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.