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

by Peter A. Diamond, Alicia H. Munnell, Gregory Leiserson, and Jean-Pierre Aubry

August 2010

SLP#12

Introduction

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...

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