Before the COVID-19 recession hit, states already faced more than $1 trillion in unfunded liabilities. This situation does not bode well for states, school districts and certainly teachers. In the absence of a dramatic comeback in the markets for plans to recoup these losses, states and school districts across the country will need to find ways to make up for these losses. The effect of this collapse is that public K-12 systems will face unprecedented budgetary pressures, and nobody knows how long these challenges will persist.
The current economic downturn will have rippling effects on the health of pension funds for public school teachers and other public employees. In theory, pension funds should be positioned to take these recessionary blows. After all, the country just ended the longest period of economic expansion in its history, twice as long as the average duration of economic expansion post-World War II, and surpassing the dot-com expansion that ended in 2001 and subsequent expansion ended by the 2008 recession.
Unfortunately, most states are not well positioned to weather such a recession, even coming out of this long bull market.
Let’s first take a look at how public pension funds fared after the dot-com bubble burst in 2000.
One measure of a plan’s funding health is its funded ratio, or the amount of assets on hand as a percentage of liabilities. In FY 2001, the median funded ratio for state-sponsored public employee pension plans was 99 percent, meaning that the typical plan had 99 cents on hand in assets for every dollar of liability.
For teacher-covered pension plans, the median funded ratio was only slightly lower at 96 percent, reflecting total unfunded liabilities of $22.9 billion for these plans (or $485 for each student enrolled in the public school system).
Generally, states behaved as they should when economic times were good: They rode the bull market up and kept enough funds on hand to pay for pension promises.
But the long bull market has not fixed the budgetary pressures many states today face. That is simply because growth in liabilities has outpaced asset growth.
The current economic downturn recently ended the longest bull market in the history of our country when state-sponsored pension plans were just 73 percent funded. Simply put, if all these public employees retired today, states do not have enough funds on hand to cover their pension promises. And the problem will just keep growing under a traditional pension model.
The median teacher-covered plan was 72 percent funded, and total unfunded liabilities had ballooned to $740 billion (or $14,600 per student).
According to analysis by economist Robert Costrell, retirement benefits today for public sector workers cost twice that for their private sector counterparts. Annual inflation-adjusted costs for retirement benefits and Social Security for public teachers has doubled since 2004, while costs for private sector counterparts have remained flat. Annual costs in per-pupil terms for public K-12 retirement benefits comprise more than 10 percent of current expenditures for public K-12 today, twice what the share was in 2004.
Rather than fully funding their obligations, pension plans have dug a deep hole—and today they are more than one-quarter unfunded.
With the COVID-19 recession, it is likely that this downward slide will continue for many state public worker pension plans.
Double Whammy of Falling Interest Rates
The 2008 recession is sometimes blamed for underfunded systems, but the truth is plans were already on shaky ground—the funded ratio for the typical plan having already decreased by about 15 percentage points before the recession hit.
There are a number of reasons for this funding decline, such as inadequate funding by states and underestimating the actual value of pension liabilities. Falling interest rates are a significant factor.
In the wake of the COVID-19 recession, pension debt accrual will significantly worsen. A major contributing factor will be falling interest rates. The yield on a 30-year treasury bond has fallen by more than one percentage point since the beginning of the year, from 2.33 percent to 1.23 percent (as of April 20). Three-quarters of that drop happened between February and today.
There are two reasons why falling interest rates will increase unfunded liabilities for public pension plans:
1. Because assumptions about investment returns are used to determine the level of contributions needed to cover benefits, falling interest rates mean that plans must take on riskier investments just to have a chance of meeting their investment target. The typical pension plan currently assumes about 7.25 percent rate of return on investments.
2. Falling interest rates also mean that the cost of pension benefits goes up. Most pension plans currently use the assumed rate of return to discount future liabilities. Most economists, however, agree that liabilities are understated because the assumed discount rate is too high. Lower discount rates should be used instead to reflect the reality that public employees enjoy very strong protections for their benefits but taxpayers disproportionately take on the financial risk. The plans are guaranteed; the revenue to fund them is not.
The growing gap between the assumed rate and market rate represents substantial and increasing risk for pension plans, as discussed previously in this post. Although a 6-percentage point gap may seem small, in the world of finance, that’s a huge gap that can generate enormous deficits.
Absent an extraordinary comeback in pension funds’ investments, costs for pension plans will increase rapidly. Moody’s analysis indicates that for plans to prevent unfunded liabilities from growing (Moody’s refers to this as governments’ costs to “tread water”), annual funding costs will increase by about 60 percent in FY 2021.
Well-funded teacher-covered plans, such as South Dakota and Wisconsin, will likely weather this storm and have the capacity to defer costs. But states like California, Connecticut, Illinois and New Jersey will face greater challenges because they already have huge unfunded liabilities, making it more difficult to defer costs. That is, there is ample distance between the proverbial can and wall in some states, but in other states the can is almost against the wall.
If other actions such as increasing contributions are not taken, falling interest rates will generate greater unfunded liabilities by reducing assets and increasing the cost of benefits. Markets could rebound dramatically, but they may also degrade further. There is not crystal ball, so government officials should plan for hardship. Business as usual will only serve to increase risk for teachers, taxpayers, and students.
What to do?
So what can states and school districts do to tackle today’s crisis?
First things first: Fix the structural problems of pension plans, namely have plans where there’s a direct link between contributions and costs. More transparency also is needed. The fact that a large chunk of pension costs are hidden due to over-optimistic assumptions about discount rates exacerbates financial challenges that governments face during recessions.
Promote synergy between the public and private sectors. These sectors should be viewed as complements, especially during times of crisis. Private schools and homeschooling can serve as a release valve to budgetary pressures for governments.
Policies that expand educational options for families can also help. Especially during challenging financial times like these, states should embrace educational choice policies rather than shutter them, as is currently happening in Tennessee.
Teachers and students today deserve a system that works for them, and future teachers and students should have a system that does not place them at risk of being stuck with a hefty bill from financial sins committed decades before they stepped into a classroom.