Dropout Nation

These days, the public is learning some hard lessons about the consequences of the array of actuarial tricks and other financial sleights of hand used by states and districts over the past few decades to hide the true costs of the defined-benefit pensions at the heart of traditional compensation for teachers and other public-sector employees. This week alone, Detroit taxpayers learned that decisions by the board overseeing the city’s pensions for police, fire, and other civil servants doled out more than $2 billion in so-called 13th check payments to active and retired employees (and contributed to the city’s move to borrow $1.4 billion through the floating of pension obligation bonds in the vain hope of growing the proceeds in the financial markets in order to grow the proceeds). This mismanagement, along with the Motor City’s overall fiscal fecklessness, is why the city is now mired in bankruptcy. And such problems is why outfits such as the Government Accounting Standards Board and Moody’s Investors Service, along with researchers such as Joshua Rauh (now of Stanford University), have spent the past few years revealing (and forcing districts and governments to concede) the true costs of traditional teacher and public-sector compensation.

But as Moody’s points out in a report released earlier this month, traditional districts (and ultimately, taxpayers) face two other problems with defined-benefit pensions, and it goes beyond shoddy actuarial practices or the low levels of contributions made by teachers and other school employees to their retirements. The needless complexity that comes with overseeing the array of pension plans to which they must contribute — and the inability of districts to control the insolvency risks to which they are exposed (and have also exacerbated through their own decisions). Reformers and cost-conscious governors will have to work together to overhaul this unsustainable structure.

In more than two-thirds of all states, districts can contribute to as many as three different pensions, each with their own required contributions, and levels of risk (including massive pension deficits). Atlanta Public Schools, for example, contributes to both the Teachers’ Retirement System of Georgia (which only provides annuities to instructors) and to a pension it controls that covers its custodians along with other staffers. The gargantuan Los Angeles Unified, pays into the California State Teachers’ Retirement System as well as the Golden State’s pension for public employees who don’t work in classrooms. The most-complex pension accounting condition is for New York City. The Big Apple’s Department of Education pays into three different pensions (including the Teachers’ Retirement System and the Board of Education Retirement System, both of which had their pension deficits subjected to Dropout Nation scrutiny earlier this month).

Why such needless duplication? That’s due to the history of how pensions developed. Starting in the Progressive Era of the early 20th century, pensions were first provided to police officers and firefighters, then to other public-sector employees, and finally, teachers. As a result, in many states, the practice of multiple retirement plans for different kinds of employees has become the norm. But for districts, the differences in the benefits granted by each pension, along with the different contribution schedules, can add needless stress on accounting and human resource systems already struggling to handle basic activities such as tracking Title I dollars and hiring teachers. This was made clear earlier this month when one outlet noted that Pennsylvania state auditors have criticized Philadelphia’s near-bankrupt district for failing to keep good track of state and federal dollars it receives. This problem is exacerbated by the half-measures by states and districts to deal with pension shortfalls, which provide  by placing teachers and other staffers into new and (theoretically, less-generous) pension categories. A district in, say, New Paltz, N.Y., has to deal with contribution schedules for six different tiers of retirement benefits for its teachers, and six other tiers for other school employees.

The bigger problem for most districts is that they have little control over the levels of risk to which their balance sheets are exposed. This is because most pensions for teachers and other public employees are controlled by state governments who are the ones primarily responsible for setting contribution levels and, in many cases, work with affiliates of the National Education Association and the American Federation of Teachers (who often hold sway over pension boards as well as over state legislatures) on deciding how generous annuities can be. Seventy-five percent of the exposure to pension risks borne by districts and other state governments are controlled by states, according to Moody’s analysis. Particularly for districts in 15 states, which along with other local governments, contribute to single cost-sharing pensions, the lack of control exposes them to the risks of fiscal mismanagement both by states and by other districts. A decision by a state to grant pensioners annual cost-of-living increases, or the move by a district to aggressively engage in spiking, or granting large pay raises to retiring teachers and principals in order to help them boost final year salaries used in calculating annuity payments, can exacerbate existing insolvencies, putting more strain on district budgets. Add in the fact that shoddy actuarial practices such as inflated assumed rates of return on investments conceal the true levels of pension insolvencies, and the risks to districts (and taxpayers) is even greater than officially admitted.

Take the Clark County district in Las Vegas, whose teachers and staffers are covered by Nevada’s Public Employees’ Retirement System. Because the district’s staff accounts for 28 percent of all workers covered under the pension, it is subject to bad decisions made by the state government such as the longstanding decision to allow workers to contribute eight cents to their retirements for every dollar put in by local governments, a key reason why the pension’s underfunding has quadrupled between 2002 and 2011. As a result, Clark County bears more than a quarter of Nevada PERS’ reported pension shortfall of $11 billion (as of 2011, the latest year available). It gets worse. Because Nevada PERS overly-optimistic assumed rate of return of eight percent (which, by the way, is lower than its annual rate of return of 5.6 percent over the past decade) understates the pension’s insolvencies by at least 36 percent (based on Dropout Nation‘s more-realistic rate of return of 5.5 percent), the shortfall is likely $15 billion. If the shortfall was paid down over 17 years, it would mean that districts and other local governments would have to pay an additional $878 million a year in order to eliminate the liability. For Clark County, this means contributing another $245 million a year to the pension — or two-thirds more than the $312 million paid by the district in 2011; this would force the district to devote another eight percent of its $2.8 billion in revenues (as of 2011), which would likely lead to reverse-seniority layoffs that would force younger teachers out of classrooms regardless of their performance.

The risks are potentially even greater for districts in states 11 states, including Maryland and Illinois, where state governments shoulder the employer contributions otherwise charged to districts either through direct payments or subsidy arrangements. With the current economic malaise is still wreaking havoc on state coffers, and increases in Medicaid spending resulting from implementation of the Affordable Care Act (along with the impact of the long-term costs of dealmaking with public-sector unions and local governments) burdening budgets, cost-conscious governors will likely look to shift at least a third of existing pension payments to districts and other school operators. For districts in those states, which have gone on teacher hiring binges and other spending sprees over the past decade thanks because they haven’t had to bear pension costs, any shifting of pension costs to their budgets will do plenty of damage to them financially.

Maryland has already taken such a step, shifting half of the state’s burden (including contributions) onto districts by 2016. Thanks to the move, Old Line State districts will bear $2.8 billion (based on the officially-reported shortfall of $11 billion) or a quarter of the underfunding by next year. [But that is based on an inflated assumed rate of return of 7.75 percent; based on Dropout Nation‘s analysis, the actual burden for districts is $3.6 billion, or 30 percent greater than officially reported.] While Maryland allowed for tax increases to help districts offset those costs, the districts will have to find their own way to pay for future pension costs. One can expect Illinois, which subsidizes 90 percent of pension contributions made by districts outside of Chicago (which operates its own pension) to eventually do the same in order to deal with its officially-reported pension debt of $54 billion (which DN estimates to actually be $71 billion not including unrealized losses). If Illinois cuts the subsidy, districts would have to assume 30 percent of the state pension’s insolvency; based on DN‘s estimates, this would add between $16 billion and $20 billion in new liabilities onto their collective balance sheets that they will struggle to pay.

This isn’t to say that having control over pensions actually results in districts dealing sensibly with their financial affairs. Chicago, for example, is one of the few districts in the nation which doesn’t pay into a state-controlled pension. But the Second City’s fiscal fecklessness (including handing most of the board seats on the pension ‘ governing board to the AFT’s City of Big Shoulders local — which has contributed to the pension’s mismanagement — and the district’s avoidance of paying its contributions in full) has led to a pension deficit of at least $11 billion, according to Dropout Nation‘s analysis earlier this year. And as you read last week, New York City has acted even more recklessly in managing its pensions.

But the current structure of how pensions are structured and managed (along with traditional teacher compensation, in general) is helping to cause a fiscal perfect storm. Districts have almost no control over the growing pension liabilities that render them virtually insolvent. At the same time, their fiscal recklessness over the past few decades (along with the lack of thoughtful fiscal management by state governments) has helped contribute to the massive pension deficits which will burden them. With the high costs of pensions and other fiscal burdens weighing heavily on states, cost-conscious governors will team up with school reformers (who have long ago revealed how traditional teacher compensation does little to reward high-quality teachers, encourage new talents into the profession, or spur improvements in student achievement) to restructure pensions.

This must start with building upon the efforts of Moody’s and GASB to provide more-accurate reporting on the levels of pension insolvencies districts must bear on their balance sheets. While the new rules contained in GASB 68 will eventually require districts (along with other local governments) to provide more-accurate reporting on pension costs, it is still difficult for either policymakers or taxpayers (much less, district bureaucrats themselves) to understand the size and scope of retirement woes; Moody’s itself notes that it took it looking through five different stacks of data to get the full numbers for each district. Requiring better reporting now, along with overhauling school data systems, would help this cause.

None of this will be easy; after all, NEA and AFT affiliates benefit from their existence both in terms of influence over education policy and financially from dues paid by existing retirees and retiring Baby Boomers who are the most-active players in union politics. But the insolvencies are too big to ignore. And as Moody’s implicitly points out in its report, this aspect of traditional teacher compensation is no longer sustainable.