More than one-fourth of all state and local government employees participate in a public pension system rather than Social Security. Their pension plan provides these workers with a significant portion of their retirement income. Legal scholarship has documented tension between substantial contractual rights to promised benefits and a sponsor’s ability to cut those promises should it exhaust its pension assets.
Withdrawal of Accumulated Contributions
Since the financial crisis, a few governments have needed help to meet the actuarially required contributions needed to build a meaningful stock of assets. Some government employees have taken advantage of state retirement and pension system refund provisions, which allow members to withdraw their accumulated contributions and interest upon employment termination or vested withdrawal. These withdrawals are subject to mandatory 20% federal tax withholding and may also be subject to a 10% excise tax if you are under age 59 1/2. The vested withdrawal rules vary from system to system, but most allow you to withdraw your accumulated contributions once you have reached your vested retirement age. However, there is a risk that the amount you receive as your vested retirement benefit will be significantly less than what you would have received under Social Security. This difference is due to three key differences between public and Social Security benefit formulas: vesting periods, COLAs, and retirement-age requirements. The sampled definition-benefit pension formulas satisfy federal Safe Harbor requirements.
Cost-Of-Living Adjustments (COLAs)
Approximately one-fourth of all state and local employees participate in a pension system instead of Social Security, including most to two-thirds of all public school teachers and a majority of police officers, firefighters, and other first responders. In many states, these employees have options for how they contribute to their pensions and what benefits they will receive in retirement. These decisions include paying a higher contribution rate, or Selection A, in exchange for an unlimited COLA at retirement or selecting Selection B to lower their contributions and receive no COLA. Most courts have ruled that a future cost-of-living increase is an increase in the present value of the pension and that it must therefore be discounted at the time of distribution. As a result, a retiree’s pension is adjusted each year to compensate for inflation, typically by using the Consumer Price Index (CPI). While CPI can show deflation and inflation numerically, experts use it as a reference because it considers the prices urban workers pay for a wide range of goods and services. Some state and local defined benefit plans have COLA provisions that vary depending on their underlying pension fund’s funding ratio and investment performance. Some have maximum rates tied to inflation and plan performance, while others only increase benefits by a certain percentage of the CPI.
Defined Benefit Plan
In a defined benefit plan, the retirement benefits paid to members are determined by a set formula based on the workers’ final average pay or other factors. These plans are typically more common in the private sector, but many state and local governments offer them to their employees. For example, the Public Employees’ Retirement System (PERS) is open to all state, county, city, and school board employees. PERS retirement systems are funded by contributions from members and employers and investment returns. The cost of a defined benefit plan can be challenging to estimate, even with sophisticated actuarial software tools. This depends on several key assumptions, including the workforce’s expected lifespan and retirement age, the pension funds’ investments, and additional taxes or levies. Defined benefit plans can provide a more secure retirement, as they usually cover a large portion of an employee’s final salary. However, they should be combined with other sources of income to ensure that retirees have sufficient wealth to live comfortably and avoid dependence on public assistance programs.
Defined Contribution Plan
The employee and employer contribute a fixed amount to a participant’s account in a defined contribution plan. Upon retirement, the member’s pension income is based on the total contributions made, investment earnings, and any forfeitures. This type of plan is also known as a money purchase plan. In 2019, 58 percent of private industry workers participated in traditional defined benefit plans, while 98 percent of state and local government employees participated in these pensions. The NCS program did not identify any state and local government workers with other types of retirement funds. Many employers offer supplemental before-tax savings options for their employees, such as the ERS 401(k) and 457 programs. These plans are designed to encourage and supplement an individual’s retirement savings efforts rather than replace them. Participation in these plans is voluntary. In the ERS 401(k) and 557 programs, participants can choose from 17 investment choices to determine the accumulation of their accounts. Each choice has a detailed profile with information about the fund, including investment objectives, top holdings, and fees.