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

Publication Date: August 2010

Publisher: Center for Retirement Research at Boston College

Author(s): Peter A. Diamond; Alicia H. Munnell; Jean-Pierre Aubry

Research Area: Economics

Keywords: state and local pensions

Type: Report

Coverage: United States

Abstract:

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.