Saturday, January 14, 2012

Connecticut's Public Pensions

                                             A Tale of Two Pensions

The Connecticut State Teachers Retirement plan is one of the best in the country although neither the average teacher nor the general public seems to understand just how good it is. I’d like to compare its benefits to those provided by Social Security.  To do so, let’s compare twin brothers (we’ll call them Jeff and John) who entered the work force 35 years ago right after graduating from college at age 21.

Jeff became a teacher in a local public school and immediately was required to contribute 6% of his pay into the State Teachers retirement plan. It’s actually 7% but only 6% goes toward retirement. John went into the private sector and was required to contribute a little over 6% of his pay into the Social Security system and his employer was required to equal his contribution. If John had become self-employed, he would have had to pay the full amount.

Thirty-five years later Jeff is able to retire at age 56 on a full pension of 70% of his final average pay. He will get 2% of his pay for each year of teaching service. Normally, he would have to be age 60 to collect the normal or full pension but 35 years also qualifies for an unreduced pension. It is important to note that final average pay is based on his highest three years of salary. For example, if Jeff’s salary averaged $90000/year in his last three years of teaching, his pension would be  70% of the $90000, or $63000/ year for life.

Of course, brother John will not be able to collect his full Social Security benefit until age 66, ten years after Jeff retires. If we assume that John always made the maximum contribution to Social Security, at age 66 he will be able to get a little over $20000/year for his retirement income. The main reason for this disparity has to do with the benefit formula. The final average pay for Social Security calculations is based on the highest 30 years of service. It is easy enough to see that even though the two brothers had the same income every year, using the average of the highest three years pay will yield a much greater pension than a 30 year average.

Moreover, by the time John is able to retire Jeff’s pension will have grown to over $80000/ year due to cost of living increases which have been running between 2% to 3% per year.  To summarize, although he has worked 10 years less than his non-teaching brother, Jeff’s pension income will be about 4 times greater than John’s at age 66.

What is Jeff’s pension worth? To keep it simple just consider how much principal would be required to produce interest income of $80000/ year. At an interest rate of 4% it would take $2,000,000 dollars! This simple method is not exactly the way that the State’s actuaries actually figure out how much money the State has to come up with when a teacher retires but it gives us a good idea of the value of these pension benefits.

Speaking of actuaries, the State Teachers’ Retirement Plan is a “terminally funded” plan which means that when a teacher retires, the actuaries have to calculate the value of what the teacher will receive over his lifetime and add that amount to the “fixed” or “untouchable” portion of the State’s budget costs.  Interestingly, in a declining interest rate environment such as we have experienced in the past few years, the actuaries require the State to allocate even more money to fund retirement benefits. For example, at a 2% interest rate the State would be required to contribute $4 million dollars to fund Jeff’s $80,000 pension.

Denise Nappier, Treasurer
It was these declining interest rates that led the State Treasurer to conclude a few years ago that the Pension fund, despite record high returns, was underfunded and that significant bonding was required to make up the deficiency. According to the State Treasurer, Denise Nappier, if the State paid interest on these bonds at 4% and invested the proceeds at a higher rate, all would be well. Given what has happened to the economy since then, I wonder if her rosy prediction has come true.

Nevertheless, the State felt a need to reinforce the generous pension benefits of Jeff and the State’s 75000 teachers. But what about John? His taxes go to pay for his brother’s pension, but Jeff and all the other teachers in Connecticut do not pay into Social Security, the source of John’s retirement income. Because the State’s Pension existed before Social Security, the teachers in Connecticut do not participate in the Social Security system.

To summarize, Jeff can retire at age 56 with a retirement income of $67000 per year as well as future cost of living increases. Brother John can only retire 10 years later on approximately $20000 per year.

How did such a disparity come about? Basically, the Connecticut State Teacher’s Retirement plan’s benefit formula was designed to protect teachers, who were typically underpaid, from being destitute in old age. Until the last decade or so teacher salaries were too low to allow them to save for retirement on their own. However, a few years ago when the State decided to substantially increase teacher pay, it neglected to make an adjustment in the benefit formula. It made a slight modification in the cost of living formula for retirees but that was it. An attempt to change the average pay calculation formula from a 3-year average to a 5-year average failed largely through the efforts of the teacher unions and their friends in the legislature.

I want to make it clear that this call for pension reform does not imply criticism of teachers or their work. They have a very hard job especially today with a tangled web of government regulations, administrative red-tape, and social trends so averse to education. But as I indicated at the outset most teachers have only the faintest idea of how their pension plan works. Despite the evidence most believe that they have a poor plan especially compared to those of municipal police and firefighters, and the extremely generous plan of their colleagues in neighboring New York State whose pension obligations are helping to drive it into bankruptcy.

Given the current problems in both the national and state economies, now would be an appropriate time for the State of Connecticut to revisit the current pension benefits for all state employees, not just teachers. Minor modifications in pension benefit formulas can produce millions in savings and still provide adequate retirement income for state and municipal employees.

For example, basing final average pay on the last 5 or 10 years of service would produce significant savings. Just ask the actuaries. It probably would have eliminated the need for the costly bonding initiative. It would also eliminate a common form of abuse ("spiking") where municipal employees find ways to significantly boost salaries in the last three years of service.

A first step in the reform process should be the removal of elected officials from any future participation in the retirement system. Their current pension benefits should be frozen, and future payments could go into a defined contribution retirement plan. Otherwise, they would have no incentive to modify the existing arrangements. ###

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