By RiShawn Biddle
DropoutNation

ALEXANDRIA, Va. – One of the least-considered aspects of the defined-benefit pension deficits that have made traditional teacher compensation far too expensive to keep around is the fact that the full costs of the retirement plans to taxpayers and children are still not dealt with in a fully honest way.

Because pension systems often use inflated rates of returns on their investments (often around eight percent, even as actual rates of return of stocks on the Standard & Poor’s 500 index was only around four percent during the last decade), pension deficits are often reported as being lower than they actually are. This deliberate hiding of real costs, along with unrealized losses on investments, and methods of valuing assets that wouldn’t be used by private sector pensions, often mans that states and districts are not fully reckoning with the true costs of pensions. Add in the so-called “smoothing”, or adjustments used to keep the volatility pensions experience with investments from wrecking havoc on budgets, and essentially the $1.1 trillion in pension deficits and unfunded retired teacher healthcare liabilities estimated by Dropout Nation may actually be greater than realized.

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Which is why school reformers, along with cost-cutting governors and legislators, should pay attention to a report released last year by Moody’s Investor Service, one of the big three bond rating agencies. As part of its effort to bring more transparency to the credit-worthiness of state and local governments — as well as address complaints that it and its counterparts, Fitch and S&P, were too lax in monitoring credit-worthiness of Fannie Mae and private-sector players during the run-up to the nation’s current fiscal woes — Moody’s announced that it would adjust how it calculates defined-benefit pension deficits that governments (including school districts) actually bear. The key step starts with ditching the often-inflated rates of returns on investments set by pensions and instead valuing the assets based on the interest rate of high-grade long term corporate bonds (about 5.5 percent, or more than two percentage points lower than rates if return assumed by pension operators); such a move, in turn, would give taxpayers (and government bond investors) a better sense of the real size of pension deficits.

Through this approach (along with other moves such as a 17-year schedule to amortize, or decrease, those deficits) Moody’s would also show how much states, municipalities, and districts should actually be paying over time. On average, a pension with an inflated rate of return of eight percent would have an estimated underfunding that would be, on average, 35.6 percent larger than reported; each point of difference between the Moody’s rate of 5.5 percent and the inflated rate of return general equals a 13.3 percent increase in estimated underfunding. Based on these new estimates, states, districts and municipalities face $2.2 trillion in pension deficits — and this doesn’t include the unfunded healthcare costs for retired teachers and other public-sector employees. Based on the model (along with those offered up by researchers as University of Rochester professor Robert Novy-Marx and Joshua Rauh of Northwestern University), many governments and districts are insolvent in all but name only.

The consequences of Moody’s move are just beginning to be understood. As Redwood Valley, Calif. pension analyst John Dickerson noted in an analysis released earlier this month, six California counties with their own pensions (instead of paying into the Golden State’s Public Employees’ Retirement System) would actually have to pay down $10 billion in pension deficits, versus the $4 billion they currently report bad on inflated rates of return. As a result, these counties would be expected by bondholders to pay out $1.4 billion a year just to pay down their pension deficits, more than double the $640 million they currently pay. For Contra Costa County near San Francisco, the percentage of property tax dollars devoted to pension deficit pay down would increase from 33 percent to 54 percent, crowding out funding for basic municipal activities. In short, these governments would be considered technically insolvent under Moody’s model, which would be the one bond investors would accept. Such a judgment will make it harder for municipalities to borrow without considerable costs that could be too difficult to bear.

For school districts such as Chicago and New York City, which handle their own pensions, the impact on their borrowing and budgets will be devastating. Under the Moody’s model, Chicago would likely have to pay 50 percent more than the $196 million in pension payments it will make this year and the $535 million it will pay out next year just to cover a pension of $9.3 billion, 35.6 percent greater than the $6.8 billion listed on its 2011 comprehensive annual financial report; a doubling in 2014 would add to the $1 billion budget gap the district must fill before the start of the next school year. Like many pensions, Chicago assumes an eight percent rate of return in spite of what is actually likely to be reaped on the market over time. Moody’s has already looked askance upon Chicago’s fiscal management — especially the deal it struck with the American Federation of Teachers’ Second City local that will add $295 million in additional costs — and this will cost the Second City dearly every time it goes out into the bond market; the district’s $116 million float in November (along with $6 billion in debt outstanding), was rated by Moody’s as A2 Stable with a “negative” outlook.

For New York City, which reported a $17 billion underfunding in 2009 (the latest year available) — and is likely larger than that based on the fact that the market value of its assets that year was $7.7 billion lower than the actuarial valuation — that underfunding would likely be $23 billion under the Moody’s model. The city already pays out $2 billion a year in pension payments, about 10 percent of its $24 billion annual budget; if the district’s payments increased by 50 percent or more as required under Moody’s model to pay down the pension deficit, the Big Apple would likely have to lay off some of the 75,000 teachers on its payroll; this would adversely hit the district’s less-senior teachers, who, under New York State’s reverse-seniority rules, would be the first to lose their jobs. Again, like most pensions, New York City’s teacher retirement system assumes an inflated rate of return of eight percent.

But the trouble isn’t just faced by municipalities with their own pension funds. School districts paying into statewide pension systems such as California’s Teachers Retirement System would also take a hit because Moody’s would assign a share of the newly-adjusted pension deficits to their respective balance sheets — and bondholders can know what they would have to pay out if they were behaving in a fiscally sensible manner. For Illinois’ state government and districts outside of Chicago, the notoriously-underfunded teachers’ pension would see its reported 2012 underfunding increase from $52 billion to $71 billion under the Moody’s model (based on reducing its rate of return from eight percent to 5.5 percent under the model), and would be expected by bondholders to have to pay out $4.7 billion more a year just to pay down the deficit. In Maryland, where Gov. Martin O’Malley successfully off-loaded a portion of teachers’ pension costs onto districts (and the counties that essentially control their finances), the pension deficit would increase from $12 billion to $15 billion based on the model; districts would then be assigned shares of those increased costs and then bear the judgement of Moody’s and bondholders on their fiscal health. As for states that bear the full burden of teachers’ pensions? The hits to the fiscal bottom lines just keep coming.

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The move by Moody’s, along with the efforts of the Government Accounting Standards Board to force districts (as well as states and municipalities) to come clean about the high costs of their compensation regimes, will certainly serve as a lever for reform. As your editor has written in The American Spectator and elsewhere, the long-term burdens of the defined-benefit pension deals, near-lifetime employment, and seniority- and degree-based pay scales struck between states, districts, and affiliates of the AFT and the National Education Association will likely do as much to spur reform as the systemic academic failure that is the most-public aspect of the nation’s education crisis. As Moody’s begins to apply its model to districts and other governments, expect more governors and districts to embrace performance-based pay scales as well as efforts to cash-balance existing pensions (and move toward defined-contribution plans for newly-hired teachers) in order to address these burdens. Which will mean more battles between states, districts, and NEA and AFT affiliates from here on.