Blog: Funding

Every state except Vermont has a balanced budget amendment, yet states have wracked up large unfunded liabilities for their pension and retiree health plans. How can both of these things be true at the same time?
Illinois recently passed pension reform legislation with a number of complex provisions. To better understand the legislation and the issues around it, I spoke with Illinois State Senator Daniel Biss, a co-chair of a bipartisan working group exploring solutions to the state's pension crisis and a co-sponsor of the recent legislation.
Hyping the difficulty of public employee pension funds is one of the few growth industries in the current economy. The reality is that teacher pensions face a mixed situation.
Placing all workers on a path to a secure retirement regardless of tenure or when they were hired should be the principle aim of any retirement system. Unfortunately the current system falls short of this aim in most jurisdictions today.
In terms of teachers and other public school employees, the real challenge is recruiting and retaining the most accomplished professionals to help ensure the success of all our students and ultimately our nation.
The big news out of the latest Public Education Finances Report is official confirmation that school districts spent less money per student in 2010-11 than they had the year before, the first one-year decline in nearly four decades. It’s worth taking some time to reflect on that fact, but the full report is also a valuable source of data on state and district revenues and expenditures and the entirety of the $600 billion public K-12 education industry. One key takeaway is that employee benefits continue to take on a rising share of district expenditures.

Conventional wisdom says that public sector pensions are far too optimistic in assuming an 8-percent investment return. Indeed, the stock market has far underperformed that goal lately, leaving pension plans in precarious financial shape.

But, if we expand our time frame to a longer horizon of, say, 25 years, it turns out that conventional wisdom is false. Using actual investment return results from state pension plans as of the end of 2012, the National Association of State Retirement Administrators found that median investment returns actually exceeded state targets over longer time periods:

5 years: 2.9 percent

10 years: 7.5 percent

20 years: 7.9 percent

25 years: 8.9 percent

This 25-year period included the bull market of the 1990s, one of the longest economic expansions in modern history, but it also included the subsequent crash, the disappointing 2000s, and the Great Recession of 2007-09. It wasn’t a “typical” 25-year period, but no 25-year period is typical. In fact, if you look at the performance of a balanced investment portfolio over long time horizons, it almost always beats state investment assumptions. As is often repeated, past performance is no guarantee of future results, but we shouldn’t ignore it, either. It’s tempting to focus on how bad the last five years have been, but it would be odd to argue that we should pay attention to only very recent history while disregarding the longer perspective.

So why are state pension plans in such poor financial shape today? There are two main reasons. One is that at the end of the 1990s, when state pension plans looked like they were in great shape, many states adopted benefit enhancements. State legislators looked at well-funded retirement plans, buoyed by an amazing stock market run, and decided they could support higher benefit payments. They couldn’t. Inevitably, short-term thinking put them in trouble today.

Second, the plans suffer from tremendous volatility. Investment returns now contribute about two-thirds of a pension plan’s earnings in a given year. When they turn negative during an economic crash, plan funding falls precipitously. But looking at a state pension plan after a recession and declaring it financially insolvent is no different than spendthrift state legislators expanding benefits at the end of the 1990s. They’re both driven by short-term thinking.

Articles on retirement security, like this one from the NY Times, are good to read and know about. The short version is that few of us are saving enough for retirement, so we’re going to see more “retired” people working part-time, retiring later, or, worst case scenario, looking for a government fix. The situation is even worse for younger Americans.

One thing that’s particularly relevant for this blog is that defined benefit pension plans are more or less a thing of the past for most workers, and in the next five or ten years we’re going to have a whole class of workers becoming eligible for retirement age who’ve never had a DB plan in their entire working career.

To see why this matters, check out the chart below from a recent McKinsey report.  It’s divided by age and income, and it shows how much, or how little, workers have saved for retirement and what form that savings takes. At the bottom right-hand side are workers aged 60-65 who earn $20-50,000 a year. Sixty percent of their retirement income will come from Social Security, 22 percent will come from a defined benefit pension plan, only 1 percent will come from personal savings, and they’re facing a 17 percent shortfall between what they have saved and what they’re likely to need. Looking at the next youngest age bracket, workers aged 40-59 earning the same amount, they can expect 48 percent from Social Security, only 4 percent from a DB plan, an 6 percent from personal savings (including 401k plans and IRAs). They face a 42 percent shortfall.

These figures would be improved, although not erased, through a stock market boom. The awful truth is that Americans just aren’t saving enough for retirement.

It’s common nowadays to read critiques of public-sector pension plan investment assumptions. State and local pension plans assume an average investment return of 8 percent, which, in this economy, just feels too rosy. The mainstream media has picked up on it, running articles pointing out that the 8 percent mark has not been met over the last decade, and there’s an entire cottage industry in the accounting world arguing the unfunded liabilities should be evaluated on much lower investment assumptions.

Are they right?

To find out, I compared long-term real investment returns with the real rate of return assumed by state teacher pension funds*. The word “real” in this context means investment returns minus the effects of inflation. The investment return data calculates the real return of a conservative portfolio invested 25 percent in the S&P 500, 25 percent in small US stock, 25 percent in long-term US corporate bonds, and 25 percent in an equal split of 30 day treasury bills, intermediate-term treasury bonds, and long-term treasury bonds**. I calculated the assumed real rates of return of state teacher pension plans by subtracting their inflation assumption from their investment return assumption.

The average one-year real return for the balanced portfolio has been 6.72 percent since 1926, a common starting place for the modern stock market. For comparison’s sake, the average state teacher pension plan assumes a real rate of return of 4.59 percent. In other words, they’re relatively conservative in relation to historical averages.

Averages, of course, can mask highs and lows. What’s more important is to see how various extended periods of time performed compared to the state assumptions. To do that, I used 30-year rolling averages of real returns. So, for example, 1926 to 1956 was one period and 1927 to 1957 was another. The series ended with the 30-year period from 1989 to 2009. Thirty-year periods also matter in the real world, because that is the time horizon states are given to calculate how much they would have to invest today in order to be fully funded in the future.

In the midst of an excellent piece arguing unions aren’t winning negotiations on salaries–they’re winning negotiations on everything else–David Leonhardt makes a really important point:

Unfortunately, though, politicians do not have the same incentives to be tough negotiators on issues besides money. Why not? Because most government agencies are monopolies. They face no competition. Whether they perform beautifully or miserably, they cannot be run out of business. They also can’t be run out of business by pushing off costs until a future day. So they delay too many costs and don’t perform their jobs well enough.

The delaying of costs is obvious. Both politicians and union leaders have decided that generous future benefits offer the easiest way to hold down spending and still satisfy workers. The result is government pay that’s skewed too heavily toward pensions and health insurance.

Study after study has found that public-sector workers have traded lower salaries for better benefits, but there’s no particular reason that trend must continue. A smart governor would approach the public-sector unions in her state and ask to trade some of the expensive, unpredictable health care costs and back-loaded pension benefits for higher salaries**. This could even be a revenue-neutral trade that manages to make both sides better off.  The governor would be getting greater predictability in her budget, while union leaders would put more cash in the pockets of their members. A smart union leader would take the deal, because people tend to value cash more than they do in-kind contributions, so union members may even feel like they’re better off. Perhaps most importantly, it would help put public-sector worker compensation more in line with that of private employees.

**In many states, it’ll illegal to reduce the accrued retirement benefits of workers, but the courts have found such reductions acceptable if they’re accompanied by increases in compensation. 

This blog entry first appeared on The Quick and the Ed.