The decision to teach in Maryland’s public schools would seem to be a no-brainer; Maryland’s K–12 public education system is ranked sixth in the country, and funded by the fifth highest annual per capita personal income nationwide: $56,125. Maryland’s teachers earn even more, almost $70,000 annually, the seventh highest average teacher salary in the United States.
Deciding to retire as a teacher in Maryland, however, can be a different story because the average annual pension payout for newly-retired teachers is roughly half of that, slightly less than $35,000—tied for eleventh place nationally, according to nonprofit watchdog Bellwether Education Partners. The median annual pension payout for newly-retired teachers is even worse, a jaw-dropping $20,500, ranking 30th in the nation. In fact, this overall imbalance between Maryland’s per capita personal income and pension payouts trails much poorer states like Kentucky, South Carolina, Louisiana, and West Virginia, whose K–12 public schools are ranked among the lowest in the country (Kentucky’s are 40th; South Carolina’s 42nd; West Virginia’s 47th, Louisiana’s 50th).
How is it possible that the fifth richest state with the sixth best schools pays its newly retiring teachers a median figure that ranks only 30th in the nation?
The answer to that question is the result of several, equally impactful variables. The first is how much is paid into the Maryland State Retirement and Pension System from employee contributions and the percentage of matching state contributions that the legislature provides from public taxes. The second is investment performance, which is directly related to how the pension fund is managed and, if necessary, modified. The third is how much compensation a retiree receives, which is based on a complex formula that Maryland uses to compute a particular person’s benefit, using a combination of average annual income and years of teaching experience.
These variables can then be compared to how pension funds perform in other states and how much their retirees are paid. The Maryland State Retirement and Pension System—which includes teachers, state police, and judges—has come under intense scrutiny in recent years for what appears to be a consistent track record of underfunding and underperformance. Yet its administrators and many state legislators in charge of its oversight have countered with a vigorous defense of what, they believe, is a steady, safe, long-term strategy that will ultimately provide what has been promised for Maryland’s growing number of state retirees.
Depending on who you talk to, the pension fund is either in great shape or in need of a sweeping overhaul. Intrigued by the opposing interpretations of what the numbers actually mean, we set out on a journey to discover why such a wide disagreement exists.
The History
The Maryland’s Teachers’ Retirement System was established in 1927 and, by 1941, expanded into the Employees’ Retirement System. According to the Comprehensive Annual Financial Report prepared by the State Retirement Agency of Maryland, by 2005, the state provided monthly payouts to over 100,000 retirees and beneficiaries out of more than 188,000 active participating members.
Although the System had seen an “exceptional” 16 percent investment return in 2004, fiscal year 2005 provided merely a “notable” return of 9.5 percent. While still higher than the System’s “actuarially determined target investment return of 7.75 percent”—which had been established as the long-term target—the report also warned that “deviations from this target can be expected, both positive and negative, from year to year.” In fact, the 2005 report admitted that the System had experienced an almost 3 percent decrease in its funding ratio. Despite this “temporary downturn,” the 2005 report also declared the System “financially strong and ahead of schedule with regard to its long-term funding goals” and went on to state that the unfunded actuarial liability (that had existed since June 30, 2000) would be amortized over the next 15 years until June 30, 2020.
As that date draws near, independent financial experts are publicly clashing with in-house analysts over the fund’s overall performance since the 2005 report and whether the ambitious goals set forth back then will ever be achieved, let alone on schedule.
The Firestorm
About 10 years after the 2005 report, The Washington Post published a series of articles that were extremely critical of the Maryland State Retirement and Pension System, which had more than doubled to almost 388,000 active participating members. One article, by Josh Hicks, asked, “Maryland pays more than $320 million in fees to manage pension funds. What does the state get in return?” (June 12, 2006).
Another was a scathing rebuke by the Post’s Editorial Board entitled “Maryland Procrastinates on Pension Fund Fixes—Again” (February 8, 2007). Their findings were troubling: In 2007, Maryland’s pension system investment fees, paid annually to professional fund managers, totaled $76 million; by 2015, they had quadrupled to $347 million. In 2007, actively managed funds accounted for about 49 percent of the System’s portfolio; by 2017, that number had skyrocketed to 80.4 percent. An annual average annual return rate of 11.3 percent from 2002–07 had decreased to 9.36 percent between 2010–15. Still well above the 7.75 percent long-term investment return targeted in 2005, but nonetheless a decline affected by the increase of actively managed funds with hundreds of millions of dollars in annual fees.
Hicks then turned to Jeffrey Hooke to analyze the data and verify his prognosis.
Hooke, a Senior Advisor of Focus Securities and a senior lecturer for the Carey Business School at The Johns Hopkins University, previously worked for Emerging Markets Partnership, the World Bank, Lehman Brothers, and Schroder Wertheim in New York. Hooke, a proven investment executive with decades of experience, is also a respected author of several books and articles on financial accounting. In his report, Hooke argued that high-priced professional fund managers don’t earn their exorbitant fees; they simply copy “a well-known benchmark like the S&P 500.”
According to Hooke, Maryland’s pension system investment fees “exclude lucrative ‘carried interest fees’ paid to hedge funds and private equity funds, which the System is not obligated to disclose. Maryland’s returns fall over 1 percent short per annum…The deficiency has cost Maryland roughly $4 billion in lost income over ten years, a large discrepancy that has been totally ignored by the last two governors and legislatures.”
Maryland began to depart from passively managed investments after the 2008 financial crisis. Ever since, Hooke argues, the pension system’s actively managed portfolio has underperformed, failing to beat “well-known benchmarks like the S&P 500 index and the 60/40 stock/bond index that are relevant to their investment styles.”
Back in 2014, Hooke crunched the numbers from 33 state pension funds that use the same fiscal year as Maryland and discovered that the 10 states with the highest fee ratios—Maryland ranking fourth highest among them—had lower return rates than the states that had spent the least on professional fund managers. If the decline continues, Hooke argued, Maryland should abandon high-priced professional fund managers and put additional monies into passively managed index funds, a strategy that even Warren Buffett has endorsed.
Many states and municipalities have already done so, such as: Nevada, which, since 2014, has transitioned almost entirely to passive management; California, which laid off half of their professional fund managers in favor of less complexity and expense; Illinois, which cut hedge fund use by 70 percent and substituted 40 percent of its high-priced professional fund managers with index-based portfolios; New York City, where the pension board withdrew from its $1.5 billion hedge fund portfolio when their system’s performance didn’t justify the fees; and North Carolina, which began paying market-rate salaries for its investment-managing employees.
Many states are taking reform even further. Kentucky, Pennsylvania, Michigan, Rhode Island, and Tennessee are phasing out traditional pensions in favor of a hybrid structure with 401K-style accounts. Pennsylvania called their program a “risk-managed hybrid plan” that “requires that the state evaluate policies to increase investment fee transparency and regularly perform stress test analysis to assess financial market risk.” In all, 48 states have enacted some sort of pension reform since the 2008 stock market crash.
While Maryland has not converted to a hybrid model, in 2017 the Post’s Editorial Board pointed out that “Reforms enacted under then-Gov. Martin O’Malley—higher contributions, lower benefits and later retirement age for future employees, plus a sizeable bump in the state’s own annual set-aside—put the fund on course to reestablish good health by 2023.”
However, Maryland’s dependence on actively managed funds continued. After Larry Hogan was elected governor, he proposed creating a hybrid program after lawmakers wanted to cut contributions to the $46 billion fund, whose obligations outweigh its balance, the Post argued, by roughly $20 billion. Andrew C. Palmer, CIO of the Maryland State Retirement Agency, denied the pension fund was performing as badly as the two Post articles described, stating that “actively managed funds can be more stable than low-fee indexes, which tend to experience dramatic dips and spikes. When investments do poorly, pension participants sometimes have to contribute more money to the system to keep it healthy. We try to minimize contribution volatility to the extent that we can.”
Ultimately, the Maryland General Assembly passed a bill in 2018 that increased employees’ contributions, promised the full employer’s share, and provided more consistent fund monitoring and reports on its performance to the governor and the legislature in order to track any glaring inconsistencies. When Hogan signed the bill into law, the Post was not impressed; Hogan “seems content to join forces with the legislature, which prefers to…let the looming long-term pension problem sort itself out. Or rather, foist the problem on a future generation of politicians and taxpayers…the target for restoring the pension fund to good health has slipped by five years, to 2028…the fund’s investment returns have been anemic for two years straight. On balance, Maryland has been a competent manager of its finances, with the glaring exception of the pension fund.”
In 2019, R. Dean Kenderline, the Executive Director of the Maryland State Retirement Agency, wrote a letter to the Post calling the assertions a “myth” while acknowledging that from 2007–2017, Maryland’s pension fund earned only 4.2 percent. He criticized those who “suggest converting state employees and public school teachers to a defined contribution, a ‘401(k)-style’ plan. In Michigan, touted as the model for reform in Maryland, the average balance for a state employee age 60 or older with at least 15 years in the plan was just $124,000. How does this compare with a defined benefit plan, like Maryland’s, which guarantees a lifetime benefit and no fear of that benefit being outlived? Not well.”
Hicks wrote in his 2016 Post article that Delegate Brooke Lierman (D-Baltimore), who sits on the House pension-oversight subcommittee, said she and other members of the panel “will take a hard look at investment fees. ‘I don’t want to pay exorbitant fees or unnecessary fees,’ Lierman had said. ‘It’s something the oversight committee has been paying attention to and talking to the treasurer about. I want to hear the full stories before I make any judgment.’”
Delegate Lierman has now had three years to “hear the full stories,” so we asked her if we could sit down and talk about the current health of the pension fund. She agreed, but in light of Kenderline’s comments, before we met with her, we spoke to Jeffrey Hooke to find out how the pension fund had performed over the past three years.
NEXT MONTH: Mark Croatti discusses the status of the pension fund, including what was done in the 2019 legislative session, with Jeffrey Hooke and five Maryland state legislators who sit on the Joint Oversight Committee on Pensions: Delegates Brook Lierman (D-Baltimore) and Michael Jackson (D-Prince George’s County) and senators Douglas J.J. Peters (D-Prince George’s), Adelaide Eckardt (R-Dorchester, Caroline, Talbot and Wicomico counties) and Andrew Serafini (R-Washington County).
Mark Croatti teaches American Government at the United States Naval Academy and Comparative Politics at The George Washington University. He has also taught conflict resolution courses within the University of Oregon School of Law.
