The Principal Cause of the CalSTRS Funding Shortfall

Blog entry Jack Ehnes

As CalSTRS begins to emerge from the worst economic downturn since the Great Depression, renewed focus on the sustainability of the defined benefit pension has surfaced, with some calling for the elimination of a plan that has provided a secure retirement to California’s educators for the last 100 years.

Some questionable articles and studies conclude that soaring liabilities, overly optimistic investment assumptions and overly generous benefit enhancements are the true cause of the funding shortfall and charge CalSTRS with downplaying or ignoring these factors intentionally. Nothing could be further from the truth.

Efforts to shore up CalSTRS’ approximately $71 billion unfunded liability should not be sidetracked by the misinformation and ill-formed conclusions that often characterize such negative efforts. If we are to make any headway in what we forecast as difficult dialogue ahead, we’ll need to inform ourselves with technical finance subjects like asset performance and actuarial pension math to better understand what is needed to restore the plan to an actuarially sound funded status.

Investment Returns Not Enough to Restore Funding

CalSTRS and its independent actuary, Milliman, realize that significant misconceptions about the cause of the decline in CalSTRS’ funded status, from having a surplus to being significantly underfunded, may not be easily understood. In April 2013, Milliman presented an analysis of the change in CalSTRS’ funded status from 2000 to 2012. The conclusion was that two-thirds of the decline during that period was due to investment-related asset performance.

Despite many years in which benchmarks were exceeded, asset performance fell short of the actuarially targeted return. CalSTRS has long said returns on its investments alone will not be enough to fully restore the fund’s health. Only a thoughtful, long-term solution crafted by the Legislature and the Governor can do that.

Although CalSTRS has met its assumed investment return of 7.5 percent for the last 20 years, the market cannot restore the fund’s long-term health. In order for that to occur, CalSTRS estimates that it would need at or above a 10 percent investment return each year for the next 30 years to achieve full funding by about 2043 – a near impossibility. Simply put, reliance on the market is not a viable alternative.

Good Math, Faulty Conclusions

Some recent articles on CalSTRS’ unfunded liability appear to show an understanding of pension math. Comparing actual investment performance to the assumed investment return of 7.5 percent is correct when looking at retirement system funding. To the extent that actual investment performance falls short of the expected return, all else being equal unfunded liabilities tend to increase.

However, these articles go on to draw faulty conclusions that inaccurately attribute a growth in the cost of future benefit payments, rather than asset decline as the primary cause of the increase in unfunded liabilities. For example, from 2008 to 2012 there was a $48 billion increase in CalSTRS’ unfunded liabilities. During this time, assets decreased by $11 billion, which led some to conclude that the difference was due to liability growth. In actuality, the correct comparison of the impact of the asset return is the actual return compared to the expected return.

When making this comparison, returns less than the assumption are what caused an increase in the unfunded liabilities that exceeded $48 billion. The liabilities actually increased less over that period than projected by CalSTRS actuaries. This is why CalSTRS says the unfunded liability “stems largely” from the 2008-09 market decline.

Benefit Enhancements not the Primary Cause of the Shortfall

In 1998 CalSTRS was 104 percent funded. It was the first time in the fund’s history that assets were more than sufficient to meet current and future obligations. Shortly after, several benefit enhancements designed to attract and retain teachers at a critical juncture when schools were mandated to have no more than 20 students to a classroom, were enacted. Moreover, the Legislature had the foresight to end some of the benefit enhancements within 10 years.

It’s fair to say that CalSTRS liabilities along with its assets increased as anticipated by CalSTRS actuaries. What subsequently occurred was a considerable economic downturn in 2001, followed by a second, more substantial one, later in the decade. These downturns had almost twice the impact of the benefit enhancements.

Thus, these events less than 10 years apart, coupled with contributions made by members, employers and the state that are set in statute and have not been adjusted in recent years to offset the resulting investment losses, have negatively affected the fund.

CalSTRS has made considerable effort to call attention to its unfunded liability, which is the outstanding debt for projected future benefits, and the risk of not addressing it. The fiscally sound approach to sustain the long-term viability of the fund is a gradual, predictable increase in contribution rates, equitable to all parties involved.

I urge those who would dismiss our evidence to take a moment and think about the effects the dot com bust and the Great Recession had on individuals, families and our nation as a whole. We all suffer in hard times, even the California State Teachers’ Retirement System.