The term “pension” most often refers to an employer-provided defined benefit retirement plan. The benefits from these plans are “defined” because they pay a pre-determined amount for a person’s remaining life after work. Individuals participating in the plan do not direct their own investments; rather, the funds in the plan are pooled together and invested in one portfolio that is managed by professionals. Returns from the investments are used to help pay for the benefits. Defined benefit pensions are the preferred retirement plan in the public sector where 75% of state and local government workers in the U.S. participate in these plans.
Participants in pension plans must meet certain criteria in terms of their age and how long they have worked to gain access to their benefit. The criteria varies from plan-to-plan, as each plan will designate the amount of work required to be eligible for a benefit (called “vesting”) and a retirement age. An example would be a participant who has reached age 60 and has participated in the plan for at least five years would be eligible to start receiving a retirement benefit. Most plans also offer a reduced retirement benefit available at an early retirement age, and some even provide disability and death benefits.
Pensions pay a retiree an amount, usually for their lifetime, based on the person’s working career. The amount of the benefit is known ahead of retirement because it is either a specific amount (e.g. $500 per month), or it is determined using a formula. Formulas vary from plan-to-plan, but normally include the years a person works and may also look at a person’s working salary. Because retirement benefits increase the longer a person works, defined benefit pensions help build a loyal workforce and decrease employee turnover.
Here are a couple examples of basic defined benefit pension formulas:
0.016 x $3,500 (monthly salary) x 30 years of participation = $1,680 per month
$50 x 15 years of participation = $750 per month
Formulas for pension benefits can be much more complex than the examples shown here. Some formula components change with the number of years of participation, the date the employee was hired, or the age the employee retires. Because of the hazards associated with public safety jobs (police, fire, EMS), retirement plans for these workers typically offer lower retirement ages and/or increased benefits.
Defined benefit pensions typically have three sources of funding: contributions from the employer, contributions from the employees, and the investment returns of the pension fund’s portfolio. The investment returns of the portfolio are normally the largest source of funding for the plan.
The employer’s contribution is determined by an actuary and will vary from year-to-year based upon economic and demographic factors. An actuary is a business professional who is highly trained in the measurement of risk and uncertainty. It is imperative that the full contribution recommended by the actuary is put into the plan each year. Plans that receive the full annual contribution are in the best position to meet all of their obligations now and into the future.
Employee contributions to the plan are often a specific dollar amount or a specific percentage of the employee’s salary. These contributions are used to help fund the future retirement benefit and normally do not impact the amount the employee will draw in the future. The employees’ accounts typically earn a set amount of interest annually. Though the employees’ money is invested in the same portfolio as the employer’s money, the employee does not take on the risk of losing their money in the markets and does not receive the same rewards for strong market performance. Instead, the employer sponsoring the plan receives the risks and rewards of investing in the markets.
The contributions received from the employer and employees are invested in the markets in order to help fund the retirement benefits of the participants. Investment returns, though they vary from year to year, often are the plan’s largest funding source. The investment returns of the pension fund will vary based upon the asset allocation of the portfolio, market performance, and the talent of the professionals managing the funds. Because market returns are unpredictable, public pension funds typcially smooth gains and losses over a three to five year period in order to add stability and decrease volatility.
Retirement planning is difficult for the average American. Financial products are confusing; investing in the markets is risky; and education is lacking. Investing for retirement is not easy, and low-to-middle income workers are affected the most because they may not have the means to set aside enough to support themselves during retirement. In fact, 87% of Americans say retirees don’t know enough about managing investments to make their savings last.
Pensions help take some of the guesswork out of retirement planning by providing a stable lifetime income base. Retirees don’t have to worry about running out of money because benefits from a pension are paid for life, and studies show that pensions help keep older Americans out of poverty and off of public assistance programs.
That’s not to say pensions are a silver bullet for retirement.Workers participating in a pension still must plan appropriately for the future in order to ensure they will be able to maintain their standard of living during retirement. In most cases, a pension provides a modest monthly benefit that must be combined with other sources of income to safeguard their financial independence.
Pensions are a tool for government employers to attract good workers who provide valuable services to the taxpayers, keep those workers during their most productive years, then provide a dignified exit from the workforce. The amount of a pension benefit is tied to longevity, so defined benefit plans discourage turnover. Defined benefit plans also help employees retire when they should. This is good for the employer so they can avoid the additional costs incurred when employees stay on the job too long. All of these advantages of a defined benefit retirement plan are good for the taxpayers as well. Taxpayers want well maintained streets, good parks, healthy businesses, and great public safety. These things are a product of well-trained, experienced, and motivated public workers. Plus, nine in ten retired Missouri local government workers remain living in the towns they served while working and reinvest in their communities by spending their pension payments on local goods and services.
While most public pension plans in the U.S. are in good shape, there are a few that face challenges. The most common reason a pension plan runs into trouble is when the plan has not received the funding necessary to meet their obligations. This may occur when policymakers choose to pay less than the full, recommended contribution. Doing so is similiar to not paying the full amount of your monthly mortgage payment. Interest continues to accrue, and you become further away from your goal of fully funding your home.
Required payments to public pension funds, on average, are a small component of state and local government budgets and most public pension plans in the U.S. are doing a good job in keeping up with their retirement plan payments. On average, public pension plans in the U.S. paid 94% of their required contributions in 2015.
Studies show Americans spend more time each year planning their vacations than planning for their retirement. But, if you think about retirement as your longest vacation, it may make planning seem a little more interesting. Financial planning is confusing. It is difficult to determine how much money you will need in retirement and to make sure all of your other potential risks are minimized. But you have to start somewhere, and we are here to help!
It is important for you to understand the value of your pension and how it may impact your life today and in the future. Learning more about your pension will help you have peace of mind, and while your pension may represent a significant portion of your retirement income, it will likely not be enough to meet all of your needs. Combining your pension with Social Security and your own savings is essential to a successful retirement.
According to the National Institute on Retirement Security (NIRS), retiree spending of public pension benefits creates a ripple effect across local, state and national economies. The monthly income received by these retirees is not stuffed under a mattress but spent on local goods and services. Since pension benefits provide steady monthly income, retirees don’t have to adjust their spending based upon market performance or economic concerns. In 2014, the most recent year data was available, the total economic impact attributable to state and local pension benefits in the U.S. was almost $560 billion. Plus, pension checks generated $190 billion local, state and federal tax revenue.