Teaching Profession

States Facing Fiscal Strain of Pensions

By David J. Hoff — May 17, 2005 8 min read

Illinois has a $20 billion problem.

The state has promised $51 billion in pensions to 225,000 current and retired teachers, but it has only $31 billion in its accounts to pay for those pensions.

Gov. Rod R. Blagojevich of Illinois is at odds with teachers' unions over large raises some teachers get near the end of their careers. He says the raises are too costly to the teacher pension fund.

At $20 billion in the red, the Illinois teacher-pension fund has the country’s biggest deficit for such a fund, but it’s not the only state with a problem. Faced with a tepid stock market, a rise in life expectancy, and teacher contracts that critics say inflate pensions, many states are seeking ways to tweak or even overhaul the way they underwrite educators’ retirement benefits.

“It’s coming from every direction right now,” said Bernard Jump Jr., a professor emeritus of public administration at Syracuse University and an expert on publicly financed pensions. “It’s a very ugly time out there.”

For many states, the solution is to wait for investment returns to fully rebound. But for others, the trouble can be fixed only by cutting benefits or by increasing state payments into the system. Neither of those steps is easy, pension experts say.

“It’s very, very difficult to make structural changes” in pension benefits, said Ronald K. Snell, the director of the economic and fiscal division of the Denver-based National Conference of State Legislatures. Pension obligations, he notes, are usually based on contractual agreements that can’t be modified without the consent of both parties. Even changes in programs that aren’t protected by such agreements face fierce opposition from teachers who are counting on benefits promised at the start of their careers.

The health of employee retirement systems is something states of all sizes are grappling with right now, as public-sector pension funds have 89 percent of the money they need to meet their long-term obligations.

“We’re all pretty much in the same boat,” said Rhode Island Treasurer Paul J. Tavares, a Democrat. “The universal challenge is … what is the future of [pension] plans.”

Right now, several states are weighing different approaches to shore up their pension funds for teachers and state employees.

For example:

• In Illinois, Gov. Rod R. Blagojevich is proposing to cap the amount that end-of-career raises would contribute to a teacher’s pension—a move that would reduce the payouts. Too many teachers are receiving big raises toward the end of their careers, thus inflating their pension income, the Democrat says.

• Rhode Island legislators are debating plans from Mr. Tavares and Gov. Donald L. Caricieri, a Republican. Both would raise the teacher-retirement age and cap cost-of-living increases for current and future retirees.

• Alaska and California officials are proposing individual-investment programs akin to 401(k) plans–moves that teacher unions are fighting.

Defining Benefits

More than 19 percent of public school teachers, other school employees, and other civil servants are covered by “defined benefit” pensions. Except for major urban areas such as New York City, Los Angeles, and Chicago, the plans are administered by states. In some states, teachers and other educators are in the same pension program as all state employees; other states have separate funds for educators.

State Pension Programs Vary

Although the rules for public-employee pension funds vary, they operate under the same guidelines.

Throughout their careers, teachers and other state and local employees contribute portions of their salaries into retirement funds managed by states and municipalities. In almost all cases, the employers also pitch in a percentage of the employees’ salaries.

Pension funds guarantee teachers, and their surviving spouses, regular payments after the employees’ retirement. The size of the annual payout is typically determined by multiplying years of service by final salary (or by the average of the three highest salaries), then calculating a percentage of the resulting figure.

For example, a 25-year veteran teacher whose final salary was $40,000 in a state that gives pensioners 2 percent under such a formula would get an annual pension of $20,000. Two-thirds of states provide cost-of-living increases for retirees, according to the National Conference of State Legislatures.

Generally, teachers are fully vested in pension funds after teaching for 20 to 30 years, and they become eligible for full benefits anywhere from age 55 to age 65.

In 31 states, all teachers contribute to the Social Security system and are eligible for benefits from the federal program, according to the National Education Association. In the other 19 states and the District of Columbia, employees and employers pay nothing into Social Security, but extra money into their pension funds to substitute for of Social Security benefits.

To calculate whether a pension fund is adequately funded for the future, actuaries use mathematical formulas that consider a variety of factors, including life expectancy, investment returns, and future salary growth.

In defined-benefit plans, participants contribute a portion of their annual salaries to an investment fund managed by an independent panel. In almost all cases, the employer also chips in. When employees retire, they and their spouses are guaranteed regular payments for life.

States and some cities have assets totaling $2.1 trillion in 103 pension plans, according to the National Association of State Retirement Administrators. That amount is enough to cover 89 percentof the money promised to the 12.7 million current employees and 5.8 million retirees collecting pensions.

The stock-market decline since the dot-com boom days is not a threat to the overall solvency of the funds. Each funds’ health depends on individual factors, said Mr. Jump.

A fund that is accumulating assets through employer contributions and good financial management is likely in better shape than one whose assets are dwindling, even if the former’s funding level is lower, Mr. Jump said.

Overall, the pension funds are in better financial shape than 30 years ago, said Nancy L. McKenzie, the pension and security specialist for the 2.7 million-member National Education Association.

For a pension fund headed in the wrong direction, its long-term problems will mount for every year the state doesn’t address them.

Teacher Raises Targeted

Again, take Illinois.

Until 1995, the state’s contribution to its pension funds was subject to an annual appropriation by the legislature. But, just as individuals saving for retirement don’t always follow the advice of financial advisers, Illinois lawmakers failed to put enough money in to cover the funds’ liabilities, state officials say.

Since 1996, the state has paid 14 percent of educators’ salaries into the fund. Districts have added contributions equal to 0.5 percent of those salaries. Those contributions have helped, but have not solved the problem.

At the end of fiscal 2003, the Illinois Teachers Retirement System had a little less than half the $47 billion that state official estimated was needed to pay off current and future retirees. Last year, the state bolstered its payments to the teachers’ fund and the four other funds it manages for state employees by selling $10 billion in what are called pension-obligation bonds.

In response, Gov. Blagojevich has identified at least one place to scale back payments in the teachers’ pension fund. Illinois districts routinely give veteran educators large salary increases in the final three years of their careers. The practice, the governor says, drives up costs to the pension fund. He proposes that only salary increases of up to 3 percent annually during those final three years be part of the benefit calculation.

“Taxpayers across Illinois shouldn’t have to pay billions of dollars more in increased pension costs just to cover those end-of-career raises,” Mr. Blagojevich said in his Feb. 16 state budget speech.

The state’s largest teachers’ union has joined local school officials to fight the proposal in a series of rallies and lobbying days aimed at influencing the legislature, which is considering the governor’s proposal.

Local unions negotiate the pay raises as a “deferred compensation” for years of working for low salaries, said Charles McBarron, a spokesman for the Illinois Education Association, a 120,000-member affiliate of the National Education Association. “This is simply a way to compensate teachers at the end of their career,” he said.

A similar debate is under way in Massachusetts.

The Massachusetts Teacher Retirement Board is actually rejecting portions of teachers’ pensions because, it says, end-of-career bonuses are inflating their pension payouts.

The decisions are unfair, teachers’ unions say, because the bonuses are part of contracts, and the practice of giving large bonuses and basing pension payments on them has been sanctioned by state courts.

“To take away what has been legally bargained for is patently unfair,” said Catherine A. Boudreau, the president of the 100,000-member Massachusetts Teachers Association, an affiliate of the National Education Association, which is representing teachers’ whose pensions have been reduced by the decision.

Big Changes

While Illinois and Massachusetts debate how much retirees should receive, other states are trying to completely overhaul their pension programs.

The Alaska Senate has passed a bill that would change the state’s pension plans so employees would have to manage retirement savings on their own.

The measure would require the state and employees to contribute set percentages to individual retirement accounts. That approach is called a “defined contribution” plan because it doesn’t promise any payouts other than ones accrued over the life of an individual’s fund.

In California, Gov. Arnold Schwarzenegger proposed a similar pension setup for teachers and state employees who are hired after July 1, 2007. The governor had aimed to get an initiative on the ballot this year that would have created a defined-contribution plan, but he backed off when the idea drew the wrath of teacher and state-employee unions. He now says he plans to try to get the proposal on the ballot next year.

Unions lobby against defined-contribution plans because they may not yield all the money retirees need, said Ms. McKenzie of the NEA.

“Defined-contribution plans are not secure because they’re subject to unpredictable account balances,” Ms. McKenzie said. “It’s impossible to know in advance what the benefits will be at retirement.”

Meanwhile, West Virginia took steps recently to abandon its 14-year-old defined-contribution plan and return to a traditional plan.

Under legislation passed this year, the state will ask voters to approve $5.5 billion in pension bonds to shore up its teachers fund and a separate fund for judges. The teachers hired since 1991, who have been in a defined-contribution plan, will vote next year whether to join the defined-benefit plan.

Looking ahead, Mr. Tavares, the Rhode Island state treasurer, says that teachers across the nation may not get a choice between defined-benefit and defined-contribution funds. They may get both.

“I suspect that in the future, you’ll see a combination of both” types of plans, said Mr. Tavares, who called his proposals to shore up the state’s existing defined-benefit plan a “stopgap.”

Under the hybrid approach, he said, retirees would get a safety net from a traditional plan and supplement that with their own savings.

“Collectively, they’ll have a secure retirement,” he said.

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Staff Writer Joetta L. Sack contributed to this report.

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