Pensions 101
Some basics of how pensions work
Let’s talk about pensions.
My impression is that a lot of people in Chicago know pensions are a big deal. They know it’s related to their property taxes, and they probably understand there’s some kind of funding issue. Past that, I don't know how much detail people have about how the public pension system works. In the next month or two, I want to cover a lot of pension-related topics - our underfunding issues, the scope of the problem, a look forward - but that's not super useful if the basics aren’t understood first! With that in mind, I thought it'd be useful to provide an explainer on the basics of the system.
What is a pension?
We'll start at the beginning. A pension is a form of retirement benefit that provides monthly income to a worker after they retire. Typically speaking when people refer to pensions they are referring to what’s properly known as a defined benefit plan. This provides a fixed a set payment - a defined benefit - to the retiree every month, based on the retiree’s earnings while they were a full-time worker. This number might adjust over time to keep up with inflation, but otherwise it’s intended to be risk-free. In this way, it’s more comparable to a benefit like Social Security (which provides a guaranteed payout from the government) than something like 401(k) (where your payout depends on on how your investments do over time). The 401(k) version, incidentally, is properly referred to as a defined contribution plan. The amount paid into the plan - your contributions - are defined, but the benefits you receive down the road are not.
How is the benefit determined?
Benefits are calculated based on (1) a worker's salary while they were employed, plus (2) a measure of how long they were employed. It's also worth noting that you don't get a pension on day one of the job - you need to work for a certain number of years before your pension 'vests'. An example might be useful, so let’s walk through a calculation for a teacher in Chicago:
Tier 1 teachers (those who started working prior to 2011 - we’ll talk more about tiers later) can retire for a full pension at either age 62 with 5 years of service, 60 with 20 years of service, or 55 with ~34 years of service. They could also choose to retire at 55 with 20 years of service for a reduced pension.
The level of that benefit is then based on the average of the four highest consecutive annual salaries in the 10 years before retirement. Those salaries can't increase by more than 20% from one year to the next for calculation purposes.1
That salary then gets multiplied by 2.2% times the total years of service (capped at a max of 75%) to determine the total annual pension benefit.
Given this, a teacher retiring at age 65 with 20 years of service and a final average salary of $100,000 would receive an annual pension of $44,000 (100,000 x 2.2% x 20 = 44,000).
Most pensions also have some sort of cost of living adjustment (or ‘COLA’) to protect beneficiaries from inflation. Our example 65 year old teacher would receive a 3% increase beginning every year after retirement.
Where does the money come from?
The short answer is “from a workers pension fund” (specific to our example, the Chicago Teachers’ Pension Fund). This leads to an obvious followup question of where the fund gets its money. The answer is typically from three sources - employee contributions, employer contributions, and fund investment returns.
Employee contributions are pretty straightforward - a set percentage of an employee’s salary goes into the pension fund instead of their paycheck. This is roughly the same as how a share of your paycheck goes towards FICA taxes for Social Security, or how you might contribute a percent of your salary into a 401(k).
I’m going slightly out of order, but investment returns are also pretty simple to grasp. Based on employee and employer contributions, money flows into the fund every year. Some money flows out to pay that years’ benefits, but most stays in the fund. Pension plans have investment managers who manage that money to grow the fund’s assets over time. This helps reduce the employer’s liability (since every dollar of returns is one dollar less the employer has to come up with themselves). The actual returns vary widely year to year - same as any investment plan - but generally pension plans are targeting something like 6 to 8 percent annually.2
Employer contributions are a bit more complicated. Because the benefits paid out to beneficiaries are easy to calculate, employers can calculate their total liabilities over time pretty easily as well, based on actuarial projections for employee turnover, future salary growth, retirement schedules, and life expectancy. That tells them how much, in total, they will have to pay out over whatever time horizon they care about. They also know how much is in the fund, how much employees are paying in this year, and how much their investments should return.
Using those figures, it’s then easy enough to calculate the gap by which liabilities exceed assets. This is referred to as the ‘Actuarially Required Contribution,’ and in a perfect world this is how much the employer should contribute to the plan. In practice, this does not always occur. This leads to problems. In Chicago, for example, for many decades the city’s contributions were instead set as a fixed multiple of employee contributions for that year. This meant that asset growth and liability growth were totally disconnected and led to our current state of severe underfunding across the various funds. Oops!
Some other Pension Miscellanea
I don’t yet want to go super into the weeds on the state of pensions in Chicago, but a couple other points about pension policy - and Chicago/Illinois specifics - are worth noting:
Social Security: While not true for all states and localities, Chicago and Cook County employees don’t receive Social Security benefits. Pensions are supposed to replace those benefits, and must by law be at least as generous as Social Security. Your mileage may vary as to how much you think this matters (on the one hand, they don’t have any other guaranteed income during retirement. On the other, they don’t have to pay SS taxes, either), but I think it’s at least relevant to note.
The Constitution: Article 13, Section 5 of the Illinois State Constitution explicitly states that any public pension benefits are an enforceable contract which shall not be diminished or impaired. The interpretation of that clause has been subject to debate, but the Illinois Supreme Court has held that to mean that any reforms which impact the future pensions current public employees (not just the current pensions of any retirees, or the currently vested portions of pensions for current employees) are unconstitutional. This is pretty key to understand in any discussions about how to reform our pension system.
Employee Tiers: Due in part to that constitutional issue, when changes to the pension system have passed they are structured to only impact future employees. This creates a tiered system, where employees with different start dates get different benefits. Tier 1 refers to public employees hired before January 1, 2011, who have the most generous benefits. Tier 2 refers to employees hired after January 1, 2011, who have somewhat less generous benefits.
The Bottom Line
As this is more of an informative post than an advocative one, we don’t have a big takeaway to wrap up with - for now, it’s enough to know that pensions are a big deal.
Note: While I haven’t always said this explicitly in earlier posts, my objective here is to help you better understand the issues facing Chicago. With that in mind, please feel free to reach out at citythatworksnewsletter@gmail.com or in the comments with any questions/suggestions/other thoughts about pensions, Chicago, or anything else.
This is intended to prevent any shenanigans around workers trying to boost their pension benefits by spiking their salaries in the final years before retirement.
These rates can also be the subject of some controversy. If a plan arbitrarily decides to assume a higher investment return going forward, their liabilities look lower as a result, given present value discounting. Arguably, if the fund is meant to be truly risk-free, it's more appropriate to discount liabilities based on a risk-free rate (or at least at whatever the municipality’s cost of capital is - they’re the ones on the hook for the benefits, after all), but under the standards set by the Governmental Accounting Standards Board (GASB) public pension plans aren’t required to do that.