Underfunded Teacher Pension Plans: It's Worse Than You Think

To all the other fiscal travails facing this country’s states and largest cities, now add their pension obligations, which are far greater than they may realize or are willing to admit. This paper focuses on the crisis in funding teachers’ pensions, because education is often the largest program area in state budgets, making it an obvious target for cuts.

Although it is generally acknowledged that education is the foundation of every modern society’s future prosperity, schools unfortunately will have to compete with retirees for scarce dollars. This competition is uneven, because retirees have a legal claim on promised pension benefits that supersedes schools’ budgetary needs. Consequently, Americans can look forward to higher taxes and cuts in services, resulting in fewer teachers, bigger classes, and facilities that are allowed to deteriorate. In several states, these developments have already arrived.

The crux of the problem is the gap between assets and liabilities affecting the fifty-nine pension funds that cover most public school teachers in America. Some of these are general state-employee pension funds, while others cover only teachers. Among the findings of our study of these funds:

• All fifty-nine pension funds studied face shortfalls.
• California, the most populous state, has the largest unfunded teacher pension liability: almost $100 billion.
• The worst-funded plan in our sample is West Virginia’s, which we estimate to be only 31 percent funded.
• Five plans are 75 percent funded or better: teacher-dedicated plans in the District of Columbia, New York State and Washington State and state employee retirement systems in North Carolina and Tennessee that include teachers.

The general picture is not a good one. According to the fifty-nine funds’ own financial statements:

According to our more conservative calculations:

• These plans’ unfunded liabilities total about $933 billion.

In addition, we have found that:

What explains the rest of the gap between the funds’ estimates and our own? The funds aggressively “discount” the cost of paying benefits in the future because they assume that stocks’ values will be much higher by the time the funds have to pay out those benefits. This assumption permits public officials to contribute fewer dollars toward satisfying these plans’ obligations, and thus to avoid taking the cautious but unpopular step of raising taxes or cutting services.

Under current guidances, which are prepared by separate bodies, state pension funds are able to set aside fewer assets than their counterparts in private companies to cover equal liabilities. Private pension plans may invest in stocks and other higher-risk assets, but those plans may not reduce their pension funding on the basis of the superior performance expected of these types of assets. This is because those higher returns are accompanied by greater risk that returns will fall short of expectations. Yet pension funds’ obligation to retirees present and future does not diminish accordingly.

By contrast, public pension plans are permitted to base the amount of money they need today to meet their future obligations on the higher expected performance of stocks, allowing sponsors to cut their contribution rates and hope the markets perform as anticipated. Unfortunately, markets can drop instead of rising, as they did in 2008-2009, when the large decline in the Standard & Poor’s 500 index of stocks created especially severe shortfalls among public pension funds. With formal bond indebtedness of U.S. states and localities reaching approximately $2.4 trillion, the shortfalls in teacher pensions alone increased the indebtedness of state and local governments by roughly one-third.

The purpose of this paper is not to instruct pension funds in how to invest their funds. Rather, it is to recommend that they account for their liabilities in the manner of private pension plans, which must estimate the present cost of future liabilities on the basis of the lower returns that high-quality corporate bonds pay. They do so because the likelihood that these instruments will fail to make payments to their owners, the pension funds, is about as great as the risk that retirees will not receive their promised payments in the promised amounts. Using these accounting rules, public plans (like private ones) would be denied the opportunity to short-change their pension plans by assuming strong asset performance.

Unfortunately, accounting reforms will not eliminate the accrued liability, which represents income already earned by public employees but not yet paid. States must simply amortize these costs over time, at taxpayer expense. In part they have grown so large because elected officials have not been held accountable for them: while the cost of higher retirement benefits is off in the future, the cost of higher wages is in the present, and thus visible and felt. Visible or not, the promise of future pensions is a very real cost of hiring teachers, one just as real as the teachers’ current salaries.

States can start by accounting honestly for the current costs of future benefits. If they did so, they would reduce the temptation of their elected officials to be overly generous in awarding benefits. Going forward, there are structural changes they can take that would avoid funding shortfalls and rein in out-of-control public pensions:

• States should consider shifting to defined-contribution retirement plans, especially on behalf of new and young employees; this is the norm in the private sector and was adopted successfully by Michigan in the 1990s. States are not obligated under such plans to provide any particular level of benefit.
• In cases where defined-contribution plans face major political resistance, states should consider hybrid options like cash-balance plans and TIAA-CREF, the latter having provided a version of defined-contribution retirement saving for employees of public colleges and universities for decades.

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