Proposed Funding Plan is Reasonable and Responsible
Since the release of the Governor’s revised budget proposal, considerable discussion on a potential funding plan for CalSTRS fills social media and news networks. The possibility of a funding plan comes as welcome news.
Decades-long discussions and extensive legislative visits have finally resulted in constructive recognition of the need to stabilize CalSTRS funding. However, questions that challenge the soundness of full funding within 30 years hold the potential to extinguish aspirations of a reasonable approach.
Last year CalSTRS submitted its , pursuant to SCR 105, on considerations necessary to achieve a long-term sustainable funding plan. The CalSTRS board stated with emphasis and intent that the definitive approach is to fully fund the Defined Benefit Program within 30 years. This strategy holds consistent with the board’s fiduciary responsibilities, governmental accounting standards and actuarial guidelines.
Recently, some have asked policy makers to consider a funded ratio target of at least 70 to 80 percent as a healthy status for a pension fund with an amortization period of more than 30 years. The attractiveness of this approach is that it requires less immediate contribution increases, but it comes at a substantial risk to an already compromised funding level. Based on the June 2013 actuarial valuation, the program’s funding fell to just below 67 percent.
One might assume that the only risk associated with this approach is its more expensive price tag. While this is true, an even greater and more substantial risk is that the target funded ratio will never actually be achieved. Much like long-range archery, the further you move the target back, the harder it becomes to reach it.
Additionally, the Legislative Analyst’s Office, along with actuarial organizations, regard it a myth to consider a pension fund as healthy at 80 percent. A third risk associated with this approach is that with a target funding of 80 percent, additional contributions will always have to be paid to maintain the funded ratio.
Put another way, if a considerable market downturn were to occur within the next few years, the funded ratio could drop to a level that makes it exponentially more expensive to provide long-term funding viability. For example, if investments decline by 10 percent annually for the next two years, the funded ratio could plummet below 50 percent by the end of the second year. In other words, a market downturn of a magnitude considerably less than the most recent Great Recession might accelerate a serious depletion of assets.
But still, why 30 years? Why not 40 or 50 as the period of time needed to achieve even full funding? This consideration best illustrates the implications of short-term versus long-term costs and the risks associated with each. Lengthening the number of years spreads out the contribution increases needed because the unfunded liability is being paid off over more years, but ultimately requires higher total contributions. The best approach is to strike the right balance between time and financial commitment.
In the CalSTRS developed at the request of the Legislature, we clearly illustrate the expenditure differences. To achieve full funding in 20 years under specific contribution rates, it would cost about $182 billion; in 30 years it would be $236 billion; in 40 years it jumps to $319 billion; and in 50 years the costs grow to $442 billion in today’s dollars. The question policy makers have to consider is which timeframe and upfront financial commitment satisfies a reasonable time and cost.
Again, keep in mind the further back you move the target, the harder it becomes to reach it. The longer amortization period also significantly extends the time that the program is dramatically underfunded, exposing the plan to greater risk of a downturn. And the less money you have to invest, earn the assumed rate of return, and reduce future contributions accordingly.
Let us explore the idea of paying down the CalSTRS unfunded liability of approximately $74 billion in 20 years. This is analogous to a 30-year home mortgage versus a 15-year mortgage. Although a homeowner with a 30-year mortgage has a lower monthly payment, because they are paying off the mortgage over twice as long a period of time, they are actually contributing less to the mortgage principal, and therefore paying more in the long run than the 15-year mortgage homeowner.
It is true that for a 15-year mortgage a homeowner’s total costs will be substantially less. But in a resource-scarce financial environment, how many folks are in a position to afford the considerably larger upfront costs?
Similarly, any attempts to restore CalSTRS’ long-term viability based on a 20-year fully funded scenario would require a steep increase in the amount of contributions needed from members, school districts and the state. The resulting amount required to pay down that liability places a tremendous and sudden financial burden, particularly on school districts at a time when student programs desperately need additional funding.
The bottom line is that timely funds on hand minimizes the long-term cost of the program and allows those funds to grow from investments when they would otherwise need to be generated from contributions alone, ultimately reducing the need for future contributions to pay for benefits associated with prior service.
There is no easy solution to how the CalSTRS unfunded liability is addressed. But the solution must be strong and complete. Any piecemeal approach only adds costs and risks to an already fragile framework.
This why CalSTRS supports the May Revision plan to share responsibility among contributors, fully fund the program in about 30 years and phase in increases as proposed. It is a reasonable and responsible solution.