Many people don’t understand how pensions work – unlike the loyal readers of ‘Defined Benefit’ – so here’s a short primer on how pensions get their money. Typically, it is from three sources: employee contributions, investment returns, and employer contributions. Let’s take a look at each of these.
Employee contributions: in nearly every state, public employees are required to contribute a portion of their salary to their pension. This can range from 3% in Florida and Indiana to 10% in Ohio and 14% in Nevada. Employee contributions are automatically deducted from payroll, so workers have never missed a payment toward their pensions.
Investment returns: the administrators of public pension plans invest their funds in equities, bonds, real estate, and other assets. The return on these investments varies from year to year and typically makes up half or more of the revenue for pensions each year. Investments took a big hit during the Great Recession, but they have rebounded and pension funding in many states is rising.
Employer contributions: the last revenue source for public pensions can be the most problematic one. In this case, the employer is either state or local government. Governments need to pay their actuarially required contribution (that’s budget speak for the amount an employer needs to pay each year to keep the system healthy, also called the ARC) in order to maintain stable funding for the pension plan. Unfortunately, many politicians are notorious for underfunding pensions in order to pay for other things, such as corporate subsidies or tax breaks for the wealthy. If every state fully paid its ARC each year, public pensions would be thriving.
Public pension plans rely on these three funding streams in order to pay benefits to their plan participants. When all three sources of revenue are strong, pension plans perform well and are able to provide a safe and secure retirement to public workers.