Your editor didn’t expected much on the education policy front from new Maryland Gov. Larry Hogan, and so far, the former patronage handler for onetime predecessor Robert Ehrlich hasn’t disappointed. Save for a plan to reduce subsidies to districts such as Prince George’s County and Baltimore as part of his effort to address an $800 million budget shortfall for the upcoming fiscal year, the Old Line State governor has taken few steps to address the education crisis that has long been ignored by Democrats and Republicans alike through such guises as excluding kids in special ed ghettos from taking the National Assessment of Educational Progress.

statelogoBut Hogan, along with legislators in Annapolis, will soon have to pay renewed attention to a financial challenge that cannot be ignored: The virtually-insolvent Teachers’ Combined System and its two defined-benefit pensions for instructors and school employees. The Republican will need to deal far more seriously with its underfunding than his immediate predecessor Martin O’Malley did during his tenure.

Even as Hogan gets into the job (including holding his first state of the state address this week), he finds himself reckoning with the legacy of O’Malley’s move three years ago to shift TCS’ future pension contribution costs outside those already borne by Maryland state government off its balance sheet onto that of counties, which are charged by the state with financial oversight of the state’s traditional districts. As with most modest pension reforms, O’Malley’s initiative did little to deal with the TCS’s growing unfunded liabilities from annuities (and cost-of-living increases) to retirees or clamp down on benefits to Baby Boomers and other teachers hired before the changes. The plan also didn’t lead to the state and counties to pay their fully-required contributions; they paid $359 million less into TCS in 2013-2014 than officially required.

The state legislature’s fiscal analysis agency determined that counties and districts will have to pay $56 million more in 2016 (when they bear the full costs) than originally anticipated. This comes just as some counties, notably Prince George’s (which is home to Dropout Nation) plan to increase sales taxes just to deal with TCS’ pension liabilities as well as the other long-term burdens from decades of dealmaking between districts, the state, and affiliates of the National Education Association and American Federation of Teachers.

Given these increased costs, and the complaints that will likely come from homeowners as counties such as Prince George’s begin hiking up property taxes, there will be strong resistance to any effort by Hogan to reduce school funding. Hogan’s plan to reduce the Old Line State’s overall tax burden, one of the nation’s highest, will likely fall apart in the face of worries over the increased costs.

But based on Dropout Nation‘s analysis of the pension’s financial numbers, the woes with which Hogan, legislators, and counties must wrangle are even worse than they realize.

As officially reported by the Maryland State Retirement and Pension System, which manages TCS, the pension is virtually-insolvent to the tune of $10.8 billion. But as this publication always reminds you, actuarial tricks such as smoothing (which allow for losses and gains to be recognized over five-year periods instead of immediately on a market-value as required in the private sector) essentially conceal the true value of pension assets, which meas that insolvencies may actually be greater than initially reported.

For TCS, the real problem lies with overly-inflated rates of returns on investments. This allows pensions to report insolvencies as being lower than they actually. How? During good times, when the stock and bond markets are performing stellar, pensions can claim that investments can cover shortfalls. This leads politicians to abandon all fiscal prudence by increasing annuity payments and reducing contributions paid by states, districts, and teachers in the hopes that Wall Street will cover the shortchanging. During periods such as the economic malaise that has engulfed the nation since 2007, pensions can simply continue assuming that the markets will cover those insolvencies some day; because rates of return are key in determining shortfalls, a high rate of return gooses up the value of assets even if isn’t reality.

The best approach is to assume a conservative rate of return, based either on yields for AA-rated corporate bonds (such as Citibank Pension Liability Index used by Moody’s Investors Service for its analysis of defined-benefit pension liabilities, or Barclays Capital Long U.S. Corporate Index), or a base rate of 5.5 percent as utilized by Dropout Nation based on an earlier version of Moody’s pension analysis model. In the case of TRS (as well as Maryland’s pensions for other civil servants), the official rate of return is 7.65 percent is at least 2.1 percentage points higher than it should be.

So to get to the full level of underfunding, Dropout Nation uses a version of the Moody’s model, using the 5.5 percent rate of return; for every percentage point decrease in rate of return, shortfalls increase by 13.3 percent. Based on the analysis, TCS’ is actually insolvent to the tune of $13.8 billion, or 28 percent higher than officially reported. Based on a 17-year amortization schedule, taxpayers would have to pay out an additional $813 million a year just to cover the shortfall; that is 81 percent more than the $1 billion contributed in 2013-2014 (which was $359 million less than was supposed to be paid).

For Hogan, addressing the shortfall in any sensible way becomes difficult because of O’Malley’s pension revamp. The governor could shift those full costs onto counties and districts. But massive property tax hikes won’t go over so well with homeowners, who will be reminded by superintendents and county executives that the fault lies with Annapolis, and thus, Hogan and his legislative colleagues. The state itself also doesn’t have a lot of wiggle room. The round of tax hikes under O’Malley’s tenure is one reason why Hogan won the top job over Lt. Gov. Anthony Brown last year.

There’s also the pressure from the Old Line State’s other virtually-busted pensions, which MSRPS officially reports as being $8.8 billion, but is more-likely $11.3 billion based on Dropout Nation‘s estimates. Taxpayers would have to pay an additional $662 million a year over 17 years (or nearly double the $734 million paid in 2013-2014) just to address those shortfalls properly. Pension costs account for 3.9 percent of state budget costs in 2013-2014, according to this publication’s analysis.

Meanwhile the problem will continue to get worse. This is because the number of retirees continues to grow. The number of TCS retirees increased by 43 percent between 2004-2005 and 2013-2014. With an average of 3,024 new retirees coming on board every year (all under the larger Teachers’ Pension System) at a cost of $61.8 million, TCS’ insolvency will continue to grow.

The state has failed to address TCS’ insolvency properly — and not just by shortchanging it by not paying the full tab. Because teachers only pay 31 cents out of every dollar put into the pension (versus contributing every dollar under a defined-contribution plan with an employer match up to six percent), they aren’t paying enough toward their own retirements.

But the problem isn’t just for taxpayers. Since three out of every 10 newly-hired teachers will leave classrooms within five years — and even higher rates of attrition are likely among high-quality instructors — defined-benefit pensions such as TCS are of no use to them. Because it takes 10 years to fully vest into a TCS pension — and the retirement funds aren’t portable as defined-contribution plans are — many teachers are unlikely to fully benefit from the few dollars they actually pay in. These problems, along with TCS’ underfunding, is why the National Council on Teacher Quality rated Maryland D-plus, or among the worst states for teacher retirement in a study it released last month. All in all, TCS is a bum deal for teachers, taxpayers, and children alike.

Hogan needs to take serious long-term steps on the pension front. This starts with fully paying down TCS’ insolvency (along with that of Maryland’s other pensions). The state will have to bear some of the additional costs; so will existing teachers, who must pay additional contributions into the pension just to address the shortfall. Since the state has no explicit laws on the books granting vesting rights to teachers and other public employees, the state should also move to shut down TCS other than to pay out benefits owed to retirees and current teachers who have already paid into it. The state must also put an end to cost-of-living increases for retirees, which add to the liabilities.

At the same time, Hogan must provide a better retirement deal for teachers, especially high-quality instructors who deserve better. This includes moving new teachers and current instructors into a hybrid system that features a contribution plan to which teachers can contribute as much toward their retirement as they so choose (with a five percent match from districts) along with a smooth accrual defined-benefit element similar to an approach advocated by Josh McGee of the John and Laura Arnold Foundation and Marcus Winters of the Manhattan Institute in a report released last year.

For Hogan, the state’s teachers’ pension woes provide a rude awakening to the realities of governing. He will need to use this early period to rally support for addressing a pension crisis that will complicate the state’s long-term prospects.