Copyright© 2008 by School Services of California, Inc.

Volume 21                   For Publication Date: October 24, 2008             No. 22

STRS and PERS:  Will Investment Losses
Cause Higher Employer Contributions?

[Editor’s Note: The following article details the immediate financial distress being felt by the state’s two major pension plans, the Public Employees’ Retirement System (PERS) and the State Teachers’ Retirement System (STRS), and offers some guidance on budgeting employer costs of the plans. But we would be remiss if we did not also mention that we think the whole discussion of underfunding of the plans is occurring in the wrong context. The retirement plans are long-term investments whose performance is defined by long-term investment returns.

The long-term has been much more stable than the short term. After all, the long term is nothing more than a series of short terms. The current debate centers on a negative short-term effect, just as the decisions made in the early 2000s to enhance benefits during extraordinarily good years focused on a positive short-term effect. We think both reactions are incorrect. On average, we expect long-term investment returns of well-managed plans like PERS and STRS to be predictably average or perhaps a little better. So, while we report the current assertions of gloom and doom, we continue to believe that drastic actions are not required at this time and that, if we stay the course, over the longer period, increased contributions may not be a necessary or viable action, at least as regards PERS, which has a better funded status than STRS.]

Both pension systems—the State Teachers’ Retirement System (STRS) and the Public Employees’ Retirement System (PERS)—reported investment losses for the year ended June 30, 2008, a reflection of the reality of the financial markets but in stark contrast to the investment earnings of recent years:

In addition, PERS reported that, as of October 10, 2008, its investment pool has lost more than 20% of its value since the time that it posted the above investment losses for June 30, 2008—and the value has dropped another 1% since then. The value of STRS assets has, as of September 30, 2008, dropped by almost 15% from the valuation done June 30, 2007.

Since both the STRS and PERS basic retirement programs are defined benefit programs, the investment losses do not affect the benefits being paid to retirees. However, questions arise as to the impact of these losses on the funded status of the basic retirement plans of both systems—and the possible impact on employee, employer, and state contributions to these plans.

STRS Defined Benefit (Basic Retirement) Program

As of June 30, 2007, the latest date for which the actuarial valuations have been completed, the STRS Defined Benefit (basic retirement) Program was actuarially funded at 88%, up from 87% the year before. In determining the funded status of the Defined Benefit Plan, the actuarial study included an assumption of 8% for annual investment earnings.

The contribution rates for STRS are in statute, and historically have been 8% for employees and 8.25% for employers. The state is currently contributing 1.855% (2.017% of pay earned two years ago), so the total of all contributions is 18.105%. STRS has completed a study of 110 public pension systems across the nation, and the average total contribution to each employee’s pension ranges from 20.6% to 27.3% of salary, depending on whether the pension plan includes employees who are covered by Social Security. Generally, employers of employees who are not covered by Social Security make higher contributions to their particular public pension plans.

STRS asserts that the employer contributions are not enough to fully compensate STRS members for the lack of Social Security coverage. In order to contribute enough to meet the appropriate level of member benefits and to secure the funded status of the Defined Benefit Program, STRS staff is recommending that the contributions to the program from all sources be increased by a total of 9%.

Legislation is required to change the contribution rates for employees, employers, and/or the state. In the past, STRS has sponsored legislation to provide its Board some latitude in setting contribution rates, but these attempts have not been successful. Until legislation is passed, the STRS contribution rates will remain as they are.

PERS Retirement Program

As of June 30, 2007, the PERS program for school employees was funded at 108%. In determining the funded status of the plan, the actuarial study assumed an investment earnings rate of 7.75%. In its report last week, PERS estimates that the funded status of its retirement plan will have dropped to 98% as of June 30, 2008. Further, if the investment losses of 20% as of October 10, 2008, continue for the rest of the year and must be recognized for 2008-09, the funded status will drop to an estimated 72% by June 30, 2009.

The contribution rate for employees is set at 7% by statute, but the contribution rate for employers is set each year by the PERS Board. In the past, the PERS employer rate has been much more volatile, and there were even some years when the rate was changed mid-year. However, now PERS has a policy in place to smooth investment gains and losses over 15 years so that the employer rate is not as volatile.

PERS has acknowledged that the recent investment losses will have an impact on future contribution rates. Each year, PERS uses the actuarial valuation and the resulting funded status of the plan to set the employer contribution rate for the second year out—for example, the actuarial valuation for June 30, 2008, will be used to set the employer contribution rate for
2009-10.

PERS estimates that the impact of the June 20, 2008, valuation may allow for a slight reduction in rates—0.1% to 0.2%. If the investment losses are 20% at the end of 2008-09, however, the employer rate for 2010-11 could increase by up to 4%. If we assume a 0.1% drop in the PERS rate for 2009-10 and then an increase of 4.0% in 2010-11, the employer contribution would be 13.328%—higher than it’s been in more than 25 years.

Conclusion

We believe that it is not necessary to plan for any rate increases for 2009-10. For STRS, legislation has to be enacted first, and previous attempts have been unsuccessful. Further, STRS has no plans to introduce legislation to address this in the next legislative session.

For PERS we believe that it is prudent to plan for a rate increase starting in 2010-11, but it is too early to estimate what that might be. There are many assumptions built into the estimates above and there are significant unknowns. As PERS prepares its actuarial valuation for 2007-08 and prepares the analysis for its employer rate change for 2008-09 in the spring, we will keep you updated and will update our Dart Board factors at that time.

—Sheila G. Vickers