Comprehensive Funding Strategy – History of Board Discussions About the Unfunded Actuarial Obligation (Funding Gap)
The Teachers’ Retirement Board began exploring the unfunded actuarial obligation—the gap between CalSTRS assets and long-term liabilities—following its adoption of the June 30, 2003 Defined Benefit (DB) Program actuarial valuation in June 2004. The valuation identified the DB Program as being 82 percent funded and carrying a $23.1 billion funding gap.
In December 2004 CalSTRS staff presented the board with possible solutions to address this gap that included:
- Reducing benefits
- Increasing contributions from members, employers and the State of California
- Extending the amortization period used to measure funding status
- Working with the state to issue pension obligation bonds
During the following two years, board members continued to analyze and discuss how to address the funding gap. Along the way, stakeholders were solicited for input on the feasibility of possible solutions.
A number of possible solutions fell short because they either were deemed inapplicable to CalSTRS based on current plan design, were very difficult to administer, or would affect only future conditions and not the existing funding gap.
Therefore, in September 2006, the board focused on a funding strategy that primarily depended on:
- Keeping existing benefits stable and pursuing a legal guarantee of the annual 2 percent benefit adjustment.
- Increasing employer contributions within a specified range necessary to fully fund the DB Program within 30 years, not to exceed 0.5 percent increase any one fiscal year.
- Increasing the state contribution within the range of 1 to 1.25 percent.
- Increasing member contributions by 0.5 percent (to 8.5 percent).
The following December, staff drafted statutory language for the funding strategy and presented it to the board for eventual legislative sponsorship and vote by the Legislature. However, given the substantial undertaking required to implement the strategic package, the board determined it would be wise to initiate an extensive communication and education effort so that members, retirees, stakeholders and policymakers would be thoroughly versed in the logic and necessity behind addressing the funding gap. This communication and education initiative would be implemented before seeking legislative sponsorship for the funding strategy.
CalSTRS staff held meetings over the following two years with nearly every organization representing CalSTRS stakeholders to educate them on the importance of addressing the funding issue.
The Impact of the 2008 Market Downturn
In June 2009 CalSTRS staff updated the board on the execution of the funding strategy. Even though staff had made a concerted effort over the prior two years to educate stakeholders on the funding strategy, the severe market downturn presented new challenges to its implementation.
For one, the negative investment returns significantly widened the funding gap beyond what was projected when the funding strategy was adopted in late 2006. Consequently, the increased contributions required to fully fund the DB Program would need to be greater than originally planned.
At a time when school district budget reductions were forcing teacher layoffs and the state was mired in a historic budget impasse and ensuing budget shortfall, prudence necessitated a more conservative pace at which CalSTRS would expect legislative sponsorship for the contribution increases outlined in the funding strategy.
The board implemented a multi-layered outreach effort to further bolster member education about the value of their defined benefit pension and the need for prompt action to address the long-term sustainability of the fund. This outreach was facilitated through several channels, including:
- The member education microsite CalSTRSbenefits.us
- Public speaking engagements by board members and CalSTRS leadership, articles in member publications
- Audio town hall meetings for retired members
Media Attention on Public Pensions
In addition to widening the funding gap beyond the original 2006 assumption and compelling CalSTRS to approach education on the funding issues with greater delicacy, the historic market downturn and unprecedented collapse of financial institutions ignited a firestorm of media attention toward public pensions.
The crux of this attention fixated on the incorrect perception that funding public pensions was a tremendous burden on state and local budgets. A byproduct of the increasingly heated rhetoric was the scrutiny from a small handful of academics that challenged and attempted to discredit the traditional methods by which public pension plans measure solvency. More specifically, the focus of this research was on the assumed investment rate—the rate of return the pension plan chooses to project the long-term return on its investment portfolio.
As long-term investors, public pension plans primarily assume around an 8 percent return on their investments, a number confirmed as suitable based on actuarial opinion and historic investment experience. However, the small contingent of academics claimed this number was unrealistic and needed to be significantly reduced (closer to 4 percent) to reflect the slumping markets and match the return on “risk free” investment instruments issued by the full faith and backing of the federal government.
The media attention this topic received created a widespread impression that public pension plans were understating their true liabilities. At the same time, public pensions nationwide, including CalSTRS, were re-evaluating their investment assumptions in light of the depressed markets of the last decade and lowered expectations in the future.
In December 2010, after extensive research and deliberation, the board lowered the DB Program investment assumption to 7.75 percent, after assuming an 8 percent return on CalSTRS investments the previous 15 years.
As of June 30, 2012, the DB Program was 67 percent funded with a $70 billion funding gap as a result of the market downturn and a reduction in the assumed investment rate.
The following graph shows CalSTRS funding levels from 1972 through 2010:
Legal Considerations for Addressing the Funding Gap
The board determined that an essential component in addressing the funding gap was to receive legal guidance on its and the state’s roles and responsibilities as they pertained to the benefits promised to educators.
In September 2010 outside legal counsel spoke to the board about the strong public policy in California, reinforced through published legal decisions over the past half century, that established the sanctity of public employee retirement benefits as contractual obligations entitled to state and federal constitutional protections.
The legal counsel concluded that, under law, the state has “guaranteed full payment” of the benefits promised to educators and had not limited its liability to the amounts administered from time to time by CalSTRS. In other words, the benefits promised to educators are guaranteed by the State of California and the state is ultimately responsible for payment of those benefits, even if all funds in the CalSTRS trust fund are exhausted.
The legal opinion also noted that the role of the board is to administer CalSTRS in a manner that will assure prompt delivery of benefits and related services to CalSTRS members and beneficiaries. Establishing the distinction between the board’s role and the state’s role was important because it further clarified why efforts to address the funding gap require a collaborative effort from all stakeholders.
The board continues to regard the solvency of CalSTRS as its primary focus. Although CalSTRS is projected to have sufficient assets to pay benefits for at least the next 30 years, long-term changes in CalSTRS funding are required to be sure funds are available in the future.
The board and CalSTRS staff continue to work with stakeholders to help develop a solution to the funding gap that balances the current budget climate facing the state and schools with the retirement security of California’s educators.