If you’ve been tuning into The Dime over the past three months, you’ve hopefully learned a thing or two about the three legs of the “retirement stool”—the sources of income that are vital to securing your comfort and stability in retirement. If you haven’t yet explored our 101 series on the topic, we invite you fasten your seat belt and prepare to enter the exciting world of pension plans (also known as defined benefit plans), 401(k)s, and Social Security. If that’s too much for you to handle right now, you’re in luck, because we’ve put together a recap of the main ideas to take away from the series. (And hey, if they whet your appetite to dig in deeper, that’s even better.)
The concept of a pension is old—like, really, really old. Historians credit the Roman Empire with conceiving the idea of an income that continued after one’s work service by offering pensions to retired soldiers during the first century B.C. Of course, public pensions like the one at Colorado PERA are a more recent development; the first can be traced back to 1850s New York City.
So what is a pension plan? The modern-day version is a retirement plan sponsored by an employer (or in Colorado PERA’s case, the state) that promises the employees paying into the plan a fixed, pre-established benefit that’s payable for the rest of their lifetime once they retire. The amount of that payout has nothing to do with the sponsor’s investment performance; rather, it’s a function of a basic formula that takes into account, among other things, how long the employee worked, and how much he or she earned (which is often calculated according to the last year or last few years' average pay). In other words, the employee’s benefit is defined by a set formula.
A number of demographic factors, including longer lifespans and lower birth rates, are negatively affecting the financial health and sustainability of pensions across the U.S.—including right here in Colorado. That’s why the PERA Board of Trustees has been proactive in its approach, putting forth a recommended package of changes to PERA’s plan before it's in dire straits. Legislation sharing the PERA Board’s goal of eliminating the plan’s unfunded liability within 30 years was introduced to the Colorado General Assembly on March 14, 2018, and is currently making its way through the legislative process. Anyone interested in remaining up-to-date on Senate Bill 18-200 and its progression should subscribe to our sister blog, PERA on the Issues.
Perhaps one of the most well-known retirement plans out there is the 401(k). A kind of defined contribution plan, the 401(k) was born after Congress passed the Revenue Act of 1978, which included a provision—Section 401(k)—that gave employees a tax-free way to defer compensation from bonuses or stock options. Ted Benna, widely regarded as the “father” of the 401(k), saw the law as an opportunity for employers to create a tax-advantaged savings account for their employees. He must have been on to something, because within a few years of the law’s passing, behemoths like Johnson & Johnson, PepsiCo, JCPenney, and Honeywell had 401(k) plan proposals in the works. (And is it really a surprise that so many corporations embraced this new investment vehicle? From their perspective, eliminating their pension plans would ultimately save them untold amounts of money.)
With a 401(k), the employees decide how much to contribute, and the employer then puts that money into individual employee accounts. Workers typically get to choose from a few different investment options, and also retain ownership of the account if or when they leave the originating employer. To incentivize their use, any money contributed to a 401(k) is tax-deferred, meaning employees aren’t taxed on it until they reach retirement or choose to withdraw the money.
The good-and-bad aspect of a 401(k) is that it’s subject to the rise (yay!) and fall (uh-oh) of financial markets; in that way, it’s less stable than a pension plan. What’s more, since it’s up to individual employees to decide how much to contribute, there’s a real possibility that they could actually outlive their retirement savings accrued (remember that part we mentioned about people living longer?).
Luckily, the defined benefit plan offered through Colorado PERA combines the best of two worlds: the portability of a 401(k) and the stability of a traditional pension. Needless to say, it’s a far cry from your grandpa’s pension plan.
Social Security 101:
Rounding out the sources of income in the three-legged stool concept is Social Security. The Social Security system was established in the aftermath of the Great Depression and signed into law by FDR in 1935 as part of the New Deal. It serves as a foundation of economic security for about 61 million Americans, including retirees, disabled workers, their dependents, and families of deceased workers. As a largely pay-as-you-go program, money from current workers flows into the system in the form of Social Security taxes, and then back out of the system in the form of monthly income to beneficiaries. This differs from “pre-funded” plans like that at Colorado PERA, in which the money is accumulated in advance so it’s available for payment to today’s workers once they retire.
Unfortunately, Social Security is in trouble. In fact, the Social Security trust funds that pay retirement and disability benefits could potentially be depleted by 2035(!). The reasons are numerous, but some of the problem is attributed to longer life expectancies, and to fewer people entering the workforce to compensate for an increasing number of retirees. (Yep—those demographic factors mentioned earlier come into play once again.)
Depleting the trust funds doesn’t necessarily mean the system will run out of money entirely, though; payroll taxes are expected to cover about 75% of scheduled benefits. However, if that gap isn't filled, retirees 30+ years from now could receive smaller Social Security benefits, and/or those in the workforce could end up paying more into the system.
Since Colorado PERA’s defined benefit plan is a replacement for Social Security, the uncertainty of the system’s future doesn’t affect PERA members quite as much. What does affect them, though, is a little something called the Windfall Elimination Provision (WEP). The intention of the WEP is to ensure that workers who receive retirement income via a pension don’t also receive a disproportionately high Social Security benefit that isn’t reflective of the total income they actually earned. The concept is a bit of a monster to wrap one’s head around, but as with most things, there’s a silver lining: As long as an employee has at least 30 years of “substantial earnings,” he or she is not subject to the WEP. (Phew.)