Archive for April, 2012

CalSTRS: on the road to ruin or recovery?

April 23, 2012

An annual look at CalSTRS, the nation’s second largest public pension system, once again raises the question of whether there is an urgent need to begin putting more money into the pension fund.

Actuaries estimate that the total annual contribution to the pension system, 19.4 percent of payroll, would have to be increased by an additional 12.9 percent of pay (about $3.25 billion) to fully fund pensions promised over the next three decades.

Each year that a contribution increase is delayed, the additional amount needed for full funding is expected to grow roughly half of one percent of pay, Milliman actuaries Nick Collier and Mark Olleman told the CalSTRS board earlier this month.

“Each year we defer there is an additional cost . . . all other things being equal,” Collier said.

Unlike nearly all public pension systems in California, the California State Teachers Retirement System lacks the power to set annual contribution rates that must be paid by employers, needing legislation instead.

So arguably CalSTRS, continuing a five-year quest for a rate increase, might have a tendency to paint a bleak financial picture, hoping to prod legislative action without unduly alarming teachers, who rely on pensions and receive no federal Social Security.

A CalSTRS news release on the actuarial report, based on data as of last June 30, focused on a growing pension shortfall. The projected assets only cover 69 percent of costs expected over the next three decades, down from 71 percent in the previous year.

The funding shortfall is $64.5 billion, up from $56 billion. The gap widened, despite stellar investment earnings last fiscal year (23 percent), due in part to lowering the annual earnings forecast from 7.75 percent to 7.5 percent in the decades ahead.

The funding level and the shortfall or “unfunded liability” are standard measures of pension fund health. And CalSTRS is indeed underwater: The fund peaked at $180 billion in 2007, dropped to $112 billion in 2009 and was $152 billion last February.

But it’s important to remember that the new “unfunded liability” of $64.5 billion is only a floating estimate of the shortfall, not an actual debt that must be paid like a 30-year mortgage.

The big variable is the earnings forecast. The huge CalSTRS shortfall is mainly due to earnings that averaged 5.5 percent during the last decade, well below the old forecast of 7.75 percent.

Critics say a CalSTRS board decision in February to lower the earnings forecast to 7.75 percent is still overly optimistic, concealing massive debt. Whether earnings targets can be hit is part of the debate about “sustainable” public pensions.

Just as being 2 percentage points under the target created the CalSTRS shortfall, the Milliman actuaries estimate that earnings averaging 2 points above the target, 9.6 percent, would fully fund CalSTRS in 30 years without a contribution increase.

More dramatically, CalSTRS could be fully funded without a contribution increase in five years if earnings averaged 16 percent.

“It’s not impossible,” said Collier. “But it’s not realistic to expect investment returns to bring us out of it.”

CalSTRS building in West Sacramento

CalSTRS, one of the nation’s oldest public pension funds, was formed in 1913 and has its centennial next year. Part of its long history is recovering from funding levels less than half of the current 69 percent — a scant 29 percent in 1975.

“One of the things that has come up when we have had discussions with stakeholders and the Legislature about the issue is ‘Why can’t you invest your way out of it?’ You did it before,” Ed Derman, CalSTRS deputy chief executive, told the board.

Among the changes as CalSTRS matured, said the actuaries, is the value of the investment fund compared to the size of the payroll. The ratio was about one to one in 1975, but now the investment fund assets are about six times greater than the payroll.

The Milliman actuaries, following the lead of the California Public Employees Retirement System and a new state actuarial advisory panel, included an “asset volatility ratio” in the new report to show how small losses create the need for bigger contributions.

For example, said Olleman, in 1975 a loss of 10 percent below the 7.5 percent earnings target could have been covered by a contribution increase of half of one percent of pay over 30 years.

“Now in 2011 with the volatility index going up from one to 5.8, that 10 percent loss instead of a half percent increase in pay would imply a 2.7 percent increase in pay,” he said.

If you don’t have the burden of trying to persuade the Legislature to begin a contribution increase, it’s possible to pick out some positive trends in the new actuarial report.

CalSTRS spreads gains and losses over three years, the shortest of the conventional actuarial methods used to “smooth” the need for contribution increases. At the other extreme is CalPERS, virtually alone with a 15-year smoothing period.

Because big losses from a previous year offset the 23 percent gain last fiscal year, the CalSTRS funding level dropped from 71 to 69 percent. But at unsmoothed market value rates, the funding level increased from 60 to 67 percent.

The amount of the contribution increase needed to fully fund CalSTRS in 30 years dropped from 14.2 percent of payroll to 12.9 percent. If there is no contribution increase, the estimate of when the CalSTRS fund runs out of money moved from 2041 to 2046.

Although rarely mentioned by CalSTRS, two old laws triggered a contribution increase last year of 2.5 percent of pay, more than double the old state rate of 2 percent of pay. (The state puts another 2.5 percent into a separate inflation-adjustment fund.)

For a decade ending Jan. 1 last year a quarter of the teacher contribution to CalSTRS, 2 percent of pay from the total 8 percent of pay, was diverted into an individual investment plan. (School districts and other employers contribute 8.25 percent of pay.)

The “cash balance” investment plan is like a 401-k plan, but with an important difference. It guarantees a minimum return based on the 30-year Treasury bond, 4.25 percent last year, and expects to hit the CalSTRS earnings target, now 7.5 percent.

The Defined Benefit Supplement, as it’s called, still gets pay beyond regular salary such as overtime, summer school and bonuses. But it no longer gets 2 percent of teacher pay, which was redirected to the pension fund after a decade-long diversion.

Another law triggered a state contribution increase of half of one percent of pay because a 1990 benefit increase is no longer properly funded. Now it’s expected to increase a quarter of one percent each year until reaching a cap of 1.5 percent.

If they weren’t automatic, a total contribution increase that could reach 3.5 percent of pay seems unlikely to get approval now: A time of deep state budget cuts, teacher layoffs and pay freezes, and what some say has been a $20 billion reduction in school funding over the last four years.

A long-term CalSTRS funding solution may await the future attention of powerful teacher unions, who hold sway over school funding at the Capitol. After years of being awash in the triage of cuts, the unions are now preparing for a battle over tax increases on the November ballot.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Posted 23 Apr 12

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