State's retirement systems need more than a mere nip and tuck

Two years ago the Thomas B. Fordham Institute issued a report critical of the financial sustainability of the State Teachers Retirement System (STRS) and the adverse effects the system’s benefits policy has on recruiting young teachers.

The June 2007 report noted the system’s unfunded liability was $19.4 billion, which then represented a debt of over $4,300 per Ohio household.“At current contribution rates, STRS actuaries estimate that it will take 47.2 years to amortize the unfunded liability, a funding period that exceeds the 30-year requirement established in state law (see here),” the report noted.  This was at a time when the Dow Jones Industrial Average stood at almost 14,000. Today it stands at about 9,500.

When our report came out, STRS officials angrily denied problems and essentially labeled Fordham and the report’s authors – the well-respected economists Robert Costrell and Mike Podgursky – scaremongers.

But what a difference a couple of years make. Last week, STRS Executive Director Michael Nehf stood in front of lawmakers and state officials and admitted that without a massive infusion of taxpayers’ dollars and trimming and adjusting of benefits, the fund eventually would be bankrupt.

"If no changes are made we will eventually be unable to pay benefits," Nehf told the Ohio Retirement Study Council. The timeline for amortizing the unfunded liability is now set at infinity (see here).

As far as Ohio education is concerned, the STRS plan affects more than just teachers, school districts and taxpayers. The very future of our K-12 education system is at stake if you believe that smart, talented young teachers make for good schools. The whole idea behind teacher compensation has been to scrimp on upfront pay for new teachers, promising them a nice, taxpayer guaranteed pension down the road.

As was noted in our 2007 report, “the system is out of step with the state’s current teacher needs, labor markets, and career patterns. While Ohio’s teacher retirement system provides impressive benefits to teachers who make it through a 30-year career, these benefits come at a serious cost to younger system members, to taxpayers, and to the state. For instance, teachers who separate from the system before the 25 or 30-year mark face substantial losses in pension wealth. Thus the system contains potent and perverse incentives that seriously hinder teacher recruitment and mobility, and that foster generational inequities between younger and older teachers.”

Last week, however, the emphasis was on retirees and the here and now. It was clear that while the pension funds may consider the measures they are contemplating tough, the changes are little more than tinkering with an archaic system. Raising the contribution rates on teachers and school districts may help in the short-term but it does nothing to deal with the long-term challenges facing a system that is not only too pricey to sustain in its current manifestation, but also in need of an overhaul to reflect longer life-expectancies and changing labor markets.

Consider the average retirement age for Ohio teachers is 58 years – well below the current minimum age for regular retirement in the Social Security system (65.5, rising to 67 in coming years). The fact that Ohio teachers retire so early also gives rise to a demand for health insurance, since Medicare coverage does not begin until 65. 

Exactly, how much the current changes requested by the STRS and the state’s four other public pension systems will ultimately cost taxpayers will become increasingly clear in coming months. Certainly, some kind of General Assembly action is likely given the political clout of the pension funds and the associated state employee unions like the Ohio Education Association and the Ohio Federation of Teachers.

Just meeting the request of the hemorrhaging STRS and the police and fire funds is likely to cost taxpayers at least $1 billion. This is at a time of fiscal crisis for state government. The state budget came together only after painful cuts to numerous social services, an infusion of $5 billion in one-time federal stimulus money, and $2 billion raised through what the Columbus Dispatch called “Peter-to-Paul fund transfers, accounting tricks and raids on specialized funds” (see here).

“For the overall legislature it’s a tough sell,” said retirement council member State Rep. Lynn Wachtmann (R-Napoleon). “But don't underestimate the political power of the OEA. There's no end to their greed in asking taxpayers for more money.”

Listening to the pension fund executives outline their plans made clear that there wasn't much more than a cursory nod to the state and the nation’s larger economic woes. Lest it be forgotten, many Ohioans have seen their 401(k)s shrink by close to half in the last two years and no one is bailing these folks out. Many have seen their property values collapse (especially Ohioans living in cities), while 11 percent of the state’s adults are unemployed.

Little was said about the plight of Ohioans who will be footing the bill for the increased employer contributions for teachers and other public servants. Only the School Employees Retirement System (the janitors and bus drivers) paid any attention to the rest of us and then mostly by pointing out that their people are the lowest paid, receive the lowest pensions and are usually the first to be laid off in times of trouble.

Scarier, however, is that public pension funds have still not figured out they are gambling with taxpayer dollars. Officials are still relying on eight percent investment returns, despite the massive losses they suffered in the last 12 months. In fact, the STRS had been using a nine percent rate until earlier this year. An eight percent rate is very common in public investment circles but is it realistic?

As economists have pointed out, despite the partial recovery in financial markets, basing pension benefits on an eight percent return is dangerous (see here). Private pension funds, for example, base their benefits on a return in the neighborhood of six percent, according to an expert at the Boston College Center for Retirement Growth. That may not seem like much of a difference but, over decades, it’s literally billions of dollars.

Jay Greene, a pension expert from the University of Arkansas, has pointed out that it makes far more sense to gauge growth, and benefit payments, on the risk-free but lower rate of long-term U.S. Treasury bonds. That might be more realistic, especially given the recent meltdown, but it would hardly fly in the public pension industry, where, remember, the promise of a big pension over several decades is the norm. A teacher pension that would have been 70 percent funded at eight percent would drop to 44 percent funded with a bond rate of four percent.

To get a significantly higher return requires taking on far more risk. Of course, what teacher pension funds and other public employee pension funds have been doing is gambling that the market will rebound and deliver their big payouts. The STRS portfolio dropped $24 billion from the end of its 2007 fiscal year through June 30 of this year (see here), yet the state constitution guarantees all promised pension benefits (but not healthcare) will be paid in full.

Now taxpayers are about to be asked to bail out the STRS and protect its generous benefits and backfill market loses. The STRS, for example, wants its members and school districts to pay an extra 2.5 percent each – raising member contributions to 12.5 percent and school districts’ to 16.5 percent. The police and fire fund proposal calls for an increase in the payments made by municipalities that eventually would reach 25 percent, while employees would pay 2 percent more.

In exchange, the pension funds promise to tighten benefits. The STRS promises to change the way final average salaries are calculated, increasing years for eligibility, changing the benefit formula and reducing the annual cost-of-living adjustment (COLA). But there’s no real effort to address the larger problem—that teachers and other public sector employees can retire far younger than most of their fellow citizens and receive a pension that is far more generous than most Americans receive.

As we wrote in 2007, “Ohio’s teacher system was designed for a different era (one in which employees were far less mobile), and for a time when life expectancies were considerably shorter than they are today. Now, many new retirees can expect to collect pensions for more years than they taught. These incongruities are expensive, and the costs rise further when relatively young people (some in their early fifties) retire.”

Boston University economist Laurence J. Kotlikoff compares the running of state pension funds to a Ponzi scheme even in the best of times. In a paper (see here) published earlier this year by the National Center on Performance Incentives, he compares pension fund operations to a legal version of the cataclysmic investment fraud perpetrated by imprisoned New York City financier Bernard Madoff.

Kotlikoff wrote “…if these plans and the governments that explicitly or implicitly back them are in as bad a shape as appears to be the case then the plans are likely to renege on their commitments to young and middle age teachers in precisely the same manner that corporate America has been reneging on its obligations to its workers.”

Kotikoff urges school districts to actually pay young teachers more while promising less in retirements. “The alternative – continuing to run Ponzi schemes whose ultimate debacle is only a matter of time – will continue to leave both teachers and taxpayers at great risk.” For example, despite the run up in stock prices that pension funds like to tout, in 2007, three in five teacher pension plans in the United States were underfunded by at least 20 percent.

In this light, the parade of pension fund executives last week in Columbus was inevitable as is a big part of their solution – more taxpayer dollars to meet their benefits. They’re also going after younger teachers by asking for higher contribution rates from them. Young teachers will have to pay those higher rates the longest and this is sure to come at lower starting salaries.

This is surely a disincentive to enticing the best-and-brightest young Ohioans to teach. Many young teachers and young prospective teachers, who are paying off student loans, attempting to start families, and hoping to buy homes, might prefer more of their compensation up front rather than see it deferred into a system from which they may well never benefit.

For purposes of teacher quality and fairness across the generations, Ohio’s lawmakers should use the current crisis with the STRS system – and the other state retirement systems – to ask tough questions and debate tough changes. Here are five to consider:

  1. Should defined benefit plans for public employees be phased out or drastically curtailed to reduce the risk to taxpayers and future generations?
  2. Should the state move towards defined contribution plans and/or cash balance plans as most of the private sector has in America?
  3. Is it fair for public sector employees to expect retirement at 54 or 55 when most Americans are looking at retirement ages of 65 or 67?
  4. Can STRS and the other retirement systems continue to offer generous healthcare coverage that provides 75 percent of the cost of insurance premiums for most retired teachers?
  5. Is the current system transparent? Can the STRS trustees, who are mostly teachers or former teachers themselves, really make the hard decisions necessary to reform their retirement system?

Taxpayers and pension-fund members deserve answers to these questions and only by rejecting any request for more taxpayer dollars will we actually get answers that are honest.

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