Journal of Education Finance

Introduction

The heightened national attention on school performance and accountability in recent years has increased concern among states to find ways to better attract and retain high-quality educators. Because education is a very labor-intensive industry, it is not surprising that policymakers and researchers have turned their attention to the role of educators in raising student performance. Research on administrators, for example, suggests that the ability of schools to find and keep school leaders who are successful in guiding schools toward the achievement of performance targets is very important (Chubb and Moe 1990; Leithwood, Seashore Louis, Anderson, and Wahlstrom 2004; Marvel, Lyter, Peltola, Strizek, and Morton 2006). One obvious factor in the decisions of both teachers and administrators as to where they will work is their level of compensation. All else held constant, educators should prefer to work in states with more generous compensation levels.

Although salary is usually the largest single component of an educator's compensation, non-salary compensation in the form of in-kind benefits—such as payments and subsidies for medical and dental services—and deferred compensation (retirement benefits) is also important. According to data from the National Center for Education Statistics (NCES 2010), in 2006-2007 employees in public elementary and secondary schools received more than $64 billion in in-kind benefits, which represents almost one-third of total employee salary expenditures. Similarly, every state provides educators in their P-12 public system with deferred compensation through a pension plan. In every case except Alaska, the state primarily uses a defined benefit plan where an educator receives a specified payment for each year in retirement. The annual payment is determined by a formula that takes into account the years of service for the educator in the state and the person's earnings during his or her career.

Even though benefits are a sizable part of any educator's lifetime compensation, there has been little scholarly inquiry into these benefits and how they affect educators. As noted by Hanushek, Kain, and Rivkin (2004), "Unfortunately, we, like all past researchers, lack information on fringe benefits" (p. 239). Within the broad category of non-salary compensation, even less attention has been directed towards the retirement/pension benefits of educators than towards fringe benefits. This omission in the literature is surprising for several reasons. First, state pension plans are an important policy instrument that states have at their disposal for possibly attracting and retaining teachers and administrators. Second, defined benefit pension plans are widely used in P-12 education and affect the vast majority of educators in the public education sector. According to the Public Fund Survey (2010), in 2009 state and local pension systems in the [End Page 25] United States, including those for other state employees, had collective assets of over $2.5 trillion for 13.5 million active members and 6.6 million annuitants who are covered by state pension plans. Finally, deferred compensation in the form of retirement benefits is a sizable portion of most workers' total lifetime earnings. In the case of school administrators, for example, their pension benefits can easily add up to millions of dollars during retirement and perhaps exceed the salary that they earned during their career.

Accordingly, the pension plans available in each state are likely to be important to educators and have the potential to affect the state where they choose to work. To illustrate, the results from a 2003 survey of superintendents in Colorado revealed that making pension benefits more portable would be an effective strategy to improve retention in the field (Colorado Association of School Executives 2003). The design of defined benefit plans may, however, have some unintended consequences for states. Costrell and Podgursky (2009) argued that if a state's defined benefit plan is too generous, it may actually encourage educators to retire early. Because defined benefit plans reward employees based in part on years of service, such plans have also been blamed for discouraging new and mid-career entrants to the teaching profession (Sawchuk 2009). Concerns have also been raised about whether states will be able to meet the large financial obligations to educators in their pension plans (Diamond 2010; Novy-Marx and Rauh, 2009; Rauh 2010). Despite the potential importance of retirement benefits on the employment and retirement decisions of educators, very little is known about how these programs work, how the retirement benefits compare across states, and whether they influence the labor market decisions of educators.

The fact that defined benefit plans are very complex makes it challenging for educators to accurately determine their likely pension benefits in a given state. Even though all defined benefit plans rely on the same basic formula for calculating annual pensions—final average salary times formula multiplier times years of service—no two state defined benefit plans are exactly alike. An educator's gross pension benefits can be affected by a range of factors including the parameters used to calculate a person's first-year pension, whether any caps are placed on the pension, the provisions used for adjusting future pension benefits for cost-of-living increases, and whether the educator can also receive Social Security benefits. Educators also need to take into account the direct costs that they will incur for participating in the state's pension plan. These costs can vary from 0% to more than 10% of a person's salary in some states. Similarly, states have different rules for whether pension benefits are subject to state income taxes.

Taken together, educators are likely to have a very difficult time using information on all of these aspects of defined benefit plans to accurately inform [End Page 26] their labor market decisions. Decisions across states can prove even more challenging as employees must balance multiple system rules. For example, would it be more lucrative to work in a state with a high formula multiplier even if that state placed a cap on the annual payout? Could a state with a higher annual payout than another turn out to have a lower net return after subtracting the employee's contributions for participating in the plan? Typical educators have little recourse in answering these complex questions that bear directly on their compensation.

This study seeks to address this aspect of educator compensation by analyzing the differences among state-run defined benefit plans and how they can affect the net pension benefits for educators. The first part reviews the empirical and theoretical literature on retirement benefits and their effects on the labor market decisions of educators. The second section describes how to calculate the net benefits from state-run defined benefit plans, and how the components of these plans can affect an educator's retirement compensation. Next, data are used on the defined benefit plans for educators in 49 states to simulate the net retirement compensation for educators and demonstrate how the net benefits vary across states. Finally, this article concludes with some suggested implications of changes in pension systems for educators and directions for future research.

Literature Review

Even though the use of defined benefit plans for public employees is extensive, with more than $140 billion being distributed annually to beneficiaries (National Council on Teacher Retirement 2007), there have been relatively few studies of these plans and their effects on public school employees. Most analyses of these pension systems stem from reports produced for legislative research commissions and typically address all public retirement systems—not just those for educators (Ford 2005, 2007; Indiana Legislative Services Agency 2006; Graycarek, Hurst and Kennedy 2008; Schmidt 2010). In addition, the National Association of State Retirement Administrators and the National Council on Teacher Retirement produce an annual national survey, report, and scorecard of state pension plans (Public Fund Survey 2010).

Although these reports provide useful descriptions of the main components of these pension plans, they do not attempt to estimate the net benefits from these plans or compare states in terms of the net benefits. The few studies that do focus on educational retirement systems examine teachers and not other school employees such as administrators, but even within the teaching profession, there is a lack of research about the way in which retirement benefit systems work and their effects on the education labor market. [End Page 27]

There have been several studies conducted in non-education labor markets that have shown that the value of pension benefits has a strong influence on employees' decisions about when to retire (Burkhauser 1979; Fields and Mitchell 1984; Hogarth 1988; Kahn 1988; Kotlikoff and Wise 1985; Lumsdaine, Stock, and Wise 1990; Pozzebon and Mitchell 1989; Samwick 1998). The results suggest that workers do incorporate the financial benefits from pensions into their long-range planning and decision making. Furgeson, Strauss, and Vogt (2006) argue that the structure of defined benefit plans could have mixed effects on the retirement decisions of workers. This would arise because a state with a generous defined benefit plan may, on the one hand, provide an incentive for educators to work in the state, but on the other hand may lead them to retire early if the benefits are overly generous.

As noted in the introduction, the literature on the effects of defined benefit plans on the labor market decisions of educators is surprisingly thin, given the amount of funding that is allocated for this purpose and the potential importance of the topic for retirement and employment decisions of educators. Those studies that do investigate the effects of selected factors on the decisions of P-12 teachers to enter or leave the profession typically do not consider retirement benefits (Bradley and Loadman 2005; Elfers, Plecki, and Knapp 2006; Elfers, Plecki, and McGowen 2007; Hanushek, Kain, and Rivkin 2004; Ingersoll 2001, 2003; Kelly 2004; Luekens, Lyter, and Fox 2004; Murnane 1984; Murnane, Singer, and Willett 1988; Shen 1997; Stinebrickner 1998, 2002; Theobald 1990). The dependent variable in these studies usually represents whether a teacher has departed the school/district/state/profession, and independent variables often include the teacher's salary and experience level, characteristics of the students, and characteristics of the school and community—but not pension benefits. Hanushek, Kain, and Rivkin (2004) and Strauss (1993), for example, studied how selected factors such as salary—but not pension benefits—affected the retirement decisions of teachers.

The most complete analysis of teacher pension benefits was conducted by Furgeson, Strauss, and Vogt (2006), who studied the effects of pension benefits on the decisions of Pennsylvania teachers to retire. In addition to using control variables for years of experience, age, salary, and demographic characteristics of teachers, the models included the present value of current pension benefits and the present value of the best future pension benefits to help explain why teachers retired. They found that teachers are more likely to retire as the current value of pensions increase, and some evidence that teachers who have the promise of higher future pensions are less likely to retire in the current time period. They also found that teachers were more likely to retire when they satisfied the minimum eligibility requirements for full benefits. This finding was echoed by [End Page 28] Costrell and Podgursky (2009), who noted the perverse incentive structures within pension systems that may actually discourage mid-career teachers from entering the profession and encourage current teachers to leave the profession earlier. They recommended that policymakers explore cash balance or defined contribution plans, in opposition to most states' defined benefit plans, to more closely resemble the incentives in the private sector. The pressure on states to move towards defined contribution pension plans has been heightened in recent years because defined benefit plans impose significant risks on states to ensure that they can fund all beneficiaries through their retirement years. Rauh (2010) argued that "many state systems will run out of money in 10-20 years if some attempt is not made to improve the funding of liabilities that have already been accrued" (p.1). Likewise, Diamond (2010) reported that the recent financial crisis has led at least 24 pension funds to reduce their benefits in the past year. Given these concerns, it is even more important for education policymakers to examine the costs and benefits associated with state educator pension plans.

Data and Methodology

Retirement programs are typically structured as either a defined contribution plan or a defined benefit plan—or a combination of the two. In a defined contribution plan, the employee and employer each invest defined dollar amounts in specific financial assets, and the resulting value of a person's retirement benefits depends on the future value on these assets. In contrast, defined benefit plans specify the retirement benefits for an individual using a formula based on their years of service and lifetime earnings. Whereas the risk in the defined contribution plan is on the individual to save enough money for retirement, the risk in the defined benefit plan is on the state to guarantee that it can make the promised payments to an educator for every year in which they are likely to draw benefits. In 2010, every state except Alaska used a defined benefit plan for public educators in the P-12 sector—Alaska replaced its defined benefit plan with a defined contribution plan in 2006.

For this study, data were collected on a representative state-run pension plan in each of the 49 states with defined pension plans for educators in 2008. Only statewide pension programs that cover public school educators were used here. Accordingly, some municipal-specific pension plans for educators—such as those in New York City and St. Louis—were excluded from the analysis. The Public Fund Survey was the source of information on the employee contribution rate, whether Social Security benefits were retained by employees, the formula multipliers, and the provisions for annual increases in pension benefits. As noted by the Public Fund (2010): [End Page 29]

"The Public Fund Survey is an online compendium of key characteristics of 102 public retirement systems that administer pension and other benefits for 12.8 million active public employees and 5.9 million retirees and other annuitants, and that hold more than $2.1 trillion in trust for these participants. The membership and assets of systems included in the survey represent more than 85% of the nation's total public retirement system community. The survey is sponsored by the National Association of State Retirement Administrators and the National Council on Teacher Retirement."

The Schmidt (2010) study was used to obtain additional information on these plans as to whether benefits were subject to state taxation, whether caps were placed on the annual payout in year N, and the number of years used to compute the final average salary. While these pension systems are subject to constant legislative and regulatory change, this combined dataset represents a snapshot of the majority defined benefit pension systems in effect in 2008 for states.

Table 1 provides an overview of key aspects of the defined benefit retirement plans for educators in each of the 49 states with such plans in 2008. The first data column shows the contribution rate required for educators to participate in the state's pension plan. The formula multipliers used by states for each year of service credit are contained in the second column. An indicator for whether educators would also receive Social Security benefits is shown in the next column. The fourth column reports the number of years that states used to compute each educator's final average salary. In the fifth column, information is provided as to whether the state placed a cap on the first-year pension for educators, and if so, the type of cap that was imposed. Finally, the last two columns show whether and how educator pension benefits were subject to state taxation.

The results show that there were wide variations across the states in terms of the key parameters used in their pension plans for educators. Several states—Florida, Indiana, Nevada, Oregon, Utah, Virginia—did not require educators to contribute any of their salary to participate in the state's pension plan. At the other extreme, states such as Massachusetts, Missouri, and Ohio stipulated that educators had to forego 10% or more of their salary each year in order to take part in the pension plan. The formula multipliers varied from a low of 1.1% per year (Indiana) to a high of 2.55% per year (Missouri). In general, states that used higher formula multipliers also did not permit employees to receive Social Security benefits. The majority of state pension plans based an educator's final average salary on the average from their three highest years of earnings, while 11 states used the person's last five years of employment for this calculation. Although the majority of states did not place caps on the first-year pension of educators, 22 of the 49 states restricted an educator's first-year pension to be [End Page 30]

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Table 1.

Overview of Parameters in State Pension Plans for Educators

[End Page 31]

at most a fraction of their final average salary. The most restrictive first-year pension cap was found in Vermont, where an educator's first-year pension could not exceed 50% of their final average salary. Finally, it can be seen that the majority of states taxed pension benefits, and that the tax rates varied both across states and within states due to the progressive nature of state income taxes.

Under a defined benefit retirement program, the educator is typically guaranteed a specific annual payout for each year during retirement. The payout is set according to a formula established by the state. The lifetime retirement benefits for an educator will depend on the size of the payouts, the length of time in retirement, and any adjustments that are made for inflation. In some states, an educator may receive a pension from Social Security, and according to Schmidt (2010), Indiana provides educators with an additional money purchase annuity for retirement. There are also costs that the educator may incur for participating in the pension plan, and some of the future pension benefits may be reduced due to state income taxes. Accordingly, as depicted in Figure 1, the net benefits represent the gross benefits from the state pension and Social Security (and possibly an annuity), minus the costs of participating in the plan and the benefit reduction due to taxes.

More precisely, suppose that an educator is hired in year t=1, retires in year t=N, and expects to receive retirement benefits for T years (t=N+1 to t=N+T). The net retirement benefits in current (non-inflation adjusted) dollars (NB) can be represented as follows:

Where:

NB = net lifetime retirement benefits

P_t = state pension in year t

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Figure 1.

Depiction of Benefits and Costs from State Pension Plans

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tx = state taxes paid on pension income

r₁ = annual cost-of-living adjustment to state pension

SSB_t = Social Security pension in year t

r₂ = annual growth in Social Security benefits

C_t = cost of participating in the state pension plan in year t

SSC_t = cost of contributing to Social Security each year

A = value of lump-sum retirement benefits from state-operated annuities at retirement date t=N

r₃ = annual rate of growth in the annuity during retirement

The formula shows that the net pension benefits are defined as the annual payouts from the state's pension plan for the T years in retirement, plus any pension benefits from Social Security and state-run annuities, minus the costs that the educator had to pay to take part in the state's pension plan and Social Security for the N years of employment and lost income due to state income taxes. As described in the previous section, all of these factors can vary across states, making it very difficult to determine the net benefit from a state's pension plan.

Because the costs and benefits are incurred at different time periods, adjustments for inflation are needed for calculating net benefits at the time that the educator is first hired. This issue is particularly relevant for properly assessing the net benefits from pension plans because the purchasing power of the future benefits may appear to be extremely large due to the fact that they will not be received for many years after first being hired. To make a more accurate comparison of costs and benefits, it is therefore necessary to calculate the net benefits in constant (inflation-adjusted) dollars (denoted NB*) by dividing each quantity by the estimated price level in current dollars:

where i = annual rate of inflation. Most of the attention in defined benefit plans is given to the parameters used by the state to calculate the annual pension benefits (P_t ). This calculation begins by multiplying the educator's final average salary by the formula multiplier and the years of service credit to find their unadjusted annual payout. The formula is typically expressed in this fashion:

Where:

Y_N = unadjusted annual payout in the first year of retirement

FAS = final average salary [End Page 33]

FM = formula multiplier

YOS = years of service

Although the defined benefit plans in all states use this general framework to determine an educator's annual pension, the plans can vary considerably in the details of how each component is calculated. These variations can then lead to substantial differences in the pensions received by school administrators after they retire.

The final average salary represents the average salary for an educator over a specific number of years. Typically, the final average salary is calculated based on a given number of final years of employment or years with the highest salary. Schmidt (2010) showed that the number of years used in the calculation varies from three to five, with the majority of state pension plans (63%) using three years in the final average salary calculation. In general, as the number of years in the calculation increases, the final average salary will decrease because one or more years with lower salaries are being averaged into the final figure. However, as will be shown in the simulations in this article, the effects of using different numbers of years to calculate an educator's final average salary on their pension benefits are fairly minor.

The formula multiplier is the second part of the defined benefit calculation. The formula multiplier is the percentage of an educator's final average salary for each year of service that they would receive in the form of an annual pension from the state. For example, a multiplier of 2% means that for each year of service credit, an educator would receive a defined benefit in retirement of 2% of their final average salary. Across the nation, the formula multipliers varied between 1.1% and 2.55% per year of service credit, with every state except for Indiana and Maryland using a multiplier of at least 1.5%. Equation (3) shows that as the formula multiplier increases, so will the unadjusted pension benefit.

Finally, the third part of the state pension formula is the years of service credit for each person. The calculation of years of service credit is perhaps the most complicated portion of the defined benefit formula because of the many restrictions and options for educators with regard to determining their years of service credit. The years of service credit represent the length of time that an individual has been employed in education in some capacity. States even vary in terms of the specific definitions of a year of service credit.

Many states, however, place limitations on the annual pension benefit for educators. Some states specify that the annual pension cannot exceed a specific percentage of the person's final average salary, or in the case of Georgia the state caps the number of years of service credit that can be used for calculating pension benefits. In this study, it was found that almost half of the state pension plans reviewed imposed some form of restriction on the annual pension benefits that [End Page 34] an educator can receive. Therefore, the adjusted pension received by an educator in their first year of retirement (PN) would be written as:

where Cap% = maximum percentage of a person's final average salary that can be received in the first year of retirement.

The state pension plans for educators also vary in terms of whether and how they provide increases to the pension to reflect cost-of-living increases over time. Those state programs with higher cost-of-living adjustments would be more beneficial to educators than other programs with lower cost-of-living adjustments. Schmidt's (2010) review of state pension plans revealed that almost three-quarters of the plans provided for automatic adjustments for the cost-of-living each year based on either the Consumer Price Index (CPI) or fixed-percentage increases. Most of the remaining pension plans relied on the state legislature to determine the cost-of-living adjustments each year, and yet other state plans made no provisions for cost-of-living adjustments.

One important aspect that can be overlooked when comparing pension plans across states is that states vary in whether they allow educators to receive Social Security benefits along with their state pension. It is usually the case that states with higher formula multipliers do not allow educators to receive Social Security benefits, although there are exceptions such as Pennsylvania and New Mexico. In states where educators cannot receive Social Security benefits, they also do not have to contribute 7.65% of their annual salary to the Social Security pension plan. Both the benefits and costs of Social Security need to be taken into account when making comparisons across states in the attractiveness of their defined pension plans.

States may also offer supplementary retirement benefits in the form of annuities. For example, Indiana provides educators with an additional benefit in the form of an annuity savings plan where 3% of a person's annual salary is contributed by the school district to the annuity. Also, some school districts in Texas provide school administrators with supplemental retirement benefits in the form of annuities. Annuities such as these should be counted in the lifetime pension benefits provided by a state as long as some of the contributions for the additional retirement benefit were made by someone other than the educator—typically the district or state.

Up to this point, the discussion has centered on the gross pension benefits received by educators. It is important to keep in mind, however, that educators can be made to contribute a portion of their salary in order to take part in the pension plan. Schmidt (2010) noted that only six of the pension plans he reviewed [End Page 35] did not require employees to make contributions to their pension plans, and employees in roughly half of the plans had to contribute more than 5% of their salary each year in order to participate. Schmidt (2010) further observed that in some states, the employee contribution is paid by the school district. In general, as the participant contributions to the pension plan increase, the net annual pension benefit—gross benefit minus contribution—will fall.

States also differ on whether the annual pension benefits for educators are subject to state income taxation. In 30 of the 49 state plans examined here, pension benefits were subject to state taxation. In addition, the effective tax rates applied to pension benefits vary by income levels within states, and states may exempt certain amounts of pension income from taxes. The pension benefits received from Social Security may also be subject to taxation at the state level. Schmidt's (2010) review showed that in about one-third of the pension plans that he reviewed, pension benefits were exempt from state income taxes.

Simulations of Net Pension Benefits

The approach used for comparing the state pension plans was to simulate the net benefits that an educator would expect to receive from each state—given a set of assumptions. All of the simulations began with salary data for a hypothetical educator who worked in each state as a teacher from age 22 to 65. It was assumed that the teacher started at a salary of $30,000 per year and expected to receive salary increases of 3% per year throughout their career. Accordingly, the educator would expect to earn a total of $2.67 million—$1.32 million in constant dollars—in salary during their career. Other key assumptions that were used in the simulations are shown in Table 2.

Table 3 provides comparisons of the first-year pensions (year 45 in the simulation) for the hypothetical educator across the 49 state pension plans.

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Table 2.

Assumptions Used in Simulations of Pension Benefits

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Table 3.

Simulated First-Year Pensions for Educators by State

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The first column contains the final average salaries in each state, which were calculated by finding the weighted average of the salaries for the educator in the last years of employment. The unadjusted first-year pensions (second column) were obtained by multiplying the final average salary by the formula multiplier and the number of years of employment (YOS = 44). The next column shows the adjusted first-year pensions that would be received by an educator in each state after taking into account caps that were placed on pensions. The fifth column contains the estimated Social Security pension in the first year of retirement for the educator under each state's pension plan. The sums of the state and Social Security pensions are shown in the next to last column. Finally, the last column contains the ranking of each state in their total pension (1=highest, 49=lowest) based on the set of assumptions used in this simulation. It should be noted that all dollar figures in Table 3 are in current dollars and have not been adjusted for inflation, and that changes in the assumptions used may impact the rankings of state pension plans.

The results show that the variations in final average salaries across states due to the different number of years used in their computation were fairly minor. The unadjusted and adjusted pensions in the first year of retirement, however, did vary significantly across the 49 state pension plans. A comparison of the values in columns 2 and 3 show that some states, that imposed caps on the first-year pensions, had substantial reductions in the first-year pensions for educators. For example, an educator in Massachusetts would appear to have a substantial first-year pension of nearly $156,000 based on the final average salary, years of service, and the high formula multiplier. However, because Massachusetts restricts the first-year pension to be at most 80% of a person's final average salary, the educator's first-year pension would be only $83,000. Other states in which educators would experience large declines in first-year pensions due to caps include Nevada ($36,000), Vermont ($25,000), Illinois ($23,000), Rhode Island ($18,000), and Missouri ($13,000). After making adjustments for the caps on pensions, the first-year state pensions varied from a high of $114,000 (Pennsylvania) to a low of $48,000 (Indiana). Prior to comparing states, it was also necessary to add in an educator's pension benefits from Social Security to the state pension in those states where educators receive Social Security pensions. Doing so raised the total educator pensions in states with low multipliers such as Indiana, Maryland, and Michigan. The final two columns show that the total first-year pensions for educators—state pension plus Social Security—ranged from a high of $150,000 in Pennsylvania to a low of $76,000 in Illinois, with a median combined pension of $113,000.

Table 4 contains descriptive statistics on the estimated gross and net pension benefits for the hypothetical educator in the 49-state defined benefit plans. Net [End Page 38]

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Table 4.

Effects of Years in Retirement on Gross and Net Pension Benefits

benefits represent the gross pension benefits from the state and Social Security, minus personal contributions to the pension plans and state income taxes on pensions, as shown in Equation 2. In this simulation, the number of years in retirement was varied to demonstrate how the length of time that an educator spends in retirement will affect their gross and net benefits from the defined benefit plan. Unlike Alaska's defined contribution plan, where the bulk of the retirement benefits are accessible to the person beginning in the first year of retirement, the benefits from defined benefit plans vary directly with the length of retirement. Table 4 shows the mean, maximum, and minimum gross and net pensions that educators were projected to receive in these plans assuming that the person's retirement duration was either 5, 10, 15, 20, or 25 years. The statistics are also reported as percentages of the educator's expected lifetime earnings to illustrate the size of pension benefits for the educator relative to earnings. In Table 4 and all subsequent tables, the dollar figures are expressed in constant (inflation-adjusted) dollars in order to facilitate comparisons between costs and revenues that are paid and received at different points in time. For example, while contributions to pension plans and salaries were earned for years 1-44 in [End Page 39] the simulation, the pension benefits were received in years 45-69. Accordingly, as noted earlier, adjusting all figures for inflation allows for a more accurate comparison of costs and benefits.

The results of the simulation show that the average gross benefits for the educator in this simulation was $30,000 per year in constant dollars, and increased by about $150,000 for every five additional years in retirement. In terms of net benefits, however, an educator who spent only five years in retirement would find in this simulation that on average the costs of the pension plan only slightly outweighed the benefits that they received. The projected net benefits increased along with time in retirement by slightly more than $140,000 for each five-year increment. As a percentage of salary, the net pension benefits rose dramatically along with length of time in retirement.

Table 5 contains simulations of the effects of changes in the assumed salary growth rate on gross and net pension benefits. It shows the gross and net pensions (in constant dollars) that the hypothetical educator would receive if their salary increased by 2.0% per year up to 4.0% per year—increasing at 0.5% per year increments. In all simulations, it was assumed that the educator spent 25 years in retirement. The results show that even modest changes in an educator's salary growth during their career had substantial impacts on their gross and net pension benefits. For example, the mean net pension benefit for the educator in

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Table 5.

Effects of Salary Growth Rate on Gross and Net Pension Benefits

[End Page 40]

this simulation increased by $390,000 if salaries grew by 4% per year rather than 2% per year.

Table 6 provides a state-by-state comparison of the expected gross benefits that the hypothetical educator would be expected to receive in each plan. The gross benefits were calculated for three time horizons: 10, 15, and 25 years in retirement. The gross benefits shown in Table 6 do not take into account personal contributions to participate in the state pension plan or Social Security, or income taxes that would have to be paid to each state on pension benefits.

In these simulations, the projected gross benefits varied widely across the 49 states. The states with the most generous gross benefits were Pennsylvania, New Mexico, Wyoming, Mississippi, and Arizona. Most of these states were characterized by having relatively high formula multipliers, educators retained Social Security benefits, and there were no caps on first-year pensions. The pension for an educator in Pennsylvania represented 31% of the person's lifetime earnings if they were in retirement for 10 years, and increased to nearly 78% if the person spent 25 years in retirement. At the other extreme, the gross pensions in Connecticut, Illinois, Nevada, Massachusetts, and Vermont ranked among the five lowest in the nation. These states tended to impose caps on first-year pension benefits, had below-average formula multipliers, and did not permit educators to retain Social Security benefits. Even in the lowest-ranked state (Connecticut), however, the projected pension benefits were still sizable, representing 16-38% of the hypothetical educator's lifetime earnings in inflation-adjusted dollars.

With the exception of Indiana, the rankings of states were not greatly affected by the number of years spent by an educator in retirement. What made Indiana different from other states according to Schmidt (2010) is that in addition to their regular state pension, educators in Indiana also received an annuity in retirement which operates much like a defined contribution plan. In the annuity, 3% of an educator's salary each year—paid by the educator's school district—was placed into an account. Assuming that the annuity funds grew by 6% per year, the annuity for this hypothetical educator at the time of their retirement was projected to be $78,000 in constant dollars. This quantity, along with expected future interest on the annuity, accounted for about 30% of the total pension benefits for the educator who receives pension benefits for 10 years. The percentage share of total retirement benefits due to the annuity fell as the length in retirement increased, however, because the growth of this revenue stream in retirement would be similar to revenue from a defined contribution plan and thus be smaller than the additional revenue that an educator received from a defined benefit plan. For this reason, Indiana's pension plan ranking among state pension plans falls as the educator's time spent in retirement increases. [End Page 41]

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Table 6.

Gross Retirement Benefits by Years in Retirement and State

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It is important to note that the cost of participating in educator pension plans also varied by state, as shown in Table 7. The first column reports the salary that an educator would have to forego in order to take part in their state's pension plan (and Social Security). The third column estimates the state income taxes that the educator would have to pay on their combined pension benefits assuming that the person received benefits for 25 years. For simplicity, it was assumed here that the state's taxation rules apply equally to pension and Social Security benefits. State taxes on pension benefits were estimated by subtracting the exempt income level from the predicted total pension, and then multiplying the remainder by the appropriate state income tax rate. All figures are shown in inflation-adjusted dollars.

Among the most favorable states in terms of both low contributions to pension plans and low state income taxes were Nevada, Florida, Texas, and Louisiana. In these states, the inflation-adjusted personal contributions to pensions amount to $100,000 or less. Other states such as Arizona, Idaho, Montana, Nebraska, and New Mexico, had both relatively high-projected pension contributions and income taxes. In these states, the inflation-adjusted costs amounted to $250,000 or more in constant dollars. In between these extremes were states that either had a low tax burden but a medium to high contribution rate, or a low contribution rate but a higher state tax burden. Taken together, the projections show that the costs associated with defined benefit pension plans do not outweigh the benefits, but can still take up a substantial portion of the gross benefits that an educator would expect to receive during retirement.

Table 8 shows the state-by-state comparisons of the gross and net benefits for the hypothetical educator who receives pension benefits for 25 years in each state. The last two columns in Table 8 show the net benefits—defined as gross benefits minus contributions and taxes—all in inflation-adjusted dollars. The rankings reveal that the states with the most generous net pension benefits, based on the assumptions used in simulations in this study, were Pennsylvania, Wyoming, Utah, Mississippi, and New York. The net benefits in these states in constant dollars ranged from $825,000 to $717,000. In contrast, the bottom five states in terms of net benefits were Kentucky, Massachusetts, Illinois, Connecticut, and Vermont, with benefit levels ranging from $449,000 to $381,000. Although these rankings provide an easy basis for comparison across states, it is important to remember that this is only a simulation of costs/benefits for a hypothetical educator, and that the actual benefits of the retirement systems may vary greatly for actual educators with differing career paths. In addition, it should also be kept in mind that retirement benefits are only one consideration in total compensation and that other factors, such as proximity to family, may weigh just as heavily in educator decisions on the costs and benefits of alternative employment locations. [End Page 43]

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Table 7.

Gross Contributions and State Taxes on Pension Benefits by State

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Table 8.

Gross and Net Pension Benefits by State

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Conclusions and Implications

The manner in which educators are compensated for their work is very important for states, policymakers, school leaders, and academics to understand when designing, entering, or educating people about pension plans. This form of compensation for educators is more than a billion dollar enterprise that place significant burdens on state budgets, yet little attention is paid in scholarly circles to these systems for educators. This study shows that there are many different ways in which states structure their pension plans. There is also a complex interaction of these elements in the payout of the retirement benefits, as seen in the simulations presented in this article. The complexity of these plans makes it very difficult for educators to compare states and draw conclusions as to which state provides the highest level of expected retirement benefits.

This study has shown that the pension benefits for educators can be a sizable portion of their total compensation. Due to the structure of defined benefit plans, the return on such plans increases steadily along with the person's time in retirement. As a result, defined benefit plans are more lucrative for those who spend more years in retirement. For the educator used in this simulation, who might be characterized as a new teacher who stays in the profession throughout their career, the person would have to spend more than five years in retirement in many of these states to fully recoup the costs of participating in the pension plan. However, for those educators who anticipate living into their 90s, the cumulative net benefits from the pension plan can approach and possibly exceed their earnings during their time in the classroom.

The results of this study demonstrate that the defined benefit plans can vary significantly across states in terms of both the benefits and costs. The net retirement benefits in some states are more than twice as large as in several other states. In general, the states with the more lucrative pension plans are those with higher formula multipliers, no (or minimal) caps on first-year pensions, and below-average contributions to participate in the pension, and they allow educators to receive additional benefits from Social Security. The study also demonstrates that it is important for educators to consider more than the formula multiplier when comparing the pension plans across states. In fact, two of the top ten states in terms of net benefits have formula multipliers of only 2.0%. At the other extreme, three of the lowest-ranked states in terms of net pension benefits (Illinois, Kentucky, and Massachusetts) all had formula multipliers that exceeded 2.0%, and thus may be viewed by some educators as having relatively generous plans. Clearly, educators need to look beyond the formula multiplier when making comparisons of the relative pension benefits in each state.

There are a number of limitations to the study that should be acknowledged. [End Page 46] First, states may offer other financial advantages to educators beyond what are shown in their official pension plan. Gammill (2007), for example, documented how the salaries for some superintendents in Indiana are increased by the equivalent of certain fringe benefits in lieu of receiving additional retirement benefits. Salaries can vary across states and thus a state with more generous salaries would have higher net pension benefits than shown here. Of course, such an analysis would also have to factor in differences in the cost-of-living across states. The taxes faced by individual educators can also differ considerably from the simulated values here depending on the person's marital and family status, other income earned, and deductions that can change the tax burden. The relative attractiveness of a state's pension plan might vary with the person's income due to the progressive nature of state income taxes and caps on first-year pensions. Finally, the pension benefits in states where legislative approval is required each year for cost-of-living benefit increases may be lower than shown in these simulations—if political pressure leads states to reduce or eliminate these adjustments in bad financial times (Diamond, 2010). To illustrate, the average cost-of-living benefit increases enacted between 2006 and 2010 by nine of the states that require legislative approval were all lower than the average increase in the CPI for the same period of time. ¹

Given the complexity involved in comparing pension plans across states, an open (and important) question is what factors do educators consider to be the most important? It is likely the case that educators pay the most attention to the formula multipliers when comparing states and give less attention to factors such as the caps on pensions, costs of participating in the pension, state income tax rules and rates, and the mechanisms for increasing annual pensions during retirement. This article has shown that all of these less-recognizable factors can add or subtract hundreds of thousands of dollars from a person's cumulative pension benefits and thus should be considered when making employment decisions.

States can also use the results from this study to evaluate their own educator pension plans. Because the labor market for teachers tends to be more regional than national in scope, state policymakers might be particularly interested in how their state's pension plan compares to those in neighboring states. Policymakers have to keep in mind how changes in their pension plans might affect the cost to the state of providing benefits to educators. Raising the benefits in pension plans would certainly be helpful to recipients, but would put added strain on state coffers and increase the risk of states having to take drastic measures to fulfill their future obligations.

Finally, there are a number of additional topics worthy of research relating to the defined benefit plans for educators. One such topic would be to examine the [End Page 47] effects of defined benefit pension plans on the mobility of educators across state lines. Because these plans reward educators for years of service within a given state, those who move from one state to another at some point in their careers would stand to lose pension benefits—unless they could transfer years of service credit from one state to another. An educator who is considering to move from one state to another would also have to take into account the respective states' vesting requirements to receive pension benefits. In Georgia, for example, 10 years of in-state service is required for the educator to receive a pension.

Another potential area for future research is to compare the defined benefit plans reviewed here with defined contribution plans for educators, where the future payoff to employees is more uncertain but potentially greater. In what situations would a defined benefit plan be more lucrative than a defined contribution plan for educators? Do these plans have differing impacts on the mobility of educators? Defined contribution plans are likely to become more appealing to states as a way of shifting the risk for funding educator retirements from the state to individuals. It is well known that the financial viability of entitlement programs such as Social Security is certain to be negatively affected by demographic trends as the number of retirees drawing benefits begin to exceed the number of employees paying into the program (Gokhale and Smetters 2005; Ohlemacher 2010). A similar problem is confronting states with regard to how to fund their educator pension plans (Diamond 2010; Rauh 2009). As scholars and policymakers move to bring public employee retirement systems more in line with entitlement programs used in the private sector (Costrell and Podgursky 2009), more states may view annuities as a way of gradually moving towards defined contribution plans, or they may simply replace defined benefit plans with defined contribution plans. This research needs to focus on the impact of this change over time as the simulations in this study showed that the net pension in the one state with a defined contribution component to its pension (Indiana) did not keep pace with the net pensions in other states as our hypothetical educator aged.

As pressure continues to mount on states to find ways to improve the performance of their schools, educator compensation in all of its forms will be an important policy consideration to help achieve this goal. The results shown here highlight the fact that there are sizable variations in retirement benefits for educators across the nation, and that little attention has been given to measuring these differences and determining what impact they may have on the labor market choices of educators and ultimately on the performance of schools. State policymakers need to pay closer attention to this mechanism for supporting P-12 public education and encourage research that will lead to the design of more effective pension plans for educators. [End Page 48]