CalSTRS Funding Report Offers Hope for the Future

While system is on track to full funding by 2046, investment volatility could throw a wrench into the process.

Battered by a huge investment loss during the financial crisis, the California State Teachers’ Retirement System (CalSTRS) was on the path to running out of money by 2046.

The state legislature stepped in in 2014 in a funding rescue plan for the second-largest US pension plan. It doubled contributions from school districts over seven years and gave the CalSTRS board the authority to double state contributions over the long term, in a plan aimed at increasing the pension’s funding ratio to 100% by 2046.

A November report says the $219.3 billion CalSTRS is moving in the right direction to reach full funding and that there is an approximate 70% chance the system could achieve it by 2046. However, the report says the largest risk to CalSTRS achieving 100% funding is investment volatility.

It notes that frequent low returns or a major shock in one year to the pension system could put CalSTRS off track.

“Following the financial market crash in 2008–09, the funded status of the system dropped by more than 30% in a single year, resulting in the need for the funding plan to avoid a future depletion in assets,” the report said. “CalSTRS remains at risk if another investment return ‘shock’ were to occur in the future.”

The report said the impact of a decline will also depend greatly on the timing as the ratio between the  number of teachers on the payroll and retirees collecting benefits decrease.

“As the system continues to mature, investment declines will be harder to absorb the later they occur in the duration of the funding plan,” it said.

The report is a prelude to a formal report to be presented to California legislators in July 2019. The report is required every five years as part of the legislature passing a bill back in 2014 that gave CalSTRS more funding, including the ability to increase state contributions to the pension system.

The CalSTRS 2018 funding levels and risks report said the rate-setting authority given CalSTRS officials to raise the state’s contribution “has considerably improved CalSTRS funding trajectory but significant risks remain in funding the system.”

In May 2018, the CalSTRS board exercised its authority under the funding plan for the second year in a row to increase the state’s contribution rate by the maximum allowed 0.5% of payroll. The state now contributes more than 9% of the combined payroll of teachers in California covered by CalSTRS, but that rate could more than double over the next 26 years given the CalSTRS board’s power to raise the state rate.

CalSTRS is 65.5% funded as of June 30, but the report noted that the funding level increased from 64% from the year prior because of the 9% return CalSTRS realized in the 2017-2018 fiscal year. CalSTRS anticipates a 7% return on an annualized basis.

Rising financial markets have been kind to CalSTRS the last several years. On a three-year-basis ended June 30, the system earned a 7.8% net return, and on a five-year basis, 9.2%. Longer term, returns have been more disappointing: 6.3% for the 10-year period and 6.5% over the 20-year period.

CalSTRS officials insist the 7% return is realistic over the long term while critics have contended that CalSTRS and other pension plans have overly optimistic return expectations, which will lead to new financial crises.

Investment returns make up around two-thirds of the benefits paid to CalSTRS retirees, so low returns below the expected 7% annually would be a problem, especially as the ratio between active teachers and retirees declines.

CalSTRS, like other retirement systems across the US, is facing declining enrollees making contributions as baby boomers retire. Back in 1971, CalSTRS had six active members to every retiree, now it has 1.5 active members to each retiree, the report said. This means that even with investment income, CalSTRS payments to retirees exceeded inflows by $3 billion in the June 30 fiscal year.

The report says CalSTRS has not been forced to sell assets because investment returns have covered the gap.

Investment volatility could change CalSTRS’s funding level quickly, the report said.

“It would take only one or two years of lower-than-expected returns in the near term to push the funded status below 60% or even below 50%,” it said.

Could CalSTRS still run out of money at some point in the future, even with the funding plan?

The report said that the risk has been reduced considerably over the last few years with the adoption of the funding plan. “However, that risk has not been completely eliminated and may never be fully eliminated as a result of the maturity level of the system, investment volatility, and the board’s limited rate-setting ability,” it said.

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