Your pension benefits are based on a formula
First, the good news. Pension benefits are typically a fixed monthly payment in retirement that is guaranteed for life. The value of a pension benefit is based on (1) how long you work and (2) your final average salary.
Notice that the formula does not take into account any of the money that is contributed into the pension fund itself, or investment returns.
So even though the COVID-19 pandemic has led to financial market losses for pension funds, this does not affect the base value of your pension benefit.
“Funded status” measures your pension system’s health
Next, here is an important term to know for understanding the effects of the pandemic: funded status. Pension plans measure their ability to keep promises made to teachers and other public workers by using this simple “funded status” metric.
Here is how it works: Dollars flow into a pension fund from contributions and investment returns on those contributions. Benefits promised to current and future retirees are counted up each year. Funded status measures the dollars a pension fund has on hand compared to the pension payments it needs to make.
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. If the pension plan has 70% funded status, that means there is only 70 cents in the fund for every dollar of benefits promised to current workers and retirees.
The pandemic will hurt pension funded status
Now, the bad news. The pandemic has led to lower than expected investment returns, which has hurt the funded status of teacher pension funds. Low tax revenues created by the economic recession have already causes some states to withhold part of their pension contributions and will likely cause more states to skip out on part of their pension funding.
Taken together, this will mean lower funded status and additional pension debt. Going into the pandemic, teacher pension funds already were facing problems. On average nationally, they were only holding 68 cents for each dollar promised to current and future retirees (known as 68% funded).
The pandemic might increase your contributions
State pensions are paid using money collected by investment returns and contributions — provided by both your employer (like a school district) and yourself.
The pandemic’s effect on pension funded status very well could mean your state decides to increase your contributions into the pension fund.
Governments across the country are going to struggle with low tax returns because of the COVID-19 recession. And most financial experts are predicting a slow recovery. This means state legislatures could require that educators and other public workers chip in more to the pension fund, so that the state has to pay less. Or not as much of an increase in the future.
After the Great Recession, almost all states increased the contribution rates from employees in order to help pay for pension benefits. Multiple states have already considered legislation in 2020 to start increasing employee contributions.
The pandemic might reduce your future benefit
Remember, pension benefits are based on a formula that factors in years of service. You have to work a few decades before the value of the benefit is enough to be your only source of retirement income. Most teachers need to work 25 to 35 years to earn a large enough pension for retirement security.
This means teachers with 10 to 15 years of service do have reason for concern. They will have qualified to receive a pension by reaching the vesting point for their benefit. But they will not have worked long enough to have earned a very significant benefit.
The first cause for concern will be employment. If low tax revenues because of the pandemic lead states to layoff teachers (like they did after the Great Recession) this could mean those individuals never really earn that significant of a retirement benefit.
The second cause for concern will be salary. Even if those in the early to middle stages of their careers keep their jobs and stay in the teaching profession, the pandemic will likely have lasting effects on teacher wages. The slower teacher pay rises, the less the ultimate value of a teacher’s pension is likely to be.
The pandemic might reduce COLAs
Most teacher pension funds will adjust the value of your benefits after retirement based on inflation. But many of them link the qualification for a cost-of-living adjustment (COLA) to whether the pension fund can afford the extra money.
In at least 16 states, COLAs are linked to the funded status of the pension fund, and in three more the inflation adjustment is linked to investment performance. Other states might try to save some money by changing the law to reduce COLAs within the next few years. Ultimately, it is likely that the pandemic will mean at least one to two years of small or zero increases to retired teacher benefits in many places around the country.
There is hope
The good news is that all teacher pension funds have enough money on hand to pay retirees through the pandemic. The bad news is that funded status is eroding and active teachers should be concerned about how this will affect their future benefits and current take home pay.
After the Great Recession in 2008-09, there were a few states that made improvements to their retirement system design that will help them navigate this mess. Other states can learn from these trends.
The more you understand about how your retirement benefits work, the more you can be prepared for your family’s financial future. Find out more about solutions to today’s funded status and benefit challenges by diving into our full TeacherRetirementU program.