California Crumbling?

Richard W. Raushenbush, a former Piedmont Unified School District Board of Education member and an attorney, wrote an op-ed for the East Bay Times: Increased pension payments threaten state’s schools:

In 2014, the Legislature finally addressed the $74 billion unfunded liability in the California State Teachers Retirement System (CalSTRS) Defined Benefit Program.

While long overdue, the Legislature’s action will significantly degrade California’s K-12 public education system. By placing the burden of paying down this debt primarily on school districts without providing any new funds to do it, the Legislature’s 30-year mandate will force stagnant wages and teacher layoffs.

The CalSTRS’ Defined Benefit Program provides pension benefits to our children’s teachers, who do not receive Social Security benefits. Teachers count on the CalSTRS benefits in pursuing a teaching profession.

The Legislature caused CalSTRS to become drastically underfunded. Under California law, the Legislature is the CalSTRS administrator — it sets the contributions into, and the benefits paid out of, CalSTRS. School districts have no control over contributions or benefits. In 2000, excited by temporary high investment returns, the Legislature passed a package of bills that increased CalSTRS retirement benefits without increasing the contributions necessary to pay for them, and in fact cutting the state’s contributions.

The mirage of endless high investment returns quickly vanished. A 2013 study found: “Had the Legislature not increased benefits, even if CalSTRS’s investments had still underperformed, the funding ratio would currently be 88.4 percent, thereby making CalSTRS one of the nation’s best-funded public pension plans.”

A 2013 report to the Legislature explained: “In 2001-02, when the DB Program first became underfunded, the state and employer contributed 90 percent of the amount needed to fully fund the program within 30 years. By 2011-12, that percentage had declined to 46 percent.” For over a decade, the Legislature ignored the CalSTRS Board’s warnings that the plan was underfunded, and it was getting worse.

In 2014, the Legislature adopted AB 1469, which seeks to pay down CalSTRS underfunding over about 30 years by relatively small increases in contributions from teachers and the State, and by increasing school districts’ contributions over seven years by 10.85 percent. In 2020, school districts’ CalSTRS contributions will be 19.1 percent of teacher payroll!

This is not sustainable. School districts are funded by the public to provide free public education; they do not make profits that can be devoted to paying off the Legislature’s CalSTRS debt. The Legislature did not provide any new funds to pay the significant CalSTRS’ increases. Worse, school districts are being hit twice.

Other school employees are covered by the California Public Employees’ Retirement System (CalPERS), and those contribution rates are projected to go up from 11.442 percent to 20.4 percent by 2020. Think of it this way. School districts spend about 60 percent of their budgets on teacher and staff compensation, so a 10 percent increase in retirement contributions means roughly 6 percent of the entire budget has to be reallocated from educating children to paying off underfunded pension plans.

School districts have few tools to manage their budgets. Absent sufficient funds, pretty quickly the ugly choice is to limit employee compensation or reduce the number of employees. Stagnant or declining compensation will reduce the pool of dedicated and qualified teachers. Teacher layoffs will impact children with larger class sizes and fewer courses. For school districts covering some of the CalSTRS and CalPERS increases with large LCFF “supplemental” and “concentration” grants, the impact may be deferred for a short time. For those districts without, the harm is now.

In Piedmont, where I have served on the Board of Education for the past eight years, the expected state LCFF funding increase in 2017-18 is less than the increase in CalSTRS and CalPERS contributions. For PUSD, the projected LCFF increase in 2017-18 is $196,000, while the CalSTRS and CalPERS increases are projected at $450,000. That’s a budget crisis even with no spending increases on employee compensation, health insurance contributions, Special Education, maintenance, instructional materials, technology, professional development, etc. Absent an increase in State funding, this will get worse as the contribution rates increase through 2020, and then persist until 2046.

The Oakland Unified School District faces significant deficits also. Some of this is caused by the CalSTRS and CalPERS increases. New funds from the state to cover this cost would help OUSD bring its budget back into balance.

Teachers cannot be expected to accept stagnant wages for decades. Good teachers will leave public schools and good candidates will avoid the teaching profession. Students will suffer from larger class sizes, reduced program, loss of counseling and poorer teaching. By placing the burden of paying off the CalSTRS debt on school districts, without any new funding, the Legislature is degrading, and may ruin, California’s public K-12 education system.

There are no easy solutions. The legislators in the 2000 Legislature put unfounded hope over fiscal prudence, and 15 years of adequate retirement contributions were lost. Now, the bill is due. The Legislature and Gov. Jerry Brown must act, and there are two choices, which can work in tandem. First, some budget surplus could be devoted to reducing the CalSTRS debt. Like any other loan, the quicker you pay it off, the less it costs. Second, the state must take responsibility for the portion that must be paid over time, either by increasing the state contribution rate and decreasing the school districts’ rate, or by providing new funding to school districts to pay the CalSTRS increases.

There are many demands on the state budget, but our children’s education must come first. Undoubtedly, this asks our current legislators, who mostly were not around in 2000, to make hard choices. But it must be done. Finally, once the Legislature has made these hard choices, it should then remove itself as CalSTRS pension manager and leave pension administration to professionals driven by their fiduciary duty to current and future retirees.

This is an excellent op-ed which explains the repercussions of California's pension gap and how stupid pension policy has long-term consequences on public finances, education and society at large.

What prompted this op-ed? Robin Respaut of Reuters reports, CalSTRS to consider lowering expected return rate:

The California State Teachers' Retirement System will consider lowering its expected return rate to 7.25 percent from 7.5 percent, based on economic factors and improvements to beneficiaries' life expectancies.

CalSTRS Board is scheduled to consider the move during its February meeting. The recommendation was published late on Wednesday on the public pension fund's website.

The changes are based on new lower assumptions for price inflation and general wage growth, which reduced the probability that CalSTRS would achieve its 7.5 percent return to 50 percent over the long-term, according to the report.

Across the country, public pension funds have been steadily decreasing their expectations for investment returns from an 8 percent median discount rate in 2010 to 7.5 percent today, according to the National Association of State Retirement Administrators.

CalSTRS's sister fund, the California Public Employees' Retirement System (CalPERS) in December lowered its expected rate of investment return from 7.5 percent to 7 percent by 2020, citing lower market growth forecasts over the next decade.

CalSTRS must also take into account improvements in beneficiaries' life expectancies, the report noted.

Under the proposed changes, CalSTRS's funding ratio would drop to 63.9 percent from 67.2 percent, and contribution rates would rise.

CalSTRS estimates that under a 7.25 percent expected return, the state contribution rate would increase by 0.5 percent of payroll for each of the next five years. Currently, the state contribution rate is 8.8 percent of payroll.

The key thing to remember is when CalSTRS or CalPERS lower their long-term expected return assumptions, contribution rates necessarily go up. Unions and governments don't like that because it means teachers and other public-sector workers and the state government need to pay more into the pension system to sustain it over the long run.

More money for pensions means less money for other services and that's where things get hairy. Unfortunately, there's not much of choice. In my opinion, both CalSTRS and CalPERS were running on delusional investment return assumptions for years, much like most US public pensions, and now that reality has caught up to them, they need to act or their pension beneficiaries will pay the ultimate price as benefits will necessarily be slashed if chronic pension deficits persist.

Unfortunately, and I have to be brutally honest here, CalSTRS, CalPERS and pretty much all other large US public pensions are still living in Lala Land when it comes to their long-term investment assumptions. In my opinion, they will be very lucky to obtain 6% nominal annualized ten-year rate of return over the next decade.

What am I basing this on? I look at the discount rate Ontario Teachers, HOOPP, and many other large Canadian public pension funds use and it ranges from just under 5% (OTPP) to 6% for others. How can these US public pensions, all of which are running much less sophisticated operations than their Canadian counterparts, justify a 7% or 7.25% long-term investment return target to discount their future liabilities?

It just doesn't add up. Worse still, the benefits they dole out to their beneficiaries are much more lavish than what Canadian teachers and public sector workers receive, not to mention double-dipping, pension spiking and other rampant abuses.

It's a joke and I keep telling people pensions are all about managing assets AND liabilities. If the math doesn't add up, pension deficits just keep getting worse until they threaten the pension system and other public services. By then, it's often too late to act.

Another problem with CalPERS, CalSTRS and most US public pensions is they keep avoiding implementing some form of a shared-risk model, which Ontario Teachers', HOOPP and other large Ontario pensions have adopted to make sure pension deficits are equally shared among all stakeholders.

Instead, they keep praying Mr. Market will keep going up, up, up, and that by some miracle, if markets go up and interest rates soar back to early 1980s level, voila, pension deficits will disappear and everyone will be happy.

Keep dreaming folks, if my long-term forecast of global deflation materializes -- and I am rarely wrong on my big macro calls like my recent one on the reflation chimera -- then every pension system in the world will be in big trouble, especially those that are already severely and chronically underfunded.

That is when some of you will remember my dire warnings of deflation decimating pensions, but most of California's retired teachers and public sector workers will meet a fate much like those poor retired Greek pensioners that saw massive cuts to their pension benefits.

What happened in Greece can never happen in the United States which prints the world's reserve currency and has a much bigger, more diverse and richer economy than that of Greece? Absolutely true but the thing is when it's time to pay the pension piper and taxpayers aren't able or willing to bail out public pensions, something will give and it isn't going to be pretty.

Let me end with something from The Daily Breeze which cites a study that says two-thirds of California's teachers are ‘pension losers’:

Labor unions and other supporters of traditional defined-benefit pensions tout the oftentimes generous and guaranteed nature of pensions, but many — and sometimes even most — do not come out ahead.

This is particularly true for California teachers, according to a recent University of Arkansas study. In fact, the authors estimate that fully two-thirds of all teachers in the California State Teachers’ Retirement System will be “pension losers” because either they will be among the 40 percent of new teachers who leave before they satisfy CalSTRS’ five-year vesting period, and thus receive no pension, or the value of their pension will be less than what they contributed to the system. A teacher who starts her career at age 25, for example, will have to work until age 53 before merely breaking even with her employer’s pension contributions, the study concludes.

“Under traditional defined-benefit plans, employees and employers make contributions of a given percentage of pay, but those contributions are an average of widely varying individual costs to fund the retirement system,” the authors note. Those costs vary greatly based on how old teachers are when they start working and how many years they end up working.

“With benefits de-linked from contributions, some individuals will receive benefits that cost more than the contributions made on their behalf and some will receive less, effectively a system characterized by cross-subsidies,” they explain.

In other words, those who remain in the system for a very long time are significantly subsidized by newer — and even many not-so-new — teachers.

This is in stark contrast to 401(k)-style defined-contribution plans or cash balance plans, a hybrid that has elements of both defined-benefit and defined-contribution plans. “Under such plans, there would be no cross-subsidies,” the authors observe.

There is also the matter of how financially sound CalSTRS actually is. Under current assumptions, the system is only about 69 percent funded. The CalSTRS board will meet this week to consider reducing the pension fund’s annual investment rate of return assumption from 7.5 percent to 7 percent.

The proposal was prompted by a report from the pension system’s actuary, Milliman Inc., which counseled that keeping the 7.5 percent rate “is not recommended since the probability of achieving this return is less than 50 percent.” It would follow CalPERS’ decision last month to reduce its return rate assumption from 7.5 percent to 7 percent over three years, and would be the third reduction for CalSTRS since 2010, when the rate was as high as 8 percent.

Critics have long argued that such assumptions were unreasonable, and led to smaller government pension contributions that shortchanged the system because they were inadequate to cover future liabilities. The move would require the state to sock away an additional $153 million next fiscal year, and the approximately 80,000 teachers hired since the Public Employees’ Pension Reform Act went into effect in 2013 would have to contribute approximately $200 more per year.

In light of the pension subsidies paid by all but the most seasoned teachers and the financial difficulties experienced by CalSTRS’ defined-benefit system, it would be better for teachers and taxpayers alike to switch to a reasonable defined-contribution or cash balance plan instead.

My thoughts? Any study on pensions from the  University of Arkansas which is heavily influenced by the Koch brothers should be immediately disqualified. Why? Because any study which fails to outline the brutal truth on defined-contribution plans and recommends switching from a DB to a DC, 401(k) type plan is absolute and utter rubbish. Period.

Don't waste your time reading this nonsense. You are much better off reading a study from University of California, Berkeley which shows that for the vast majority of teachers, the California State Teachers’ Retirement System Defined Benefit pension provides a higher, more secure retirement income compared to a 401(k)-style plan.

If the Koch brothers want me to explain in "right-wing, conservative terms" why defined-benefit plans make great sense and are the way to move forward to address America's looming retirement crisis and long-term fiscal crisis, I'd be more than happy to do so. All they need to do is donate or subscribe $5,000 to my blog and fly me over to Wichita and I will explain to them in clear detail why DB plans are far superior to DC plans as long as the assumptions, risk-sharing and governance are right.

Below, CalPERS CIO Ted Eliopoulos discusses reducing the fund’s annual investment return it anticipates to 7 percent from 7.5 percent. It is my understanding that Eliopoulos wanted to reduce the rate even more but they opted to lower it gradually and only to 7 percent.

Eliopoulos also talked about plans to shift as much as $30 billion to internal managers. Smart move, confirms my last comment on the big push to insource pension assets.