California taxpayers have almost become immune to stories about
the high cost of generous defined-benefit pensions,
employer-subsidized healthcare plans, job protections and degree-
and seniority-based pay scales struck by the state, school
districts, and affiliates of the National Education Association and
American Federation of Teachers. Not even the fact that 3,090
of its retired teachers are earning more than $100,000 a year
in annuity payments causes a stir.
But they are getting riled up — and learning about such
concepts as internal rate of return and special situation fund —
thanks to the notoriously underfunded California State Teachers
Retirement System. Over the past four decades, CalSTRS has fueled
these pension deals by offering rates of return on its portfolio
that were way too optimistic given the historic volatility of the
stock and bond markets. Even now, CalSTRS assumes that its
portfolio will increase in value by eight percent a year, three
points higher than the 20-year compound annual growth rate for the
S&P 500 stock index. To meet those return rates, CalSTRS has
spent the past three decades pouring money into an array of hedge
fund and other risky investments, including purchasing minority
stakes in private-equity firms and real estate deals that haven’t
exactly panned out.
But these days, CalSTRS can no longer keep up the ruse.
Thanks to an (official) $23 billion
pension deficit, billions more in investment losses (including
$43 billion in the 2008-2009 year alone), and embarrassing reports
about its unrealistic investment expectations, it is preparing to
reduce its expected annual rate of return to a barely less-inflated
7.5 percent. The state government and districts will have pony up
$5 billion more a year just to meet the growing payouts to the
pension’s dependents. By the way, CalSTRS’ request comes just as
news
came out that it paid $1 million in bonuses to its top officials —
including $116,604 to its chief investment officer.
But this is only the start of the pain. If CalSTRS
adjusted its investment growth to reality — including admitting
that the past growth rates for its investments were inflated —
taxpayers would face a $97 billion pension deficit, according to
Manhattan Institute scholar Josh Barro and University of Arkansas
graduate student Stuart Buck in a study
released earlier this year. For once-and-future governor Jerry
Brown, it will mean a tough conversation with the state NEA and AFT
affiliates that supported his successful effort against former eBay
boss Meg Whitman to return to the office he last held some three
decades ago.
California isn’t the only state dealing with the
consequences of overly optimistic investment assumptions and
bungled investments (along with an overly lavish traditional
teacher compensation system) now coming home to roost. States are
just beginning to reckon with the overly burdensome costs of
defined-benefit public pensions for teachers and other civil
servants, (along with at least $365 billion in unfunded retiree
health costs).
But even those stated deficits don’t reveal the full
burden. Thanks to inflated growth rates, unrealized losses, and
methods of valuing assets that wouldn’t even be used by private
sector pensions, the full cost of teacher pensions are just being
understood. This will result in an end to the grand bargain struck
by states and the NEA and AFT that has made teaching the
best-compensated public sector profession.
Certainly the attention these days is on what will happen
to President Barack Obama’s school reform efforts (including his
effort to pour more money into the Race to the Top initiative to
expand charter schools and improve the quality of America’s
teaching corps). The ascent of Minnesota Congressman John
Kline — a critic
of Obama’s initiatives — gives some comfort to NEA and AFT and
their allies among suburban school districts and traditional public
education. But the victory of reform-minded Republican governors
likely means that the nation’s school reform movement will continue
to win influence over the course of federal, state. and local
education policy.
An even more-heated battle has come in the last year as
state governments, fitfully emerging from the last decade’s
economic downturn and no longer able to count on more than $100
billion in federal bailouts, turn their attention to school budgets
that increased by 2.3 percent during the recession. This means
dealing with the heavy pension and healthcare deficits (fueled by
the upcoming retirements of Baby Boomers, who make up 36 percent of
all teachers) that are driving up costs — and revamping
traditional teacher compensation, which have proven both costly
and ineffective in either improving student achievement or teacher
quality. States such as New York, Vermont and New Jersey — where
Governor Chris Christie successfully
forced Garden State teachers to pay more for their healthcare costs
— have made their teacher benefits (slightly) less
lucrative.
But it is the overly inflated investment growth models
used to justify the hefty payouts (and help state governments
strike these deals without actually bearing the actual costs on
their ledgers) that will force states to take more drastic
action.
In Illinois, the state’s infamous teacher pension —
already renowned as one of the nation’s most-underfunded thanks to
a $44 billion pension deficit — lost $4 billion in 2008-2009
thanks in part to its array of derivatives and other alternative
investments. The portfolio and strategies, already considered the
nation’s fourth-riskiest according to Pensions and
Investments, are so arcane that one
investment guru thought it had belonged to a hedge
fund.
Another high-flyer is the Teacher Retirement System of
Texas, whose investment portfolio declined by 13 percent in
2008-2009 before recovering some lost ground. It has deferred $16
billion in investment losses in the hopes that the investments will
recover enough so it can fulfill the 8 percent annual rate of
return it continues to promise in vain. Meanwhile in New York City,
the teachers’ pension there continues to maintain that its
portfolio will earn 8 percent a year even after it lost 25 percent
of its value.
One problem lies with loose standards for accounting for
risk and rates of return. Teacher pensions should take a
conservative approach to investments growth and liabilities, basing
rates of return on what would be gotten if funds were invested in
corporate bonds. Instead, they inflate their rates of return, and
then use those same numbers to aggressively discount the present
cost of their annuity payouts. As a result, pensions are
overstating the actual value of their portfolios while understating
their deficits.
The other problem lies with the very pension deals struck
by states, districts, and teachers unions in the first place. Since
the 1960s, annuity payments have gotten sweeter as teachers have
been allowed to retire at ages younger than those allowed in the
private sector. A Missouri teacher can technically retire as early
as age 52 so long as her combined age and time of employment totals
80 years, then double-dip, going back to work and collecting two
checks at once.
Many state governments refused to devote enough of their
budgets to pay for the them and also allowed teachers to pay less
into them. Given the growing liabilities and the lack of
contributions to pay for them, pensions began overpromising high
rates of growth. To meet those rates — and to take advantage of
the bull markets of the past three decades — pensions began
pursuing more complex investment deals to make up the costs. But
the collapse of the last bull market, along with the ever-growing
number of Baby Boomer retirees, has made recovery more
difficult.
This pressure, along with the
fact that at least four states will run out of funds to pay
their full array of pensions by 2019, may force officials to
finally end the decades of deal-making they have done with the NEA
and AFT.
