California should learn from past mistakes made with unfunded pension benefit increases

A bill advancing in the California State Senate would increase pension benefits for the state’s public school teachers and community college educators who retired before 1999. This bill would allow for a pension benefit hike without an offsetting increase in employer or employee contributions to fund it. In doing so, California Senate Bill 868 could negatively impact the financial health of California’s State Teachers Retirement System (CalSTRS). 

California has a prior negative experience with unfunded benefit increases. In 1999, the state adopted Senate Bill 400, which increased public pension benefit formulas for members of the California Public Employees’ Retirement System (CalPERS) without requiring additional contributions. The CalPERS board endorsed the bill, arguing that it would not impact taxpayers and would be fully funded with the system’s ‘excess assets.’

Unfortunately for California taxpayers, those claims were very wrong. Since SB 400 passed, employer contributions, i.e. taxpayer contributions, to CalPERS have increased by a factor of 27 while the system’s funded ratio has fallen sharply. Its 2020-21 financial report showed CalPERS was just 70% funded as of June 2020, with $163 billion in unfunded liabilities. Strong investment returns for 2021 have reportedly upped the plan’s funded rate to 80 percent. While SB 400 was not the sole contributor to the state’s dramatic rise in pension costs and debt over that period, it certainly was a major factor and lawmakers should learn from those mistakes.  

According to the Legislative Analyst’s Office, as of Nov. 2021, CalSTRS was just 67 percent funded and had $106 billion in unfunded liabilities. Supporters of SB 868 note that this benefit increase would be smaller than the 1999 bill because it only increases public pension benefits for older retirees. According to a CalSTRS analysis of the retiree population as of June 2021, about 55,000 retirees would be eligible for the benefit increase. Of these, most would be eligible for a 5% increase in pension benefits because they retired between 1990 and 1998. Smaller numbers of workers who retired in the 1980s would see a 10% increase in benefits, and fewer than 2,000 surviving retirees who retired before 1980 would get a 15% increase. Average mortality rates will further shrink these numbers.  

The actuarial firm Milliman estimates the present value cost of the proposed pension benefit increases in the bill to be $592 million, assuming CalSTRS earns a 7% rate of return on its assets. The costs of this benefit increase would be borne by the CalSTRS Supplemental Benefit Maintenance Account (SMBA), which is a special fund whose purpose is to maintain the purchasing power of CalSTRS benefits when the normal 2% CalSTRS cost-of-living adjustment proves insufficient. CalSTRS describes this fund as follows: 

When inflation depletes the value of the current benefit to less than 85 percent of the value of the original benefit, CalSTRS pays a quarterly payment from the SBMA to the benefit recipient to restore the value of the benefit to the 85 percent purchasing power level…In addition to the contribution to the SBMA being a contractual obligation of the state, the right of Defined Benefit Program benefit recipients to receive SBMA payments is also vested, but only to the extent there are funds in the account. If SBMA funds are insufficient to maintain even the 80 percent purchasing power, the supplemental benefit would be reduced to an amount that can be funded with available money. 

With a balance of $30.7 billion and an actuarial surplus of $11.9 billion, SBMA would seem to be able to easily accommodate a new $592 million liability. Milliman concluded that the benefits increase would have a minimal impact on the fund’s long-term solvency. The actuary calculated that SBMA had a 66% chance of remaining sufficient to protect retiree benefit purchasing power through 2089 without SB 868 compared to a 65% chance if the law is enacted. 

This optimistic assessment could be undermined, however, if recent high rates of inflation become chronic. In that case, SMBA would have to be drained to maintain purchasing power for all retirees. Further, Milliman used CalSTRS’ assumed rate of return on assets of 7% for its analysis. Reason Foundation has previously discussed evidence supporting a lower assumed rate of return, which would result in poorer sustainability prospects for SBMA. 

Aside from the risk that Milliman’s forecast is too optimistic, there is also the risk that SB 868 could serve as a precedent for further unfunded benefit enhancements in the future. Indeed, the bill’s sponsor, State Sen. Dave Cortese (D-San Jose), the bill’s lead author, falsely claimed in a hearing that SB 868 would “draw new teachers to the workforce at a time when they are so desperately needed in our classrooms.” The current bill only applies to retirees who left the profession more than 20 years ago, so SB 868 on its own would not attract new teachers. Thus, State Sen. Cortese was either mistaken about the bill he wrote or is foreshadowing plans to provide additional pension benefits to current and future teachers.

It is certainly understandable that state legislators want to help retired educators who may be struggling with the impacts of today’s inflation. But California is experiencing a record state budget surplus this year, so the state and local governments should find a more fiscally responsible way to fund cost-of-living adjustments or benefit increases for retired teachers.