The Problem With Public Pensions

If you're a teacher, firefighter or other public employee, you're probably covered by a pension. Nearly 80% of state and local government employees are covered by a defined-benefit plan, and so are federal government workers.

But don't assume your retirement will be worry-free. To start, even a short stint as a public-sector worker could reduce your Social Security due to what's known as the "windfall elimination provision," or WEP. This provision of federal law reduces benefits for workers who are eligible for Social Security but who also earned a government pension on wages that weren't covered by Social Security. The WEP affects government workers in 15 states. (For a complete list, go to www.nea.org/home/16819.htm.) Workers who have 30 or more years of earnings covered by Social Security are exempt from the WEP.

A separate provision, known as the government pension offset (GPO), could reduce your Social Security spousal or survivor payments if you worked in a public-sector job not covered by Social Security. Usually, a spouse gets up to 50% of a worker's Social Security benefit, and a survivor gets up to 100%. The GPO provision reduces the spousal or survivor benefit by two-thirds of the recipient's public worker's pension. You can check your status by reviewing your Social Security benefit statement (find it online by signing up for an account at www.socialsecurity.gov). You'll see zeroes for years in which you weren't covered by Social Security.

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Dan Otter, 50, who teaches at the University of New Mexico, wasn't covered by Social Security during the nine years he worked in the California public school system. "When I look at my Social Security statement, there are these very bleak nine years" for which there is no income that counts toward Social Security benefits, says Otter. He's working with a financial planner to figure out how big a dent those lost years will make, but it could be more than $700 a month in reduced Social Security benefits.

Government employees, like private-sector workers, are more mobile than they used to be, and that has diminished the value of their pensions. A 2015 study by Bellwether Education Partners, a nonprofit education advocacy group, estimates that only 20% of new teachers will qualify for the maximum monthly payment under their pension plan. The rest will see their benefits reduced or eliminated because they changed jobs.

Longtime public-sector workers have another concern: the financial stability of their employer. The Pew Charitable Trusts estimates that there's a $1 trillion gap between the amount of money state-run pensions have and the amount they've promised their workers. Some academics believe the shortfall is more than three times that amount. Estimating liabilities is difficult because state pension administrators aren't subject to the same financial and accounting standards as private pensions, says Olivia Mitchell, a professor at the University of Pennsylvania's Wharton School and executive director of the Pension Research Council. "States have tremendous leeway in how they calculate liabilities," she says. In particular, states can project much higher investment returns than private pensions can.

Illinois, Connecticut and Kentucky have the largest shortfalls, with less than half of their estimated liabilities covered, according to a 2014 Pew analysis. Other states are in much better shape. Wisconsin's funding ratio is nearly 100%, and South Dakota and North Carolina have more than 95% of the amount needed to cover their estimated liabilities.

Closing the gaps. To close funding gaps, states and municipalities have sought to reduce cost-of-living increases and raise age and tenure requirements for new employees. Some states are trying to move away from traditional pensions entirely. Oklahoma recently eliminated its traditional pension for some new state employees in favor of a 401(k)-style plan. Pennsylvania lawmakers are debating a similar proposal.

Some of those efforts have been blocked by state courts. The Illinois Supreme Court has ruled that the state's reform plan, which would have increased the retirement age and reduced cost-of-living increases, was unconstitutional. There's no precedent for a fiscally troubled state seeking bankruptcy relief, but it has happened at the local level. About 12,000 Detroit retirees saw their pension checks cut by nearly 7% last March as a result of the city's bankruptcy.

What to do. Teachers can enhance their retirement security by contributing to a 403(b) plan, a tax-deferred savings plan that's similar to a 401(k). Unfortunately, as far as investment choices are concerned, many 403(b) plans are vastly inferior to their private-sector counterparts. They're often aggressively sold by insurance agents, and the primary offerings are products such as equity-indexed annuities, which often carry high fees and offer limited market returns.

In 2000, Otter cofounded 403bwise.com to advocate for better retirement plans for teachers. He says he has seen some improvement since then. Last year, for example, the board of education in Montgomery County, Md., a suburb of Washington, D.C., contracted with no-load mutual fund company Fidelity Investments to administer its 403(b) plans. In many states, though, school districts have shown little desire to negotiate with financial services firms, and they're not legally required to do so. In California, state law prohibits public school employers from putting 403(b) plans out for competitive bidding. Instead, school districts turn the job over to sales representatives who don't have much of an incentive to offer low-cost mutual funds.

Other public employees have better savings options. Federal government workers can save through the Thrift Savings Plan, generally considered the gold standard of retirement savings plans because of its slate of ultra-low-fee index funds. Employees of state and local government agencies are often offered a 457 plan, which is similar to a 401(k) or a 403(b), with a couple of key differences. If you have a 457 plan and leave your job, you can take penalty-free withdrawals, no matter what your age. With a 401(k) or 403(b), you'll usually pay a 10% penalty if you withdraw money before age 55. In addition, workers who are within three years of their "normal retirement age" (typically the age when they can collect un­reduced benefits in their pension plan) can double the $18,000 basic maximum contributions for three years if they haven't maxed out on contributions in the past.

Some school systems offer both a 403(b) and a 457 plan to employees. In that case, employees can contribute the maximum ($18,000 in 2016, plus $6,000 in catch-up contributions if they're 50 or older) to each plan. If the 457 plan offers better investment options, you should max it out first.

Another option for teachers with lackluster 403(b) plans is a Roth IRA (see Reap the Rewards of a Roth IRA). In 2016, you can contribute up to $5,500, or $6,500 if you're 50 or older. You can withdraw the money tax-free after age 59 1/2, and you can tap contributions without paying taxes or penalties at any time.