Posts

Examining the CalSTRS Shareholder Bailout

“CalSTRS has a $70-plus-billion unfunded liability – even with assumed investment earnings that Brown deems ‘highly unlikely’ – and says it needs about $5 billion more a year to regain solvency.”
–  Dan Walters column, “Brown budget reflects state’s massive debt,” May 25, 2014, Sacramento Bee

Those “investment earnings” that Walters quotes Brown as finding “highly unlikely,” refer to the long-term annual return on investment projection of 7.5% used by CalPERS (ref. FYE 6-30-2013 CalSTRS Annual Report, page 29).

So what happens if investment earnings generated by CalSTRS are destined to, as even California’s union-friendly Governor Brown attests, achieve more “likely,” lower returns? In November 2013, using data from CalSTRS FYE 6-30-2012 Annual Report, the California Policy Center released a study “Are Annual Contributions Into CalSTRS Adequate?,” that examined this question.

The first objective of this study was to calculate how much CalSTRS was actually paying down on their unfunded liability. Here’s what it found:

“For the fiscal year ended 6-30-2012 the California State Teachers Retirement System, CalSTRS, collected $5.8 billion. Of this $5.8 billion, $4.7 billion was the normal contribution and the remaining $1.1 billion was a ‘catch-up’ payment to reduce the unfunded liability, which as of 6-30-2012 was officially estimated to be $71.0 billion.”

Based on these numbers, which are all pulled directly from CalSTRS official disclosures, it should come as no surprise that Gov. Brown’s CalSTRS bailout plan requires annual contributions into CalSTRS to double. When you are paying down mortgage of $71 billion – the imperfect analogy that nonetheless applies quite accurately in this context – and in a given year you only pay $1.1 billion (one seventieth), you will never pay off your mortgage. Rather, you will incur negative amortization, owing more every year.

Where will this money come from?

To put this challenge in perspective, it is relevant to note just what CalSTRS retirees are getting. According to 2012 data provided by CalSTRS, as summarized in a March 2014 California Policy Center study “How Much Do CalSTRS Retirees Really Make?,” the average CalSTRS employee after a 30 year career currently retires with a pension of $51,500 per year; their average retirement age is 62. How many private sector employees can work 180 days a year for 30 years and retire with a guaranteed annuity this big – including annual cost-of-living adjustments? The conventional wisdom of retirement planners is to save approximately 25 times the amount you intend to eventually withdraw each year to live on. That’s $1.3 million. How many people can work 180 days a year for 30 years and save $1.3 million?

The idea that CalSTRS participants can save this much money via their 8.25% payroll withholding is ludicrous. And the idea that contributing 8.25% to CalSTRS vs. 6.4% to Social Security justifies a pension benefit this much higher than what participants can expect from Social Security is equally unfounded. Here is the conclusion of a February 2014 California Policy Center study “Comparing CalSTRS Pensions to Social Security Retirement Benefits.”

At age 62, the average CalSTRS retiree collects 56% of their final salary in the form of a pension, whereas, depending on their income, the average Social Security recipient collects between 29% and 36% of their final salary in the form of a retirement benefit. At age 65, the oldest age necessary to collect the full CalSTRS benefit, a CalSTRS retiree with 35 years experience will collect a retirement benefit equal to 84% of their final salary. At age 65 a Social Security recipient will collect a retirement benefit between 30% and 35% of their final salary.

The CalSTRS bailout – and it is a bailout – will cost California’s taxpayers an additional $5.0 billion per year, and only if, as Governor Brown says, the “highly unlikely” average returns of 7.5% per year are realized. But as documented in the aforementioned study “Are Annual Contributions Into CalSTRS Adequate?,” using a 20 year payback period, here’s what lower rates of return mean for California’s taxpayers:

  • At 7.5% per year, unfunded contribution = $7.0 billion per year (increase of $5.9 billion over what was actually paid).
  • At 6.2% per year, unfunded contribution = $9.6 billion per year.
  • At 4.8%, unfunded contribution = $12.2 billion per year.

The 20 year amortization period, recommended by Moody’s investor services, used in the study, resulted in an estimate $900 million over the latest figures from Governor Brown. This minor discrepancy validates these calculations more than anything else – they probably used a 30 year payback period. Fine. Let’s continue.

  • At 7.5% per year, the normal contribution necessary to CalPERS, i.e., not the “catch up” payment on the underfunding of prior years, but just the payment necessary to cover future pensions earned in each most recent year, is $4.7 billion per year.
  • At 6.2% per year, the normal contribution = $5.8 billion per year.
  • At 4.8%, the normal contribution = $7.2 billion per year.

To summarize:  In the FYE 6-30-2012 CalPERS, assuming a long-term return of 7.5% per year, received contributions (normal and unfunded) of $5.8 billion; they should have collected total contributions of $11.7 billion ($10.7 billion using Brown’s numbers). But if their rate of return going forward drops to 6.2% per year, they would have had to collect $15.4 billion. Got that? If the highly unlikely 7.5% average annual return isn’t realized, and only 6.2% is realized instead, taxpayers will pitch in nearly $10 billion more per year, just to bail out CalSTRS.

The money is not there.

And why is the 7.5% return “highly unlikely?”

(1) Pension funds are starting to pay more in benefits than they collect via contributions, for the first time ever. As a result, pension funds, who own over 20% of all U.S. equities, are becoming net sellers in the market instead of net buyers, pushing prices down.

(2) The U.S. population is aging, with citizens over age 65 projected to represent 22% of the population by 2020, compared with just 11% in 1980. All of them will be slowly selling off their retirement assets instead of buying and saving assets for retirement – twice as many people as a generation ago – also pushing prices down.

(3) A major factor in the market rise of the past 40 years was the accumulation of debt and progressively lower interest rates, which flooded the economy with cash and caused rapid stock price appreciation as companies profited from debt-fueled consumer spending – those days are over.

(4) Pension funds are now too big to consistently beat the market, assuming they ever could.

There is a larger question, however. Why is it that government unions, and their progressive partners, are so anti-corporate, when it is corporate profits that fuel the high returns of their pension funds? Why is it they urge us to blame pension challenges on banks, when it is the banks that lowered interest rates to literally zero (accounting for inflation), in order to create the asset bubble that keeps their pensions marginally solvent? Why is it they blame corporations for caring more about shareholders than workers, when their pensions are dependent on the pension funds reaping massive shareholder benefits from this supposedly misplaced priority?

Ultimately, the solution to the pension crisis facing CalSTRS that is most consistent with progressive principles would be for teachers from now on to collect Social Security instead of pensions, and for existing participants in CalSTRS to collect a pension benefit that is reduced by precisely the amount CalSTRS is underfunded – i.e., a 30% cut to benefits, across the board, to everyone. That solution would epitomize “fairness,” a concept of which they speak so eloquently, and so often.

*   *   *

Ed Ring is the executive director of the California Policy Center.

Public Sector Pension Plans Do Not Pass the "Smell Test"

“Pew’s relationship with the Arnold Foundation does not pass the smell test,” said Meredith Williams, Denver-based executive director of the National Council on Teacher Retirement.
–  “Pension Funds Press Pew to Cut Arnold Foundation,” Philanthropy Today, March 4, 2014

If you’re looking for an example of how, increasingly, political debate in America is framed as a battle between tainted – and very powerful – special interests who harbor nefarious personal agendas, instead of a rational exchange of competing facts and logic aimed at finding optimal solutions, look no further.

Apparently, across the United States, any reputable nonprofit, from Pew and PBS to your underfunded start-up, now has to refuse gifts from major donors unless they happen to be (1) funded by public sector unions, or (2) originate from the pockets of left-wing billionaires. Everything else is tainted. Everything else fails the “smell test.”

Apart from the absurdity of tagging individuals and organizations with terms as archaic as “right-wing” and “left-wing,” when it is left-wing government unions that have joined forces with right-wing crony “capitalists” to exterminate what remains of America’s private sector middle class and small business community, the tactic of tainting the messenger results in a tragic smothering of constructive dialog.

When debate focuses on facts, the truth, and sound policy, emerges. When debate focuses on which participant stinks more, truth doesn’t matter. And the likely truth that should be debated is this: If anything doesn’t pass the “smell test,” it is the long-term financial solvency of public sector pensions as they are currently formulated. They are on a collision course with reality.

Over the past several months the California Public Policy Center has produced numerous short studies assessing public sector pension plans in California. Since the National Council on Teacher Retirement is probably concerned primarily with teachers pensions, here are two points from those studies, submitted for genuine debate, regarding CalSTRS:

CalSTRS Contributions Are Well Below Levels Necessary to Maintain Solvency

The officially recognized amount of CalSTRS unfunded liability is $71 billion. In their fiscal year ended 6-30-2012, CalSTRS made an “unfunded payment” towards reducing that liability of $1.1 billion. If CalSTRS were to adhere to the GASB and Moody’s recommended repayment schedules – which take effect later this year – that payment would have to be many times greater – to quote from the study “Are Annual Contributions Into CalSTRS Adequate?

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the “catch-up” payment is calculated based on a level payment, 20 year amortization of the $71.0 billion unfunded liability – still assuming a 7.5% rate-of-return projection – this catch-up payment should be $7.0 billion per year. The study also shows that if the CalSTRS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $107.8 billion and the catch-up payment increases to $9.6 billion per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $154.9 billion and the catch-up payment increases to $12.2 billion per year.

CalSTRS Retirees Collect Pension Benefits Far In Excess of Social Security Retirees

Here is a quote from a press release issued by CalSTRS in opposition to the proposed citizen initiative, the Pension Reform Act of 2014, (already DOA for 2014, by the way), “California’s educators do not participate in Social Security, retire on average around age 62, and earn a retirement income that replaces only about 56 percent of their salary.

The implication here seems to be that CalSTRS retirees would prefer to be part of Social Security. So here’s the comparison between a typical CalSTRS benefit and the Social Security benefit, from the study “Comparing CalSTRS Pensions to Social Security Retirement Benefits.”

“At age 62, the average CalSTRS retiree collects 56% of their final salary in the form of a pension, whereas, depending on their income, the average Social Security recipient collects between 29% and 36% of their final salary in the form of a retirement benefit. At age 65, the oldest age necessary to collect the full CalSTRS benefit, a CalSTRS retiree with 35 years experience will collect a retirement benefit equal to 84% of their final salary. At age 65 a Social Security recipient will collect a retirement benefit between 30% and 35% of their final salary.

The study then examined how much more a CalSTRS participant might have accumulated based on having 8.0% of their paycheck withheld vs. only 6.4% for a Social Security participant. For a CalSTRS paticipant retiring at age 65 with a final income of $80,000, the study estimated the value of this extra 1.6% in annual contributions to equal $138,502 after 35 years of withholding. This is equal to just over three years of the difference in the amount of a typical annual CalSTRS pension and a typical Social Security annual retirement benefit, i.e., it does not come close to closing the gap between the typical Social Security benefit vs the typical CalSTRS benefit.”

What these two points exemplify ought to be quite clear, and ought to be the topic of debate that relies on facts, logic and fairness, instead of competition to discredit the messengers – or their sources of funding: (1) Public sector pensions are not financially sustainable without major changes to contributions and benefit formulas, (2) Public sector pensions provide far more retirement security than Social Security, despite requiring comparable mandatory levels of withholding from employee paychecks.

Anyone who actually reads material from the Arnold Foundation will likely be impressed by the level of scholarship and objectivity they bring to their analyses. The open minded reader may wish to peruse this solution paper, “Creating a New Public Pension System,” authored by Arnold Foundation scholar Josh McGee, a Ph.D economist who has studied public pensions for many years.

Solving America’s public sector pension crisis, and it is a crisis, doesn’t necessarily require abandoning defined benefit plans. But they will have to be converted to “adjustable defined benefit” plans that can, for example, freeze COLAs, lower benefit formulas (at least) prospectively, and raise required employee contributions, whenever necessary, in order to preserve solvency, protect taxpayers, and spread the sacrifice among all participants – new hires, active veterans, and retirees – in order to minimize the sacrifice any single class of participants might have to experience.

Ultimately, what doesn’t pass the “smell test” is the alternative to reform: Increasing the tax burden on private sector workers and small business owners in order to subsidize public employee retirement plans that offer benefits many times better than Social Security.

Are America’s public sector pension plans financially sound, or are they are a rotting, stinking carcass, sprayed with public relations perfume and papered over with pretty ideological colors? Are they healthy financial contributors to America’s prosperity, victims of unwarranted attacks from “right-wing” ideologues, or are they an oppressive, inequitable, gargantuan, putrescent bubble that shall someday pop, pouring a reeking stench across the economic landscape of this nation?

That is the debate that ought to rage, focusing on facts, not pheromones.

*   *   *

Ed Ring is the executive director of the California Public Policy Center

RELATED RECENT POSTS AND STUDIES

Comparing CalSTRS Pensions to Social Security Retirement Benefits, February 28, 2014

Pension Reform Comes to Ventura County, February 25, 2014

The Fall of Pacific Grove – Conclusion: The “California Rule” Cannot Stand, February 25, 2014

Pension Funds and the “Asset” Economy, February 18, 2014

How Much Do CalPERS Retirees Really Make?, February 13, 2013

How Does “Zero-point-Eight at Sixty-Eight” Sound for a Pension Plan?, February 11, 2014

Why Middle Class Private Sector Workers Are NOT “Ripping Off the Next Generation,” December 17, 2013

How Unions and Bankers Work Together to Protect Unsustainable Defined Benefits, November 26, 2013

CalSTRS Contributions Inadequate; Unions Call Reformers “Right-Wing Ideologues,” November 12, 2013

Are Annual Contributions Into CalSTRS Adequate?, November 8, 2013

Saving Pensions Will Require Unions To Face Reality, August 27, 2013

Social Security is Healthy Compared to Public Sector Pensions, July 30, 2013

A Method to Estimate the Pension Contribution and Pension Liability for Your City or County, July 24, 2013

Calculating California’s Total State and Local Government Debt, April 26, 2013

How Lower Earnings Impact California’s Total Unfunded Pension Liability, February 18, 2013

California State Budget Increases 9%, Includes Raises for Unionized State Workers

Shortly after Jerry Brown was first elected governor, nearly 40 years ago, he famously said, “This is an era of limits and we all had better get used to it.”

In keeping with this theme, it is now taxpayers who look at Governor Brown’s proposed 2014-15 budget with reduced expectations.

In fairness, there are aspects of the budget plan that taxpayers can endorse. The budget reflects at least some measure of fiscal restraint and austerity. Brown’s desire for no new taxes, continuing to pay down the ‘wall of debt’ and establishing a prudent reserve is commendable.

Nonetheless, there was much unsaid — some positive, some negative — in the budget plan. On the plus side, at least Brown did not launch a jihad against Proposition 13, which must have come as a serious disappointment to some of the more rabid Democratic members of the Legislature.

On the negative side, the failure to address major fiscal problems is a glaring omission. The teachers retirement fund — CalSTRS — has a huge unfunded liability that renders meaningless all the “happy talk” about surpluses. [Editor’s Note: ref. November 2013 CPPC study “Are Annual Contributions Into CalSTRS Adequate?“] Add to that the massive shortfall in the unemployment insurance fund and the long term obligation to provide health care benefits to government employees and the good news turns out to be not so good. Without action, these liabilities will continue to expand and come back to haunt both taxpayers and the state economy in the future.

Sadder still is that the governor wants to throw good money after bad into the moribund high speed rail project which is a horrible misapplication of precious transportation dollars. Adding insult to injury, he announced a plan to use “cap and trade” revenue to pay for the high speed rail boondoggle which may exacerbate the major legal problems he is already facing.

Also, there is a lot more money for state employees. This criticism may sound mean spirited, but it is important to note that California already has the highest paid public employees in all 50 states and the additional pay is coming from the Proposition 30 tax increase. So while state workers will get more, average Californians will have less because they have to pay for the higher compensation.

Finally, with respect to a spending limit proposal, the governor said, “The devil is in the details,” which does not show that he has clear vision or sense of urgency on this important policy issue. (And do we really think the California Legislature will sign on to a plan that limits their spending power in a manner that is remotely effective?)

There is another quote from Jerry Brown’s first term that is worth noting. In response to criticism from liberal members of his party for failure to spend even more he said, “It’s not because I’m a conservative, it’s because I’m cheap.”

However, this year’s budget proposes increasing spending by nearly 9 percent and it is clear that counting on the governor’s parsimony is not sufficient protection for taxpayers. And this budget is just a first offering. The administration will issue a revised budget in May, based on more up-to-date revenue forecasts, and what lawmakers finally approve prior to the June 15 deadline may include a great deal of additional spending.

It is clear that California needs a spending limit with teeth that allows increases only for inflation and population growth. Perhaps one of those super wealthy individuals, who, in recent years, have put massive amounts of money behind their pet ballot measures, would like to put their shoulder behind an initiative measure that would actually do some good.

Jon Coupal is president of the Howard Jarvis Taxpayers Association — California’s largest grass-roots taxpayer organization dedicated to the protection of Proposition 13 and the advancement of taxpayers’ rights.

Are Annual Contributions Into CalSTRS Adequate?

Preface: Earlier this year the California Policy Center published a study evaluating the Orange County Employee Retirement System (OCERS) to explore this same question: Are Annual Contributions into OCERS Adequate? That study adopted a unique focus, evaluating contributions into OCERS not based on percent of payroll, but by looking at the actual amount of cash being contributed each year. In particular, the study evaluated how much cash each year was being contributed to reduce the unfunded liability. This report performs the exact same analysis, using the exact same template. Different numbers; same story. Pension analysts and pension activists are encouraged to download the spreadsheets (CalSTRSOCERS) used in both of these studies, and use them to perform similar analysis for whatever pension systems they are concerned about. For whatever pension fund they choose to analyze, it is quite likely they will find that the amount of money being contributed to reduce the unfunded liability is alarmingly low.

Summary: For the fiscal year ended 6-30-2012 the California State Teachers Retirement System, CalSTRS, collected $5.8 billion from employees and employers to invest in their pension fund. Of this $5.82 billion, $4.7 billion was the so-called “normal contribution,” which was a payment to cover the present value of future pensions earned during FYE 6-30-2012 by actively employed participants. The other $1.1 billion that was collected and invested in the fund was a “catch-up” payment to reduce the unfunded liability, which as of 6-30-2012 was officially estimated to be $71.0 billion.

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the “catch-up” payment is calculated based on a level payment, 20 year amortization of the $71.0 billion unfunded liability – still assuming a 7.5% rate-of-return projection – this catch-up payment should be $7.0 billion per year. The study also shows that if the CalSTRS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $107.8 billion and the catch-up payment increases to $9.6 billion per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $154.9 billion and the catch-up payment increases to $12.2 billion per year.

This study also finds that the $4.7 billion normal contribution into CalSTRS for FYE 6-30-2012 was based on a rate-of-return assumption of 7.5%. The study shows that lowering the rate-of-return projection from 7.50% to 6.20% would require the normal contribution to increase by another $1.1 billion; lowering it from 7.50% to 4.81% would require the normal contribution to increase by another $2.5 billion. The rate of 6.2% represents the historical performance of U.S. equity investments (including dividends) between 1900 and 1999. The rate of 4.81% is the Citibank Pension Liability Index rate as of July 2013, which is the lower risk rate recommended by Moody’s Investor Services for pension liability forecasting.

The conclusion of this study is that CalSTRS relies on optimistic long-term earnings projections and very aggressive unfunded liability repayment schedules in order to pay the absolute minimum into their pension fund. If CalSTRS is required to even incrementally lower their rate-of-return projections – something that market conditions may eventually dictate – their funded ratio which is already only 67.0% will fall precipitously. Unless extremely favorable market conditions occur for the next several years without interruption, in order for CalSTRS to remain solvent, they need to dramatically cut retirement benefits, or increase their annual contributions by 50% or more per year.

*   *   *

INTRODUCTION

The purpose of this brief study is to assess whether or not the $5.82 billion contributed during the fiscal year ended 6-30-2012 into the CalSTRS pension fund was sufficient to ensure the long-term solvency of the fund. Using methods recommended in July 2012 and finalized in April 2013 by Moody’s Investor Services, and elucidated in a recent CPPC study “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County,” this study will perform what-if scenarios, estimating the size of the CalSTRS unfunded liability at various rates of return.

This study will also discuss whether or not the current contributions, both normal and catch-up, add sufficient assets to the CalSTRS fund to ensure solvency, and how much contributions would need to increase using more conservative assumptions regarding return on investment and payback periods. Finally, throughout this study an attempt will be made to discuss and explain key concepts of pension finance, in keeping with the CPPC’s mission to inform and involve more people in discussions of sustainable public finance. The tables in this study were produced on an Excel spreadsheet that can be downloaded here:

DOWNLOAD SPREADSHEET:  Analysis-of-CalSTRS-Pension-Liability-and-Contributions.xlsx

The officially recognized amounts for key variables used in this study, including the total contribution to the pension fund, normal contribution, “catch-up” contribution to reduce the unfunded liability, as well as the total assets, total liabilities, and unfunded pension fund liability, were all drawn from publicly available CalSTRS financial reports.

*   *   *

HOW MUCH WAS CalSTRS UNDERFUNDED AS OF 6-30-2012?

The underfunding of any pension fund is calculated by subtracting from the amount of the total invested assets the present value of the liability to pay pensions in the future. Because these future pension obligations are intended to be paid sometime between next year and 50-60 years from now, the liability today is calculated by adding up the net present values of the estimated payments to be made for each year in the future. If the total value of the pension fund’s invested assets is equal to the present value of all future pension payments, the fund is said to be 100% funded.

Using data from the CalSTRS “Defined Benefit Program Actuarial Valuation as of June 30, 2012,” here are the officially recognized amounts for CalSTRS assets, liabilities, and underfunding at the end of last year [1]:

  • Actuarial accrued liability (AAL) = $215.19 billion
  • Valuation value of assets (VVA) = $144.23 billion
  • Unfunded Actuarial Accrued Liability = $70.96 billion

*   *   *

HOW MUCH WAS CONTRIBUTED INTO CalSTRS IN FYE 6-30-2012?

Again using data from CalSTRS “Comprehensive Annual Financial Report, FYE 6-30-2012,” the total contribution into the pension fund in 2012, via direct payments by participating employers and withholding from participating employee paychecks, was $5.82 billion [2].

Annual pension fund contributions have two components, the “normal contribution,” and the “unfunded contribution,” which is the amount paid towards reducing the plan’s unfunded liability. The “normal contribution,” simply stated, needs to be an amount equal to the present value of future pension payment obligations earned in the current year.

Normal Contribution: The total employer and employee normal cost for FYE 6-30-2012 was $4.69 billion as documented on page 15 of the Milliman actuarial report for CalSTRS, “Defined Benefit Program Actuarial Valuation.” [3].

Unfunded Contribution: The amount paid into the CalSTRS pension fund during their FYE 6-30-2012 to reduce their unfunded liability is not explicitly disclosed on official documents. But logic dictates the total unfunded contribution to be the difference between the total contribution, $5.82 billion, and the normal contribution, $4.69 billion, or $1.13 billion.

  • Total contribution = $5.82 billion
  • Normal contribution = $4.69 billion
  • Unfunded contribution = $1.13 billion

The remainder of this report will consider whether or not this level of contributions is adequate by estimating required contributions based on more aggressive payback terms, as well as more conservative rate-of-return projections. The first step is performing these what-ifs is to estimate how the unfunded liability is affected by changes to the rate-of-return projections.

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT CalSTRS UNFUNDED PENSION LIABILITY?

To be 100% funded, a pension plan must have invested assets equal to the present value of all future pension payments. For every participating employee, whether they are active or retired, actuaries estimate their salary growth, their year of retirement, their initial pension, their subsequent pension payouts based on COLAs, and their life expectancy. The present value of all these future payments is how much a fully funded pension plan’s assets must be worth.

The rate at which these future payments are discounted per year must be equivalent to whatever rate the pension fund managers believe they will earn interest, on average, over the life of the fund. The theory is that if no future work were performed, and no future pension benefits were earned, and no additional money were contributed to the fund, the assets currently invested in a fully funded plan would earn enough interest to support every future pension payment until the last participant died of old age.

Since the amount of assets in a pension plan is a known, objective quantity, the debate over how much unfunded liability a plan may have centers on what assumptions are used to estimate the present value of the future payments, i.e., the “Actuarial accrued liability (AAL),” which CalSTRS valued as of 6-30-2013 at $215.2 billion. In order to assess whether or not that amount is overstated or understated, we can use a short-cut formulated by Moody’s Investor Services in their July 2012, “Moody’s Adjustments to US State and Local Government Reported Pension Data.”

In order to revalue a pension fund’s liabilities without having access to every actuarial calculation from every fund, what Moody’s does is estimate the midpoint of the future payments stream. They select 13 years into the future, which is quite conservative. Using a longer duration than 13 years will greatly increase the sensitivity of the liability to changes in the projected rate-of-return. Here is their rationale [4]:

“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate. For example, a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.

We recognize this duration estimate may be higher than warranted for some plans and lower than warranted for others. Each pension plan has a unique benefit structure and demographic profile that affects the time-weighted profile (duration) of future benefit payment liabilities. However, plan durations are not reported, and calculating duration individually for each plan is not feasible. Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.”

Here is the formula that governs this readjustment:

Adj PV = [ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years

Table 1, below, shows how much the CalSTRS unfunded liability will increase based on two alternative rate-of-return projections, both of which are lower than the official rate of 7.50% currently used by CalSTRS. Here they are:

Case 1, 6.2%  –  here is the rationale for this rate-of-return, excerpted from the report “Pension Math: How California’s Retirement Spending is Squeezing The State Budget” [5] authored by Joe Nation, a Ph.D., Stanford Institute for Economic Policy Research, and former California Democratic assemblyman: “This 6.0 to 6.5 percent figure is based on the performance of a hypothetical fund containing 80 percent equity and 20 percent income instruments between 1900 and 1999. It assumes an equity rate based on the 20th-century Dow Jones industrial annual average of 5.3 percent, plus 2 percent in dividends, less 0.5 percent in fees. Combined with income instruments with a net rate of return of 4.5 percent, this hypothetical fund would have earned an average annual rate of 6.2 percent.”

Case 2, 4.81%  –  the rationale for this rate-of-return comes from Moody’s Investor Services “Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013 [6]“For adjustments to pension data, Moody’s will use the Citibank Pension Liability Index (Index) posted on the date of the valuation instead of its original proposal to apply a single rate for all plans each year.” Citigroup Pension Discount rate as posted by the Society of Actuaries in July 2013 was 4.81% [7].

Table 1 makes the revaluation method specified by Moody’s transparent. To download the spreadsheet that contains all of these tables, click here:  Analysis-of-CalSTRS-Pension-Liability-and-Contributions.xlsx, and refer to the first tab “unfunded liability.” To make the logic of these calculations as plain as possible, the spreadsheet cells where assumptions are input are shaded in yellow, and the result cells at the bottom are shaded in green. Column 1 shows the baseline case, using the official projected interest rate of 7.50%, meaning the end result is unchanged. Column two uses the “case 1″ lower rate of 6.20%, column three uses the “case 2″ rate of 4.81%. The first three rows show how the officially reported unfunded liability is calculated. The first four rows of the second second section, “Revaluation of Unfunded Pension Liability,” projects the liability forward 13 years to develop a future value at the official rate of return, 7.50%. The final three rows of the second section then calculate the present value using the baseline rate of 7.50%, the case 1 rate of 6.20%, and the case 2 rate of 4.81%.

As can be seen, even with what is probably an unrepresentative duration of only 13 years, if the pension fund is only projected to earn 6.2% instead of 7.50%, the unfunded liability estimate jumps from $70.0 billion to $107.8 billion, and at a projection of 4.81%, more than doubles to $154.93 billion. These are not implausible scenarios.

TABLE 1  –  RECALCULATING CalSTRS UNFUNDED PENSION LIABILITY

CalSTRS_solvency_analysis_Nov2013_table01a

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT CalSTRS UNFUNDED CONTRIBUTION?

Table 2, below, shows how much CalSTRS should be paying back each year to reduce their unfunded liability if they were to pay it back using the terms of a conventional amortized loan with level payments each year. And this “level payment” method is what has been adopted by Moody’s Investor Services in their Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data, “Moody’s adjusted net pension liability will be amortized over a 20-year period on a level-dollar basis using the interest rate provided by the Index.” [8]

When reviewing Table 2, bear in mind that the payment made in FYE 6-30-2012 into the CalSTRS pension fund towards reducing their unfunded liability was $1.13 billion. As the baseline case in column 1 shows, if this payment were calculated using a level payment, 20 year term as recommended by Moody’s Investor Services, they would have had to pay $6.96 billion during 2012, more than six times as much. This observation merits repetition: By applying repayment terms that Moody’s Investor Services – the largest credit ratings agency in the world – has recommended public sector pension funds adopt, and without changing the return-on-investment assumptions that many analysts (including Moody’s who recommend using the Citibank Pension Index rate which typically is under 5.0%), CalSTRS is underpaying their unfunded contribution by a factor of more than six times.

Columns 2 and 3 in Table 2 help illustrate why it isn’t excessive to specify a 20 year, level payment plan to eliminate a pension plan’s unfunded liability. Because the amount of the unfunded pension liability, the principle being repaid, will fluctuate according to how much fund managers think the invested assets are going to earn. And as Table 1 shows, the amount of the unfunded liability is extremely sensitive to these changes.

In column 2, case 1 shows the impact of a 6.20% rate of return projection for the CalSTRS pension fund. The unfunded pension liability increases from the official $70.0 billion to $107.8 billion, which more than offsets the using the lower 6.20% rate to calculate the required payments. In case 1, a 6.20% projected rate of return for the CalSTRS pension assets will equate a $9.55 billion annual payment to reduce their unfunded liability. In case 2, a 4.81% projected rate of return for the CalSTRS pension assets will equate a $12.2 billion annual payment to reduce their unfunded liability.

Note: The first table in the Appendix to this report shows more detail on how CalSTRS is currently incurring negative amortization, i.e., how the unfunded pension liability will increase each year if only $1.13 billion is paid annually toward reducing that liability, as well as how the unfunded pension can be eliminated within 20 years using the higher payments calculated using the level payment method.

TABLE 2  –  RECALCULATING CalSTRS UNFUNDED CONTRIBUTION

CalSTRS_solvency_analysis_Nov2013_table02a

*   *   *

HOW DO LOWER RATES OF RETURN AFFECT CalSTRS NORMAL CONTRIBUTION?

No discussion of whether or not sufficient funds were contributed to CalSTRS during FYE 6-30-2012 would be complete without considering the “normal contribution,” which was $4.69 billion. The normal contribution is defined as how much future pension obligations were earned by actively employed participants during the current year, in this case, during the 12 month period ended 6-30-2012. If a pension plan is considered to be 100% funded, the normal contribution is the only payment necessary.

Table 3, below, revalues the normal contribution using methods recommended by Moody’s Investor Services. Again, a shortcut of this type is necessary because it is impossible with publicly available information to apply various rates of return to estimated future annual pension payments accrued during 2012 according to the actuarial profile for every actively employed participant in CalSTRS. Instead, the normal payment, representing the present value of the entire stream of future pension payments earned by actively working participants in the most recent year, is recalculated, using the official rate-of-return projection, 7.50%, at a future value set 17 years from now, representing the average remaining service life of active employees. This future value is then discounted back to present value using the lower rate-of-return, in our cases, at 6.20% and 4.81%. This process will yield a higher required normal contribution. Here’s how Moody’s describes this method in their July 2012 proposal “Moody’s Adjustments to US State and Local Government Reported Pension Data.” [9]

“The ENC [employer’s normal cost] adjustment reflects the lower assumed discount rate and the use of a 17-year active employee duration estimate for all plans – i.e., each plan’s normal cost is projected forward for 17 years at the plan’s reported discount rate, and then discounted back at 5.5% [based on the Citibank Pension Liability Index, as Moody’s specifies, which has dropped subsequently dropped to 4.81% – this study uses two lower rate scenarios, 6.20% and 4.81%], after which employee contributions are deducted to determine the adjusted ENC. The 17-year duration assumption reflects our estimate of the average remaining service life of employees based on a sample of public pension plans. We acknowledge that this is a simplifying assumption that may be too long or too short for different plans. Using this approach, a reported ENC payment of $100 million based on an 8% discount rate would grow to $149 million based on a 5.5% discount rate.”

As case 1 and 2 show on Table 3, lowering the CalSTRS pension fund’s rate-of-return projection from 7.50% to 6.20% increases the normal contribution by $1.1 billion; if it is lowered from 7.50% to 4.81% the normal contribution increases by $2.5 billion.

TABLE 3  –  RECALCULATING CalSTRS NORMAL PENSION CONTRIBUTION

CalSTRS_solvency_analysis_Nov2013_table03b

*   *   *

CONCLUSION

Using evaluation formulas and unfunded liability payback terms recommended by Moody Investor Services in April 2013, this study shows that if the CalSTRS “catch-up” payment is calculated based on a level payment, 20 year amortization of the $70.0 billion unfunded liability – still assuming a 7.50% rate-of-return projection – this catch-up payment should be $6.96 billion per year, rather than the $1.1 billion unfunded payment that was actually made. The study also estimates that if the CalSTRS pension fund rate-of-return projection drops to 6.20%, the unfunded liability recalculates to $107.8 billion and the catch-up payment increases to $9.6 billion per year. At a rate-of-return projection of 4.81%, the unfunded liability recalculates to $154.9 billion and the catch-up payment increases to $12.2 billion per year.

This study also estimates that the $4.7 billion normal contribution into CalSTRS for FYE 6-30-2012, based on a rate-of-return assumption of 7.50%, would have to increase to $5.5 billion based on lowering the rate-of-return assumption to 6.20%. Further, the study shows that by lowering the rate-of-return assumption from 7.50% to 4.81% would require the normal contribution to increase to $6.9 billion.

The 2nd table in the appendix, “Required rate-of-return at various levels of underfunding,” shows why underfunding is a slippery slope by illustrating how much higher rates have to be just to keep the underfunding from getting worse. Pension spokespersons have consistently stated that annual earnings in any mature fund will always greatly exceed annual contributions. On the table, the 5th column “baseline” shows how much earnings have to increase at CalSTRS current official level of 67.02% funded. At that level of funding, as can be seen, just in order for the unfunded liability to not increase, CalSTRS currently has to earn an annual return of 11.2%. At that sustained rate-of-return, the surplus earnings beyond the projected 7.50% do not reduce the unfunded liability at all, they merely prevent it from getting larger.

To recap, for the fiscal year ended 6-30-2012, here are some CalSTRS financial highlights as determined in this study:

  • Lowering the earnings projection to 6.20% increases the normal contribution by $1.1 billion per year; lowering it to 4.81% increases the normal contribution by $2.5 billion per year.
  • The unfunded “catch-up” contribution of $1.1 billion did not lower the officially recognized unfunded liability of $71.0 billion, in fact, it grew by $4.2 billion (ref. Appendix 1, baseline case).
  • If the earnings projection is lowered from 7.50% to 6.20% the unfunded liability increases from $71.0 billion to $107.8 billion; if it is lowered to 4.81% the unfunded liability increases to $154.9 billion.
  • At the official return projection of 7.50%, if the unfunded liability is paid back according to 20 year level payment amortization terms, the annual catch-up payment would have been $6.9 billion.
  • Using 20 year level payment amortization terms, at a return projection of 6.20% the annual catch-up payment should have been $9.6 billion; at 4.81%, it should have been $12.2 billion.
  • An annual return projection of 6.20% represents the long-term appreciation of equities [5], an annual return projection of 4.81% represents the Citibank pension liability index rate as of July 2013 [7].

The conclusion of this study is that CalSTRS relies on optimistic long-term earnings projections and very aggressive unfunded liability repayment schedules in order to contribute the absolute minimum each year into their pension fund. As a result, their unfunded liability increased during FYE 6-30-2012 by over $4.0 billion. If CalSTRS is required to even incrementally lower their rate-of-return projections further – something that market conditions may eventually dictate – their funded ratio which is already only 67.0% will fall precipitously. Unless extremely favorable market conditions occur for the next several years without interruption, in order for CalSTRS to remain solvent, they need to dramatically cut retirement benefits, or increase their annual contributions by 50% or more per year.

*   *   *

FOOTNOTES

(1)  CalSTRS Defined Benefit Program Actuarial Valuation as of June 30, 2012, page 32, Table 8

(2)  CalSTRS “Comprehensive Annual Financial Report, FYE 6-30-2012, page 41, “Statement of Changes in Fiduciary Net Assets.”

(3)  Milliman: Defined Benefit Program Actuarial Valuation, as of June 30, 2012, page 15, Section 4 “Actuarial Obligation, Normal Cost.”

(4)  Moody’s Adjustments to US State and Local Government Reported Pension Data, request for comment, July 2nd, 2012, page 6.

(5)  Pension Math: How California’s Retirement Spending is Squeezing The State Budget, Stanford Institute for Economic Policy Research, page 13, December 2011.

(6)  Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” ref. “The Adjustments,” item 1, April 2013.

(7)  Citigroup Pension Discount Curve, Society of Actuaries, July 2013

(8)  Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data, ref. “The Adjustments,” item 3, April 2013.

(9)  Moody’s Adjustments to US State and Local Government Reported Pension Data, ref. page 8, section four, part one “New discount rate applied to normal cost.”

*   *   *

APPENDIX  –  TABLE 1  –  UNFUNDED LIABILITY AMORTIZATION SCENARIOS

CalSTRS_solvency_analysis_Nov2013_appendix01a

APPENDIX  –  TABLE 2  –  REQUIRED RETURN AT VARIOUS LEVELS OF UNDERFUNDING

CalSTRS_solvency_analysis_Nov2013_appendix02a