A modest proposal for pension reform

The state budget deficit and collective
bargaining reform are consuming much of the energy at the Statehouse, but
legislators are also considering much-needed fixes to the state’s public pension
systems. The authors of this piece also wrote the Fordham Institute’s 2007
report,
Golden
Peaks and Perilous Cliffs: Rethinking Ohio’s Teacher Pension System
,
and in this article share their most
recent research and recommendations about improving teacher pension systems.

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.

 Tying benefits to contributions would also eliminate the massive penalties for mobility in current systems.

 
   
 

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.

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