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Public pension primer

State Budget Solutions | by Shannan Younger | April 16, 2012

Public pensions are an arrangement to provide people with an income when they are no longer earning a regular income from employment.

Types of Plans

There are two kinds of public pensions, defined benefit plans and defined contribution plans.

  • Defined Benefit Plans

Defined benefit plans provide a guaranteed lifetime retirement benefit based on an employee's years of service and salary, the amount of which is calculated differently by different states. Although most statewide plans require employee contributions, the retiree's benefit is not tied directly to his/her contribution amount. The majority of public pension plans are defined benefit plans.

In 2009, governments provided defined benefit plans to 84% of state and local workers compared to 21% of private-sector employees.

  • Defined Contribution Plans

In contrast, in defined contribution plans both employers and employees contribute to the employees account. Then, the employee determines how the contributions are invested, usually selecting from options presented by the plan administrator. At retirement, the amount of money in the fund is the basis of the employee's retirement benefit. The sponsoring public entity does not ensure a particular benefit amount, and usually does not provide post-retirement benefit cost of living increases.

In 2009, Michigan, Nebraska, and Alaska have mandatory defined contribution plans for general state employees, and Alaska was the only state to have a mandatory defined contribution plans for teachers. States offering optional or hybrid defined contribution plans to state employees included: Colorado, Florida, Indiana, Montana, North Dakota, Ohio, Oregon, South Carolina and Washington.

  • Deferred Compensation Plans

All states offer employees and teachers optional deferred compensation plans, like Section 457 plans, as a means of augmenting employees' primary pension coverage.

Benefits

Individuals receiving a state pension receive a financial benefit, and most are adjusted annually with a cost of living increase. They also typically receive other benefits, including disability, life, health and dental insurance coverage. For health insurance benefits, employers make a contribution towards the member's monthly premiums, with members covering the difference between the employer's contribution and the actual premium amount. Health insurance in many states is now available to the children of recipients until the child reaches age 26.

For example, in West Virginia, state employee and teacher retirees receive a monthly subsidy to defer the cost of their health insurance premiums. The average subsidy is $333 per retiree. New hires, however, will not receive the subsidy.

Public pension funds also include other benefits.  They often provide death benefits for active and retired members paid to eligible beneficiaries or survivors. In addition, some states offer supplemental benefit plan options to those receiving pension benefits. In Delaware, for example, supplemental benefit plan options include: Auto/Home Insurance, Long-Term Care Insurance, Legal Insurance, Vision Insurance and Pet Insurance.  In California, CalPERS recipients may take advantage of three different long-term care benefits and a Member Home Loan Program offers members security, protection, and choice when purchasing or refinancing a home, in addition to health insurance, disability and death benefits.

An estimated 30% of public-sector workers across 12 states are not part of the Social Security system.

Employee eligibility

When employees are eligible for benefits varies by state. The average retirement age for public employees is nearly 60 years old, whereas the average is around 63 years old for private sector employees. In New York, the Department of Civil Service estimates that state employees retire at an average age of 58.

Many states are increasing the number of years which new employees must work before they can retire with a full pension. States have done so for several reasons: longer lifespans add pressure pension systems, lawmakers to demand more years from employees given the fiscal crises facing their states and, as many states cut services, citizens are scrutinizing the compensation of public workers more than in prior years.

Illinois lawmakers raised the retirement age to 67 from 55, and reduced the maximum allowed pension to $106,800 from $391,000. The reforms apply to workers entering the work force in 2011, thus lessening the impact of the reforms. The state's pension gap will not shrink noticeably as a result of these changes for years. In Illinois, teachers could retire as early as age 55 with 35 years of service. As of Jan. 1, 2011, new hires must reach age 67 with 10 years of service.

Only a few state plans provide for normal retirement benefits when a person reaches a specified age without an accompanying service requirement. As of 2011, 4 plans provide benefits without a service requirement after the age of 65.

Twenty plans allow normal retirement with longer service requirements than earlier and generally increased age requirements to 65 or 67. Nine state plans require 10 years of service and one requires 25 years of service. Four plans, however, allow retirement when a member reaches 65 regardless of length of service.

Experts say changes are less likely with firefighters and police due to the beliefs that older workers should not or cannot be in these positions and that people who do hold these often-dangerous jobs deserve long pensions. Some police and firefighters New York can retire after 20 years of service.

Pension Funding

Pensions are funded through contributions by the state, employees and tax payers, as well as the investment income that money earns.

  • Rate of Return

Pension funding could be in more trouble than is typically reported by public retirement systems. This is because they typically report an expected return on investment of 8 percent, which has not held up in the market. However, if this figure decreases, the amount of unfunded liabilities skyrockets by billions of dollars. Since the financial crisis, at least 19 state and local pension plans have cut their return targets, while more than 100 others have held rates steady, according to a survey of large funds by the National Association of State Retirement Administrators.

  • Tax dollars

Taxpayer dollars fund public pensions. Taxpayers are obligated to pay government workers' pension benefits as promised through collective bargaining agreements.

What amount of tax dollars goes to the pension fund is determined by legislators and included in each state's budget. In Maine, 10% of each tax pay dollar goes toward the pensions for state employees and public school teachers, and estimates say that could rise to 20% within the next five to six years.

  • Employee contributions

Whether or not state employees must contribute to their pension, and how much, varies by state.

In Florida, public employees did not contribute to their pensions for the past 30 years and in 2011 a court found that a law requiring public employees pay part of their pension costs was unconstitutional.

State unfunded pension liabilities

State government pension liabilities are the unfunded liabilities that state governments take on when they provide pension and other post-employment benefits to state government employees without simultaneously accumulating the funds to pay for those eventual liabilities.

Economist Joshua Rauh and Robert Norvy Marx estimated in October 2011 that the total unfunded liability of state and local pensions is $4.4 trillion.

State pension crisis

State and local workers face retirement systems that may be short of funds by as much as $4 trillion. Experts predict insolvency of some pension funds within a decade. State pension funding levels vary dramatically in the U.S. Several states have pension plans with high levels of funding, but the majority of states have pensions that are extremely underfunded. The crisis is due to an aging workforce, delayed and suspended contributions, increased benefits, and investment losses.

  • Demographics

Demographics are exacerbating the budgetary burden of the public-sector workforce. Current retirees leave work at an earlier age and live longer, thus drawing substantially more retiree health care and pension benefits than their predecessors. Currently, every private sector worker in America would have to pay $12,000 to support the current pension promises to public sector workers. This figure does not include health benefits.

  • Economic Factors

The current pension crisis goes back the late 1990s when the stock market was booming. Growing stock prices increased the value of pension funds to such levels that many state and local governments reduced or eliminate the annual benefit payments made by employees.

According to the Pew Center on the States, in 2000, states only needed to pay $27 billion total into their pensions funds and that amount more than doubled to a $64 billion deposit required in FY2008, when an economic recession had reduced states' revenues. In 2008, prior to the economic downturn, 54% of plans had assets totaling at least 80% of their liabilities, and in 2009 that number declined to 43% of plans. The blow to pension system's returns was dramatic. For example, the 2008 stock market crash reduced the Maine pension system's returns in fiscal year 2009 by 18.7% and by 11.1% in FY2010.

Susan Urahn, managing director of the Pew Center on the States, also noted that the 8%return on investments most states typically expect may need to be lowered.

States' investment losses, which exceeded $800 billion in 2008, have worsened the budgetary pressures of pension obligations. Health care obligations likewise are sapping state budgets. Unlike the private sector, state and local governments have largely adopted "defined benefit" plans, under which specific types of services are assured. The costs of defined benefit plans escalate annually. In contrast, "defined contribution" plans provide a fixed payment for pensions and thus in fully funding pensions. Public employees contribute far less to their health care coverage compared to workers in the private sector.

In addition, mew accounting practices introduced in the early 1990s also revealed the pension funding of previous generations was even worse than previously thought.

The pension crisis has been hurt not only by the large numbers of retirees and the challenging economy, but also by financial institutions. The Ohio Public Employees Retirement System saw a decline in value from $441.4 billion in December 2007 to just $73.3 illion in December 2008, three months after Lehman Brothers, which managed the system's investments, filed for bankruptcy protection.  In the second quarter of 2010, state and local pension funds lost $58 billion on investments, the worst lost since 2008.

In response to the bad financial performance, many states are also considering lowering their assumptions of pension fund earnings, which will further hurt revenues for future state budgets.

  • COLA adjustments

Cost of living increases in pension benefits have also exacerbated the fiscal crises facing public pensions. Rhode Island included in its FY2011 budget a limit on the cost-of-living adjustments (COLA) provided future retirees to the pensioner's first $35,000 in benefits and require eligible individuals to wait until age 65 to begin collecting the annual COLAs. Other states that have recently limited cost of living adjustments include Colorado, Maryland, Michigan, Minnesota and South Dakota.[27]

A Colorado law passed in 2010 reduced the raise that people who are already retired get in their pension checks each year, capping the cost-of-living adjustment at 2% instead of the 3.5 percent raise that many of them were getting. Some retirees and those eligible to retire then filed suit against the state to keep all of the annual cost-of-living increases they anticipated receiving.

  • Cost of Health Benefits

Of the unfunded pension and other post-retirement promises made to workers by states, $587 billion is for retiree health care, according to Pew, with less than 6% of that amount funded as of fiscal year 2008. Only two states, Alaska and Arizona, have set aside at least 50% of the needed assets. On average, states have a 7.1% funding rate of their non-pension benefits.

New York city public employees currently do not contribute to their healthcare plans, but do pay co-pays when visiting the doctor. A recent study by the Rockefeller Institute of Government Analysis found that if New York public employees would contribute 10 percent of their earnings, like state workers do, it would save the city nearly a billion dollars annually. Other local governments in New York could save $838 million if their employees would contribute to their healthcare costs.

  • Delayed and Suspended Contributions

States have stopped paying into pension funds. The economic downturn isn't the only cause of the current pension funding crisis. "Over the last 10 years, many states have shortchanged pension plans in good times and bad," said Susan Urahn, the managing director of the Pew Center on the States, who called the beginning of the century a "decade of irresponsibility."  The levels to which states opt to fund pension benefits seem to depend largely on budgetary convention and the appropriation levels of previous legislatures, experts say.

For example, New Jersey Chris Christie skipped a $3 billion payment into the $66.9 billion fund in his first budget and has said that the state may not be able to make the expected $512 million contribution to the pension system in FY2012. As of June 30, 2009, the New Jersey pension fund that provides benefits for nearly 800,000 current and retired state employees and teachers had a gap of $46 billion between assets and anticipated payouts.

Current news and information about public pensions can be found on the State Budget Solutions Pension page here.

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