Thursday, September 3, 2009

Still Ticking

Last December, I wrote a piece titled Time Bomb which discussed the deep trouble the State Teachers Retirement System (STRS) had gotten itself into. Today, the Columbus Dispatch published an article on the same subject. I'm glad to see this topic get more attention, because it has a direct impact on the school taxes we'll have to pay going forward.

The story is this: the STRS was created by Ohio Law to operate a retirement system for the benefit of Ohio's public school teachers. Each teacher may currently choose from one of three plan options: 1) a Defined Benefit Plan; 2) a Defined Contribution Plan; and, 3) a blended plan. Most choose the Defined Benefit Plan because, as the name implies, commitments are made to pay out certain amounts each month for life to a retired teacher based on retirement age, years of service, and the average of the three highest salary years.

The Defined Benefits Plan is funded by contributions from the teacher, currently set at 10% of their salary, and contributions from the employer – meaning us – of another 14% of the teacher's salary. However STRS members do not participate in Social Security, neither paying the Social Security tax nor receiving Social Security benefits (although some will have worked in other jobs in which Social Security tax was paid, and benefits earned).

Just like any other retirement system, the premiums paid into the retirement fund and the investment earnings on the fund are supposed to be sufficient to pay out future obligations. However, there must be decisions made about how to invest the money in the retirement fund.

One of the fundamental assumptions of investing is that risk and reward are related: the safer the investment, the lower the return. The complimentary case is also true – in order to earn larger returns, greater risk will have to be taken. It is the duty of the State Teachers Retirement Board to determine how much risk they should take with the teachers' money.

Once the risk/return parameters are established, the actuaries can calculate whether the funding, earning estimates, and benefits are in alignment. If the actuaries determine that there is more than enough money coming into the fund than is needed to pay future obligations, any or all of these factors can be adjusted by the Board. The funding requirements can be lessened, the risk profile reduced, or the benefits increased.

Conversely, if the actuaries determine that there is not enough money coming into the system, the Board can ask for an increase in contributions, choose to take greater risk, and/or reduce benefits.

For some time, the State Teachers Retirement Board has opted to manage their retirement fund inhouse, under the supervision of a Chief Investment Officer who is required to be a "licensed state retirement system investment officer." This decision was likely made to both increase perceived control over the money (versus hiring an investment firm to manage the fund), and reduce the amount of money paid out in commissions and fees.

However, to recruit and retain competent investment professionals, it would be customary for the retirement fund to pay their inhouse investment staff bonuses based on performance. Designing incentive compensation plans are one of the trickiest things one does as a manager. They always work as designed, which isn't always what the management expected.

The STRS investment managers were put on a plan where their performance was gauged relative to a well-known index, such as the S&P 500 Stock Index. The idea is that the STRS investment managers should not be rewarded for generating a 10% return on the portfolio if the market (represented by the S&P 500) went up 10% as well. The common expression is "all boats rise with the tide."

For a number of years, the STRS investment managers did indeed outperform the market, and they were paid well. There was a time in years past when the earnings of the STRS portfolio was such that the Board elected to pay out a "13th paycheck" to retirees – essentially an 8% bonus. Maybe they should have kept that extra money in the portfolio – it might have softened the blow of what came later.

But the STRS Board didn't think carefully enough about what would happen if the market crashed. It turns out that the incentive plan for the investment managers didn't take into account whether money was gained or lost, only if the earnings of the plan exceeded the market index. So if the S&P 500 went down 30%, but the portfolio value decreased by only 20%, the plan said the investment managers "beat the market" and their bonus were paid.

The retired teachers have taken great exception to this. Regardless of the fact that the investment managers were paid exactly according to the rules of their bonus plan, which was approved by the STRS Board, these teachers wanted the investment managers to give their bonuses back. In other words – in tough times, they expect their own employees to give back bonuses even though they were earned. One of the strongest voices of this faction of teachers is Kathie Bracy, who writes her own blog – you are encouraged to read a little bit of it to understand how these folks think.

And times are particularly tough for STRS, as shown in this chart from Ms. Bracy's blog.

At its lowest point, the value of the STRS retirement fund had plummeted from a high of $80 billion in Oct 2007 to $46 billion in March of this year, a loss of 42%. A respectable chuck of that has been restored with the inexplicable recovery of the stock market – rising back to $56 billion by June 2009. While this is a gain of 22% in three months, this $56 billion is still 30% less than the 2007 peak. To get back to that $80 billion peak, the fund will need to grow by another 42%. That will take either a long time at reasonable risk, or a short time at great risk. It will be interesting to see which bet the STRS Board allows its investment managers to make.

The Dispatch article today reports that the STRS Board doesn't believe that their investment manager can generate enough income to fully fund its future obligations. So they need to go back to the other two of their three knobs: increasing contributions and reducing benefits.

Ms. Bracy does a nice job of describing the changes proposed by the STRS Board, in a great deal more detail than the Dispatch article, so I'll not go into all of them here. Both retirees and working teachers will take a hit – significant in some aspects. Two of the big ones are that a teacher's retirement benefit will be based on the highest five (rather than three) salary years, which will almost always result in a lower number; and a reduction of the payout percentage.

In the current plan, a teacher gets 2.2% of the average of their highest three years times the number of years of service, up to 30 years. So a teacher who retires at 30 years gets 66% of the average of the three highest years. If a teacher stays to year 31, the benefit is 66% plus 2.5% for the extra year, or 68.5%. Stay to year 32 – the teacher gets 68.5% plus 2.6%. This escalation of .1% for each additional year continues theoretically until a teacher reaches 100% of their final average salary, which would happen at 42 years of service.

The real payoff is if the teacher stays to 35 years. In that case, the payout is set to 2.5% of the average of the three highest years times 31 years, plus 2.6% for the 32nd year, etc. This means that a teacher retiring after 35 years of service receives a pension of 88.5% of the final average salary for life.

A Hilliard teacher who retires after this school year at the top of the pay grid (Masters + 15 and 23 years) would receive an annual pension of $77,600 - for the rest of their life.

The new plan eliminates the special case for 35 plus years or service, saying "The 35-year enhanced benefit is no longer needed to encourage teachers to work longer and is eliminated."

No kidding. Even under the new rules, a Hilliard teacher retiring at the top of the grid with 35 years would still receive an annual lifetime benefit of $67,500.

The STRS Board also decided to increase contributions. The teachers will have a phased-in increase that reaches 2.5% by 2015, making the total teacher contribution equal to 12.5%. The employers – we taxpayers – will be required to increase our contribution from the current 14% to 16.5%, with a phase-in starting 2016 through 2020.

It could have been worse. I calculate that this increase in employer contribution will increase our 2020 employer contribution from $8.5 million to $10 million, and that the total extra paid from 2016 to 2020 will be $4.4 million. By 2010, we will be paying an extra $1.5 million/yr to cover this increase in employer contribution, representing 0.6 mills of tax burden. This assumes a 3% annual growth in salaries and a constant number of teachers.

Of course, this depends on how well the STRS investment managers handle the money. If they lose another big chunk of money on the investments, they'll come right back to us for more money. According their 2009-2010 Investment Plan, they still hope to make 7.7% return on their portfolio. To achieve this, they are keeping more than 60% of the portfolio in equities, and expect to make an 8.5% or more return on those. That doesn't sound like much for those who recall the go-go years of the 1990s, but remember that 60% of the fund is over $30 billion – and that's how much they're exposing to stock market risk which, as we've all seen, is more volatile and unpredictable now than it has ever been. This is against a backdrop of an economy that is unlike anything experienced before in America.

And I hope the teachers remember how they treated their investment managers – expecting them to give back bonuses they earned under a plan agreed upon by the STRS Board. My recollection is that most if not all did, as doing otherwise would likely have meant losing their jobs. Those teachers didn't care what the contract they negotiated in good faith said – they felt that if money was lost, the investment managers had to share in the pain – maybe even be punished.

Let's apply that same logic when the HEA contract is negotiated next year. Regardless of what the norm has been in the last several contracts, times are tough for many of us, and it's appropriate for the teachers to share that pain as well. It might even require some give-back.

Think about who it is that you want negotiating that contract. The same Board who negotiated the last one? Or a Board with a majority of new members who are finance, legal and management professionals?

Vote for the team of:





  1. Thanks, Paul.

    This story is like so many others these days, in that it leaves me (1) thinking that there aren't too many options left to us at this point, and (2) feeling betrayed by people who were supposed to be operating in a position of fiduciary responsibility.

    If this scenario plays out such that everyone shares the burden for making the system whole again, I'll view that as a positive outcome, but I'm also interested in putting in place some checks and balances to make sure we don't repeat these mistakes.

    Thanks for your continued vigilance.


  2. Let's apply that same logic when the HEA contract is negotiated next year. Regardless of what the norm has been in the last several contracts, times are tough for many of us, and it's appropriate for the teachers to share that pain as well. It might even require some give-back.

    Pretty sweet deal for the teachers retirement plan, from start to finish. Those in the private sector pay half of their
    Social Security, their employer picks up the other half (Self-employed folks get to cover both ends, whoopee!)We have to wait until age 63+ to start receiving
    benefits, and if we take another job at that time, we get our benefits reduced. Teachers, on the other hand, have a majority of their retirement "contributions"
    paid by the taxpayer, can retire at approximately 56 years of age with 88% of their income, and can go back to work, even in their present district, and start the ball rolling again. Nice!
    Yes, it is time for new blood on the Board, folks who agree with those of us who are feeling the pain, and feel that teachers should not be exempt. Our present Board was obviously too gun-shy to be effective negotiators as they gave out 5-7% raises even after the levy defeat last spring. Of course, the voters validated the boards decision by passing the levy in November. They either did not know, or did not care, where their increased taxes were going.
    Paul, and others here, have done an excellent job in showing us exactly where that money is going, and where more is headed. It is up to us to spread that word - it is not "about the kids" but rather all about increased compensation. That 82% of the budget must be contained and there is only one fair way to do it. Hint - it does NOT involve cutting programs and services for the kids while increasing the benefits for the teachers. They already have a pretty sweet deal.
    Let's do our part to get Paul, Justin, and Don elected and put some teeth back in to the school board. Although I am a long time follower and sometime contributor around here, work has kept me from
    having an active role in their efforts. I have done what I can, though, and encourage all who stop in here to do the same. Thanks Paul! I'm getting as many people as I can to follow yours and the others efforts.