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).

Fundamental reform—based on tying benefits to contributions—is needed to fix these broken systems.

 
   
 

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
.

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