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Will Pensions Bankrupt Your District?

State retirement funds are in crisis, and school systems will likely pay more of the bill.

As the superintendent of the St. Mary Parish (La.) Schools since 2004, Don Aguillard faces many fiscal challenges in overseeing the rural district’s 1,500 employees and 10,000 students. But for the 2010-2011 school year, a new and significant financial burden will be added to his annual budget. In an effort to make up a large funding shortfall, Louisiana’s two largest teacher retirement systems will be raising their required employer contribution rates, one from 15.5 percent of salary to 20 percent, the other from 17.6 percent to 24.3 percent. Aguillard estimates the total increase will add between $2.3 million and $2.6 million to his district’s annual budget of $83 million. “ The rates are calculated by each retirement system, and we do not have any power to alter them,” Aguillard says, adding that the sudden rate increases “will have devastating impacts on our operating budget.”

A similar situation exists in nearly every state in the country. The financial state of the nation’s public pension funds—which provide the retirement incomes for all state employees but in most states are dominated by teachers, administrators and other school employees—has gone from bad to worse, and for most it is only projected to worsen in coming decades. A perfect storm of factors has combined in the past year. Long-term trends of insufficient state funding, ever-increasing payment obligations and retirees living longer than ever, coupled with the market crash at the end of 2008, have put most teacher retirement funds on a path to financial disaster.

Worsening a Crisis

Since public pension funds count on investment returns for asset growth—and because the market boom of the 1990s caused many fund managers to make riskier investments and states to reduce their contributions and rely even more heavily on returns—the 2008 stock market decline was catastrophic, pushing what were already declining values in many states off a cliff.

The Iowa state pension fund’s value dropped over $3 billion in the course of the year, putting the total deficit at nearly $5 billion. A recent report by the University of Kansas described that state’s pension fund as “bankrupt,” with a projected shortfall between assets and payout obligations of $8.3 billion in the next 25 years.

In Colorado, the state employee pension fund plummeted in value from $43.1 billion at the end of 2007 to $30.8 billion at the end of 2008, a drop of more than 25 percent, with the state retirement agency acknowledging in a recent report that the fund “cannot invest its way out of” the situation. The New York state retirement fund—which has also been rocked by a kickback scandal that resulted in October in the arrest and guilty pleas of officials in the state comptroller’s office—lost $23 billion over the year. And the largest funds of them all, the California Public Employee Retirement System (CALPERS) and the California State Teacher Retirement System (CALSTRS), together lost a total of $100 billion of their high of $260 billion in assets after the 2008 crash. While they have since regained about $40 billion of the loss as the stock market has rebounded in 2009, the funds are still tens of billions short of future obligations.

"If no changes are made, we will eventually be unable to pay benefits."
-Michael Nehf, executive director, Ohio State Teachers Retirement System

Pension Politics

While the market crash accelerated the problem, many states’ retirement programs were in trouble well before 2008. A 2007 report by the Pew Charitable Trusts’ Center on the States found that the nation’s public pension funds were a total of $731 billion short of obligations—which it admitted was a “conservative figure”—the result of risky investments, chronic state underfunding, and increasing levels of benefit guarantees from legislators. The American Enterprise Institute calculated, based on numbers from the Center for Retirement Research at Boston College and market adjustments from Forbes, that in 2007 only Oregon had funded over 80 percent of its future pension obligations, leaving 49 states with less than 80 percent funding and over a dozen with less than 60 percent. “The tension at the heart of pension politics is the incentive to satisfy today’s claimants in the here and now at the expense of long-term concerns,” says Frederick Hess, AEI director of education policy studies. Legislators are pressured to increase benefits paid but rarely, if ever, to provide adequate future funding, especially not if it involves raising taxes. “Public pension promises are huge and, in many cases, funding is woefully inadequate,” Warren Buffett wrote in a 2008 letter about the subject to Berkshire Hathaway shareholders. “Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that the problems will only become apparent long after these officials have departed.”

In addition, teacher pension systems encourage early retirement and have no limit to the number of years in which benefits are paid—and retirees are living longer. This combination is costly, as some retirees collect pensions for as many years as they worked, or in some cases, many more years. The Ohio School Employees Retirement System, for example, is one of five Ohio funds that has lost billions of dollars—one officially cites “infinity” for the length of time it would take to make up the shortfall—and currently has 55 retired school employees receiving benefits who are over 100 years of age. “If no changes are made, we will eventually be unable to pay benefits,” says Michael Nehf, executive director of the Ohio State Teachers Retirement Fund, which lost $24 billion in assets over the year.

Unaffordable or Underfunded?

Are the pensions guaranteed to school employees unaffordable? Or should pensions be maintained by significantly increasing contributions, reducing benefits, or a combination of both? It depends on whom you ask, and in which state. In 2005, California Gov. Arnold Schwarzenegger made his position clear. “We are going to take action and overhaul the political, educational, and financial institutions in the state,” he said in a policy speech. “And a big part of that is reforming our out-of-control government pension system. California passed out some sweetheart pension deals in the past, promising state workers more than it should and more than it could.” The governor’s attempt at overhauling the system by replacing pensions with 401(k)-style private accounts failed, due in part to tremendous opposition from unions including the California School Employees Association, the largest school employee union in the country. Five years later, the fund has a $50 billion unfunded liability.

The private sector has almost completely abandoned the traditional “defined benefit” pension—which nearly all school employees nationwide enjoy and the enormous costs of which crippled sectors like the American automotive industry—in favor of “defined contribution” plans like the 401(k) and other private investment accounts. According to the Center for Retirement Research at Boston College, just 17 percent of all private sector workers in 2007 exclusively had a defined benefit plan for retirement income, down from 62 percent in 1983. Conversely, 63 percent of all private sector workers exclusively relied on a 401(k) defined contribution plan in 2007, compared to 12 percent in 1983, almost an exact reversal.

Perhaps unsurprisingly, teacher unions have the opposite viewpoint of Schwarzenegger and other likeminded critics of pensions, and don’t hesitate to question the legitimacy of claims that a crisis exists. “Pension funds have been around for over 100 years and have weathered every economic crisis during that time, including the Great Depression,” says John Abraham, director of the Member Benefits Department for the American Federation of Teachers. “The writers of these stories are people who want to do nothing less than destroy state governments. That’s what’s driving all this negative press, these tax cutters.” Bill Raabe, director of the Collective Bargaining and Member Advocacy Department at the National Education Association, is also skeptical. “Pension systems, state governments, employers and employees need to look at the whole problem and first ask, “Is our problem real?” says Raabe. “Then, if they decide that it isn’t something created for political reasons, they have to examine the rates of contributions, investments and benefits, and determine what mix of those will solve the problem.”

Costly Solutions for Districts

Union skepticism notwithstanding, proposed solutions to the crisis are moving forward and vary by state, but in most, the proposals are going to cost districts. “We have an advisory committee that has been studying this for months,” says Julie Economaki, spokesperson for the Iowa Public Employees Retirement System, which had an investment return last year of negative 16.27 percent, losing over $3 billion. “It advised the legislature to both increase pension contribution rates and reduce future benefits,” says Economaki, adding that both school employees and districts would have to contribute to the rate increases.

"These changes will have devastating impacts on our operating budget."
-Don Aguillard, superintendent, St. Mary Parish (La.) Schools

The Ohio pension system has recently proposed a number of reforms, including raising the contribution rates for school districts from 14 percent to 16.5 percent of payroll over five years beginning in 2016, and capping the number of years of pension payments at 33.4 years. Similarly, Oregon—often touted as an example of a successful state pension overhaul after 2003 reforms cut retirement benefits to current employees, erasing an unfunded liability of $15.7 billion—is considering a significant increase in employer contributions after the state fund lost $17 billion in the 2008 market crash, possibly doubling school district payments to 25 percent of payroll in the next five years, or even higher, depending on stock market returns.

The state of Vermont is facing a $700 million unfunded liability in its teacher pension system, according to State Treasurer Jeb Spaulding. “People are living longer and living in retirement longer. We’ve seen our benefit payouts increase significantly every year, and they are projected to go up another 50 percent in the next five years,” says Spaulding. A committee including Spaulding has proposed not only raising the retirement age, increasing the number of years required to earn a pension, and reducing benefits to future retirees, but also requiring districts to contribute a percentage of payroll to the pension fund or retiree health plan costs, which they do not currently do in the state. “But adding those costs to districts is controversial, because taxpayers are already under a lot of financial pressure to pay their local property tax, which is the source of that revenue,” says Spaulding, adding that raising those taxes would be a difficult proposition.

Defined Contribution

Even more controversial are proposals to dramatically overhaul pension systems by transitioning from defined benefit plans to defined contribution accounts like the 401(k), following the broader trend across the private sector. Reform attempts such as Gov. Schwarzenegger’s in California have largely failed after consistent opposition from unions. According to the Government Accountability Office, only Alaska, Michigan and the District of Columbia exclusively use defined contribution retirement plans for their public employees, and only Indiana and Oregon use a “hybrid” system with both defined benefit and defined contribution accounts. In Iowa, the idea of defined contribution plans “pops up every now and then, but there hasn’t been a serious effort to change,” says Economaki. “But our fund is in better shape than most.”

The political will for such reform could be growing, however. Chicago Public Schools is facing a $475 million deficit that could reach $900 million this year due in part to pension costs, while the Illinois Teachers Retirement System ended its fiscal year with an unfunded liability of $35 billion. Schools CEO Ron Huberman has insisted that “everything is on the table” in addressing the shortfall, including transitioning the teacher pension system to defined contribution plans, which he negotiated for new hires while serving as head of the Chicago Transit Authority.

This notion also made the 2009 New Jersey governor’s race highly significant in the realm of pension politics. The New Jersey Education Association was heavily involved in the election campaign; the state teachers’ union endorsed incumbent Democrat John Corzine, who had sought only minor reforms in the state pension system, which has an unfunded liability of over $34 billion. Republican Chris Christie won the election despite vigorous opposition from the NJEA—which one state senator described as having thrown “everything and the kitchen sink” at the candidate—and his stated intentions to overhaul the public pension system and freeze or make significant cuts in state spending, including pension fund contributions.

An Uncertain Future

Short-term costs will almost certainly increase for districts and states alike, but such proposals won’t satisfy those who believe the pension system is inherently obsolete and prone to vast funding shortfalls. Some levels of financial reforms are nearly inevitable for most states. Now is a critical time for district administrators to stay informed about proposals in their state governments, as coming legislative changes could have huge impacts on their district finances. As Frederick Hess concluded in a recent highly critical report on teacher pensions for the American Enterprise Institute, “Only time will tell whether looming fiscal crises, unaffordable promises and heightened attention to the costs of public pensions will yield a new era in which the electoral rewards for fiscal responsibility [...] rival those of placating impassioned claimants.”

Kurt Eisele-Dyrli is products editor.