What a difference a quarter of 1 percent makes.
The decision last week by the board of the California State Teachers Retirement System to lower the expected rate of return on investments from 7.75 percent to 7.50 percent equates to an additional $475 million that school districts and the State Legislature must eventually contribute annually to make up for the shortfall and keep the pension fund healthy. That’s on top of the $4 billion extra per year that CalSTRS says contributors should already start paying to compensate for the big hit that investments took when the market tanked in 2008. The Legislature, facing a General Fund shortfall of its own, hasn’t acted on CalSTRS’ recommendation, and it’s also not expected to act this year on the latest change. But the increased liability will add pressure on lawmakers to deal with Gov. Jerry Brown’s proposed reforms to reduce pension costs. Last week, Brown provided a conference committee on pension reform the details that he had promised on his 12-point proposal.
The CalSTRS board’s action marks the second time in a year and a half that it has lowered the investment forecast by a quarter percent – and reflects a new realization that CalSTRS can’t rely on the high annual return that the pension fund has assumed. Certainly the last volatile decade should temper its optimism. In the 2011 calendar year, CalSTRS earned only 2.3 percent on investments. It was 0.7 percent over the last five years, 5.4 percent over the last decade, and 7.2 percent over the last 20 years.
CalSTRS depends on strong returns on its investment portfolio for the bulk of income for the projected pension payouts of its 856,000 teachers and administrators. The rest must come from annual contributions from members, school districts, and the state. If investment income falters, as it has over the past decade, then the difference must come from higher annual contributions.
Critics are saying that CalSTRS’ 7.5 percent return is still too high. (CalPERS, the worlds’s largest public pension fund, serving state and municipal workers, is still projecting 7.75 percent.)
“It’s a step in the right direction, but not enough of a step,” says Joe Nation, a professor of the Practice of Public Policy at Stanford University, leading critic of the state’s public pension funds, and author, in December 2011, of “Pension Math: How California’s Retirement Spending is Squeezing the State Budget” (see press release; the report was too large to link in this post).
Based on projections of savvy investors like Warren Buffett, Nation said a reasonable rate of return on investments, also called a discount rate, would be 6.2 percent. That assumption, in turn, would require districts and the state to ante up about a sobering $2.5 billion per year more – money that otherwise could go to fund classroom programs.
CalSTRS presently collects $5.6 billion in contributions. That works out to 18.25 percent of current payroll, with teachers and administrators kicking in 8 percent of their pay, districts paying 8.25 percent, and the state, through the General Fund, adding 2.01 percent. (The state contributes another 2 percent through a separate fund to minimize the impact of inflation on employees’ pensions.) Because CalSTRS currently has an unfunded liability of $56 billion, CalSTRS staff recommended that the Legislature increase the contribution rate 14 percentage points to 32.25 percent of payroll, requiring collecting an additional $4 billion annually. In addition, they suggested adding an additional 1.8 percent of payroll, to 34 percent, to compensate for the CalSTRS board’s latest decision to lower the investment rate to 7.5 percent.
But here’s the catch: As opposed to laws dealing with private employers’ pension programs, California courts have ruled that public employees’ contributions cannot be unilaterally raised. Teachers and administrators have a vested right to the pension benefits in effect when they were hired. The only way to raise the rates that members pay is to give them a comparable benefit, such as higher pay. As a result, all of the additional liability for investment shortfalls or higher contributions must be borne by school districts and the state, in the case of CalSTRS. Because taxpayers ultimately bear all of the burden, Nation argues that CalSTRS should adopt a more conservative discount rate – under 5 percent – and then adjust contributions or benefits if, as historically has been the case, the investment returns come in higher. The current system is “an asymmetric risk for taxpayers, who must pay the whole freight,” Nation says.
In his reform proposals, Brown would raise the retirement age for most public employees to 67, substantially reducing the payout over time, and convert part of employees’ pensions to a 401 (k) type program, in which employees would bear more of the risk. But, consistent with court decisions, Brown proposes to impose these changes only on new public employees. As a result, the savings in the first decade would be modest.
