CalPensions.com: CalSTRS is a Public Pension Hybrid Already

CalSTRS surprise: It’s a pension/401(k) ‘hybrid’

by Ed Mendel
CalPensions.com
Posted 06/06/2011
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/ Posted 6 Jun 11

Under little-noticed legislation a decade ago, the nation’s second largest public pension fund, CalSTRS, became what is now advocated by several reformers — a “hybrid” combining pensions with a 401(k)-style individual investment plan.

CalSTRS was not cited as an example earlier this year when switching public employees to hybrids was proposed by Gov. Brown, the nonpartisan Legislative Analyst and the watchdog Little Hoover Commission.
That’s not surprising. The California State Teachers Retirement System has rarely, if ever, called itself a hybrid. But that changed last week when the term was used during a CalSTRS board meeting and again the next day in a news release.

“It might be a surprise to hear us refer to our system as a hybrid plan, because we haven’t discussed it that way in the past,” Peggy Plett, CalSTRS deputy chief executive, told the board. “But we really do have a hybrid plan.”

To the regular CalSTRS monthly pension guaranteed for life, legislation in 2000 added a new program, the Defined Benefit Supplement, that is similar to a 401(k) individual investment plan receiving contributions from the employer and employee.

The hybrid Brown and others advocate presumably is intended to reduce employer costs and risk. In a typical hybrid, a smaller pension is combined with an investment plan that rises and falls with the market.

The smaller pension cuts the employer’s long-term retirement debt, which spans decades and helped push firms like General Motors into bankruptcy. Employees still have the security of a lifetime pension check, with additional money from investments.

But CalSTRS is not a typical hybrid.

Pensions for newly hired teachers were not lowered, and the supplement investments have a guaranteed return based on an annual average of the 30-year Treasury bond, now yielding 4.2 percent.
Importantly, the supplement program undermined the seriously underfunded CalSTRS pension fund in two ways.

1) Money that should have gone into the pension fund was skimmed off to build the supplement during the first 10 years, ending as scheduled last Jan. 1.

A quarter of the annual teacher contribution to the CalSTRS pension fund (2 percent of pay from a total of 8 percent of pay) was diverted into the supplement, which had a market value of $6.2 billion last June.

The 2 percent of teacher pay diverted into the supplement is about a tenth of the total contribution the pension fund should have received during the last decade (teachers 8 percent of pay, employers 8.25 percent and state 2 percent).

2) The minimum guarantee of earnings in the supplement has added to the long-term debt or “unfunded liability” of the CalSTRS pension fund.

Most 401(k)-style investment plans, which do not guarantee a minimum rate of return, had major losses during the deep economic recession and stock market crash in the fall of 2008.

The unusual minimum guarantee protected CalSTRS members against investment losses. But the guarantee based on 30-year Treasury bonds was higher than CalSTRS investment earnings, which averaged 3 percent during the last decade instead of the assumed rate of 8 percent, lowered last December to 7.75 percent.

Covering the gap between the supplement guarantee and actual earnings added $1.5 billion to the CalSTRS unfunded liability as of June 2009. As markets fluctuated during the decade, earnings above the guarantee did not pay down the long-term debt.

Instead, the CalSTRS board approved additional earning credits to the supplement of 2.49 percent for fiscal 2005 and 4.41 percent for fiscal 2006. (See page 102 of the CalSTRS 2010 Comprehensive Annual Financial Report)

Now the CalSTRS pension fund has a $56 billion unfunded liability as of last June and a funding level of 71 percent, according to an actuarial report given to the board in March.

Getting to an estimate of 100 percent of the funding needed during the next 30 years would require an additional contribution of 14.3 percent of pay or about $4 billion, nearly doubling the current total contribution of roughly $5 billion.

That assumes earnings will average 7.75 percent, a forecast critics say is overly optimistic. Adopting a lower earnings assumption would sharply increase the additional contribution needed to reach full funding.

Much of the CalSTRS funding problem is due to massive investment losses. The CalSTRS pension fund peaked at $180 billion in October 2007 before dropping by more than a third to $112 billion in March 2009.

The CalSTRS pension fund was at $153 billion last week with a 21 percent gain 11 months into the fiscal year, following a 12 percent gain last year. The recent gains have not changed the view that CalSTRS needs to phase in a major contribution increase to close the funding gap.

Part of the funding problem is that when the stock market boomed a decade ago, pushing pension funding levels above 100 percent, CalSTRS and the California Public Employees Retirement System and UC Retirement all made the same basic changes.

In what can look like questionable management now, contributions were cut and pensions raised. Among a half dozen CalSTRS legislative bills, including a pension increase for persons already retired, was the creation of the Defined Benefit Supplement.

“No (state) general fund effect and no effect to the solvency of STRS,” said the analysis of AB 1509, unusually brief for legislation shifting billions of dollars. “The STRS surplus will absorb the cost of DBSP (Defined Benefit Supplement Program).”

When AB 1509 moved through regular committees, it dealt with a different issue, credit cards. The cut in contributions to the CalSTRS pension fund apparently was negotiated during the state budget process, presumably with powerful teacher unions.

Rolling back some of the changes made a decade ago, state worker unions in CalPERS and UC regents have approved what has become a common response to pension funding problems:

Increased employee contributions (and employer contributions at UC) and lower pensions for new hires.
CalPERS and the UC regents have the power to set contribution rates for employers. Pension benefits for
CalPERS and UC Retirement are customarily set through bargaining with unions.

Unlike most California public pension funds, CalSTRS lacks the power to set employer contribution rates, needing legislation instead. And CalSTRS pension benefits have been set by legislation, rather than through bargaining with unions.

So far there has been no legislation proposing that CalSTRS join CalPERS and UC in raising employee contributions and giving new hires lower pensions. The political clout of teacher unions may be one reason.

Another potential obstacle: Under state education law, CalSTRS lawyers say any increase in employee contributions would have to be offset by giving employees another benefit of equal value.