How are teacher pension benefits funded? Under traditional plans, the full cost of career teachers' 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 nontrivial 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% of earnings, nearly triple the corresponding contributions of 17.5%. To understand this gap, which fiscally affects 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.

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.

Teacher pension funding and benefit design are technical subjects, but since they increasingly impact all areas of education policy, it is valuable for education researchers and practitioners to keep abreast of these issues. This chapter begins with a brief overview for non-specialists of the basics of traditional pension benefits and funding. We then go on to survey recent developments in teacher pension funding, benefits, and current debates over funding policy and plan design. The key issues we survey include: the high and rising costs of funding pension debt, which are squeezing salary growth and other classroom expenditures; the uneven distribution of benefits between career teachers and young and mobile teachers; the intergenerational tradeoffs in funding policy; and the hidden costs of risk. Tying all of these issues together is the fundamental challenge of funding retirement benefits with investment in risky assets. We conclude with a discussion of alternative pension designs that states are increasingly considering.

In this paper we propose a new approach to sustainable public pension funding, as an alternative to: (i) traditional actuarial full-funding policies, on the one hand; and (ii) recent proposals aimed instead at stabilizing pension debt at current levels. Actuarial contribution policies aim to fund liabilities that are wrongly discounted at the expected rate of return on risky assets; and these policies promise to do so with amortization schedules that terminate in a precipitous future drop in contributions, which never materializes. Conversely, recent debtstabilization proposals (Lenney, Lutz, and Sheiner, 2019a; 2019b) properly discount liabilities at a risk-free rate, but effectively untether contribution policy from those liabilities. Our analysis integrates properly discounted liabilities with investment strategies that may be risk-tolerant to some degree, in a policy framework that more transparently conveys the tradeoffs we face. We begin with the fundamental equations of motion for assets and liabilities – how these two sides of the ledger evolve with contributions, asset returns, and newly accrued liabilities. From these equations we formally derive the characteristics of steady-state pension funding – which we take as the definition of sustainability. We also derive the set of contribution adjustment parameters that smoothly achieve steady-state – a non-trivial exercise. The resulting contribution schedules differ conceptually from the traditional setup of normal cost plus amortization. Building on previous work (Costrell, 2018, Costrell and McGee, 2020), we examine the steady-state implications of differentiating between the assumed return on assets (r) and the discount rate on liabilities (d). We integrate these insights into a semi-formal social optimization framework to sketch out a contribution policy approach that conveys the tradeoffs between intergenerational burden-sharing, the pursuit of returns, and the cost of risk-bearing.

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 with 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-term teachers 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.

This paper builds on previous work (Costrell and McGee, 2017a, Education Finance and Policy) on the redistribution of teacher pension benefits, as measured by the wide variation in individual normal cost rates by age of entry and exit, and the associated cross-subsidies. The further steps taken here are: (i) to examine the impact of the discount rate on the degree of redistribution, and the analytics behind it; and (ii) to identify the distribution of the market value of the pension guarantee. Using the example of the California State Teachers' Retirement System, I find that: (i) high-assumed returns substantially understate the extent to which costs are redistributed for back-loaded plans; and (ii) the market value of the pension guarantee is highly concentrated among long-term teachers.

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In this brief, we examine an important but obscure form of state spending on K–12 education—state subsidies of school district pension costs. In 2018, this exceeded $19 billion across 23 states. To put that amount into perspective, 2018 federal spending on Title I programs was $15.8 billion. This revenue stream is often ignored in analyses of state aid for K–12 and its distribution across districts. Until recently, accounting standards did not require pension plans to report these implicit subsidies to the school districts, so they did not typically know the size of their subsidy. In some important cases, it was missing from state totals for education aid. In the first comprehensive tabulation of these data, we show that this subsidy can be as much as $2,400 per pupil, as it is in Connecticut. In Illinois, it comprises an additional 56% of state spending on K–12 on top of all formula and categorical aid.

ABSTRACT: Our goal in this paper is to better understand pension funding dynamics with a focus on sustainability and intergenerational equity. We examine the steady-state properties of deterministic models and simulations of stochastic models to illuminate the implications of recently proposed policies to alleviate funding pressures and of certain modeling assumptions. 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 the California Teachers Retirement System (CalSTRS), which publicly provides particularly full projections of the underlying cash flows.

The value of pension benefits varies widely, by a teacher's age of entry and exit. This variation is masked by the uniform rate of annual contributions, as a percent of pay, to fund benefits for all. For the first time, we unmask that variation by calculating annual costs at the individual level. In California, we find that the value of a teacher's benefits ranges from about 4 to 22 percent of pay, and exhibits some idiosyncratic patterns, as is endemic to traditional pension plans. The variation in individual cost rates generates an extensive but hidden array of cross-subsidies, as winners receive benefits worth more than the uniform contribution rate, and losers receive less. Almost two thirds of all entering teachers, past and present, are losers in California. By contrast, a prominently invoked study finds that nearly all active teachers are winners there. That result is shown to be highly skewed by excluding the losses of prior entrants who left early, thereby violating the funding fact that the gains and losses of winners and losers must offset each other. Our main policy conclusion is that cash balance plans can rationalize or eliminate the current system of cross-subsidies and provide the transparency lacking in traditional plans.

When policy advocates debate how best to ensure equity in public education funding, the topic of teacher pension reform rarely comes up. But, in fact, pensions represent a very large and fast-growing source of education spending, much of it distributed in ways that are, in a number of states, anything but equitable. When states subsidize teacher pensions directly, rather than expecting local school systems to fund those pensions themselves, affluent districts tend to benefit the most.

This paper provides a methodological critique of an influential method for assessing the impact on the Unfunded Accrued Liabilities (UAL) of the gap between assumed and actual investment returns over extended periods, and offers a sound replacement. The method in question simply sums over time the components of the annual actuarial gain/loss report. This implicitly assumes that in the counterfactual exercise, the interest on the additional UAL is covered dollar-for-dollar by amortization. But under actual funding formulas amortization usually varies less than interest. This means there are large intertemporal interactions between the gap in investment returns and subsequent shortfalls between contributions and interest. Using the actual funding formula in the counterfactual can lead to much higher estimates of the UAL impact of the gap in investment returns because it does not assume away these interactions. This method can more accurately inform policy-makers, regarding the importance of cutting the assumed rate of return.

Presentation by Robert M. Costrell to the Teacher Pension Workshop at the RAND Corporation on March 8–9, 2018.

Generational inequity in pension funding is highly sensitive to the lax policies of 80% funding targets and high assumed returns to investment. I develop a simple, powerful relationship between steady-state (SS) inequity in contributionsthe percent of extra contributions to fund prior cohortsand the SS unfunded ratio. I then show how the SS unfunded ratio is governed by x% funding targets and the gap between assumed and true returns. The SS degree of inequity is over 60% under an 80% funding target and over 50% with a one-point gap between assumed and true returns. (JEL H75)

It is well-known that public pension plans exhibit substantial cross-subsidies, both within cohorts, e.g. from early leavers to those who retire at the “sweet spot”, and across cohorts, through unfunded liabilities. However, the cross-subsidies within and across cohorts have never been provided in an integrated format. This paper provides such a framework, based on the gaps between normal cost rates for individuals and the uniform contribution rates for the cohort. Since the unfunded liabilities and associated cross-subsidies across cohorts derive from overly optimistic actuarial assumptions, we focus on the historically most important such assumption, the rate of return. We present two main findings. First, an overly optimistic assumed return understates the degree of redistribution within the cohort. Second, persisting with an overly optimistic assumed return leads to steady-state contribution rates that exceed the true normal cost (let alone the low-balled rate), i.e. cross-subsidies from the current cohort to past cohorts. Using the case of California, we show how that negative cross-subsidy can easily swamp all positive cross-subsidies within the cohort, as contributions exceed the value of benefits received by even the most favored individuals – those who retire at the “sweet spot.”

Under traditional defined benefit pension plans, annual contributions are set at a uniform percentage of pay to fund accruing benefits. That normal cost rate masks wide variation in the cost of individual benefits, generating an extensive and non-transparent pattern of cross-subsidization. We provide a comprehensive analysis of cross-subsidies in employer contributions across all entry and exit ages. The gains and losses of winners and losers must add up to zero, and we explain why they do not in some previous work, which claims that nearly all teachers are winners in the California Teachers Retirement System. To the contrary, we find about two-thirds of all entrants are losers. The losers earn benefits with an average annual employer cost of 0.8 percent of pay, vs. 5.7 percent for the winners. In effect, this is a system of widely varying, but non-transparent employer matches to the employee contribution, unlike a retirement account plan with a uniform match.

District costs for teachers’ health insurance are, on average, higher then employer costs for private-sector professionals. How much of this is attributable to collective bargaining? This article examines the question using data from the National Compensation Survey (NCS) of the Bureau of Labor Statistics (BLS) and the state of Wisconsin. In addition, the impact of collective bargaining on employer costs is decomposed into the impact on total premiums and the employer’s share of those premiums.