By Ed Mendel.

Using new power for the first time, the CalSTRS board is expected to increase the state contribution to the teacher pension fund this week, a response to new forecasts of lower investment earnings and longer retiree life spans.

The new forecasts adopted in February increased the funding shortfall. But actuaries still expect CalSTRS to stay on a long path to full funding, thanks to a long-delayed record rate increase in 2014 that will more than double school district pension costs by 2020.

At a media briefing last week, an actuary said one of the factors maintaining a projection of full funding by 2046, despite the larger shortfall from the new forecasts, is new but tightly limited rate-setting power given CalSTRS as part of the funding package three years ago.

“We still think that probability is greater than 50 percent,” said David Lamoureux, CalSTRS deputy chief actuary. A new annual risk report issued last November, before the new forecasts, put the probability of reaching full funding in three decades at 60 percent.

The big risk for public pension funds like the California State Teachers Retirement System is that investment earnings, expected to pay nearly two-thirds of future pensions, will fall below the forecast in the long run, creating massive debt or “unfunded liability.”

California public pension funds originally were limited to bonds with predictable earnings, limiting the risk of major long-term losses. But voters approved initiatives in 1966 and 1984 that now allow any “prudent” investment.

Much of the pension money was shifted into stocks and other higher-yielding but risky investments. Reaching “full funding” when stock markets boomed was used as a rationale (see previous post) for increasing pensions and cutting employer contributions.

But “full funding” is based on earnings forecasts for stocks and other risky investments. Since CalSTRS, like CalPERS, cut contributions and raised pensions when fully funded around 2000, the stock market has fallen, crashed and then rebounded to all-time highs.

A report by Milliman consulting actuaries in 2013 said if CalSTRS were still operating under its 1990 structure, without the changes made around 2000, pensions would have been 88 percent funded instead of 67 percent.

Now a new actuarial report prepared for the board this week said CalSTRS funding is 63.7 percent with an unfunded liability of $96.7 billion as of last June 30, compared to 68 percent funded and a $76.2 billion unfunded liability the previous year.

The new report is based on an earnings forecast lowered from 7.5 to 7.25 percent. The forecast will be lowered again to 7 percent next year. Using current data, funding would drop to 61.8 percent and the unfunded liability would increase to $105.1 billion.

A four-decade history of CalSTRS funding in the new actuarial report shows the funding level or ratio increased each year from 1975, when it was only 29 percent, to 1999 when it remained at 104 percent before peaking in 2000 at 110 percent.

The string of steady increases continued through a major transition when legislation in 1982 gave CalSTRS management of its investment fund, which previously was managed by the larger California Public Employees Retirement System.

The history also shows how the downward zig-zag of CalSTRS funding since the peak in 2000 is the result of rapidly growing future pension costs outpacing the modest gains from contributions and investment earnings.

The actuarial assets increased by more than half, growing from $102 billion in 2000 to $170 billion in 2016. The actuarial obligation for future pensions nearly tripled, growing from $93 billion in 2000 to $267 billion in 2016.

The table showing the history of CalSTRS funding does not include a large and unusual inflation-protection side fund, valued at $12.8 billion last June. In the latest report, the fund had a surplus of $5.6 billion as of June 30, 2015.

Most pension funding is based on projections of money received in the future. But the CalSTRS Supplemental Benefit Maintenance Account is expected to have enough money on hand to keep pensions at 85 percent of original purchasing power through June 30, 1989.

The account is funded by a vested annual payment from the state of 2.5 percent of teacher pay ($607 million last fiscal year) and a rare fixed investment return equal to the CalSTRS earnings forecast, whether actual earnings are above or below the target.

The table shows that since the stock market crash in 2008 the CalSTRS pension fund grew from $155.2 billion to $170 billion last fiscal year. The inflation-protection account more than doubled, growing from $5.3 billion in 2008 to $12.8 billion last fiscal year.

During the same period, the number of CalSTRS retirees receiving the inflation-protection payments dropped from 89,412 receiving $348 million in 2008 to 47,764 receiving $172 million last fiscal year.

In the latest biennial report for the fiscal year ending June 30, 2015, Milliman actuaries projected that if inflation remained at 3 percent, the account could keep pensions at 85 percent of original purchasing power forever or at 91 percent through June 30, 1989.

But if inflation remained at 3.75 percent, Milliman projected the account would be empty in 40 years. CalSTRS members do not receive Social Security, and their annual 2 percent cost-of-living adjustment is based on the original pension amount, not compounding.

Will the big surplus in the inflation-protection account become a target as school budgets continue to be squeezed by the doubling of CalSTRS rates for teachers, in addition to the doubling of CalPERS rates for non-teaching employees?

The state withheld payment to the account in 2003 to help close a budget gap. An appeals court ruled in 2007 that the account must be repaid $500 million, citing a law (AB 1102 in 1998) that made the state contribution, 2.5 percent of pay, a vested right.

Why the law made the contribution a vested right, but not 85 percent of orginal purchasing power, is unclear. (See previous post) Perhaps the intent was to create a fund surplus large enough to allow an increase in purchasing power protection.

The Supplemental Benefit Maintenance Account began with legislation in 1989 that restored 68.2 percent of original purchasing power. Later legislation moved the purchasing power to 75 percent in 1997, 80 percent in 2001, and 85 percent in 2008.

There apparently has been no study or analysis of whether the CalSTRS inflation-protection program is cost efficient or wasteful. CalPERS, for example, provides inflation protection through its overall employer-employee contribution rate.

The new risk report issued last November said the inflation-protection account is expected to grow from the current 6.4 percent of combined CalSTRS investments to nearly 15 percent in 30 years.

The growth will create “increased volatility” or larger swings in investment returns and the need for contribution increases, said the report. The CalSTRS board, with its limited power, will have more difficulty setting contribution rates that ensure full funding if long-term returns fall short.

The funding legislation in 2014 authorized CalSTRS to raise state rates by up to 0.5 percent a year, reaching a maximum of 23.8 percent of pay before the legislation expires in 2046.

This week, the CalSTRS board is expected to use the power for the first time, raising the current state rate of 8.8 percent of pay by 0.5 percent. The increase is included in the $2.8 billion payment to CalSTRS in Gov. Brown’s proposed state budget.

The funding legislation will more than double CalSTRS rates paid by school districts, up from 8.25 percent of pay to 19.1 percent by 2020. After that, CalSTRS can raise school district rates to no more than 20.5 percent.

Reform legislation giving teachers hired after Jan. 1, 2013, lower pensions requires them to pay half the “normal cost” of pensions earned during a year, excluding debt or unfunded liability from previous years that can be a much larger amount.

The CalSTRS board previously was expected to raise the rate for new teachers by 1 percent of pay in July, up from the current 9.21 percent of pay. Now the increase is not expected until next year, actuaries said last week.

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Originally posted at Cal Pensions.