teachers—a sector of public employees who do not receive Social Security for their CalSTRS-covered employment.”

A California Legislative Analyst’s Office report in February said the CalSTRS funding plan is being implemented differently from how the LAO originally understood it, and that it might be placing a heavier burden on school and community college districts in contradiction to the “shared responsibility” principle the plan is supposed to follow.

“As implemented, the abstract calculation central to the funding plan has decreased the state’s share of CalSTRS’ unfunded liabilities from $20 billion to $15 billion,” the LAO found. “Meanwhile, that calculation, coupled with CalSTRS’ treatment of the higher teacher contributions required by the funding law, have increased the school and community college district share from $47 billion to $58 billion.”

Petek said the state budget is potentially more exposed to than districts because the law caps school district contribution rates at just over 20%, and they are already scheduled to increase to 19%. In a poorly-performing market California could be on the hook for a liability approaching $150 billion, Petek found, while districts would be shielded from all but a minor additional rate hike.

AB 1469 is a mixed bag for school districts, said Dennis Meyers, an assistant executive director at the California School Boards Association.

“The increase of employer cost is being felt by every district in the state,” Meyers said. “Every district is impacted the same, but not every district’s revenues are increasing the same.”

Meyers said the Local Control Funding Formula instituted in the 2013/2014 school year to replace California’s previous K-12 funding allocation system grants more money to districts with heavy English language learner or at-risk students, resulting in a disparity between how much state money districts receive. Meyers said that the AB 1469 has been positive, though, from the point of view of recruiting and retaining employees who want a solid retirement plan in place.

“Over the long term, we should have a good, healthy, funded system,” said Meyers.