Problems with State-Local Final Pay Plans; Options for Reform

Introduction

As widely publicized, the financial crisis dramatically worsened the funded status of state and local pension plans.  In response, public sector sponsors are making a number of changes.  Most of these changes involve increasing employer and employee contributions and cutting benefits for new employees primarily by increasing the age for full benefits.  A couple of states have cut cost-of-living adjustments for current retirees, but they are in the process of being sued.  One item not on anyone’s agenda is reconsidering the basic design of public-sector defined benefit plans.

Defined benefit pension plans for public employees – both here and abroad – almost universally compute benefits based on final pay.  That is, employees’ initial pension benefits are based on their age at retirement, their years of service, and their average earnings in a small number of years.  It is unclear whether the motivation for relying on short periods of earnings was record-keeping constraints before the age of computers, an interest in relating pre-retirement to post-retirement income in a seemingly transparent way, a desire to reward long-service employees, or some other factor.  Whatever the initial motivation, final pay plans suffer from serious shortcomings: they (1) severely “backload” benefits; (2) treat very differently workers on different career trajectories; and (3) invite mischief in terms of sudden late-career promotions.  They are also riskier for workers than they appear.

This brief proceeds as follows. The first section describes commonly used pension designs. The second section illustrates the consequences of the final pay formula for retirement incentives, different earnings profiles, and late-career salary increases. The third section presents an option for reform based on use of average compensation over the full career and indexation of the earnings history. The final section offers some concluding thoughts.

The Typical State-Local Plan

Although state and local defined benefit plans vary enormously across states and between states and localities, they share the same basic structure. They calculate the initial benefit at the full retirement age as the product of three elements: the plan’s benefit factor, the number of years of employee service, and the employee’s average earnings. The calculation of average earnings is generally based on the three to five years of highest earnings . Such plans are referred to as final pay plans because the highest earning years are typically the final years in a  worker’s career>

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