Robert M. Costrell

We propose an economic reformulation of contribution policy integrating:  (1) formalization of sustainability as the steady-state contribution rate, incorporating both the expected return on risky assets and a low-risk discount rate for liabilities; (2) derivation of contribution adjustment policies required for convergence toward the target funded ratio and contribution rate; and (3) a stylized optimization framework for simultaneous determination of the target portfolio return and funded ratio.  This analysis provides new theoretical insights into the basis for pre-funding vs. pay-as-you-go, resting on the convexity of the long-run risk-return relationship, and also potentially practical guidelines for contribution policy.

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The ongoing crisis in teacher pension funding has led states to consider various reforms in plan design, to replace the traditional benefit formulas, based on years of service and final average salary (FAS).  One such design is a cash balance (CB) plan, long deployed in the private sector, and increasingly considered, but rarely yet adopted for teachers.  Such plans are structured with individual 401(k)-type retirement accounts, but with guaranteed returns.  In this paper I examine how the nation’s first CB plan for teachers, in Kansas, has played out for system costs, and the level and distribution of individual benefits, compared to the FAS plan it replaced.  My key findings are:  (1) employer-funded benefits were modestly reduced, despite the surface appearance of more generous employer contribution matches; (2) more importantly, the cost of the pension guarantee, which is off-the-books under standard actuarial accounting, was reduced quite substantially.  In addition, benefits are more equitably distributed between short termers and career teachers than under the back-loaded structure of benefits characteristic of FAS plans.   The key to the plan’s cost reduction is that the guaranteed return approximates a low-risk market return, considerably lower than the assumed return on risky assets.   

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How are teacher pension benefits funded?   Under traditional plans, the full cost of a career teacher’s benefits far exceeds the contributions designated for them.  The gap between the two has three pieces, which may (with some license) be mnemonically tagged the three R’s of pension funding:  Redistribution, Return, and Risk.  First, some contributions made for the benefits of short-term teachers are Redistributed to fund the benefits of career teachers.  Second, pension plans assume rosy Returns on their investments, which push costs onto future teachers and taxpayers.  Finally, the Risk inherent in providing guaranteed pensions carries other costs, tangible and intangible, notably including the non-trivial risk of insolvency, which would dramatically raise mandated contributions and endanger future teacher benefits.   I quantify these three components of the gap between benefits and contributions using the same metric as annual contributions.  Illustrating with the California plan, I find the full cost of a career teacher’s annual accumulation of benefits can be as high as 46.6 percent of earnings, nearly triple the corresponding contributions of 17.5 percent.  To understand this gap, which fiscally impacts all areas of education policy, researchers and practitioners may find it helpful to think of the three R’s of pension funding:  Redistribution, Return, and Risk. 

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Our goal in this paper, presented at the 2020 Brookings Municipal Finance Conference, is to better understand teacher pension funding dynamics with a focus on sustainability and intergenerational equity.  The origin of this paper is our analysis of the funding policy recommended in a highly publicized paper first presented at the 2019 Brookings Municipal Finance Conference (Lenney, Lutz, and Sheiner, 2019a; 2019b).  That proposed policy aims to alleviate rising pension payments that crowd-out classroom expenditures and teacher salaries by abandoning the attempt to pay down pension debt.  While the problem of crowd-out is real, we show that, with uncertain investment returns, the recommended policy would carry significant risk of pension fund insolvency and a jump in contributions to the pay-go rate, which is much higher than current rates. We close by proposing a policy evaluation framework that better incorporates risk and the intertemporal tradeoffs between current contributions and likely future outcomes.  We illustrate throughout with data from the California Teachers Retirement System (CalSTRS).

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