Discounting Teacher Pensions

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 I just returned from a great conference co-sponsored by Vanderbilt, U. of Missouri, and my department at the University of Arkansas on teacher pensions.  One of the major issues discussed at the conference was the financial sustainability of those pension systems.  And at the heart of that discussion was a debate over the appropriate discount rate to apply to pension liabilities.  Essentially, the debate was over what we should assume to be the return on pension investments in the future.

This may seem like an arcane and dry issue, but let me tell you that it is incredibly important.  If you don’t care about it now, you will care if those pensions fall short of their assumed rate of return on investments over a long period of time.  If teacher pension plans run out of money, taxpayers are on the hook to make up the difference to the tune of tens of billions of dollars.  I know that in the era of trillion dollar bailouts tens of billions don’t seem like a big deal, but after a few of these trillion dollar bailouts there may not be much left for the teacher pensions if they go kablooey (that’s the technical term).

Public pensions are generally considered well-funded when they have assets that are roughly 80% of liabilities.  Don’t ask me why it is considered OK to know that you are short 20% of what you owe, but most folks who work on these issues just don’t think it’s realistic to have 100%.  Besides, when plans get close to 100% funding of their liabilities they tend to increase the generosity of their benefits to bring that ratio down. 

About 40% of the major teacher pension plans failed to meet the 80% standard for being adequately funded as of 2007 — before the current market meltdown.  But the 60% that did meet this standard did so assuming that they would return 8% on their investments going forward.  Is 8% the right rate to assume?

Remember that teacher pensions are promising to pay teachers a certain amount of money 20, 30, or 40 years from now.  They also expect to receive a certain amount in contributions from the teachers, from their employers (the state or school districts), and from investment returns on those funds.  Whether you have enough money to make the promised payments to teachers is extremely sensitive to the assumed rate of return on investments.

Some folks, often public finance economists, argue that assuming an 8% return is irresponsible.  They say that the market tells us what rate we should use and it is the risk-free rate of long-term US treasury bonds, currently earning a little less than 4%.  To get a significantly higher return one has to take-on significantly more risk, with the distinct possibility that one will earn far less than 8% and even less than 4%. 

If one assumes a 4% return rather than an 8% return, a teacher pension that would have been 70% funded assuming 8% would drop to 44% funded assuming a 4% return.  Just how under-funded teacher pensions are hinges heavily on whether we assume a 4% or 8% return.

Other folks, often pension plan actuaries, argue that the 8% assumption is reasonable.  They point to the historic rate of return on pension assets to support 8% as a reasonable figure.  They also say that risk is different for the government since it is a perpetual entity.  They can endure losses for a long time and eventually make up for them in a way that a private organization cannot.

I find it hard to support the 8% assumption.  Historic rates of return are hardly reassuring.  We may have received an average return of 8% over the last century, but who knows whether the next century will resemble the last one?  And who knows if we might be like Japan, where stock indices are still less than half of the peak they obtained three decades ago.  There is a good reason why investments ads say past returns are no guarantee of future returns.

And being a perpetual entity provides no protection if future rates turn out to be less than 8%.  Being perpetual only means that one can endure a very long period of under-performance.  That assumes that eventually the mean return will revert to being 8%.  But why should that be?  What if the mean return over the next infinite period is only 4%?  No matter how long we wait, we would never get 8%.

If it were really true that the government could be assured an 8% return while private entities can only be assured a 4% return, then it would make no sense to have a private financial industry.  The government could borrow at 4% to buy up the entire private sector and guarantee everyone an 8% perpetual return.  People should give all of their money to the government to invest so that they could be assured the 8% return with no risk.  If they invest it privately they can only be assured a 4% return with no risk. 

But defenders of using an 8% discount rate respond saying that if you assume a 4% rate and end up making 8%, the plans will be grossly over-funded.  That would essentially involve the transfer of wealth from this generation to a future generation, which would be grossly unfair.

Of course, the only way that the pensions could get more than 4% would be if they took on additional risk by investing in equities, real estate, hedge funds, etc…  If you lent me money at 4% and I took it to Vegas and put it all on black, I might also come back with a lot more than the 4% I would owe you.  I just can’t be guaranteed to come back with extra money.  Similarly, the teacher pension plans cannot be guaranteed the 8% return and should not assume extra risk in the attempt to get it.  If pensions switch to a 4% discount rate they should probably be restricted in their investments to mostly risk-free investments, like government bonds.

Switching to a 4% discount rate is going to be painful, especially with already under-funded teacher pension plans and with the recent market meltdown.  But if we don’t do it, eventually we may well face a future financial crisis brought on by pensions rather than by housing.  Let’s spot the bubbles before they burst.

In addition to reading the papers listed at the conference web site, you may also want to check out this new piece by my colleagues Bob Costrell and Mike Podgursky in the current issue of Education Next.

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9 Responses to Discounting Teacher Pensions

  1. Jay,

    You raise some interesting points, I have a few quibbles:

    1) Investing in equities isn’t quite the same as gambling in Vegas, yes it is “risky”, but you are investing in economic growth. Charles Murray pointed out once, in comparing Social Security to personal accounts, that the worst 40-year period in the stock market ended in 1934 (i.e. the worst year to retire in American history); that still represented a 4% annual return on stocks.

    2) “We may well face a future financial crisis brought on by pensions” – too late. States like Pennsylvania already face a 500% increase in pension contributions from taxpayers (assuming an 8.5% rate of return) in a few short years. http://cfpolicyblog.blogspot.com/2009/02/more-on-pa-pension-spike.html Many local governments are in worse shape.

    3) The problem is not the assumed rate of return or the investment strategy, but the plan design and benefits itself. The solution is to get out of the defined-benefit pension plan and moved to a defined contribution, 401(k) model of retirement benefits. These plans can be generous, but will be predictable, affordable for taxpayers, and not subject to political manipulation.

  2. I mostly agree with you, Nathan. We already have a big pension problem on our hands, but the full problems don’t hit for another decade or two. And I agree that a defined construbition or cash balance plan would reduce risk and cost to the taxpayer.

    But I don’t think you can reasonably assume that the worst 40 year return going forward will be 4% just because it has been in the past century. We have had one world history over the past century and we have fared well. What if we don’t fare so well in the next century? There is nothing “natural” about an average 8% return on equities over a long time period.

    I’m just saying that investing (you are right, it is not gambling) involves risk. People should be free to take risks for themselves and enjoy the rewards or experience the pain. But the government shouldn’t be taking risks on your behalf. If things don’t pan out the taxpayer is on the hook.

  3. Greg Forster says:

    If it were really true that the government could be assured an 8% return while private entities can only be assured a 4% return, then it would make no sense to have a private financial industry. The government could borrow at 4% to buy up the entire private sector and guarantee everyone an 8% perpetual return. People should give all of their money to the government to invest so that they could be assured the 8% return with no risk. If they invest it privately they can only be assured a 4% return with no risk.

    But isn’t that exactly what government is doing now – borrowing huge sums and using it to buy up the private sector, on the theory that public ownership will add economic value?

    And if all the economic eggheads in both parties say it’s right, it must be right. Right?

  4. You may be right, about future returns, and your are certainly right about government taking risk.

    But the answer isn’t reducing the expected rate of return and investing in only fixed-rate securities. That removes risk, by guaranteeing the cost to taxpayers will sky-rocket, above what is already coming.

    The answer is, I think you will agree, to get government out of guaranteed pension plans.

  5. Control N (Nathan’s right)

  6. The problem with defined benefit pensions in the public sector is a fundamental misunderstanding of retirement compensation. All of the attention on unfunded liability and rates of return obscure the crucial issue of retirement compensation.

    The risk borne by taxpayers has a tremendous compensation value. Defined benefit pensions in many states are effectively ensuring an 8%+ rate of return with benefits indexed to the specific wage increases of each employee. If these pensions are retained, an accurate assessment of retirement compensation must be done.

    In my study of K-12 pensions in Colorado, the value of the risk assumption by taxpayers is on the average more than $500,000 per retiree. This excess deferred compensation is in addition to employee/employer contributions compounded at conservative interest rates. When allocated across working years, this excess deferred compensation would add 30% to 50% additional compensation per employee.

    At the heart of excess retirement compensation is highly subsidized early retirement. In Social Security and most private DB plans, retirement before the normal retirement age is penalized 4% to 7% per year. In K-12 plans, there is no penalty for early retirement after the longetivity requirements are met (often 50/30 or 55/30).

    Ending highly subsidized early retirement would be a major step in reforming K-12 pensions. K-12 employees should not be entitled to retirement compensation far beyond private sector counterparts. If reform is not made soon in K-12 (and other public employee pensions), substantial tax increases and budget reductions will be necessary. These tax increases and budget reductions will not improve the education product. To contrary, the tax increases and budget reductions will lead to reductions in other areas of K-12 and taxpayer resistance to additional school funding.

  7. bendegrow says:

    You can find a copy of Michael’s study on deferred retirement compensation in the Denver Public Schools at:

    http://www.i2i.org/files/pdf/IP_9_2008.pdf

  8. Thanks, Michael and Ben!

  9. art says:

    I have known this for a number of years, and in the late 80’s was in a taxpayer group that addressed it. The problem is that these programs were started during a time when every private sector person had a pension so the unpaid elected leader, who turn over constantly, took the path of least resistance and caved in. Starting in the late 80’s private sector defined pensions went away, were routed in the 90’s and nonexistant now except for legacy employees. With 15% of the population employed by government, and the teachers union being the largest union, and public school parents being the largest voting block, it is bad form to even mention it. I asked a wise older man “why doesnt the public get mad when the facts are known?”- he answered “nobody will go public because it would be admitting that they were not well fixed themselves- too embarassing”

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