A Modest Proposal for Pension Reform
Educator pension systems are becoming increasingly expensive and, in a number of states, plagued by severe problems of underfunding. Given concerns about cost and long-term sustainability, several states have cut benefits, usually for new teachers, and many more are considering doing so. However, in making these changes, policymakers should carefully consider their labor-market effects. Some of the proposed cuts reproduce—and even exacerbate—undesirable features of current systems.
That’s because they violate the paramount principle upon which pension systems should be built: Benefits should be tied to contributions. In other words, benefits paid to any teacher should be tied to the lifetime contributions made by or for that teacher. If $300,000 has been contributed on behalf of a teacher (including accumulated returns) then the cash value of an annuity provided to this teacher should also be $300,000.
This principle is routinely violated in current defined-benefit pension systems. Our analysis, Reforming K-12 Educator Pensions: A Labor Market Perspective, shows that the current systems result in very large implicit transfers from young teachers working short teaching spells to “long termers” who spend entire careers in the same system. In our view, a teacher who works ten years or thirty years should accrue pension wealth roughly equivalent to total pension contributions (with accumulated returns).
Illinois is a cautionary example of how not to reform teacher pensions. The Land of Lincoln recently implemented a two-tiered plan, with teachers hired after January 1, 2011 in the second tier. Tier 2 teachers will make identical contributions (9.4 percent) as their Tier 1 colleagues, but will have a massive cut in pension wealth accrual over their work lives. Moreover, by our calculations, a new teacher entering the Illinois plan at age twenty-five will accrue no net pension wealth until age fifty-one. If the teacher leaves the classroom in her thirties or forties, she will walk away with nothing but her own cumulative contributions.
Tying benefits to contributions would have positive workforce consequences. First, it would provide rational incentives for retirement versus continued work. Each year, an educator would accrue pension wealth in a smooth and transparent way, providing an appropriate addition to the annual salary she is earning. This would generate neutral incentives to work or retire based on individual preferences and effectiveness.
That is not the case with current systems, where pension-wealth accrual is highly back loaded and concentrated at certain arbitrary points in teachers’ careers. Some years (e.g. at twenty-five or thirty years of service) yield increases in pension wealth that are several times the teacher’s salary. This provides a huge incentive to stay on the job until that pension “spike,” regardless of classroom effectiveness. There is no economic rationale for favoring one year of work over another in this way. Nor should an additional year of work reduce pension wealth, as is the case in current pension plans after a certain point in time, often at relatively young ages. This penalizes good teachers who wish to stay but are encouraged to retire early.
Tying benefits to contributions would also eliminate the massive penalties for mobility in current systems. It is well understood in the private sector that in order to recruit and retain talented young employees it is necessary to provide portable retirement benefits. This is accomplished by defined-contribution (DC) or cash-balance (CB) plans that vest immediately or nearly so. Current teacher plans typically have five or even ten year vesting. But even for vested educators, our research finds that the loss in pension wealth for those who split a teaching career between two states is massive. In a system where benefits are tied to the cumulative value of contributions it does not matter whether contributions have all been made in one or many jobs: Penalties for mobility are eliminated.
We favor cash-balance plans that generate notional individual retirement accounts, with contributions from employer and employee, and an investment return guaranteed by the employer. Such plans resemble the DC design, but without transferring investment risk or asset management to the teacher. They are transparent, offer smooth wealth accrual, and are readily annuitized at retirement. Large private employers such as IBM have converted to such plans, as have a few public employers. The TIAA plans that are common in higher education are similar in operation. They have provided retirement security for generations of college professors who often spread careers over multiple institutions.
As states grapple with the current pension crisis, a window of opportunity is open to implement more modern and strategic plans, or to make matters worse. Fundamental reform—based on tying benefits to contributions—is needed to fix these broken systems.
Robert M. Costrell is the endowed chair in education accountability at the University of Arkansas’s College of Education and Health Professions. Michael Podgursky is a professor in the Department of Economics at the University of Missouri, Columbia, as well as a fellow at the George W. Bush Institute at Southern Methodist University. An expanded discussion of these points, with references to the research literature, may be found in the authors’ new study published by the TIAA-CREF Institute.