What Are the Options for States Dealing With Unfunded Pension Liabilities?

By 01/11/2017

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Collectively, states face $1.4 trillion in unfunded pension liabilities, and $500 billion of that is due to teacher pension debt. As much as we here at Teacherpensions.org would like to shift the conversation to whether or not those pension plans are providing adequate retirement security to all teachers—they generally are not—the reality is that state legislators are much more focused on these large budgetary pressures than they are on retirement benefits for individual teachers.

ednext-jan2017-blog-aldeman-pension-debtAnnually, states are contributing roughly $37 billion* a year just to pay off teacher pension debts, and those pension debts can’t just be wished away. So, what are the choices states face in dealing with those large pension debts? I see at least six options:

1. Wait and see. This is the approach most states are taking. They’re essentially hoping that stock market returns will surpass their assumptions and allow their investments to grow enough to wipe away their debt. This hope isn’t without precedent. Around 2000, at the end of the dot-com boom in the 1990s, the typical pension plan was fully funded (see Figure A here). Unfortunately, state legislators acted as if those market returns were the norm, and they proceeded to dramatically cut contributions and enhance employee benefits retroactively.

Those decisions turned out very badly, and I suspect states are making similarly short-sighted mistakes today. Remember, the $500 billion figure above already assumes states are able to hit their investment rate targets of 7.5 or 8 percent a year. States need to hit those targets every year or else their debt piles will grow even more. Basically no credible analyst thinks this is possible anytime soon, but states will continue to hope they can miraculously escape the pain.

The downside of the wait-and-see approach should be obvious. States and school districts are already dedicating increasing shares of their budgets toward pensions, and any stock market crash, or even just a few years of mediocre returns, will only accelerate that trend. Plus, as plans have increased in size, they’ve become even more susceptible to large swings in the stock market.

2. Restructure the debt. This is another common choice for states. Rather than dealing with the debt, they might just change the time period for when they have to pay it off. Imagine you have a 30-year mortgage on your house. After a couple years, you decide that you can’t meet the full monthly payments, so you take out a 30-year loan on those monthly payments as well. This may sound crazy, but some states do this automatically every year, while others revisit their decisions every couple years and promise to really, seriously, finally, make their payments this time. Generations of politicians have all made the same promises.

3. Cut benefits. State pension debts are promises to retirees, and it might be tempting for some state leaders to try to trim the debt by cutting those promises. That could involve anything from reducing cost-of-living adjustments given to retirees or altering the formula for current workers. While these approaches could lead to large cost savings, and there are some approaches that would only affect teachers with many more years left in the profession, as a general rule I would caution states against cutting benefits. There’s big financial gain, but large potential downsides in terms of political, legal, and moral backlash.

4. Offer pension buy-outs. Another way to reduce pension liabilities is to get people to voluntarily opt out of them. By offering upfront cash payments, states may be able to induce some teachers to switch from the current defined benefit plan, with large and unpredictable debt costs, to more predictable defined contribution plans. When presented with such a choice, we don’t know if teachers would make smart financial decisions, or if there might be some perverse incentives for people who take up the buy-out offers, but judging by places that have tried similar efforts, there might be large portions of teachers who would prefer upfront cash payouts over long-term pension promises.

5. Issue bonds. State pension debt is flexible, and legislators have a tendency to shirk their long-term pension funding responsibilities in favor of other, more immediate spending priorities. That pattern has led us to where we are today, where states have over-promised and under-saved. States could decide to commit themselves to a more tangible payment schedule by issuing “pension obligation bonds.” Bonds would force states to make regular payments, and, in theory, they offer the state a way to reduce their obligations. After issuing bonds paying interest at, say, 5 percent, they would invest the proceeds and hope that they could earn a higher rate of return over the life of the bond.

The theory behind pension obligation bonds hasn’t always worked, especially over shorter time periods, when returns can be more volatile. States have used pension obligation bonds as a way to escape temporary budget problems, but the basic problems resurface if the state isn’t disciplined enough to continue making pension contributions. And with the stock market around all-time highs, now might not be the best time to invest billions of dollars in new money.

6. Find new revenue. This is perhaps the best option, but I haven’t seen many states try it (with some exceptions). There are lots of choices here, though. My personal preferences would be for states to impose a new consumption tax on something that’s bad for the world, like gambling or carbon emissions or sugar or cigarettes, but states could also impose a special tax on millionaires or rent out some state asset (like highways or parking lots). The specific solutions would vary by the state, but the important thing would be finding a new source of revenue to pay off pension debts.

There are better and worse choices on this list, and states could choose to pursue more than one of them at a time, but regardless of which path a state chooses, none of them are permanent solutions unless they’re also paired with broader structural changes that close existing defined benefit pension plans to new members. In return for their (higher) contributions, it seems reasonable for taxpayers to insist that the state come up with a reasonable plan to prevent the state from accruing these debts ever again.

Unfortunately, most state leaders are letting their debts prevent reforms that would be good for teachers. Instead, they’re using the new generation of teachers to pay off past debts. That’s not fair, and it’s not the way pensions are supposed to work, but that’s the bet most states are making today.

Ideally, states would adopt a package of reforms that accomplished three things simultaneously—pay down existing debts, prevent the state from accruing similar debts in the future, and provide all teachers with adequate retirement savings. That sort of bargain would provide relief to taxpayers, give confidence to existing teachers and retirees that their benefits are safe, and put all new workers on a path to a secure retirement.

*To get the estimate of $37 billion, I took the $313.4 billion schools and districts are spending on salaries and multiplied it by the 12 percent of salary the average state is spending on pension debt costs. That’s not a perfect estimate because the pension costs quoted here represent a state average, not the average across all teachers nationwide, but it’s a reasonable approximation.

— Chad Aldeman

Chad Aldeman is a principal at Bellwether Education Partners

This post originally appeared on TeacherPensions.org.

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