Where Does My Pension Come From?
Government employers have made promises to public workers that at retirement they will get guaranteed monthly income for life. But how do pension plans keep these promises? It all starts with one of the most important measurements a pension plan has: funded status.
Funded status measures the dollars a pension fund has on hand compared to the pension payments it needs to make. The dollars flow into the pension fund as money from government employers (like a school district or state legislature), contributions by employees, and through investment returns on that money.
When a pension plan has 100% of the money it needs to pay all benefits to current retirees and promised to current workers, that’s fully funded status. It is okay of the funded status is below that for a year or two at a time. But after a few years, it is a problem if the funded status is less than 100%.
How Are My Benefits Determined?
Pension benefits are typically a fixed monthly payment in retirement that is guaranteed for life. But how are your benefits calculated in the first place?
The value of a pension benefit is based on how long you work and your final average salary. Here is a visual way to think about how the formula typically works:
- Years of service is how many qualifying years you have worked for your school district or other districts in the same state. All of these years need to be in the same state in order to count toward the formula because each state runs its pension plans separately.
- The higher the multiplier, the larger the benefit. Multipliers are sometimes known by other terms, such as “accrual rate” or “crediting rate” but they mean the same thing. They turn years of service into a percentage.
- Final average salary, or final average compensation, is defined slightly differently from state to state. But it always refers to the compensation that a pension will be based on. This might be the average of the final five or seven years of service, or the average of the highest three to five years worked.
Depending on your state, your base pension amount might also get adjusted for inflation when you’re in retirement. And this certainly is ideal to protect the purchasing power of the pension from eroding over time. Depending on your state, a portion of your pension benefits can be passed on to a spouse or dependent, but typically are not inheritable.
Notice that the formula is not dependent on the amount of money that is contributed into the pension fund itself. So if your contributions into the pension fund are increased, that is unlikely to mean your benefits are increasing too. This also means the minimum value of your pension won’t change based on investment returns or funded status.
Will I Qualify to Receive a Pension?
Most public workers have to work five to seven years before qualifying to receive a pension benefit. In some states it is 10 years, in others as few as three years. Reaching this threshold is known as vesting.
Before vesting, no pension benefits have been guaranteed. People who leave public service like teaching before they vest are not entitled to the contributions their employers’ have made on their behalf. Most states will give back your own contributions with interest, but the amount varies.
Most veteran teachers say that they know the exact day that they will be eligible to start collecting a pension. (It is an exciting day!) Reaching retirement eligibility is usually a combination of years of service and age. For example, a pension plan might offer two kinds of eligibility:
- Complete at least 10 years of service and be 60 years old.
- Complete at least 5 years of service and be 65 years old.
Another common kind of qualification is “Rule of 90,” where the threshold to cross is any combination of age and years of service that add up to 90, such as 65 years old with 25 years of service.
How Do States Ensure They Can Pay for Promised Pensions?
How does a state, or the fund administering pension benefits, make sure it will be able to pay promised retirement income to public workers when they retire? The answer can be boiled down into a simple idea: B + E = C + I.
Retirement systems work to make sure that (C) contributions into the pension fund, plus (I) investment returns on that money, match the value of (B) benefits promised to public workers, plus (E) expenses to run the pension plan in the first place.
The value of promised benefits is the combination of: one, all benefits owed to current retirees; plus, two, the value of all benefits that have been promised to active workers or those who have qualified for a benefit but haven’t retired yet. Expenses to run a pension system are usually small relative to value of benefits, but have to be counted.
Contributions can come from multiple sources, but typically come from participants and their employers.
Investment returns are supposed to make up the majority of money that a pension fund uses to pay benefits. Pooled contributions are invested, and the money earned by those investments becomes part of the pension fund. The pension fund assumes its investments will earn a specific rate of return over the long-term. Once a contribution rate is set and that money is flowing into the pension fund, it is up to the pension board and investment managers to make sure that actual rates of return are at least as good as expectations.
When everything is working, the value of Benefits plus Expenses will be matched by the appropriate amount of Contributions plus Investment Returns. If any of these elements is out of balance, the pension system could be underfunded.
How Do I Know I’ll Have Enough Money for Retirement?
As an educator, you’ve devoted your career to helping students—not to getting rich. As a professional, you deserve a secure and dignified retirement, with the ability to relax, travel, and spend time with family without worrying about money. But how will you get there?
According to most experts, a decent target is for your retirement income to equal between 60% and 80% of what you were earning just before retirement. The exact amount you should have depends on whether you’ll be working a part-time job in retirement and whether you still have major life expenditures, such as paying a home mortgage or college tuition for children.
A path to retirement security does not necessarily require a “pension” plan. Retirement income in general can come from a range of sources, such as individual retirement accounts that are turned into annuities, supplemental savings, and/or Social Security.
Just because you are enrolled in a pension doesn’t mean you’ll have enough money in retirement. The value of the pension might not be adequate, or it might not come with a cost-of-living adjustment. Ideally, at least one source of retirement income would be adjusted for inflation so that as the cost of living changes over time, you won’t struggle to make ends meet.
A typical pension plan has a 2% “multiplier.” If you work 25 years, you’ll get 50% (25 years x 2%) of your final average salary. That might not be enough on its own. But if you can work longer, or have other retirement income (like Social Security or personal savings) you can get to that 60% to 80% replacement rate target.
Ultimately, “retirement security” means having enough income to meet the needs of you and your family. A lot depends on how much you plan to spend in retirement, and how valuable your government benefits — like a pension — will be. It is important to know what the value of your pension will be and how that fits into a comprehensive plan for retirement.
How Does Social Security Work for Teachers Like Me?
Social Security is formally a “defined benefit” plan, meaning the retirement income you will receive is defined in advance. Usually, there is a formula prescribed in advance of your retirement that is used to calculate a specific benefit. Social Security benefits are based on how many years you worked and an average of the salary you earned in your working years.
The primary differences between pensions and Social Security are (1) the formula for how the benefits are calculated, and (2) when you start to receive money. Most teacher pension plans calculate your benefits using the final five years or less of your salary, whereas Social Security calculates benefits using a lifetime average of your wages. And most teacher plans provide benefits much earlier than Social Security.
More than a million teachers across the country do not participate in Social Security. There are 12 states that have totally opted out of Social Security. And another 5 states have school districts with mixed coverage.
Knowledge is power, dive deeper
Now you know the answers to some common questions of how your pension is supposed to work.
But this just scratches the surface. If you want to dive deeper into how pension systems are supposed to work and how pension benefits work in your state, check out our full Teacher Retirement U program.