Josh Barro: Teacher pensions are a ticking time bomb
By: Josh Barro
April 28, 2010
What could be worse news than that public school teacher pensions across the country report an unfunded liability of over $330 billion? How about the fact that these reports understate the size of the liability by a factor of three?
Recently, the Manhattan Institute and the Foundation for Educational Choicereleased a report (which I co-authored with Stuart Buck of the University of Arkansas) that scrutinizes the financial statements of the 59 pension plans covering most teachers in the United States. We applied private sector-style standards to their estimates of future liabilities, and adjusted their asset values to fully reflect the last two years' drop in stock prices.
The results aren't pretty. Applying more realistic standards, these plans are $933 billion short of the assets needed to cover their promises to retirees, or more than $18,600 per public school pupil.
That figure represents a debt that governments owe to active and retired teachers--and paying it off will mean a combination of higher taxes and lower education spending in the classroom.
How did this gap grow so large? Public pension plans made risky bets on equity investments, and assumed that fast gains in the stock market would enable them to cheaply provide generous pensions to teachers.
When the stock market performed strongly (such as during the tech bubble of the late 1990s) this strategy appeared to be working, and then some. Many state legislatures chose to sweeten retiree benefits because their pension plans appeared to be overfunded.
Then, the pendulum swung the other way, and the stock market reported negative returns over the last decade. Employees are still owed generous benefits, but pension funds are in much sorrier shape--and they're telling state and local governments to cough up lots of cash to fix the gap.
It's obvious why legislators behaved like they did. Increasing pension benefits makes employees happy now and mostly creates problems for future legislatures, years or decades down the line. A decade ago, funds' financial statements suggested those changes were affordable. Unfortunately, that strong funding situation was always a mirage.
Unlike pensions in the private sector, public pensions used expected asset returns to estimate how much cash was needed today to pay future benefits. This was despite the fact that those investments were risky, and the risks could not be passed onto pension beneficiaries, whose benefits are guaranteed regardless of what the market does.
Private sector pensions instead base funding estimates on the risk actually experienced by pension beneficiaries--that is, a low risk, similar to that of a corporate bondholder.
When private companies invest pension assets in risky equities, they recognize that that investment risk is borne by the company, which effectively insures retirees against loss of value. The use of a more conservative accounting assumption reflects the fact that this insurance isn't free.
Applying this private sector methodology to teacher pension plans adds roughly $484 billion onto the $332 billion official gap. Another $116 billion comes from marking plan assets to market--under pension accounting, the plans take several years to recognize market losses, understating the pain their asset portfolios have faced. This brings the grand total gap to $933 billion.
This situation presents two challenges for state lawmakers and taxpayers: what to do about the existing gap, and how to prevent future gaps from forming.
On the existing gap, the news is not good. The gap represents promised compensation to employees for work already performed. In general, it can only be closed by cutting checks over the next several decades to pay those benefits.
Several states have begun taking action to prevent future gaps from forming. In the last six months, New York, New Jersey and Illinois have all enacted reforms that reduce the generosity of pensions for newly hired employees.
These are steps in the right direction, but they do not go nearly far enough. Because the reforms apply only to new employees, they will take years to produce real savings. (New Jersey, to its credit, also began immediately requiring all employees to pay part of their health premiums.)
Most problematically, these austerity measures are likely to be undone by future legislatures. Indeed, New York's reform late last year created Pension "Tier V" for new employees, designed to be less generous than the current Tier IV.
Notice the high numbers--in the last four decades, New York has seen the introduction of three previous tiers designed to reduce unaffordable pension generosity. These reforms were repeatedly weakened by legislatures under pressure from public employee unions, when the public coffers were flush.
This cycle is asymmetrical--when pension generosity is reduced, that applies only to new employees, but all employees get the benefit of sweetened pensions. There is only one way for states to break the cycle: move employees from defined-benefit pension plans to 401(k)-style defined-contribution plans.
This change is almost complete in the private sector: while 84 percent of state and local employees have access to a defined-benefit plan, only 21 percent of private employees do, and just 16 percent of non-union private employees.
Corporate America has recognized that defined benefit pensions are unaffordable and unsustainable. For the good of taxpayers across America, it's time for governments to make the same realization.
Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute. His new report, "Underfunded Teacher Pension Plans: It's Worse Than You Think" is available online at: http://www.manhattan-institute.org/html/cr_61.htm
Read more at the Washington Examiner: http://www.washingtonexaminer.com/opinion/columns/Manhattan-Moment/...