California public employees now enjoy the highest benefits of any state in the nation. To pretend to fund this largess, California State Teachers’ Retirement System (CalSTRS) is an “outlier” among public pension plans in using creative accounting to blur its grossly underfunded status. This has allowed its school district clients and unionized employees to short-check their annual payment for the nation’s most lucrative teachers’ pension benefits. But pressure from Moody’s credit rating agency is causing CalSTRS clients and unionized teachers to make big increases in pension and benefit funding.
The latest “hokey-pokey” drama is the California State Teachers’ Retirement System deciding if 7% or 7.5% is a good estimate of future investment performance. Private pension plans that are subject to federal oversight buy a mix of stocks and bonds, with a conservative expectation of earning about 5% annual returns. But public pension plans that are not subject to federal law use accounting tricks and a speculatively high expected investment return so they can minimize the amount state and local government and union employees must contribute each year to keep the pensions from running out of money.
The credit rating service, Moody’s, has never accepted CalSTRS or any of California’s public pension and healthcare liability calculations. They calculate pension underfunding by using a 5% earning expectation. The lower Moody’s rate would mean that CalSTRS current underfunding would skyrocket to $300 billion.
Moody’s has advised its institutional clients that invest in municipal bonds on September 25, 2014, that despite double-digit investment returns over the last decade, “between 2004 and 2012, unfunded liabilities for these [public pension] systems as calculated by Moody’s tripled to just under $2 trillion.” According to Moody’s, government used accounting tricks to allow “deferral of contributions for budgetary reasons, but the back-loading of costs through asset smoothing and 30 year amortization.”
Before 1987, public pension plans in California invested only in bonds. The pensions were adequately funded because everyone knew that the bonds earned interest and eventually would mature. The life-time pension benefit required both the union employees and the government entity to fund about 50% of the lifetime pensions. The other 50% was expected to be paid from bond interest.
But after 1987, public pensions were allowed to invest in stocks. Since stock returns were difficult to predict, the public pension plans would hire “experts” to estimate future earnings. But the pension plans were motivated to hire experts who would predict highly inflated returns so government and union employees could minimize contributions.
The state’s “experts” currently predict all the state benefit plans are wildly underfunded, despite incredibly dubious assumptions that 1) investments will always yield 7.5% per year without a loss, 2) no employees will get big raises in their last years of employment, 3) all employees will work for 30 years before retiring; and 4) all employees who retire early will die early. Based on these unrealistic assumptions:
CalSTRS Pension – $80.4 billion underfunded
State Retiree Health Care – $63.8 billion underfunded
State Employees’ Pension – $48.6 billion underfunded
UC Healthcare Pension – $25.0 billion underfunded
This underfunding was supposed to change in 2012 with the Proposition 30 tax increase. It provided $3 billion a year to schools for funding CalSTRS “catch-up” funding payments. Although this was a start, union teachers were not required to make sufficient payroll contributions to keep the fund solvent.
But with Moody’s threatening to downgrade the state’s debt over pension shortfalls, the California Legislature passed a law this summer to increase CalSTRS funding by $5 billion. The school districts’ contribution rate will ratchet up from 8.25% of employees’ pay to 19.1% by July 2020, teachers’ contribution will rise from 8% to 10.25% of pay, and the state’ contribution for two CalSTRS funds will increase from 5.5% to 8.8%.
Although this is a good start toward becoming solvent, cutting CalSTRS’s 7.5% expected rate of return on investments to 7% will result over thirty years of compounding with 25% less return. CalSTRS surveyed eight consultants and five asset managers they hand-picked to estimate future compound earnings. But the experts agreed that “consensus assumptions likely lead to expected compound long-term returns of 7 percent or less for typical institutional portfolio over a 10-year period,” according to its spokesman.
To adequately fund CalSTRS pension promises with a 5% investment return expectation advocated by Moody’s would require the unionized teachers’ contribution to more than double to 25% of their pay. CalSTRS will remain substantially insolvent because it would be political suicide for members of the legislature to demand that unionized teachers actually pay for the pension and healthcare benefits they receive.