New Report on Teacher Pensions

[Guest post by Stuart Buck]

Yesterday, the Manhattan Institute and the Foundation for Educational Choice released a report written by me and Josh Barro. The title: “Unfunded Teacher Pension Plans: It’s Worse Than You Think.” The main finding:

According to the fifty-nine funds’ own financial statements, total unfunded liabilities to teachers—i.e., the gap between existing plan assets and the present value of benefits accrued by plan participants—are $332 billion. But according to our more conservative calculations, these plans’ unfunded liabilities total about $933 billion.

In addition, we have found that only $116 billion, or less than one quarter, of this $600 billion discrepancy is attributable to the stock market drop precipitated by the 2007 financial crisis. The Dow Jones Industrial Average would have to nearly double overnight to make up for the present underfunding of these plans.

The meat of what we did is this: Most state plans assume that their current investments will get about an 8% rate of return in perpetuity. So that means that they set aside less money now to cover the pensions that will be paid in 2015, 2020, 2025, etc. But the 8% assumption is wrong, we argue, for two reasons: First, recent history shows that it may be too optimistic. Second, investments that have an 8% expected rate of return necessarily carry some risk — risk that the plan will actually fall short in a given year or even decade. And when a plan falls short, the burden falls to the taxpayer to make up the difference.

So we reanalyzed the teacher pension plans using the same interest rate that private plans are allowed to use — about 6%, based on corporate bond rates. When we do that, it turns out that pension plans are way more underfunded than they are publicly admitting.

Over at The Quick and Ed, Chad Aldeman has a response to our study:

States, unlike private companies, do not fold under. Indiana, which according to the authors has a DB pension plan for teachers that is only 42% funded, is not likely to go out of business and take its workers down with it. The state of Indiana can assume a riskier investment return for its pension fund than an employer like those mentioned above or any other modern private firm (and, just for good measure, it’s worth pointing out that Indiana assumes only a 3 percent real rate of return).

All this is lost on the report’s authors, who would prefer states lower their assumptions on stock market returns from about 8 percent down to 6, the standard rate used by corporations in their calculations. This would mean telling a state like Pennsylvania, which has accumulated a 9.23 percent return in the stock market over the last 25 years (as of February 2010), that its 8 percent investment assumption is too high.

This is all irrelevant. We’re not saying that when states engage in risky investments, teachers then are at risk of not being paid their pensions. The problem is precisely the opposite: Teacher pensions are guaranteed by states that don’t go out of business. But that doesn’t make the risk magically go away. The risk just ends up being borne by the taxpayer. So if a state decides to blow all of its pension money gambling at a horse race, the teachers will still get their pensions, but taxpayers will suddenly find themselves paying higher taxes to make up the shortfall (or else seeing huge budget cuts to other important state services).

In the last sentence, Aldeman cites a document put out by the Pennsylvania pension system, but that document actually proves our point. The Pennsylvania pension system may have made an average of 9.23% per year for the past 25 years, but they still predict that looking forward, there will still have to be “significant and perhaps prohibitive tax increases at the State and/or Local levels.”

Moreover, to focus on the 25-year rate of return, as Aldeman does, ignores three things: 1) past performance is no guarantee of future success; 2) the PA pension system now has less assets on Dec. 31, 2009 than on June 30, 2004, which means it lost money over a 5.5 year period; and 3) this kind of variability (i.e., risk) requires taxpayers to pay extra when investments are disappointing for years on end.

The problem with Pennsylvania, as with many other states, is that when times were flush (the late 1990s or the mid-2000s), legislators did not have the foresight to let pension systems accumulate some savings for possible tough times ahead. Instead, they decided to lower contributions to pension systems and/or increase pension benefits, all on the assumption that high stock market returns would magically pay for it all. But when the stock market falls, the pension systems are left with extra liabilities that no one ever paid for, and the risk ultimately rests with the taxpayer.

It’s a heads-I-win, tails-you-lose system. That’s why taxpayers need state pension systems to use an accounting method that more properly and honestly accounts for all of the risk that they’re shifting onto us.

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2 Responses to New Report on Teacher Pensions

  1. Laura says:

    Are pensions guaranteed, or can they be changed even for those already receiving pensions? I think the entire pension/social security needs an overhaul. We cannot afford to give these payouts without shifting large tax burdens to hard working citizen. If you are retired you should get some benefits, but you should also save money and not rely totally on pensions/social security

  2. In every state there are constitutional provisions, laws, or case laws guaranteeing that pension benefits cannot be changed once they are promised. That means changing the system requires focusing on new employees and will take a long time before those changes make a financial difference. But since this is a long-term problem it is worth getting started as quickly as possible.

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