Understanding the Tiers of the Pension System
Today’s column will be the first of a two-part series combining a history lesson and an economics lesson exploring how the current tiered public pension system came to be and how it has decimated the retirement picture of those in New Jersey who are new teachers and new school administrators as well as others who are part of the group known as public employees.
July 1, 2019 will mark the twelfth anniversary of the introduction of tiers for members of the two major statewide pension systems in New Jersey: the Teachers’ Pension and Annuity Fund (TPAF) and the Public Employees’ Retirement System (PERS). Prior to July 1, 2007, all new entrants into public sector employment were enrolled in the same retirement plan. That plan, with a few tweaks, traced its origin back to the 1950s, the time that the defined benefit pension plan and Social Security were combined for New Jersey educators. Other New Jersey public employees also had their defined benefit pension plan combined with Social Security at that time. Therefore, whether enrolled in TPAF or PERS, all State and local employees enjoyed the same retirement benefits from the 1950s to July 1, 2007.
The majority of current public employees in New Jersey are still enrolled in the pension system that existed before 2007, which is today known as Tier 1. As long as they continue working in education or public employment without a break of two or more years, they will remain in Tier 1. However, their numbers will gradually shrink as they retire because all new employees are currently enrolled in the latest tier, Tier 5, which has been in effect since June 29, 2011.
Those in Tier 1 can retire at age 60 (Service Retirement) or after 25 years of credited service (Early Retirement), whichever comes first. In either case, the retiree begins collecting the pension at the time of severance from active employment. (Those who retire with 25 years of credit and are not age 55 must accept a reduced benefit of 3% per year or 0.25% per month for each year and month they are shy of age 55.)
The pension amount is based on a formula (N Times FAS Divided by 55 = My Pension) in which N equals the number of years of credit; FAS equals the average of the highest three years of full salary; and 55 is a factor, not an age. (Example: 31 (Years of Credit) times $120,000 (FAS) divided by 55 (Factor) = a pension of $67,636.)
In addition, those retiring with 25 or more years of pension credit receive health benefits either partially or fully without cost, depending upon when the 25 years were served.
In 2007, several changes became effective for employees hired on or after July 1, 2007. The changes were intended to reduce the cost of funding the pension system, which had become significantly underfunded because the State had not met its funding obligation – not making any contribution or not making its full contribution – for many years beginning in the 1990s. Educators and other public employees had made their full pension contributions as prescribed by law every year that the system had been in effect, but the State had not. The funding shortage that resulted required some action by the State, which the State sought to meet by reducing the benefit structure for new employees hired on or after July 1, 2007. The new benefit structure was called Tier 2.
Tier 2, which reduced some of the benefits for new employees, includes the following changes:
# The salary used for averaging in the formula was capped at the Social Security wage base, which in 2007 was $97,500. (In 2019, the Social Security wage base is $132,900.) The final average salary figure for employees hired after July 1, 2007 can never be higher than the Social Security wage base in their three highest years of service when calculating their pensions.
# To make up for the salary cap, a new retirement plan, the Defined Contribution Retirement Plan (DCRP), a 401k type plan, was begun for employees who are part of the Tier 2 benefits plans. Employees whose full salary was above the Social Security wage base contribute 5.5% of the salary above the wage base and the employer contributes 3% of the salary above the wage base to the DCRP, where it is invested in financial instruments. At retirement, Tier 2 retirees have a combined retirement income based on the monthly formula amount plus the lump sum value amount to which the DCRP has grown. (The lump sum value amount can be converted to a monthly annuity, if the retiree chooses.) The two together still do not produce what would be the total monthly and annual retirement amounts of the annual Tier 1 formula pension benefit.
# A permanent 1% early retirement penalty was instituted for each year between ages 55 and 60 if an early retirement benefit is paid before age 60. In addition, the 3% penalty for each year an early retirement benefit is paid before age 55 remained in effect.
When it became obvious a year later that the changes in Tier 2 would not be sufficient to solve the funding shortfall, another piece of legislation establishing Tier 3 was passed that further reduced the pension benefits of educators and other public employees hired on or after November 1, 2008.
Tier 3 changes included:
# The Service retirement age became 62 for employees who were hired on and after November 1, 2008;
# The Early Retirement penalty of 1% was extended to age 62, increasing the total penalty for early retirement between ages 55 and 62 to 7% for those who retired before age 62. In addition, the 3% penalty for each year an early retirement benefit is paid before age 55 remained in effect.
The problem of the underfunding of the system continued to vex the systems despite the imposition of Tiers 2 and 3, because the State continued to only contribute a portion of what the actuaries of the system said the retirement plans required. In 2010 and 2011, two additional tiers, Tier 4 and Tier 5, which further reduced the benefits for new employees, were legislated, but the issue of funding continued to be a problem.
The next column will explore the details of Tier 4 and Tier 5 as well as other suggestions that have been put forth to strengthen the retirement picture for educators and other public employees.