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Equable OriginalMyth: More public employees are needed to ensure pension debt gets paid off.
Fact: Pension debt is not solved by hiring more employees because pensions are not funded like Social Security. Active employees do not pay for the benefits of current retirees.
A common misunderstanding is that pension fund financing works like Social Security, but that’s actually not the case. Social Security uses contributions from current workers, collected through tax collection, and uses the money to pay current retiree benefits. But pension benefits earned each year are intended to be funded in advance with contributions that will then earn investment returns. In the case of pensions, current employees are contributing to their own benefits, rather than those of current retirees.
Pension plans are funded using contributions from members, and employer contributions. The contributions from members typically only go toward the normal cost — the total contributions needed to pay for the pensions earned each year.[1] By federal law, retirement systems have to refund the value of member contributions if public workers leave their job before retirement and request the money back. If employee contributions were regularly used to backfill pension debt that would make funding status less stable.
This is an important distinction. For example, if the normal cost of your pension were 10% of payroll, and the pension system required employees to make contributions equal to 6% of their payroll, then those employee contributions go toward the normal cost of benefits and the government employer pays the other 4% of normal cost contributions plus any pension debt payments.
This arrangement — public employee contributions going toward normal costs — means that if a state legislature or city government wants to create a new retirement plan for future employees, it should be able to without jeopardizing the benefits of current retirees. The new retirement system could be another pension plan that has better risk management tools, something Michigan and South Dakota have done, or an alternative plan design to pensions. No matter what the new plan concept, it will not undermine the legacy pension plan because that legacy pension is not counting on future employee contributions to fund retirement checks. Current public workers only contribute to their own benefits in a defined benefit pension plan, so contributions from future teachers aren’t necessary to cover costs when they retire.
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[1] There are a few exceptions to the standard practice of employers paying for all of the pension debt costs. Arizona’s public employee pension plan — covering teachers, state workers, and municipal employees — uses a 50/50 cost-sharing model where employees cover half of the pension debt payments. Ohio’s teacher pension plan has member contributions that are higher than normal cost.
This article is part of Equable’s Pension Basics series. To learn more about how your pension works, check out the other articles in the series:
1. How Pension Benefits Are Calculated
2. Vesting
3. The Pension Funding Formula
5. Normal Cost
6. Unfunded Liabilities (aka Pension Debt)
7. Actuarially Determined Contributions
10. Governance
11. Pension Myths & Facts: The Assumed Rate of Return Does Not Determine the Value of Benefits
12. Pension Myths & Facts: The Funded Status of Pension Plans Does Not Depend on More Public Employees
