PHOENIX – A plan to fully fund the California State Teachers’ Retirement System in the next 25 years may ultimately depend on the state government stepping up contributions, the state's legislative analyst says, though school districts will also bear a heavy burden that could be tough for some of them to shoulder.

The forward-looking analysis is contained in the Legislative Analyst’s Office CalSTRS report released May 5, and paints a picture of a system that is badly underfunded while awaiting the benefits of recently approved contribution increases hitting both the state and the school districts. The LAO is a non-partisan fiscal and policy advisor to the state legislature, which in 2014 passed a law establishing higher contribution rates to the state’s second-largest public pension system.

CalSTRS’ unfunded liability jumped by $21 billion in April as a result of new actuarial assumptions its board adopted that month. Those changes include lowering the assumed return on investments from to 7.25% and again a year later to 7.0% from the previous 7.50%. Also included were changes to assumptions about the life expectancies of retirees and salary growth. The 2014 funding law, Assembly Bill 1469, aims to fully fund CalSTRS by the mid-2040s and spare teachers from massive contribution hikes by placing the majority of the burden on the state and on school districts. The state share of the new unfunded liability growth is about $15 billion, the LAO said, with districts owning $5 billion and a small portion unassigned.

“As implemented by CalSTRS, the 2014 funding legislation makes the state responsible for unfunded liabilities associated with the benefits and contributions that were in place in 1990,” the LAO report says. “This means that the state’s share of CalSTRS’ unfunded liabilities and its contribution rate are based on an estimate of what CalSTRS’ funding situation would be today had the state made different decisions about teacher pensions in the past.”

This essentially creates a hypothetical scenario in which the state had not granted teachers more generous pensions in the late 1990s and state and teacher contributions to CalSTRS’ main pension fund had not been decreased when CalSTRS was fully funded around 2000. This means that the CalSTRS theoretical portfolio is larger than the real-world one, roughly $189 billion vs. about $170 billion. As such, the assumptions that determine the state’s share, the theoretical one, are volatile because changes to the real-world portfolio are magnified by the larger size of the theoretical one.

“For example, if CalSTRS’ real world portfolio grows by $10 billion, the calculation gives the state the benefit of a roughly $11 billion gain,” the report said. “Of course, the opposite is true as well. When CalSTRS records an investment loss—as they did in 2015‑16—the loss to the theoretical investment portfolio is larger than the real world loss, making the state share of the unfunded liability grow more than the increase in the real world unfunded liability.”

Increases in the state’s contribution rate are capped under state law at 0.5% per year, creating some LAO concern that poor investment performance or further actuarial changes could prevent CalSTRS from becoming fully funded on schedule.

“Under some scenarios, the funding plan may fall short of its key goal of fully funding CalSTRS by the mid‑2040s because this cap could keep state rates below what is necessary to fund CalSTRS,” the report said. “In short, whether the funding plan meets its stated goal will depend largely on whether the state pays enough to CalSTRS.”

The report suggests that the legislature could consider ramping up state contributions to CalSTRS, through some combination of increasing the contribution rate increase cap or using capital gains currently dedicated to debt repayment to help pay down the state’s share.

“CalSTRS is heartened to learn that the Legislative Analyst’s Office, the legislature, and Governor Brown’s Administration, all view CalSTRS funding as a priority,” CalSTRS spokesman Ricardo Duran told The Bond Buyer. “The LAO, in the report, has suggested options for additional state contributions. However, CalSTRS has not made similar recommendations because, in our view, the contributions required by the 2014 funding plan are sufficient to keep CalSTRS on a trajectory toward full funding.”

While the state may bear the lion’s share of the funding increases under the new funding plan, school districts bear the heaviest cost overall. As of the latest actuarial valuation, the district share of CalSTRS’ unfunded liability increased to $67 billion out of a total unfunded liability of $97 billion. Analysts said when the funding plan was put in place in 2014 that the formula could pressure some financially weaker school districts, as districts are currently slated to see their contribution rates rise to over 19% by 2021 from 12.58% in 2017.

Local educational agencies are required to file two reports per year with the state Department of Education, and those reports must include a certification about the district’s financial health. A qualified certification is assigned when the district may not meet its financial obligations for the current or two subsequent fiscal years. A negative certification is assigned when a district will be unable to meet its financial obligations for the remainder of the current year or for the subsequent fiscal year.

Los Angeles Unified School District, the nation's second largest school district and an issuer with more than $10 billion of general obligation bonds outstanding, received a qualified certification in its most recent interim report. The district had no comment on the LAO’s findings, but said it was aware of the projections and mindful of them.

“We are reviewing the report and will build in the added costs to our multi-year projections,” said LAUSD chief communications officer Shannon Haber.

Statewide teacher contribution rates are not slated to rise very much. They will remain flat at 10.25% for teachers hired before Jan. 1 2013, and rise to 10.21% from 9.21% for teachers hired after that.

Despite the concerns about volatility in state contribution rates, the LAO concluded that the new CalSTRS assumptions are a good thing. “CalSTRS’ new mortality assumptions better reflect future expected improvements in life expectancy,” the report said. “The new assumptions will increase future state contributions to address the increases in CalSTRS’ unfunded liabilities.

“These decisions will increase contributions to CalSTRS, reduce the likelihood that unfunded liabilities materialize in the future, and keep the funding plan on track for full funding. As such, we view these developments positively.”

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