Retired Texas Teachers and Inflation - The Cruelest Tax

The Teacher Retirement System, or TRS, has been in place since 1937 and has been a reliable source of income in the past. Now its retirees are in trouble. TRS is a defined benefit pension system in which teachers and their employers make contributions during their working years and receive a pension benefit that includes average final pay and years of work upon retirement. During a teacher’s working years, her future retirement benefit increases with her pay, which ideally will keep up with inflation. However, TRS pension payments are a fixed dollar amount - there is no automatic increase in pension payments due to inflation. When inflation occurs, it reduces purchasing power and acts as a tax on those payments. 

The Federal Reserve System has publicly announced its goal of achieving an inflation rate of 2%, and over the long run, the Fed has achieved this target. The average increase in the Fed’s favorite inflation measure, the Personal Consumption Expenditure (PCE) price Index, was 1.8% annually from January 2000 to January 2020, just before Covid-19 struck the economy. The more well-known Consumer Price Index (CPI) ran a bit higher at 2.1% over this period.

But even 2% inflation erodes purchasing power, and after twenty years the purchasing power of a fixed income pension payment will decline by one-third. Ideally teachers know this and plan for it before they retire. 

Imagine their surprise and disappointment, however, when the inflation rate accelerated rapidly during the last two years. Inflation in 2021 was 5.8% using the PCE price index, and by March of 2022 the year-over-year inflation rate hit 6.6%, while the CPI rate was even higher at 8.6% in March.

Inflation has been called the cruelest tax in part because its impact is hidden and insidious, but also because for some it is difficult to avoid. Retired teachers on TRS pensions are not able to avoid paying the inflation tax that reduces the purchasing power of their pensions. 

The value today of a fixed income pension is measured by calculating the ‘present value’ of the promised payments a retiree expects to receive over her lifetime. Present value depends on the retired teacher’s expected lifetime, the annual pension payment, and the interest rate at the time of calculation. This present value is the wealth equivalent of a pension. 

Using the San Antonio ISD salary schedule, a teacher retiring at age 62 who worked 37 years’ final three years of pay averages $60,307 at the top of the scale. If she retired on December 31, 2020, the inflation rate was running at 1.3% per year and the Fed had projected 2% inflation for future years. This retiring teacher would receive pension payments of $4277 per month beginning in January 2021, or $51,321 per year for 24.2 years, her formulated life expectancy. Using the interest rate at that time on 20-year U.S. treasury bonds, 1.63%, and assuming a 2% annual inflation rate, the present value – the wealth value – of her pension, in dollars, was $1,019,566.

What happens when the Fed fails to deliver on its 2% inflation target? Our teacher retiring in January 2021 would have experienced not 2% but 5.8% inflation in her first year of retirement. Moreover, the Fed now projects inflation of 4.3% for 2022, 2.7% for 2023, and 2.3% for 2024. Using these new Fed projections at face value, i.e. leaving aside the issue that they are likely too optimistic, we can calculate the cost to our retired teacher of these four years of elevated inflation. The cumulative impact of these four years of elevated inflation is to reduce the purchasing power of her annual pension payments by 6.6%. Using the same initial assumptions, but including the higher inflation rates, the present value of our retired teacher’s pension would be reduced to $954,046, a 6.4% reduction.

It is well known that Inflation can be quite harmful, especially to those on fixed incomes. Policymakers sometimes wonder if the public overreacts to inflation. Perhaps they should consult a retired Texas teacher.

Posted: June 02, 2022 by Dennis W. Jansen, Andrew J. Rettenmaier