This blog post is the second in a two-part series explaining why recent studies claiming that teachers are better off with 401(k)s than pensions because of distributional issues and lower benefits for early leavers are misleading in their representation of the teaching workforce, and in how they compare retirement benefits. Part One highlighted the fact that these studies focus exclusively on new entrants in order to bolster the misleading message that “most teachers” don’t stay long enough to collect a decent pension. In reality, a large majority of teachers working in public schools today can expect to stay long-term, and are thus better off with a pension than a 401(k). It turns out that these studies are also misleading in how they compare 401(k) and pension benefits.
Studies attacking teacher pensions tend to neglect the value of the guaranteed retirement income provided by traditional pensions, compared to 401(k)s which subject retirement income to the whims of the market.
As the old adage goes, “A bird in the hand is worth two in the bush.” Guaranteed monthly retirement income is simply worth more to most people than an uncertain retirement benefit dependent on financial market swings and individual investment decisions. This is especially critical to the 40% of public school teachers who are not in Social Security.
In a pension, key risks–including longevity risk and investment risk–are spread out over a large group of people and over a long time frame, and ultimately backstopped by the employer. Because promised benefits are not payable immediately, but over several decades, public pensions are able to take advantage of long-term investments that yield higher returns.
When investment returns exceed expectations, the employer cost goes down. When the pension fund’s short-term investment returns fall short of the long-term projection, then the employer contributes an extra amount in order to make up the difference. As long as the pension meets its investment goals over the long run, and employer makes contributions in a prudent manner, costs average out over time.
The collective, long term nature of pensions makes them more efficient than 401(k)s. In return for shouldering some risk, public employers are able to provide a given level of pension benefit for roughly 50-70% of the cost of a 401(k).
Studies comparing 401(k)s and pensions essentially pretend that the hypothetical average returns on a 401(k) are the same as the guaranteed returns embedded in a traditional pension–a fantasy, at best.
To be sure, this is a convenient fiction to simplify benefit modeling. But it’s one thing for a study to take advantage of this fiction and still find that pensions are a better deal, as we did in our study of CalSTRS which found that 86% of teachers in California public school classrooms are better off with a pension than a 401(k). We were simply being conservative in our assumptions. A study that asserts that 401(k)s provide greater retirement security for teachers cannot ignore the difference between a guaranteed monthly benefit and a risky self-directed investment account.
Some studies claiming that 401(k)s are better model individual investment accounts using average investment returns, ignoring the risks that teachers face under this type of plan. However, most studies critical of teacher pensions (like those by the Fordham Institute and the Urban Institute) commonly skip this step and focus instead on “crossover points” when pension benefits match and exceed the estimated value of teachers’ pension contributions. These studies calculate the cumulative value of teacher contributions using the plan’s assumed investment return–typically somewhere around 7-7.5%. (The Fordham study tests values at lower discount rates, but only down to 6.5%.) Either method falsely implies that teacher contributions invested in individual 401(k) accounts can be guaranteed to earn the same returns each year as a pension fund expects to average over the long run.
For instance, let’s take a teacher who started at a salary of $40,000 a year, with no salary growth to keep things simple. She contributes 5% of her pay, or $800, to her pension annually. After 10 years, her contributions plus 7.5% compound annual interest (using typical pension fund expected returns) would be valued at approximately $36,000. But if she were to make the same contributions to a 401(k) with the hope of similarly certain results, she would have invested exclusively in safe bonds, earning only 4-5% (optimistically speaking) and ending with $24,000-$27,000 after 10 years.
The above studies disparage the fact that the value of guaranteed pension benefits surpasses the hypothetical value of employee contributions later in a teacher’s career, and the fact that benefits accelerate and max out near retirement age. (This “backloading” is a pension design feature intended to encourage experienced teachers to stay, and to exit when they reach a certain age.) The studies then claim that 401(k) benefits are “always” worth their contributions plus investment returns and thus are better for teachers. But a teacher whose 401(k) drops 30% in value as she’s getting ready to retire draws little comfort from the fact that she got exactly what she put in plus what the market returned. What she cares about is, does she have enough to retire when she planned to, and still live in dignity?
The bottom line: if an individual teacher were to try to replicate guaranteed pension income through a 401(k), they would have to contribute much more, or settle for a much lower standard of living in retirement.
If a teacher simply invests in a typical 401(k) portfolio mix of stocks and bonds, she risks having to live with significantly lower retirement income than she needs. If that teacher wants to insure that she has enough to retire on, she would have to a) invest in relatively safe investments, such as Treasuries and high-grade bonds, that have a lower rate of return than a pension fund portfolio, and/or b) purchase annuities from a life insurance company, which also invests mostly in bonds and also charges fees. Lower investment returns mean lower retirement income, unless the teacher saves more to compensate.
Ultimately, the value of a teacher retirement plan is based on the retirement security that it provides–that is, its ability to allow teachers to plan to retire at an appropriate age and maintain a decent standard of living. For the large majority most classroom teachers, traditional pensions better meet this goal than 401(k)s.