Why Teacher Pensions Don't Work

Defined-benefit systems aren't merely Ponzi schemes. They discourage talented teachers who would prefer front-loaded compensation..

Joel Klein | The Wall Street Journal
01/10/11

We live in a funny world. Bernie Madoff pretended he was getting 8% returns on his clients' investments—and he's in jail for running a Ponzi scheme. But in the public sector that kind of make-believe is common. As former chancellor of the New York City public schools, I learned that one of the options the city pension plan offered teachers and administrators guaranteed an 8.25% return, regardless of what the investments actually earned in the market. In fact, throughout the country public-employee pension plans have been massively underfunded, often pretending, like Madoff, that they'd get 8% returns forever, even if they didn't get them in reality.

Whether the investment returns are there or not, defined-benefit pensions require the government to pay retirees a predetermined amount for life. For example, today a teacher in New York City can retire with an annual pension of $60,000 (or more) that is exempt from state and municipal taxes. In short, lots of obligation; little set aside to meet it.

While irresponsible, this kind of behavior makes good political sense. After all, people run for office in the short run, and money spent now—rather than put aside in a pension reserve—is more likely to garner votes. As one legislator recently told me, "When budgets are tight, as they often are, we simply kick the can down the road by underfunding pension obligations." But as with Madoff, inevitably a day of reckoning arrives. For many states and municipalities, that day is now.

But this time it won't be private investors who get hurt. Instead, children currently in our schools, as well as future students, will be high among those paying the price. To cover the underfunded pension obligations to teachers and other public employees, cities and states have little choice but to divert money from what would otherwise be their operating budgets. And since schools make up a big part of those operating budgets, education will get significantly shortchanged as we make up for past underfunding.

This problem won't go away soon. There are lots of current retirees who must be paid, lots of people now working who have earned some part of their pensions, and, in many states, it is legally dubious whether current workers can have their pensions adjusted even prospectively. Consequently, no matter how you slice it, today's and tomorrow's students will long be subsidizing retired teachers who never taught them.

Northwestern professor Joshua Rauh has the scary numbers on Illinois and other cash-strapped states.

You would think that such a costly program, even if underfunded, would at least make sense. But while defined-benefit pensions sound good in theory—retirees should have security for their later years—they actually create incentives that impede hiring and keeping the best teachers.

To begin with, these pension systems make the total compensation package much too back-loaded: Pay in the early years is needlessly low, so we lose good people who don't find the generous benefits at the end worth the lifetime commitment.

Today in New York City, for example, the average annual per-teacher compensation is more than $110,000. The salary portion is $71,000, and the pension portion is $23,000. (The rest is for health insurance, FICA and other benefits.) A mix that was more typical of what exists in the private sector would help us attract more qualified people into teaching—and keep them there during the first five years, when we traditionally lose a third or more.

Here is an example of what that means. New York City's starting salary for teachers is $45,000, and the increases in the early years are low. If instead we started teachers at $52,000 or $55,000, gave them bigger increases in the early years, and paid for it by reducing their pensions, we would attract and keep better teachers.

At one point when I was chancellor, based on discussions with many new and prospective teachers, I proposed that we offer each new hire a choice between the current salary and benefit package and an alternative based on a higher entry salary and lower pension benefits. No one would lose anything: new hires that wanted the lifetime pension benefit could still have it, while those who preferred the proposed alternative obviously would be better off.

Nevertheless, the teachers union rejected the offer, calling it "anti-union."

On the other hand, because employees typically get a significant lifetime pension only after working 25 or 30 years, there comes a point at which almost no one leaves the system. In New York, few teachers leave after 10 years. Quite a few of these senior teachers admit they're burned out, or would want to try something else, but they stay simply because they cannot afford to forego the pension. Given that these teachers are already tenured, moreover, it's virtually impossible to remove them. This is not a good way to get the teachers that children need in our classrooms.

Defined-benefit pensions helped bring the once-vibrant U.S. auto industry to its knees. The promised benefits just proved too costly. In that industry, such pensions are mostly a thing of the past. Global competition eventually demanded as much.

Alas, the same kind of pensions are now hollowing out public education. Because there's essentially no competition in education, however, the effect has until very recently been hidden from public view. Today incoming governors—Democrats and Republicans—faced with this dismal equation are looking for a way to undo the damage and get out from under these unsustainable promises.

It won't be easy.

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