Who should foot the multi-million dollar bill for increased public pension contributions?

This year, the legislature increased the rate of local school districts' contributions for public employee pension plans by one-half percent of compensation for each of the next four years. In our district, that represents an increase of $250,000, each year, until in four years, our new unfunded pension contribution costs will reach $1,000,000. Where should this money come from? When I discuss this issue, I'm amazed that almost everyone has a visceral answer to this question, as if it were simple. The state increased the rate of the District's contribution, so logically, the District should pay the contribution, right?

The problem is that the District doesn't have a printing press for money. So, saying that the District should pay, doesn't really help at all. When the State of Minnesota increases a mandated spending level for the District, there are several choices:

• (a) the increased cost could be paid by the children of parents who send them to public school, in the form of reduced programs--increased class sizes, lower textbook budgets, or other reductions,
  
• (b) the increased cost could be factored into our compensation budget: the District could say, look, we only have so much money for compensation costs, if we have to raise our spending here, we have to lower it there, so the employees indirectly pay the cost of their pensions. This is generally how we handle all compensation costs. In times when TRA contribution costs go down, it frees up more money for other forms of compensation; in times when they go up, it reduces our ability to pay other compensation costs;
  
• (c) the increased cost could be paid by a local levy (if the State were to give us one), and absorbed by the local taxpayers in a locally imposed property tax, and
  
• (d) the State could provide increased revenues out of the State general fund, on the theory that, by golly, if the State is going to make us spend more for a State managed retirement program, then the payments are a state obligation, and should be paid out of state revenues.

I have to begin by saying that my view is that it makes absolutely no sense for the cost of a state pension plan to be carried by children in schools. This question, as unpleasant as it may be, is going to repeat itself over and over again, in the next quarter century. Our current pension obligations, especially in the public arena, haven't taken the change in the dependency ratio into account. As more and more of us retire, in comparison to the number of productive workers, we are going to have to decide again and again, whether we pay the cost of increased dependency by reducing our investment in children. This is something I touched on in a prior post.

I think its worth pausing, before we answer the question "who should pay," to look at the genesis of public pension plans for educators and other public employees.

Public pension programs in Minnesota are close to a century old, and they thus predate federal social security. You can find a history of the teachers retirement fund on the web by clicking here. TRA history you will find at this link begins with this entry:

A precursor to TRA was established in 1915, as the first statewide plan providing retirement benefits for Minnesota public school teachers. Both St Paul and Minneapolis had established City teacher retirement funds in 1909. Contributions to the 1915 fund were $5 to $10 per year, with benefits of around $100 paid per month. The minimum vesting requirement for a monthly benefit was 20 years, with no minimum age requirement. The 1915 Fund, also referred to as the Pioneer Teachers Retirement Fund, was liquidated during the Great Depression but payment of prorated benefits continued from the State General Fund.

Several of the employee retirement funds were locally created, by cities or local school districts. But the largest of our retirement funds were created by the State: the payment rules are set by the state; the investments are managed by the State; the rates of contributions are managed by the State, and the State takes responsibility to monitor and audit the investments and payments to make sure that the payments and contributions are managed effectively. The obligation--the actual legal responsibility to pay lies with the State of Minnesota. The St. Cloud School District has not promised to pay its employees a pension: the promise is made, and the benefits set, by the State of Minnesota.

When the social security act was first passed, it did not include State or local employees. Social security is a form of modified "defined benefit" plan which is designed to pay a benefit that is based on earnings history. (Social security differs from a true defined benefit plan, because the promise to pay the defined benefit is not based upon a contract with the government, but rather upon a legislative promise.) Social security imposes a tax on the employer and on the employee: the funds, however, go into the government treasury, with a separate accounting, called a trust fund, but is not really a trust fund. The money is not held in trust; it is not separately invested; there is no lock-box filled with bonds and treasury bills representing the social security trust.

Because social security is funded by taxes on employer and employee, the authors of the social security act were, at first, reluctant to require that state and local employees would be subject to mandatory coverage: one primary reason was a constitutional concern, that the federal government might not have the power to impose taxes on governmental employers, and that concern has raised special issues as to federal taxation of the State itself, as opposed to local entities. If school district and local government employees were going to have a retirement fund, then, states or local districts would have to take the responsibility. Back in the days when social security was first founded, teachers salaries were pretty minimal, and without State pensions, it would have been pretty difficult to attract qualified people into the profession.

However, eventually, states and the federal government came to an accommodation which would allow states to put their employees into social security program with consent of the State itself. But the existing state programs had significantly different benefits rules, and so they had to find some way to get the two programs to work together. The result in Minnesota was a coordination of benefits agreement which put teachers in social security and in TRA, but created a complex set of offsets to prevent duplication of benefits.

The Social Security Administration's website says:

Most employees have Social Security protection because their states and the Social Security Administration entered into special agreements called “Section 218 agreements.” Others are covered by a federal law passed in July 1991 when Social Security was extended to state and local employees who were not covered by an agreement and were not members of their agency’s public pension system.

The result of these changes in social security were to make coverage available to state and local public employees, as I have said. Minnesota eventually entered into the coordinated system which makes teachers part of the social security system and the TRA or PERA retirement systems, with the benefits and contributions "coordinated" in a way that is designed to prevent double coverage. The way in which the two systems work together, in terms of contributions, benefits, and retirement or disability eligibility is a topic I'm not at all qualified to explain.

Now TRA is a defined benefit plan, but the contributions are place in a real trust fund, and the money held by the fund is invested in bonds or other market instruments by the State Board of Investment. For some detailed information about the system, you can click here.

Now when I talk to business folks about TRA, one of the first things they want to tell me is that the business world has moved away from defined benefit plans. Most of us in the private sector, they say, have pensions that promise only to pay the actual return on the funds that have actually been invested in our 401(k), IRA, or other account. But that is not entirely correct, is it, because folks in the private employment system have social security, which is, after all, a defined benefit plan. The real difference is the supplemental part--the part beyond social security, and there we have a substantial difference, for sure. When your 401(K) takes a loss, you take the loss, not the government or your employer. If your funds were invested unwisely, you can be wiped out, even.

The advantage of a defined benefit plan like the TRA or PERA is the definite security of a promised benefit, but that security is also its biggest problem from a public policy standpoint. With a defined benefit plan it is really impossible to predict that the money invested in the trust fund will produce a rate of return sufficient to produce the promised benefits. If the funds are invested aggressively, they can realize an excellent return in good times, but the fund can take a huge loss in really bad times. So the essence of a State defined benefit retirement fund is that the State makes a promise to pay a fixed pension on retirement, provided that the employee earns enough years of service. That means that it is possible that the earnings of the investments in the trust fund may be insufficient to cover the total of the promised benefits accruing in a particular year.

After the huge market declines that occurred in 2007-2008, the State's defined benefit plans were adjudged actuarially insufficient to provide the benefits that were to accrue in the future. We can grouse and sputter and complain about that fact, but its a fact nonetheless. After a great deal of controversy, the governor and legislature responded last year by increasing the rate of contribution at the rate of 1/2 percent of compensation each year for both employers and employees. But, as usual, the State made no provision in funding for local districts to cover the increased cost.

Hence my question--who should have to pay the shortfall?

The answer, in my view, is that the State of Minnesota created the obligation--the State of Minnesota should have either solved the problem with reduced benefits (for non-vested participants) or it should have met its obligations out of the general fund. The decision to pass the problem along to local school districts was irresponsible, because it represented a significant new unfunded mandate. School districts don't have an extra pot of money, or extra revenue source,s to cover these increased contributions. And, the legislature provided no increased revenues to school districts in the general fund formula, and it created a larger deficit in special education. In my view, as difficult as it may be in these tough times, the legislature should step up to the plate and assume the increased costs, because it is the State of Minnesota's obligation.

Failing that, then we are left with the choice between taking the million dollars from children, through reduced programs or increased class size, or we can subtract it from the funds that we have available to compensate staff. Generally, when we calculate the revenues that we have available for staff compensation, we add salary plus the cost of benefits (including social security, health insurance and retirement costs). We charge all of those costs against total compensation. If we follow that course, then the increased TRA and PERA costs would indirectly result in reduction in the funds available for other forms of compensation. That's a painful solution, and its painful to discuss. But the other course, taking the money out of programs for children in school seems all the more painful.