Credit Fundamentals By Sector

• State of California: We view California's pension liabilities as moderately high, with combined net pension liabilities as a percent of state personal income at roughly 3% at fiscal year-end 2022. Although the state's fiscal outlook has moderated from its recently robust revenue performance, we believe its liabilities remain manageable. In fiscals 2023 and 2024, the state made modest extra pension contributions due to Proposition 2's mandate to set aside certain excess revenues toward long-term liability paydowns.
• Local governments: On average, most California municipalities' pension plans are moderately funded and stable, though we believe pension costs are likely to increase due in part to negative investment returns recognized by CalPERS in fiscal 2022. The ability of local governments to absorb rising costs vary and depend on active management of pension costs and available general fund reserves. Local governments that already have high pension costs and large unfunded liabilities may face an increasingly difficult budgetary environment as pension costs comprise a larger portion of fixed costs in city budgets. The high inflationary economic environment has also led to higher costs and potentially less resources available for local governments, which could worsen their ability to manage near-term rising pension costs. Additionally, the high interest rate environment will likely turn local governments away from issuing pension obligation bonds as a potential solution for short-term cost relief.
• School districts and community colleges: Pension costs for school districts and community colleges have generally increased in recent years due to rising salaries, an aging population, and changing assumptions to address weaker market conditions. So far, rated districts have been able to absorb the increased pension costs due to additional assistance from supplementary contributions made by the state. The state is responsible for about a third of the districts' unfunded pension liabilities and we expect it to absorb the brunt of future rate increases post-fiscal 2022, given statutory caps on rate increases. However, employer contributions started increasing in fiscal 2023, as the employer rate reduction provided by the state's supplementary contributions are no longer applicable. Community college pension costs are expected to increase by approximately $73 million in fiscal 2024, based on the annual California community college brief published by the California Legislative Analyst's office. We note certain rated community colleges maintain irrevocable pension stabilization funds (Section 115 Trust) that partly mitigate their pension-related risks.
• Higher education: Colleges and universities have generally been facing increasing pension costs similar to school districts and community colleges. There are two large public university systems in the state: the University of California (UC), which operates its own underfunded pension plan, and California State University, which participates in CalPERS. In our opinion, the likely continued growth in pension costs are manageable for these systems, given their balance sheet positions. We further believe these systems' market performance and changing assumptions could lead to accelerating costs and potential pressure.

Plan Summaries

California maintains several major pension plans that are administered by two agencies: California Public Employees' Retirement System (CalPERS), and the California State Teachers' Retirement System (CalSTRS), both of which are component units of the state. Both agencies are subject to oversight from their respective boards, whose members include but not limited to members elected by plan constituents and those appointed by the governor and legislature. The respective boards ultimately determine the plans' funding levels, assumptions, and methodologies.

Most local governments, school districts, state universities, and public utility providers participate in the following defined benefit plans:

• CalPERS: PERF A (agent multiple-employer): for state employees and public agencies with more than 100 active members;
• CalPERS: PERF B (cost-sharing multiple-employer): for non-teaching and non-certified school district employees;
• CalPERS: PERF C (cost-sharing multiple-employer): for employees of public agencies with fewer than 100 active members; and
• CalSTRS (cost-sharing multiple-employer): for certificated school district employees.

CalPERS

CalPERS, the nation's largest pension manager, with assets of about $439 billion, serves as the common investment and administrative agency for PERF A, PERF B, and PERF C plans. Members under all CalPERS plans are required to pay 100% of their actuarially determined contribution. Municipalities voluntarily participate in PERF A and PERF C, and plan provisions can vary among participating employers, so funded ratios can be employer specific. PERF C differs from most cost-sharing multiple-employer plans in that it offers a buffet of plan options that municipalities can choose from, and so may appear more akin to an agent plan. Membership in PERF B is required for all non-teaching and non-certified school district employees within the state and management is done at a plan level, so all employers have the same funded ratio.

The funded ratios for the majority of plan members are moderately funded in our view. While plan provisions may vary across employers, assumptions and methods are common for each CalPERS plan.

Chart 2

While the majority of the pension plans have funded ratios that fall between 70.0% and 74.9%, we note that more plans are reporting funded ratios of above 80.0%. These plans are highly funded primarily due to the issuance of pension obligation bonds in recent years, resulting in very high funded ratios at the expense of higher debt levels, as well as other prefunding efforts.

CalPERS' negative investment returns in fiscal 2022 will lead to higher pension costs for municipalities

After several years of positive investment returns, CalPERS recognized a negative 6.1% investment return in fiscal 2022, the first negative return recognized by the retirement plan since fiscal 2009. Notably, this investment loss comes after a record 22.4% return in fiscal 2021, the highest return the pension plan has seen in the past 40 years. The fiscal 2022 poor investment returns have resulted in lower funded ratios and a rise in unfunded liabilities for all members of the plan. The funded ratio for the Public Employees' Retirement Fund (PERF), the main trust fund from which almost all CalPERS retirement benefits are paid, fell nearly 9% in fiscal 2022 after growing 10% in fiscal 2021. Furthermore, the recent negative return will also result in higher contribution rates for all plan members, with pension contributions expected to rise beginning in fiscal 2025. We note that CalPERS also uses a five-year phase-in period for contribution changes, which lessens the contribution pressure during the first few years.

For fiscal 2023, CalPERS reports its preliminary investment return is 5.8%, which reflects a reversal from the prior year's negative return. However, we note that the 5.8% return is still below the plan's assumption, which signals that the trend of falling funded ratios and rising liabilities will persist in the medium-term. The ability of issuers to absorb the increasing pension costs vary, with those issuers whose pension costs comprise a larger portion of their budgets faring poorer than others. Overall, we believe that pension costs will likely remain a major item for most issuer's budgets.

Pension obligation bond (POB) issuances

Although pension obligation bonds (POBs) became highly popular among municipalities from fiscals 2019-2021, we have seen a significant drop in the number of POB issuances beginning in fiscal 2022, due primarily to the significant increase in interest rates. Previously, municipalities utilized POBs as a way to recognize expected general fund savings through lower pension costs, while smoothing out future pension cost payments to provide more predictability from a budgeting perspective. In 2021, S&P Global Ratings rated 32 new POB issuances in the state of California totaling approximately $3.3 billion. The number of new rated POB issuances dropped to three totaling approximately $70.6 million in fiscal 2022. Even if the high interest rate environment in 2022 and 2023 persists, POB issuances take time to structure, so we expect their issuances to remain suppressed in the near term.

For more on our information on POBs, please see our report "U.S. Public Pension Fiscal 2023 Update: Funded Ratios Stable, Inflation Retreats, And POB Issuance Stops," published July 11, 2023, on RatingsDirect.

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Current amortization methods and actuarial assumptions

During the past several years, CalPERS implemented several reforms to its pension plan assumptions and methodologies. As of 2023, investment gains and losses for bases established since June 30, 2019, are amortized across a 20-year period with a five-year ramp up at the beginning of the amortization period. Non-investment gains and losses as well as changes in actuarial assumptions and methodologies are amortized during a 20-year period without any ramp ups.

CalPERS' current discount rate of 6.8% is above our guideline of 6.0%. This implies a risky target asset portfolio that could result in higher volatility of plan asset values and pension contributions.

From a credit perspective, we view CalPERS' reforms in recent years as positive from a credit perspective, although we recognize several remaining risk factors. We note that a majority of the state's existing liability bases are still amortized on a 30-year declining timeframe, given that the shortened amortization timeframe only applies to new liability bases after June 30, 2019. Coupled with the high discount rate, we believe pension costs will likely continue to climb for most of local governments in the state.

CalSTRS

California public school educators from prekindergarten through community college participate in the CalSTRS pension plan, which serves 1,002,049 employees and beneficiaries and maintains approximately $301.8 billion in net assets (as of June 30, 2022), making it the country's second-largest pension fund. The plan administers a hybrid retirement system, including a defined benefit plan, two defined contribution plans, a postemployment benefit (retiree medical) plan, and an account for ancillary activities associated with deferred compensation.

Pursuant to Assembly Bill 1469 and the CalSTRS Funding Plan enacted in 2014, employer contribution increases were phased in over a seven-year period ending in fiscal 2021. Beginning in fiscal 2022, the board received limited rate-setting authority to adjust the employer contribution rate, if necessary, to achieve full funding by 2046. The statutory funding plan gives the board the authority to raise the state's contribution rate by no more than 0.5% per year. In light of the pandemic, the state's contribution rate for fiscal 2021 was frozen at the fiscal 2020 level; however, CalSTRS was made whole by the state's transfer of $297 million from its rainy day budget stabilization fund. The infusion of state funds provided districts with short-term relief, as the adopted employer contribution rates for fiscals 2020-2022 were dropped from the projected rates under the funding plan. For fiscal 2024, the employer contribution rate has remained stable at 19.1%.

CalSTRS pension costs are expected to increase for school districts and community colleges despite positive investment returns in fiscal 2023

Fiscal 2022 marked the first negative investment return since the Great Recession, a trend similar to other plans across the U.S. This investment loss comes after a record 27.2% return in fiscal 2021, the highest return on record for the pension plan. Despite the negative return in fiscal 2022, the pension plan is expected to be fully funded by 2046. However, funding progress is dependent on several factors and could be hampered by long-term enrollment declines due to slowing birth rates and local demographic changes. A declining student enrollment population could result in a decline in payroll as the teacher population mimics that of students, and if the plan realizes a similar negative investment return similar to 2022, its unfunded actuarial obligation could materially grow.

For fiscal 2023, CalSTRS reported an investment return of 6.3% which reflects an improvement from the prior year's negative return, though it remains below the assumption. We expect the plan's liabilities to be a growing cost pressure, due largely to the high assumed return (and corresponding discount rate), which means employers are reliant on investment returns to reduce their annual contributions--and if these high assumed returns do not materialize, they could increase both volatility and budgetary strain. Although the plan's funded ratios are not expected to materially decline in the near term, pension costs are expected to increase for school districts, given that the employer rate reduction provided by the state's supplementary contributions in recent years are no longer applicable. Lastly, we believe the plan's funding progress can be impeded in the long term due to enrollment declines, which would result in lower payroll growth. The ability of school districts to absorb increasing pension costs will vary but will primarily determine whether school districts are experiencing positive or negative student population growth, which serves as the main revenue driver for most school districts. We expect pension costs to remain a major budget item for most issuers in the immediate term as districts contend with the long-term COVID-19 related pressures.

Other Post-Employment Benefits

OPEB, or retiree medical, costs and their related unfunded liabilities generally reflect a much smaller portion of issuer budgets. Most California issuers fund their OPEB costs on a pay-as-you-go basis, which we typically view negatively and generally results in volatile and growing unfunded OPEB liabilities due to year-over-year medical cost increases. Some issuers have established OPEB trust funds or have set aside dedicated reserves to help mitigate contribution volatility and escalation. Contrary to CalPERS or CalSTRS, issuers have the legal ability to alter their OPEB benefits and offerings to employees with certain changes subject to negotiations with bargaining units, which provides more flexibility than pension liabilities in our view, though these changes are mostly applicable only to new employees, which could limit an issuer's ability to manage costs.

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