Pension plan choice among university faculty.

• Author: Clark, Robert L.

1. Introduction

   There has been a large amount of economic research concerning the effects of pension plans on both a worker's mobility and retirement timing. (1) Defined benefit plans tend to be less portable but limit the financial market risk faced by the employee. Defined contribution plans are more portable but expose the employee to a greater financial risk from a market downturn. Because of these distinct characteristics between the two types of pension plans, we can expect that workers would not be indifferent between them. Instead, workers will prefer a particular type of pension plan depending on their tastes and preferences as well as their aversion to various types of risk. Most private-sector employers do not offer their employees a choice of pension plan type for their primary retirement plan. (2) It is generally assumed that workers make the choice of an employer and a pension plan at the same time. As a result, there is little empirical research on the preferences of workers concerning the type of pension they receive. (3)

   Unlike private-sector employees, many university faculty members do receive a choice of pension plan after they are hired. The results of a recent survey of university administrators by the American Association of University Professors (AAUP) are shown in Table 1. Almost 36% of the institutions surveyed offered a choice to their faculty between a defined benefit and a defined contribution plan. Over half of the public colleges and universities surveyed offered a choice of pension plan types, whereas fewer than 1% of the private schools did. Among four-year institutions, approximately 40% of research and doctoral universities offered a choice compared to only 14% of the baccalaureate institutions. For two-year institutions, 69% of those with faculty ranks gave their faculty a choice, but only 30% of the two-year schools without ranks did so.

   Because of the differing effects of these two pension plans on mobility and retirement timing, understanding the pension choices of faculty members can help university administrators and other employers plan for possible quits and retirements, allowing them to better manage faculty flows. (4) Participants in defined benefit plans have lower turnover rates and higher age-specific retirement rates that include large spikes in the probability of retiring at the early and normal retirement ages specified in the plan. Faculty who select to enroll in either the defined benefit or the defined contribution plan are locked into the plan for their entire career. Senior administrators who know the distribution of faculty in the two plan types will be able to better predict retirement patterns and other turnover rates. Employers that engage in labor force planning benefit from better information on age-specific rates of termination and retirement. In particular circumstances, presidents and provosts may seek to change available plan options or to alter the incentives embedded in the existing retirement plans to better achieve the desired composition and size of their faculty (Clark and Ma 2005). In response to delayed retirement by senior faculty covered by defined contributions, some research institutions have attempted to modify their retirement policies to provide greater retirement incentives. Recognizing patterns of plan choice can help employers develop and refine their overall retirement policies.

   This study examines the pension choices of faculty in the University of North Carolina system (UNC) using employment records from 1983 to 2001. Estimates indicate that faculty choices conform to predictions based on economic models. The findings from this analysis are examined for their implications on the continued evolution of employer pension plans and the current Social Security debate.

2. Pension Plan Choice in the University of North Carolina System

   Since 1971, all newly hired faculty members in the University of North Carolina system have had a choice between enrolling in the Teachers' and State Employees' Retirement System (the state plan) or in one of several Optional Retirement Plans (ORPs) as their primary retirement plan. The state retirement plan is a final-pay, defined benefit plan. Faculty members who are enrolled in the state plan are required to contribute 6.0% of earnings to this pension plan. The benefit formula for the state plan is 1.82% of final average earnings multiplied by years of service, where average earnings are based on the employee's four highest consecutive years of earnings. Participants are fully vested after 5 years of service in the state plan.

   The state pension plan provides significant monetary incentives to retire for faculty members who meet the age and service requirements for early and normal retirement. The normal retirement age is 65 with 5 years of creditable service; however, the plan also provides unreduced benefits with 30 years of service regardless of age or at age 60 with 25 years of creditable service. Early retirement with reduced benefits is available at age 50 with 20 years of creditable service or at age 60 with 5 years of service.

   To see how the defined benefit plan includes monetary incentives to retire once eligibility is achieved, consider the case of a male faculty member hired at age 25, whose career earnings follow the typical path of the faculty in our sample (as estimated by an age--earnings profile). During his 30th year of employment, his pension wealth rises by 7.5% because he becomes eligible for full retirement benefits. By contrast, his pension wealth rises only 2.1% as he moves through his 31st year of employment. Thus, the defined benefit plan provides significant incentive to remain with the university prior to eligibility, but this incentive declines substantially once eligibility is achieved.

   The ORPs are defined contribution plans. Currently, faculty choosing to enroll in an ORP can select one of four providers: TIAA-CREF, Lincoln National, Fidelity, and VALIC. Faculty members are required to contribute 6 percent of salary, and the state contributes 6.84% of salary to the individual's retirement account. The level of benefits in the ORP at retirement depends on lifetime contributions and accrued rates of return. Every faculty member must participate in either the state plan or one of the ORPs. If a faculty member does not choose between the plan types, he or she is automatically enrolled in the state plan; however, the number of faculty placed in the state plan by default appears to be very small. (5) Employee contributions are immediately vested in both plans. In addition to their employer-provided pension plan, all UNC faculty are covered by Social Security.

   The data used in this study are employment records for the 15 campuses in the UNC system awarding tenure. (6) Each campus is required to report its annual faculty census to the General Administration in September of every year. The census reports general characteristics and employment information about each faculty member. These include gender, race, age, salary, rank, and tenure status as well as which type of pension plan the individual member selected. Unfortunately, no data are available on the size of the ORP accounts and the allocation of these accounts between stocks and bonds. These data files do not include any information on other household wealth, participation in supplemental retirement plans, marital status, or employment of spouse. The data are available from 1982 through the academic year 2001. During this time, 7035 new tenure-track faculty were hired across the 15 campuses. The hiring ages range between 22 years and 75 years with a median age at employment of 37 years.

3. An Economic Model of Pension Choice

   Within 30 days after employment, all newly hired tenure-track faculty at any of the 15 tenuregranting campuses in the UNC system must choose to enroll in either the defined benefit state plan or one of the defined contribution ORPs. This is a one-time election by a new faculty member. Faculty members selecting one of the ORPs must remain in an ORP for the remainder of their careers at UNC, but they are free to move among the ORPs offered by their institution. How does a new faculty member decide whether to enroll in the state plan or participate in one of the ORPs?

   There are several studies that have modeled the choice between a defined benefit and a defined contribution pension. Bodie, Marcus, and Merton (1988) compare the benefits of these two types of plans. They show that defined benefit plans provide a stable replacement rate of final income to workers and thus offer some degree of insurance against real wage risk. Their model also indicates that the advantages of defined contribution plans are greatest during periods of high inflation uncertainty and include the predictability of pension wealth, the ability to invest in inflation-hedged portfolios, and the fully funded promise that the defined contribution plan provides. McCarthy (2003) presents a three-period model that shows that defined benefit plans are more valuable to older employees and are more attractive when equity market returns are lower than expected or are highly variable. In addition, defined benefit plans provide more security when annuity markets are inefficient.

   Because workers can change pensions by changing employers, Childs et al. (2002) use a real options framework to examine the tradeoffs between a defined benefit and a defined contribution pension. They find that defined benefit plans are generally preferred by those who plan to remain with their current employers, older employees, and those for whom the annual defined benefit accrual rate is high. Defined contribution plans are preferred by those for whom the option to switch employers is more valuable, younger workers, and those who work for employers with relatively high defined contribution rates. Surprisingly, they also find that more risk-averse...