Pension Neutrality: Arizona
Pensions Policy
Analysis of Arizona's policies
Despite legislative changes to Arizona's retirement system, its pension plan is remains based on a benefit formula that is not neutral, meaning that each year of work does not accrue pension wealth in a uniform way until teachers reach conventional retirement age, such as that associated with Social Security. Teachers hired on or after July 1, 2011 will retire under different provisions than teachers hired prior to this date.
Teachers' retirement wealth is determined by their monthly payments and the length of time they expect to receive those payments. Monthly payments are usually calculated as final average salary multiplied by years of service multiplied by a set multiplier (such as 1.5 percent). Higher salary, more years of service or a greater multiplier increases monthly payments and results in greater pension wealth. Earlier retirement eligibility with unreduced benefits also increases pension wealth, because more payments will be received.
To qualify as neutral, a pension formula must utilize a constant benefit multiplier and an eligibility timetable based solely on age, rather than years of service. Basing eligibility for retirement on years of service creates unnecessary and often unfair peaks in pension wealth, while allowing unreduced retirement at a young age creates incentives to retire early. Plans that change their multipliers for various years of service do not value each year of teaching equally. Therefore, plans with a constant multiplier and that base retirement on an age in line with Social Security are likely to create the most uniform accrual of wealth.
Arizona's pension plan does not utilize a constant benefit multiplier. Instead, the plan's multiplier is 2.10 percent for up to 19 years of service, 2.15 percent for 20 to 24 years of service, 2.20 percent for 25 to 29 years of service and 2.30 percent for 30 or more years of service.
In addition, teachers may retire before standard retirement age based on years of service without a reduction in benefits. All teachers with 10 years of service may retire at age 62, while other teachers with less than 10 years of service may not retire until age 65. Arizona dropped its "Rule of 80" provision for teacher hired on or after July 1, 2011. Under this rule, teachers may retire when their age plus years of service equal 80. Therefore, teachers who begin their careers at age 22 can reach the "Rule of 80" with 29 years of service by age 51, entitling them to more than 14 additional years of unreduced retirement benefits beyond what other teachers would receive who may not retire until age 65. Teachers hired on or after July 1, 2011, may retire at age 55 with 30 years of service, at age 60 with 25 years of service, at age 62 with 10 years of service, or age 65 with less than 10 years. Not only are teachers being paid benefits by the state before Social Security's retirement age, but these provisions may also encourage effective teachers to retire early, and they fail to treat equally those teachers who enter the system at a later age and give the same amount of service.
Recommendations for Arizona
Utilize a constant benefit multiplier to calculate retirement benefits for all teachers, regardless of years of service.
Each year of service should accrue equal pension wealth. Arizona should use a pension formula that treats each year of service equally.
End retirement eligibility based on years of service.
Arizona should change its practice of allowing teachers with 10 years of service and teachers whose age and service equal 85 to retire before other teachers. If retirement at an earlier age is offered to some teachers, benefits should be reduced accordingly to compensate for the longer duration they will be awarded.
Align eligibility for retirement with unreduced benefits with Social Security retirement age.
Arizona allows all teachers to retire before conventional retirement age, some as young as 51. As life expectancies continue to increase, teachers may draw out of the system for many more years than they contributed. This is not compatible with a financially sustainable system (see pension sustainability goal).
State response to our analysis
Arizona did not respond to repeated requests to review this analysis.
Updated: December 2017
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Another way that pension benefits are awarded unfairly is through the common policy of setting retirement eligibility at different ages and years of service. For example, in a given state, a teacher with 30 years of service may retire at age 55, while teachers with fewer years of service may not retire until age 62. This means that a teacher who started teaching in this state at age 25 would reach 30 years of service at age 55 and receive seven additional years of full retirement benefits beyond what a teacher that started at age 32 and cannot retire with full benefits until age 62 would receive. A fair system would set a standard retirement age for all participants, without factoring in years of service.
Pension systems affect when teachers decide to retire as they look to maximize their pension wealth. The year teachers reach retirement eligibility by age and/or years of service, their pension wealth peaks; pension wealth then declines for each year they work beyond retirement age.[2] Plans that allow retirement based on years of service create unnecessary peaks, and plans that allow a low retirement age create an incentive to retire earlier in one's career than may be necessary. For every year teachers continue to work beyond their eligibility for unreduced retirement benefits, they lose that year of pension benefits, thus decreasing their overall pension wealth. Although their yearly pension benefits would continue to rise as they earn additional service credit, it would only be at a small percentage per year, which would not make up for the loss of each year of benefits.
To try to balance this incentive to retire, some states have created DROP (Deferred Retirement Option Plan) programs. DROP programs allow participants to place their monthly pension benefits in a private investment account while still teaching and earning a salary, thus retaining those benefits.[3] These teachers are, in effect, earning their pension and salary at the same time, and often at a relatively young age.
A DROP program is a band-aid on the problem; it does not fix what is structurally wrong: retirement at an early age without reduction of benefits. For example, the hypothetical teacher above decides to forgo retiring at age 47 in order to wait and qualify for her state's DROP program at age 55. She now has 33 years of service and has reached a pension equal to 66 percent of her salary. She remains in DROP for the maximum allowable five years. During that time, her five years of lost pension benefits plus her five years of mandatory employee pension contribution have been deposited in a private investment account. Upon retiring at age 60, she would receive the total of that private account plus a lifetime pension benefit annually of 66 percent of her final salary. With the lump-sum payment of her DROP account and monthly pension benefit, she will receive 100 percent of her final average salary for at least 10 years, and, depending on the state, she may also receive Social Security benefits. This generous guaranteed payout would be hard to find in any other profession.
DROP programs do create an incentive for some teachers to remain past their eligible retirement age, but at a high cost. DROP programs mean that districts still must find the funds to pay pension benefits to teachers at a relatively young age when those dollars could be more effectively spent.[4]
[1] For an overview of the current state of teacher pensions, the various incentives they create, and suggested solutions, see: Costrell, R. M., & Podgursky, M. (2011, February). Reforming k-12 educator pensions: A labor market perspective. New York, NY: TIAA-CREF Institute. Retrieved from https://www.tiaainstitute.org/public/institute/research/briefs/institute_pb_reforming_K-12_educator_pensions.html
[2] For evidence that retirement incentives do have a statistically significant effect on retirement decisions, see: Furgeson, J., Strauss, R. P., & Vogt, W. B. (2005). The effects of defined benefit pension incentives and working conditions on teacher retirement decisions. Education Finance and Policy. Retrieved from http://www.andrew.cmu.edu/user/rs9f/aefa_journal_12_31_05.pdf
[3] For additional information on state pension systems, see: Loeb, S. & Miller, L. (2006). State teacher policies: What are they, what are their effects, and what are their implications for school finance? Stanford University: Institute for Research on Education Policy and Practice. Retrieved from http://web.stanford.edu/~sloeb/papers/Loeb_Miller.pdf; and Hansen, J. (2008, May). Teacher pensions: A background paper. Committee for Economic Development. Retrieved from http://eric.ed.gov/?id=ED502293
[4] For further evidence supporting NCTQ teacher pension standards, see: The Segal Group, Inc. (2010). Public employees' retirement system of the state of Nevada: Analysis and comparison of defined benefit and defined contribution retirement plans. Retrieved from https://www.nvpers.org/public/executiveOfficer/2010-DB-DC%20Study%20By%20Segal.pdf