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Program on Retirement Policy
Older Americans’
Economic Security
Number 32, July 2012
State Pension Reforms:
Are New Workers Paying for Past Mistakes?
Richard W. Johnson, C. Eugene Steuerle, and Caleb Quakenbush
When state pension plans are underfunded, someone eventually has to pay for the shortfall. Many reforms shift burdens to the young, particularly by making many new
employees net contributors to—rather than beneficiaries
of—these plans. How? Essentially, states require higher
levels of employee contributions, invest them in somewhat
risky assets, and then, like a bank or financial intermediary,
pay back many employees less in benefits than what they
contributed and expected to earn on those contributions.
How State Workers Accumulate Pension Benefits
Traditional (so-called defined-benefit) pensions, which cover nearly all full-time state employees, pay annual retirement benefits until the pensioner (or pensioner and spouse)
dies, equal to some percentage of the employee’s final or
highest salary times years of service. Once employees have
worked enough years and reached a certain age they may
retire and begin receiving their annuity. If they quit before
reaching the required age but have served enough years,
they may receive a deferred annuity that begins at the plan’s
retirement age.
Future pension benefits grow slowly early in a career
but accumulate much faster later on. Most state plans require employees to work 10 years before qualifying for pensions. Even after workers become eligible, their benefits
aren’t worth much initially because they typically must wait
many years to collect, and the benefit formula doesn’t adjust for inflation or interest in the meantime. As a result,
workers hired in their twenties who leave, say, 15 years later
accumulate few retirement benefits.
Traditional plans reward work near the end of a career
much more than at the beginning. Because wages tend to
grow with inflation and real economic growth, the formula
rewards additional work in two ways—by raising the percentage of salary to be paid out and increasing that measure
of final or highest salary. As this effect compounds, pension
benefits grow more rapidly as years of service rise.
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How States Fund Future Pension Benefits
States set aside funds to cover future benefit payments
through mandatory employee contributions as well as payments from the state. How much needs to be set aside depends on various factors affecting future payouts, including
how long employees work for the state and how much they
earn. Expected longevity matters, because pensioners receive payments for the rest of their lives.
How much funding is required also depends crucially
on what assets earn. The higher the assumed interest rate,
the fewer tax dollars the state needs to contribute to cover
future obligations. The appropriate interest rate is hotly
debated, with many economists and actuaries advocating
something close to the market rate on riskless assets, much
lower than the 8 percent or higher rate that many states
assume (Munnell et al. 2012). The assumed rate also greatly
influences whether a state plan appears well funded or dangerously underfunded.
States return to employees their required contributions,
usually with interest, if they separate with too few years to
qualify for pensions. Many also offer refunds to separating
employees with more years of service who figure that their
accumulated contributions are worth more than their deferred annuities. However, states usually credit a lower interest rate on refunded contributions than they assume
those contributions will earn for the plan. By paying out less
than it earns (or than it assumes it will earn), the state effectively hopes to make money on employee contributions
in the same way as a bank or hedge fund.
New Jersey as a Case Study New Jersey’s Public Employees Retirement System (PERS)
offers a good example of how some states are relying heavily
on new and younger employees’ contributions to subsidize
their pensions. The state overhauled its pension plan in
2011 for new hires, reducing the generosity of the benefit
formula, raising the age for full benefits to 65, and limiting
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Figure 1. Average Annual Addition to Lifetime Pension Benefits from Working an Additional Five Years,
New Jersey PERS Tier 5
26%
30%
Percentage of salary
20%
10%
1%
0%
-10%
-1%
-2%
-3%
-3%
-4%
-13%
-20%
-30%
-40%
-40%
-41%
65
70
-50%
25
30
35
40
45
50
55
60
Age
Source: Johnson, Steuerle, and Quakenbush (2012).
Notes: Estimates are net of employee contributions. The analysis assumes that workers are hired at age 25, retirees take single-life annuities, and the
plan earns 8.25% per year on assets but pays only 2% nominal interest on refunded employee contributions. The employee contribution rate is set at
7.5%, the rate now phasing in by 2018. PERS tier 5 covers general employees of the State of New Jersey hired on or after June 28, 2011.
early retirement to those with at least 30 years of service. It
is also gradually increasing the contribution rate for all employees to 7.5 percent.
Figure 1 shows how annual increments to lifetime pension benefits, averaged over five years, would evolve for a
typical new employee hired at age 25 after the reforms took
effect. We assume that the plan pays only 2 percent nominal
interest on refunded contributions (the rate it actually pays
now), but earns the 8.25 percent interest rate on those contributions assumed by the state’s actuaries. These employees accrue negative pension benefits until their late forties
in the sense that their contributions accruing at 8.25 percent would be worth more than what they get back either as
a refund or deferred pension. Only those new hires who
remain on the job until at least age 55 and retire by age 64
will come out ahead. (See Johnson, Steuerle, and
Quakenbush 2012 for details.) Everyone else subsidizes the
plan.
New Jersey’s situation is only one example of a dilemma that stretches across many states. The past underfunding of pension plans has shifted costs forward to current
and future generations. Eventually, someone has to pay but
only three groups can be tapped: existing employees or
retirees, newer employees, or taxpayers. Many states are
attempting to limit the hit on taxpayers and older current
employees, leaving newer and younger employees with the
burden of covering costs for which they were not responsible. A lower assumed interest rate would mean lower
burdens on younger employees but would put current taxpayers more on the hook to cover the shortfalls. Acknowledgment
The Alfred P. Sloan Foundation provided financial support for this brief.
References
Johnson, Richard W., C. Eugene Steuerle, and Caleb Quakenbush. 2012.
“Are Pension Reforms Helping States Attract and Retain the Best
Workers?” Program on Retirement Policy Occasional Paper No. 10.
Washington, DC: The Urban Institute.
Munnell, Alicia H., Jean-Pierre Aubry, Josh Hurwitz, Madeline Medenica,
and Laura Quinby. 2012. “The Funding of State and Local Pensions,
2011–2015.” Chestnut Hill, MA: Center for Retirement Research at
Boston College.
About the Authors
Richard W. Johnson is a senior fellow at the Urban Institute, where he
directs the Program on Retirement Policy. C. Eugene Steuerle is an Institute Fellow and Richard B. Fisher Chair at the Urban Institute. Caleb
Quakenbush is a research assistant at the Urban Institute.
Copyright © July 2012. The Urban Institute. The views expressed are those of the authors and do not necessarily reflect those of the Urban Institute, its board, its sponsors, or other authors in the series.
Permission is granted for reproduction of this document, with attribution to the Urban Institute.