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Better Pay, Fairer Pensions II: Modeling Preferences Between Defined-Benefit Teacher Compensation Plans

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Better Pay, Fairer Pensions II: Modeling Preferences Between Defined-Benefit Teacher Compensation Plans

June 24, 2014
Public SectorOther
EducationPre K-12

Most public school teachers in the United States participate in traditional, final-average-salary defined-benefit (FAS-DB) pension plans. A common, but underappreciated, feature of FAS-DB plans is their heavy reliance on backloaded retirement benefits. Under these plans, teachers generally earn relatively meager benefits during their first several years in the classroom and then rapidly accrue far more valuable benefits late in their careers, as they near their plan’s retirement eligibility thresholds. At present, the majority of teachers leave—to take teaching jobs in other states or to work in the private sector—before earning substantial benefits.

In a recent paper (Manhattan Institute Civic Report no. 79, “Better Pay, Fairer Pensions: Reforming Teacher Compensation”), we compared the backloaded benefits offered under existing FAS-DB plans, in each of the ten largest U.S. school districts, with a less backloaded, alternative defined-benefit plan that we refer to as a smooth-accrual defined-benefit (SA-DB) plan. Using each pension plan’s own assumptions about teacher attrition, we showed that the majority (and sometimes the vast majority) of teachers would be better off under a less backloaded retirement plan.

Nonetheless, teachers’ preference between these two DB plans is not immediately clear from basic descriptive comparisons. On the one hand, SA-DB plans ensure that all teachers would leave with meaningful retirement benefits, even if they do so before reaching their plan’s retirement age. On the other hand, FAS-DB plans offer larger benefits to teachers who work their entire careers under a single plan.

This paper builds upon our previous work to answer the question: Which of these designs should the rational teacher prefer at entry? For each of the ten largest U.S. public school systems, we use a standard economic model—incorporating variables such as level of financial risk aversion and degree of uncertainty over future career plans—to determine entering teachers’ preferences between current backloaded FAS-DB pension plans and our less backloaded SA-DB alternative.

Key findings include:

  • When offered a choice between two plans with the same expected retirement benefit, a rational, risk-averse teacher would consistently prefer an SA-DB plan because it offers a smaller difference between potential benefit payouts.
  • The magnitude of preference for an SA-DB plan depends both upon the severity of an FAS-DB plan’s backloading and the amount of early- and mid-career teacher turnover. Yet in nearly every case, the strength of teacher preference for the less backloaded system (SA-DB) is large, given reasonable, empirically grounded assumptions about risk aversion.
  • Indeed, certain FAS-DB plans provide remarkably little retirement security to entering teachers. For instance, a new teacher in Hawaii’s school system with a typical level of risk aversion would be wiser to accept a lump-sum payment of merely $279, rather than participate in the system’s pension plan (some 77 percent of Hawaii’s entering teachers will leave the system before earning $279 in retirement compensation).
  • As for teachers who expect to work under the same system for many years—who would, accordingly, experience a higher probability of benefiting from backloading—many would nevertheless benefit from a less backloaded SA-DB system.
  • For example, teachers certain to work under the same retirement system for five years would still prefer the alternative SA-DB plan over current FAS-DB plans. Likewise, in six of ten school systems—New York City, Chicago, Philadelphia, Clark County (Nevada), Hawaii, and Houston—a teacher certain to remain for at least ten years would prefer the SA-DB plan. (Teachers certain to work under the same retirement system for 20 years would, however, universally prefer an FAS-DB plan.) In reality, moreover, few can forecast with absolute certainty that they will remain employed under the same retirement plan for the ensuing twenty, ten, or even five, years.

In short, this paper reinforces our earlier findings: reforms to teacher compensation in favor of SA-DB plans would help school districts offer significantly more attractive teacher compensation packages, without the need for higher taxes or reduced services.