How School Choice Can Help Solve the Teacher Pension Crisis
Two of our own fiscal experts get in the weeds with teacher pensions and the bigger crisis American education is facing.
In today’s episode, Dr. Marty Lueken, our own director of fiscal policy and analysis, chats with Dr. Michael Podgursky, professor of economics at the University of Missouri. The two break down teacher pensions—how they work, why they’ve created problems and how school choice can help. Click below to listen to the full episode.
Our Interview Transcribed
Marty: Hello and welcome to another addition of EdChoice chats. Today, we’ll be discussing an issue that’s received a lot of attention for financial challenges that are facing state and local government, teacher pensions. Today, we’re joined Dr. Michael Podgursky professor of economics at the University of Missouri. Welcome to the program.
Michael P: Thank you.
Marty: So, Mike, you have done a lot of work on teacher pensions and you’ve done a lot of work with Bob Costrell from the University of Arkansas. You guys go back quite a bit. It is my understanding that you actually called this, the challenges from teacher pensions, a while ago. We’re going to be talking about teacher pensions. There are a number of different types of pension plans that are offered to all sorts of public employees. Can you talk about the different kinds and how they’re structured and what plans usually, typically, cover teachers across the U.S. or what states have been choosing to provide teachers?
Michael P: Sure. Before I go into the taxonomy, thank you for the shout out. It’s nice to be able to say sometimes in your life, “I told you so.”
There’s broadly three types of retirement plans. The first type, which is overwhelmingly what teachers are in, are called defined benefit plans. A defined benefit plan provides the teacher or the individual with an annuity, that is a payment until they die or their spouse. The value of that annuity that’s paid when they retire is tied in some way to their work history.
Social Security, for example, is a defined benefit plan but it’s tied to 30 years or 40 years of your work history and your average earnings over that work life, adjusted for inflation. Teachers are in defined benefit plans that provide an annuity, similar annuity, but theirs is what we call final average salary defined benefit plans. It ties the annuity to what they were making during basically the last few years before they retired. A key feature of defined benefit plans is the employer then has to make sure that he puts away enough money to pay for that stream of benefits. There’s no guarantee that the teacher contributes enough over his or her work life to pay for that. The employer has to make up the difference if they don’t contribute enough.
A second kind of plan that’s really become much more common place. These defined benefit plans, Social Security of course, applies to almost everyone except some teachers in some states, every private sector worker and most state and local workers, but in the private sector … The private sector’s primarily gone over to what are called defined contribution plans. These are plans where the employer simply contributes to a fund, a retirement fund, for the worker. The employer contributes, and the worker contributes. And a pot of money accumulates that the individual can draw down when they retire. These travel, these type of defined contribution plans, travel under a variety of names, individual retirement accounts, 403(b)s, 401(k)s depending on the section of the tax code. The basic idea is that there’s a pot of money that you and your employer contribute to that’s tax advantaged for your retirement, and it travels with you. It’s your account, and if you go to a new employer, you take the money with you and so on.
The first defined benefit type of plan, there is no individual pot of money. The employer is liable for the benefit that’s paid when you retire. Finally, there’s a plan that’s kind of a hybrid between the two, and it’s called a cash balance plan. In these plans, the individual contributes and the employer contributes and what people call a notional pot of money, that is the employer maintains and invests in the fund themselves but maintains separate accounts for individual workers and guarantees a certain rate of return, say 4% or something. Then, the individual can convert that into an annuity at retirement. In higher ed, TIAA/CREF, which is very common in private … it’s ubiquitous at private universities and most major research universities and public universities. It’s like a cash balance plan.
That was a little bit long winded but those are the three big flavors.
Michael P: Again, teachers are overwhelmingly in these final average salary defined benefit plans.
Marty: Right, I believe, the BLS, The Bureau of Labor Statistics, tracked those numbers. And I think something about like 87% or 88% of public school teachers nationwide are covered by these plans. Is that right?
Michael P: Yeah and I think that the 13% is just response error. It’s overwhelming.
Marty: Got you.
Michael P: The only teachers, public school teachers … There are some new teachers in some states have entered alternative plans and some charter school teachers are able to go into defined contribution plans, but overwhelmingly they’re in defined benefit plan.
Marty: Okay. With defined benefit plans, the benefit is essentially determined by how many years you work. It’s tied to your salary somehow or some final average of your salary and some accrual factor. That’s guaranteed. It’s paid for the rest of the teacher’s life from the point that they retire and are eligible to receive that benefit. Then, defined contribution plans, which I think most people are familiar with 401(k)s, but there are other types. That’s defined by the contributions that are put in. So, the level of benefit isn’t guaranteed. Then, a cash balance is, technically it’s considered a defined benefit plan, but really it’s a mix of the two, kind of in between. You have different plans that are designed to put on risk for different groups of people. With these different plans, who takes on the risk? Who’s benefiting from them, and who’s taking on different risks?
Michael P: That’s a complicated question. On the surface, the defined benefit plan, the employer seemingly is taking on the risk because they’re guaranteeing the benefit, the pension that the worker will collect. It’s up to the employer to make sure that there’s enough money in the piggy bank to pay that. As we will get to shortly, they haven’t been doing such a good job of that. Again, in the traditional story, the defined contribution plan, the employer bears no risk. The employer simply says, “Okay, I will put 5% of your salary away into your retirement account, and you’ll put in 5%, and it’s up to you to make the investment decisions. My liability is over once I put my contribution into your account.” In that situation, the worker is bearing the risk associated with investment. Of course, the employee can choose more risky investments or less risky investments. In any event, there’s no guaranteed down payment down the road independent of what’s in that savings account.
That said, it’s a little more complicated than that because the defined benefit plans, the reason employers first introduced those and really lots of private sector employers used to have those, they pioneered some of those plans, is that it was meant to reward stability or loyalty to the firm. The way these final average defined benefit plans work is they provide you with a very nice benefit if you stay with the firm or the employer basically your whole work life. If you stay 25 or 30 years, these pay off very well, but they’re designed to punish early exit and punish mobility. And they do that very effectively, particularly the teacher plans. There’s just lots of rules in the teacher’s plan that really punish teachers who move.
For example, a teacher who teaches 30 years in one state will have a much more pension wealth, that is of value, in that pension account and that stream of earnings than a teacher who taught ten years in one state, ten in another and ten in third and had the same salaries and made the same pension contribution. It sharply punishes teacher mobility. There’s a variety of ways it does that, but the easiest to understand is the annuity you collect is frozen. It’s tied to your earnings at the time you leave. If the teacher works from age 22 to 32 in Texas and then moves to Missouri, they’ll be able to collect a pension. They’ll be vested. They’ll be able to collect a pension from Texas, but it’ll be tied to what they earned when they were 32 years old in Texas. The salary they were making there. There’s no adjustment for inflation or overall salary growth. Of course, they won’t be able to collect that pension for twenty years. It really punishes mobility.
That’s why the private sector phased these things out because young and particularly professionals … professionals move around. That brings us back to the risk question. Young people, you don’t know. People starting careers don’t know how long they’re going to be in one place or with one company. The company could go out of business, for family reasons they could move to another state, or they change their mind. And they say I don’t want to be a teacher anymore, or I don’t want to be a teacher in Illinois. I married someone, and I want to move to California and be a teacher. We don’t know those things when we start our work life. These defined benefit plans punish mobility harshly, whereas a defined contribution plans are designed to be mobile.
When we return to the question of risk, defined benefit reduces risk for employees in some respects in the sense of guaranteeing on return on their pension contributions, but it increases risk in other senses in that it punishes you if you move and, you know, life happens, as we say.
Michael P: People do move for lots of reasons.
Marty: Sure. Not even geographically as well, but if you’re moving into a different sector, from public school to a private school or vice versa, that’s also a type of mobility with respect to pension plans, too.
Michael P: It just … this brings us to, I think, the core question is: is this an efficient way to compensate teachers? We’ve seen that it really is, these final salary DB plans that we see for teachers are really an anomaly in the modern work place. You just don’t see other college educated professionals in these types of plans for the most part, because other professionals are mobile, certainly private-sector professionals. You just won’t see any of them in these kinds of plans if you’re working as an accountant or manager or some other type of profession … a lawyer. They’re not in these kinds of plans if they’re working in private firms. Even in education, in higher ed, virtually all private university employees, none of them are in defined benefit plans, other than Social Security. They’re all in defined contribution plans, typically TIAA/CREF. College professors move around, and that’s why TIAA/CREF was developed, to give them a mobile retirement benefit.
It’s also true even in K–12 in private schools. Private schools don’t have defined benefit pension plans. They have … If they have plans, they’ll be like 403(b) plans, defined contribution plans. In addition, charter schools in most states where charter schools have the choice of participating in the state plan or not, they usually opt out. There’s one exception, California, and we could talk about that later. They’re heavily subsidized. Even that’s changing, most of the new charter schools in California are also opting out.
Marty: Speaking of California, there’s a report recently by a Stanford economist, Joshua Rauh of the Hoover Institution, where he estimated the unfunded liabilities or the pension debt for, I believe, it was 649 pension systems, local and state government pension systems nationwide. I think he estimated about 1.4 trillion dollars in unfunded liabilities based on the systems own measures. He showed that if you use what some financial economists have argued are more reasonable assumptions about things like the discount rate for example, then that figure is much higher. Is this something that we should be concerned about?
Michael P: Well, yes. These are dollars that are being diverted from public school classrooms to pay down the pension debt. This is a huge problem. In general, it’s a problem because almost all of these plans in which teachers participate are underfunded, which means part of the dollars per student expenditures are going to pay down these unfunded liabilities. An economist at the University of Arkansas estimates that currently we’re spending about $10,000 per student in operating expenses and about a little over $1,200 of that is simply for pensions. That doesn’t count Social Security. This is just the pension systems. That’s doubled over the last 15 years. These pension expenses are eating up more and more of the K–12 education dollar. It’s going out of the classroom to pay for these unfunded liabilities.
Part of the reason these have developed, there’s, how should we say, there’s an innocuous reason and maybe a less innocuous reason. The innocuous reason is it’s risky. These pension plans, they’re guaranteeing a benefit in the future, and they’re trying to extensively put aside money to pay for that. Increasingly, they’re putting their money into the stock market or into other types of riskier investments and sometimes, they make bad bets. Like in 2008, we had a big meltdown. They’re hoping to get a return of 7% or 8%, and increasingly it’s been hard for them to do that without taking on a lot of risk. Sometimes, the risks don’t turn out right, and they don’t hit their target. And that’s been a source of the increase in unfunded liabilities.
In addition, though, politicians … it’s tempting for politicians to not make the payment they’re supposed to make. I used to think years ago when I taught economics, I’d say, “The federal government can run a deficit but state and local governments can’t.” Constitutionally, they’re supposed to have balanced budgets, and that’s what politicians say. In fact, what states have done—Illinois, California, others—is they’ve basically borrowed from their pension fund. What they did frequently over the past couple of decades is they did not make the contributions they needed to make to fund these future benefits. What they were, in effect, doing was borrowing from the pension plan. This is another source of the unfunded liabilities is state governments, and local governments simply didn’t pay responsibly enough. It’s easy to give out these benefits and all of them, almost all of them, enhanced benefits during the nineties. But they just weren’t trustworthy enough or reliable enough to make the annual payments they needed to guarantee those. It’s simply tempting to kick the can down the road and say, “Well, we’ll pay for that next year.” Or, “Well pay for that in a few years.” We have these big unfunded liabilities.
Marty: Interesting. This is debt that has been accruing over time. How long has this been going on? Do you know?
Michael P: If you go back to the early nineties, most of these plans in theory had enough money in the bank to pay for their future liabilities. A couple of things went on. The government … union and employee associations lobbied to get more generous benefits. Virtually all these plans became much more generous over time, which allowed teachers to retire earlier for example. Teachers used to work until 62 or 65. Now, it’s common for teachers to retire in their mid-to-late 50’s. That’s expensive, and the generosity of the pensions went up over time. In many cases, teachers … again because they’re retiring so early, they lobby to get retiree health insurance because they’re not eligible for Medicare until 65. That was another source of unfunded liability. Again, these groups lobbied for these better benefits, and then governments simply didn’t put aside enough money to guarantee those benefits in the future. There’s the source of your problem.
Then, you get a sharp downturn in the market and suddenly, they have to report the short fall. That’s what’s going on here. There was a change in reporting requirements that required very clear statements of these unfunded liabilities. How much they owe. Suddenly, it became clear that they were deeply underwater. By the way, when I say underwater, the courts have basically made it nearly impossible to cut benefits for retirees and even current employees. For example, if a teacher starts and becomes vested or is hired in Missouri and they’re guaranteed … They are essentially guaranteed the right participate in a pension plan that is not only what they’ve accrued, the pension wealth they’ve accrued up to the current time protected, but their right to stay in a similar plan all the way to retirement, the rest of their work life is guaranteed as well. Basically what it means is in most states: you can’t really change the rules of the pension system, you can only do that for new hires. You really can’t change the rules going forward for incumbent teachers.
Basically, you are stuck with this big cost going forward that you can’t do anything about. You’ve got to, in a sense, make up for your shortfall in your contributions. The other thing that’s going on that EdChoice has called attention to is the fact that in K–12 education, school districts have really put a lot people on the payroll. The payrolls have grown much faster, that is the number of people employed, both as teachers but in particular non-teachers has grown much faster than the number of students. I can quote from a recent report of yours here. Between 1992 and 2014, the number of students in public schools grew by 19%, but the number of staff grew by 36%—28% growth for teachers, 45% for all other staff. Here you’ve got this system that’s just throwing lots of bodies on the payroll and providing them with these very expensive benefits, both health insurance and then retiree benefits. This has just put enormous stress on the budgets of school, because these people are accruing these future pension liabilities. The courts have said you can’t touch that, and not enough money was put away to pay for them.
They’re in an enormous bind, and the only place they cut is new hires, the benefits for new hires. It’s a challenge in many states. The Chicago Public Schools have a huge unfunded liability, but this is also true in California, New Jersey, Connecticut, a number of other states.
Marty: These benefits are costly. Now, we want to compensate teachers and staff schools with good teachers to teach kids. Some argue that these defined benefit plans, final average salary defined benefit plans, are a critical or necessary component to maintain a high-quality teacher workforce. Is that true? Has the research been done on this question?
Michael P: Rule number one in providing compensation or in compensation designed for employees is you want to make sure the employee … If you’re paying a dollar for benefits, you want to make sure the employee values that benefit at a least one dollar, or you’re being dumb, right. In other words, if you’re giving them a benefit they only value at 50 cents and it’s costing you a dollar, then it’s better to just pay them a dollar than give them the benefit that they don’t really value or they value at less than cost. That’s really what’s going on here, particularly for young teachers. These states have developed these very expensive retirement benefit plans but then you ask, “Is this what young teachers want?” Do you want to pay into a plan that’s in a sense put aside enough money to let you retire in your late 50’s at 75% of your salary, or are you willing to have a less generous plan and you work to 65 like everyone else? Young teachers would rather have the money up front, right. They have student loans to pay off, for example, or they want to save money and buy a house.
We have this system of compensation for teachers that economists describe as back loaded. It’s giving you this great benefit at the end of your career—retiree health insurance, generous pension that you can collect while you’re still fairly young. But it’s very expensive, and you’ve got to pay for that by lower salaries at the beginning of your career. Now, if you ask young teachers coming out or considering teaching as a career, is that really how … Would you rather have a dollar back loaded that way or a dollar up front in salary? Most of them would say, “I’d rather have the dollar up front in salary.”
Again, the proof … you see it in the private sector. If this is the way employees wanted to be compensated, then you would see lawyers and engineers and all of these other professionals in other sectors of the economy in these kinds of plans, but they don’t. They’re in these mobile plans that are putting aside roughly 10% of their salaries in retirement accounts, whereas teachers are in much more expensive plans.
Marty: There are some states that we hear about often that are struggling with their pensions—California, Illinois, Connecticut are three examples. They seem to be the worst funded compared to all other states. Are there other states that are struggling, and how do we fix this for state and local governments?
Michael P: There are other states that are suffering. It’s just that the poster children like California, Connecticut, Illinois, get a lot of attention. But even in states that are supposedly in good shape, they still have a lot of unfunded liabilities. For example, the Missouri Teacher Pension Fund is funded at a little over 80% and has about four billion dollars in unfunded liabilities and they think that’s … They don’t the attention of Illinois, but still they have only about 80 cents for every dollar of liabilities. That’s common in lots of states. I think what you have to do, sort of the rule of thumb, should be if you’re in a hole, stop digging. What I think should be done is to close these existing plans to all new employees and just isolate the problem and to try to deal with how you’re going to pay down what you owe. There’s are varieties of strategies there.
Then, what you want to do is put new employees into more modern and less expensive systems that will have a large defined contribution component. Here’s where I think school choice can fit in nicely. First of all, if you give parents the choice, some parents will put their kids in private schools, and private schools don’t have these problems. Right off the bat, if you provide a voucher or a scholarship to parents and they put their children into a private school, the only liability of the government is the value of the voucher, and you don’t have to worry about unfunded liabilities of private schools because there aren’t any. Now, it’s also true in charter schools. Most charter schools are opting out of the state plans as well. The second part of the solution, nearly all of the states that are deeply in trouble, the teachers are not in Social Security. Illinois and California being two examples.
There’s bipartisan agreement basically from a couple of government commissions that we really ought to be putting all new state and local workers, including teachers, in Social Security because Social Security is a mobile benefit. No matter where you go in the U.S., you have this safety net of the Social Security system in terms of both disability but also retirement income. It doesn’t matter if you work in Illinois or in Texas or in Missouri or wherever, and it doesn’t matter what kind of job you’re working in. You have that safety net, except many state and local employees are left out, and it’s disproportionately teachers.
There are sort of complicated ways to put public employees back in, but one simple way to do it is through school choice. Every student that goes to a private school, automatically that money is supporting a teacher who is in Social Security. Similarly, charter schools, if the charter school opts out of the state plan, then the teachers will automatically be in Social Security. In California for example, teachers who are in the charter school that have opted out of the state plan are automatically in the Social Security, and then they’ll get whatever additional benefit the charter school provides as well, which will typically be some kind of defined contribution of 401(k) or 403(b) plan.
School choice actually is a way to start to sort of circle the problem. It’s kind of like an oil spill. You know, how they put those … After they had the big oil spill out in the Gulf, they put these little balloons around or these little things around these patches of oil to isolate them. That’s sort of what school choice can do. It can sort of isolate and control the liability and prevent it from spreading further while you try to deal with that. Charters and school choice can help prevent the further expansions of liabilities and, in fact, can help even contract it a bit.
Marty: Have there been states that have or are currently making efforts to reform their retirement systems?
Michael P: Yes, for teachers there are. Again, most of these only apply to new teachers, although some states did this a decade or so ago and so you have some choice. Florida, for example, new teachers can be in a defined contribution plan or a traditional pension plan. In Ohio, the same is true. Kansas recently had very large unfunded liabilities in the school plan, and under new reform, new teachers are in a cash balance plan. Utah has a similar arrangement for new hires. A number of states have introduced more flexible plans for new hires. In some cases, these include teachers. I should note that in some states, in many states, teachers have their own retirement plan or public school employees have their own retirement plan, but in others they’re in consolidated state plans, like in Florida and so on. All the state employees including teachers are in one plan.
Marty: Right, okay. If state legislatures are to do anything next session in terms of reforming their pension plan and trying to handle these budgetary pressures, what should their first step be do you think?
Michael P: As I said, I think, when you’re in a hole, stop digging. I think that they should when they have these unfunded liabilities, I think they should close these existing plans to new employees. That means the employees that are currently in, they’re in the plan, you’re going to have to pay for it but you’re not growing the plan anymore. Believe it or not, the pension plans and advocates argue that it actually costs more money to close these plans than it does to continue operating them. It’s a weird argument, and it doesn’t hold water and it defies common sense, but it is made. That’s the key. You just close these existing plans and put new employees into a less costly, portable ,flexible plan. And I think that’s an important first step. As I said, I think that in the case of schools, I think that you can through school choice … in effect, you’re privatizing some of the delivery of services. If the parents pick a private school, if they have a voucher, then you’ve … the public liability is limited. You pay for the voucher, and that’s it. Charter schools are also tending to opt out and provide less expensive benefits.
I should also mention that one nice thing about the charter school sector is they’re also showing ways you can innovate. Many charter schools are developing their own retirement benefit plans that look a lot like private businesses that employ professionals, high-tech firms and so on. This is one area, actually, where charter schools can do things that traditional public schools can’t. Because even if a school district would like to do something innovative, they don’t have any choice but to participate in the state plan. Whereas charter schools in states where they can opt out, can do their own thing. We’re seeing a lot of innovation on the part of charter schools that have opted out.
Marty: Is there any new research on pensions coming out in the near future, either from your department or elsewhere?
Michael P: One study that I alluded to is an analysis of what charter schools are doing. I collaborated with some folks at the National Alliance for Public Charter Schools to look at to what extent charter schools are opting out of these state plans when that option is on the table, and then what they’re doing when they opt out. We have a new report coming out on that and as I said, there’s an increasing trend for the charters to opt out when they can, and they’re developing their own 401(k)s, 403(b)s and so on. There’s a lot of innovation going on there.
We have another study that’s looking at trying to … Some school districts and cities are concerned about their ability to recruit new teachers. There are some discussions about teacher shortages. Now in fact, there aren’t widespread teacher shortages but because of the way we pay teachers, there are shortages in some fields, like STEM. Some schools find it hard to replace a special ed. teachers, or science, or math teachers. It turns out these teachers are retiring, or existing experienced science and math teachers or special ed. teachers are retiring at relatively young ages, their late 50’s. One thing you might do within the existing framework is to offset some of the incentives for early retirements in these traditional plans. These traditional final average salary defined benefit plans have these push incentives that encourage teachers to retire at young ages. We did a recent paper estimating how you might offset that for some of your best teachers, in other words teachers you really want to hang on to, science and math, or if there’s some exceptionally good teachers or teachers teaching in high-need schools, science and math teachers in high need schools.
In turns out, it can be very cost effective to do that rather than trying to recruit new teachers and so on if you can just get your existing high-value teachers to work for two or three years more. It’s sort of offsetting, I would call them retention bonuses, offsetting the incentives of the retirement system can actually be a relatively less expensive way to staff those positions with high-quality teachers. That’s another issue we’ve looked at in some work.
Finally, we have another paper that just went into print that shows that … one consequence of these penalties for mobility is that your main labor market is less efficient. In other words, imagine you’re a teacher in Kansas City, Kansas and you want to take a job in Kansas City, Missouri. You could literally walk right across the street. There’s a road called State Line Road, and if you’re on one side of the street, you’re in Kansas and on the other side you’re in Missouri. In most professions, it’s easy to cross that line and labor markets work efficiently when workers can move around and pursue the best opportunities and employers can hire the best employees.
In teacher labor markets, teacher licensing and these pension systems reduce mobility. We have a paper that was just published in Economics of Education Review that shows that schools that are near a state line, actually the students do worse, other things equal than schools that are further inland, which is exactly what the economic theory would predict. If your teacher labor market is segmented by a state line, in other words, it’s more costly to hire teachers on the other side of the line. Then you’re going to do worse than a similar school that doesn’t face those types of barriers or that type of a segmented labor market. We have a paper on that, too. It really demonstrates, or at least provides some evidence that these penalties for mobility that are built into pension systems actually have effects on student achievement.
Marty: Interesting. I certainly look forward to reading your forthcoming papers. Is there anything else that you would like to add before we wrap up?
Michael P: I’ll just repeat what I said several times already. My best advice for the legislatures and education leaders is the old aphorism, if you’re in a hole, stop digging.
Marty: Sounds good. Thank you very much, Mike. Appreciate it.
Michael P: Okay. Thank you.
Marty: I’d like to thank you for listening. If you’d like to hear more EdChoice chats, please subscribe at the bottom. I wish you well.