California’s K-12 Pension Cost Crisis
Before 2005 my knowledge of defined benefit (DB) pension plans was limited to experience with a small business I joined in 1979 that offered a DB plan. I was pleased with the opportunity for tax-deferred compounding but also skeptical about the ability of a small business to pay future benefits. So I worried about adequate pre-funding and later became a plan trustee until I retired in 2003. When I joined the board of the California State Teachers’ Retirement System (CalSTRS) in 2005, I assumed adequate pre-funding was its goal. But then I learned four things:
- Retired teachers are assured their pensions regardless of CalSTRS's pre-funded status.
- The board is controlled by members who represent groups that do not suffer the consequences of inadequate pre-funding.
- The board was reporting the present value of pension liabilities using a discount rate tied to its investment return assumption rather than to the creditworthiness of the obligor. That means liabilities were being hidden when created, as explained here.
- The board was basing pension contributions on an unrealistic assumed rate of return on assets. That portended a large future increase in pension costs, as explained here.
Expressing concerns about hidden liabilities and deferred costs, I advocated for realistic reporting of liabilities and a realistic investment return assumption for setting contributions. Unhappy with that advocacy, the state legislature removed me from the board.
Eight years later, CalSTRS required a $240 billion bailout. The legislature and governor enacted legislation requiring the state and school districts to more than double pension spending. Examples of two districts are below:
More spending on pensions means less money for arts and computer science, teacher raises and training, and teacher and specialist staffing. Rising retirement costs are why you may be reading about district belt-tightening even though voters just passed another tax increase (Prop 55) and the state budget has been enjoying the fruits of an eight-year bull market.
Because the bailout was based on an unrealistic investment return assumption, another bailout will likely become necessary. And because CalSTRS continues to tie its discount rate to its investment return assumption and assume an unrealistic investment return assumption, additional deficits are likely.
Retirement security is a worthy objective and DB plans can work just fine in providing that security when they are properly governed. However, mis-aligned incentives all too often prevent proper governance. Because school and state employees collect their pensions regardless of pre-funded status, their representatives in control of pension fund boards have incentives to use improper discount rates to hide liabilities when they are created (because that way observers don’t see the true size of pensions being promised) and unrealistic investment return assumptions to keep contributions low in the short term (because that saves employees money and shifts more costs to citizens). Politicians fall into the same trap because they prefer to push costs to the future, after they’ve left office. This is why California’s legislature must propose reforms for voter approval to put citizens in charge of pension governance. They have all the risk.
California’s teacher pension crisis was avoidable. Solutions are difficult.
When asked about solutions, often I answer that the easiest was the one I and others proposed more than a decade ago. Because it wasn’t adopted and as a consequence of compounding, what was a small problem then has grown into a huge one now. The employment of an appropriate discount rate and a reasonable investment return assumption will prevent additional deficits, but a solution to existing deficits is harder, especially if retirees and near-retirees don’t have to share the pain. They didn’t cause the problem but neither did the young and future teachers, current and future students, and taxpayers already suffering the pain.
Selfish decisions by politicians and CalSTRS board members have put public school districts in precarious financial positions. It will take great leadership to save, much less improve, public education in California.