We've invited a range of panelists—from union leaders to economists to teacher voice organizations—to participate in an online forum on teacher pensions. We’ve collected their responses and will be posting the authors’ contributions here, in their own words, on a rolling basis this week.
Today's guest post comes from Dean Baker, the co-director of the Center for Economic and Policy Research in Washington, DC. He is frequently cited in economics reporting in major media outlets, including the New York Times, Washington Post, CNN, CNBC, and National Public Radio.
Hyping the difficulty of public employee pension funds is one of the few growth industries in the current economy. There has been a concerted effort by many well-funded organizations to highlight the problems facing these funds. In fact, Students First, the school reform organization started by Michelle Rhee has even made the elimination of traditional defined benefit pensions one of the main planks on its school reform report card.
The reality is that teacher pensions face a mixed situation. The finances of many large funds are quite solid. Actuaries consider an 80 percent funding ratio an acceptable level of funding. (This means that they have assets on hand that can cover 80 percent of their projected liabilities over the next three decades.) Many teacher pension funds have assets that place them well above this level.
For example, New York State’s teacher pension fund was nearly 90 percent funded at the end of 2012. A recent report from Morningstar showed that North Carolina’s teacher fund was 94.0 percent funded at the end of 2011. The report showed that Texas’ teachers fund was 81.9 percent funded as of August 2012, and all of Washington State’s teacher funds were more than 100 percent funded.
Clearly, these funds have no problems. They can continue current funding and benefit levels for the foreseeable future with no problem. There are however many funds that fall below the 80 percent acceptable level. In many cases this is due to a temporary drop attributable to the stock market plunge following the collapse of the housing bubble.
Even though the stock market has more than regained its losses from the downturn, the slump still has an impact on funding ratios as a result of the valuation methods used by most pension funds. Pension funds typically take an average value of their assets over a four or five year period. As a result, the depressed market values of 2008 and 2009 would still be included in a 2012 pension valuation that was based on a five year average.
However this means that underfunding is likely to be sharply reduced through time. Next year’s five year average will substitute 2013 for 2008. Assuming that the market does not plunge in the immediate future, this will mean substituting a market valuation that is more than 70 percent higher than in the year being replaced. The following year 2014 will be substituted for 2009 in the average. This would be a gain of more than 50 percent, even assuming no further rise in the stock market from current levels.
Together, these two increases in valuation will raise funds that are somewhat below the 80 percent cutoff, back to the acceptable level of funding. This would likely be the case with Minnesota’s teacher retirement fund, which Morningstar listed as being 73.0 percent funded In July of 2012 and possibly also the case with Maryland’s teacher plan which was funded at a 65.8 percent level in June off 2012.
The fact the finances of most pension funds are virtually certain to improve substantially in the near future might explain the urgency of pension fund opponents for quick action. If the stock market were to just grow in step with the economy through the rest of the decade, many of the funds that now appear to be facing serious shortfalls would be nearly fully funded, even without further changes.
However, there are some pension funds that are seriously troubled. This is almost always due to the fact that politicians opted not to make the required contributions for a long period of time. Chicago’s former mayor, Richard M. Daley, can probably get an award in this category, failing to make the required contributions to Chicago’s pension funds for close to a decade.
There are other examples like Daley, but these are the exceptions. Even in these cases, making up the shortfalls will not impose an unbearable burden. For example, in the case of Chicago, which has seriously underfunded all of its public pensions, the additional required contribution to address the problem is equal to roughly 0.5 percent of the city’s projected income over the next three decades. This is hardly a trivial sum, but it does not imply bankrupting the city to meet the contractual obligations to its workers.
It is worth noting that some of those now raising the alarm about pension funding gaps bear much of the responsibility for the development of these gaps in the first place. Moody’s stands out in this respect. It recently adopted an accounting method for pensions where it uses a much lower discount rate to assess the liabilities of pension funds. This can double or even triple the reported liabilities of pension funds, which are generally calculated using the rate of return that pension funds’ expect on their assets. Moody’s has justified the change in procedures by arguing that the new approach is a sounder, more cautious methodology.
There are good reasons for rejecting Moody’s new approach. Most importantly it would effectively imply substantial over-taxation of current workers to allow under taxation in future years. It would also lead to sharp gyrations in required pension fund contributions.
While Moody’s claims to be acting responsibly in changing its accounting procedures now, it ignored concerns that were raised about pension fund return assumptions during the run-up of the stock bubble in the late 1990s. This run-up caused the stock market to vastly exceed its historic price-to-earnings ratios. In fact, at its peak in 2000, the price to earnings ratio in the stock market was over 30, more than twice its historic average.
Given this extraordinary price to earnings ratio, it would have been impossible for the stock market to provide the same returns going forward as it had in the past. Nonetheless, Moody’s assumed that the market would continue to provide its historic rate of return in assessing pensions, effectively assuming that the price to earnings ratio would rise ever higher.
One result of the negligence of Moody’s and other rating agencies was that cities contributed very little to their pension funds in these years. When the bubble burst and they suddenly needed to contribute more to their pensions, many state and local governments were poorly prepared to allocate the additional money. Hence we had cities like Chicago that went much of a decade not making their required payments.
If Moody’s and the other rating agencies had adopted a reasonable system for evaluating pension liabilities in the stock bubble years, many pensions might not be facing their current shortfalls. Applying its new methodology that exaggerates these shortfalls is increasing the damage they have already done.