IP-9-2008 (December 2008)
Author: Micheal Mannino
The debate about defined benefit pensions in K-12 education has focused on unfunded liabilities rather than appropriate levels of retirement compensation. Public K-12 employees typically retire at much younger ages with more replacement income and better inflation protection than private sector counterparts. School districts use contribution rates derived from uncertain assumptions about pension plan returns as substitutes for estimating realistic retirement compensation levels. The contribution rates ignore the considerable value of risk assumption that public employee pension plans provide to career employees. In addition, the large amounts of deferred retirement compensation have negative impacts on employee motivation and high, uncertain taxpayer costs.
To improve understanding of public K-12 retirement compensation, this Issue Paper provides historical estimates using a substantial sample of retiree characteristics and salary histories. The sample contains 846 retirees from the Denver Public Schools Retirement System (DPSRS) who retired between 2001 and 2006. While most Colorado K-12 employees receive benefits through the Public Employee Retirement Association (PERA), DPS employees participate in DPSRS. The sample supports reliable estimation of deferred retirement compensation without simplifying assumptions about salary growth and retiree characteristics.
DPSRS is a hybrid defined benefit plan with the following characteristics:
- Promises workers a defined pension amount based on age and years of service, regardless of contributions and earnings generated from investment of contributions
- Allows workers to retire at a much younger age than Social Security, with much higher levels of replacement income especially for higher paid workers
- Provides the hybrid feature of limited portability through account balances based on pension contributions and interest
- Recovers funding shortages from taxpayers
This Issue Paper defines deferred retirement compensation from a hybrid defined benefit plan as the difference between an employee’s estimated retirement account balance and the greater pension value she expects to receive. To account for risk, deferred compensation calculations use a private sector standard, the Single Premium Immediate Annuity, and low-risk investment returns. Deferred retirement compensation is divided into two parts.
First, extra value represents benefits that exceed the amount a retiree could expect from low-risk investment of employer and employee retirement contributions. Second, withheld value keeps an employee’s account balance artificially low to subsidize career retirees’ benefits and limits pension portability.
When accounting for K-12 employee compensation, large amounts of deferred compensation should be included. For the 846 DPS retirees in the sample, average lump sum deferred compensation (LSDC) is $627,570, broken down as follows:
- Among all 96 administrators, the average LSDC is $986,791.
- Among all 577 professional teachers, the average LSDC is $636,821.
- Among all 173 non-professional employees, the average LSDC is $397,379.
- More than 80 percent of deferred compensation involves extra value while less than 20 percent involves withheld value.
- A few outlying administrators, most of whom gained large salary increases late in their careers and retired between ages 54 and 58, receive LSDC of $1.5 million or greater.
- The average deferred compensation represents an average of 38 percent to 51 percent additional compensation per year when allocated to a retiree’s working years.
The findings strongly indicate that K-12 public employee compensation is poorly structured:
Pay for teachers and administrators is heavily backloaded, penalizing non-career employees.
- Seniority and longevity are rewarded over performance and market demand, which would better align compensation with the goals of public education.
- Incentives encourage some K-12 employees to seek highly-paid administrative positions or advanced degrees late in their careers, with little value for students and schools.
- Because deferred compensation for career employees tends to decline as retirement age increases, employees may leave the profession during peak years of productivity.
- Evidence does not support the need for large amounts of deferred compensation to maintain a skilled, competent educational workforce.
The current economic situation provides strong motivation for policy makers to enact reform soon to avoid reductions in K-12 service levels. As a first step, K-12 administrators should be moved into a defined contribution plan. In addition, pensions for teachers and non-professional employees should be reformed as follows, to reduce negative economic impacts:
- Remove early retirement subsidies
- Tie the normal retirement age to Social Security
- Reform rules for calculation of highest average salary to reduce pension spiking practices
- Grant new hires the option to choose a defined contribution plan, which non-career employees may prefer over the traditional defined benefit plan.