CalSTRS’ finances reflect debt — and surplus

The main California State Teachers’ Retirement System pension fund is seriously underfunded, and school district pension costs are more than doubling, biting deep into classroom budgets. But the agency, called CalSTRS for short, has an inflation-protection fund with a growing $9.8 billion surplus and an eye-popping positive cash flow.

The Supplemental Benefit Maintenance Account keeps retiree pensions at 85 percent of their original purchasing power, a particularly important safeguard for teachers with modest pensions who live to an advanced age.

There has never been an analysis to see if building a huge separate fund is a cost-efficient way to provide inflation protection.

It’s an addition to the regular CalSTRS pension cost-of-living adjustment, an unchanging 2 percent of the original pension that does not compound earnings, thus falling well short of keeping pace with inflation over the years.

The 2 percent cost-of-living adjustment is funded the same way as the pension. The money comes from the main CalSTRS defined benefit investment fund that receives contributions from teachers, school districts and the state.

But the add-on inflation protection is a separate special fund. The program, paid for only by the state, began in 1982 and evolved through a series of legislative changes. Step by step, inflation protection grew from 58.4 percent to 85 percent of original purchasing power.

Some increases included cuts in state contributions. When the state withheld a $500 million payment in 2003, a court ordered repayment. But there has never been an analysis to see if building a huge separate fund is a cost-efficient way to provide inflation protection.

The unusual CalSTRS program created through negotiation and conflict—not rational long-term planning—has had extreme positive cash flow for decades.

Spending $161 million. The cost of keeping pensions at the inflation-protection line has not changed much for nearly three decades. It was $169 million in fiscal 1990 for 52,199 retirees at 68.2 percent and $161 million last fiscal year for 61,387 retirees at 85 percent.

Income $699 million. The state must contribute the equivalent of nearly 2.5 percent of the teacher payroll every year: $699 million last fiscal year, $649 million the previous year. It’s a “vested right” of members, protected by contract law.

Reserve $14.2 billion. The inflation-protection fund is guaranteed to earn the CalSTRS earnings forecast, now 7 percent a year, whether investment yields are good or bad. The fund more than doubled from $5.3 billion in 2008 to $14.2 billion by June 30 last year.

The rationale for the huge reserve is CalSTRS wants a fund that, combined with the projected future annual payments from the state, is large enough to keep retiree pensions at 85 percent of their original purchasing power through June 30, 2089.

The value of the CalSTRS pension fund plunged from $180 billion to $112 billion, then climbed back to $229 billion by last Sept. 30

If inflation is no higher than CalSTRS assumes, 2.75 percent, the current inflation-protection fund is large enough to maintain 85 percent purchasing power for the next 70 years, with an excess or surplus of $9.8 billion. But inflation is the key.

If inflation increases to 3.5 percent annually, actuaries say the inflation-protection fund will be depleted by 2069. And if inflation increases to 4 percent annually, the fund will be depleted by 2048.

What’s never been analyzed is whether switching the CalSTRS inflation-protection program to conventional pension funding could save money, possibly billions if the $14.2 billion reserve and the annual 2.5 percent of teacher pay were used to pay down pension debt.

CalSTRS should be looking for ways to put more money into the pension system. It had 100 percent of the projected assets needed to pay future pension costs before the international financial crisis and stock market crash in 2008.

The value of the CalSTRS pension fund plunged from $180 billion to $112 billion, then climbed back to $229 billion by last Sept. 30. The pension fund may have doubled since the bottom in 2009, but the pension debt or “unfunded liability” ballooned to $107 billion.

Legislation in 2014, six years after the market crash, finally raised teacher, school district and state rates.

Last year CalSTRS was only 65 percent funded, despite a bull market of record length. Now because of the failure to recover, if there is a market crash or a long slump, it’s a much shorter drop to 50 percent funded, a red line experts say can be a crippling blow.

CalSTRS officials know the value of promptly paying down debt. “Pay now or pay more later,” they said while urging the Legislature to raise rates. Unlike most California pension systems, CalSTRS historically couldn’t raise employer rates, needing legislation instead.

Legislation in 2014, six years after the market crash, finally raised teacher, school district and state rates. CalSTRS was given limited power to raise state rates, up to 0.5 percent of pay a year until 2046, and also to raise school district rates, but only by about 1 percent of pay.

The rate increases have CalSTRS on a path to full funding by 2046. But as the plunge from 100 percent funding a decade ago showed, full funding can be only an illusion if it’s based on unpredictable stocks, rather than investments as certain as U.S. bonds.

And the rate increases, including school district costs going from 8.25 percent of pay to 19.1 percent of pay over seven years, were not large enough, even assuming investments earn 7 percent, to prevent debt from continuing to grow until 2026.

Over about three decades, protection was ratcheted up in a half-dozen steps from 58.4 percent to 85 percent of original purchasing power.

That’s when rate contributions are projected to end the “negative amortization” and become larger than the interest on debt from previous years, usually from below-target earnings. But some experts say earnings next decade will likely be less than the current 7 percent target.

A report to the CalSTRS benefits committee in September outlined the complex legislative history that led to a $14.2 billion reserve for supplemental inflation protection, nearly three times more than the $5 billion rate increase four years ago.

The first level of inflation protection, the 2 percent cost-of-living adjustment authorized by legislation in 1972, is funded through the main pension fund. A similar CalPERS program that keeps pensions at 75 or 80 percent of original purchasing power is funded the same way.

Apparently to control costs, a separate fund was chosen for the CalSTRS supplemental inflation protection created in 1982. Over about three decades, protection was ratcheted up in a half-dozen steps from 58.4 percent to 85 percent of original purchasing power.

In 2008, in exchange for reducing its annual payment by $72 million, the state agreed to raise original purchase protection from 80 percent to 85 percent.

A major change in 1989, during a tight state budget, shows how negotiations shaped the inflation-protection program. To skip its payment for one year, the state agreed to a new rate: 0.5 percent of pay the first year, then up to the current 2.5 percent of pay.

In 1997 as purchasing power was increased from 68.2 percent to 75 percent, legislation allowed the state to reduce its inflation payment by $320 million for one year, offset by a similar amount from the sale of school lands.

Revenue from federal land given to the state to support schools had been used for the inflation-protection program since fiscal 1984. Two years ago, the remaining school land, and property purchased with money from the sale, yielded only $5 million.

In 2008, in exchange for reducing its annual payment by $72 million, the state agreed to raise original purchase protection from 80 percent to 85 percent, the current level. That was enough then to lower the state payment from 2.5 percent of pay to about 2.2 percent of pay.

But as teacher pay increased during the last decade, the $72 million is now a much smaller part of the more than $700 million payment to the supplemental inflation-protection fund this fiscal year.

At the biennial report on the inflation-protection fund in May, the CalSTRS board asked staff to meet with school groups and the Legislature to work on options for using some of the $9.8 billion surplus to aid retirees most in need of economic assistance.

Next month the board is expected to receive a report on the cost of delaying a rate increase.

Teachers do not receive Social Security, unlike state workers who have Social Security in addition to California Public Employees’ Retirement System, or CalPERS, pensions. Some longtime CalSTRS retirees have small pensions, particularly if they retired before a big spike in inflation around 1980.

The board has heard emotional testimony about impoverished retirees who served long careers. But some think dipping into the reserve might open the door for negotiations on other contentious issues, maybe even a second look at the 2014 funding legislation.

Next month the board is expected to receive a report on the cost of delaying a rate increase. An analysis to determine whether the supplemental inflation-protection fund is a costly waste might be a prudent next step.

Among other things, if experts are right about below 7 percent earnings during the next decade, maintaining 7 percent earnings for the inflation-protection fund would reduce earnings by the pension fund.

CalSTRS gave these examples in response to a question. When investments earned 9 percent last fiscal year, the amount earned over 7 percent by the inflation fund was credited to the pension fund, boosting its earnings to 9.15 percent.

But if CalSTRS investments only earned 5 percent last year, the pension fund would be credited with 4.85 percent earnings because of the need to maintain 7 percent earnings for the inflation fund.

Meanwhile, the $14.2 billion inflation-protection reserve will continue to grow because of the guaranteed 7 percent earnings and the vested annual state payment of 2.5 percent of the teacher payroll (minus $72 million).
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 Editor’s Note: Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. This story and others can be found at Calpensions.com.