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Inflation takes a significant bite out of the income retirees receive from pensions.
Many pensions periodically increase the payouts of the recipients by offering a cost-of-living adjustment. However, these increases are small compared to annual inflation of 8.5% in March highest for over 40 years.
Some schemes, especially corporate pensions, do not offer any COLA.
Pensioners who depend on pension income lose purchasing power as a result, unlike those who depend on some other sources of income such as social security, whose payments try to keep up with inflation.
“The real value of that pension will fall,” according to Jean-Pierre Aubry, an associate director at the Center for Retirement Research at Boston College. “It will basically buy less in the supermarket than it usually does.”
Take this example: A 1% inflation would reduce the value of an annual retirement benefit of $ 25,000 to $ 20,488 after 20 years; a 2% inflation rate would erode its original value by a third, to $ 16,690, according to the National Association of State Retirement Administrators.
However, it is unclear how long the current inflation rate will last. Some economists believe that it probably peaked in March and may begin to fall in the coming months.
The current dynamic is particularly acute for former employees of state and local authorities, such as retired primary school teachers, firefighters and police officers.
Nearly 11.5 million people received income from a state and local pension in 2020, according to to the U.S. Census Bureau.
State and local governments tend to use pensions instead of 401 (k) -type plans as their primary pension scheme for workers.
86 percent of government and municipal employees had access to a pension scheme from March 2021, according to to the U.S. Department of Labor. Only 15% of private sector workers had access to pensions. (They are more likely to have access to a 401 (k) -type plan, which was available to 65% of private industry employees.)
About 3 out of 4 state pensions automatically provide a COLA to beneficiaries, according to the National Association of State Retirement Administrators. The others rely on ad hoc actions by state legislators or another governing body.
However, the formulas for determining the magnitude of the automatic rise vary considerably. Some link their adjustment to the inflation rate, typically up to a ceiling. Others only offer the regulation when the pension e.g. have adequate funding or reach certain return on investment thresholds.
“Very few plans yield much more than 2% or 3% [a year]”said Keith Brainard, research director at the National Association of State Retirement Administrators.
There are 5,340 state and local pension systems in the United States, according to the Census Bureau. Local plans are also “across the map” in terms of cost-of-living adjustments, but largely reflect state policies, Brainard said.
Furthermore, 5 million state and local workers (approximately 25%) are not covered by social security at their current jobs, according to to the Center for Pension Research. This means that long-term civil servants who have not had another job paying into the social security system may not receive any of the inflation-protected income.
Many of these individuals are in states like Massachusetts, Ohio and Nevada, where state employees do not pay for social security, according to Aubry. That applies to specific occupations in other states, such as teachers in Minnesota, he said.
“It magnifies the role and importance of [pension’s cost-of-living adjustment]if they do not get social security, “Brainard said.
Some states throttled the generosity of their retirement COLAs back after the Great Recession, Aubry said.
By 2021, inflation had been low for years, and pension COLAs had largely kept pace; some were even higher than inflation.
Only one state pension – a plan for police officers and firefighters in Washington state – keeps pace with the current inflation rate, according to a National Association of State Retirement Administrators report released in June. Its adjustments are fully indexed to The Consumer Price Index, an important measure of inflation. The plan (Washington LEOFF Plan 1) is only available to workers employed before October 1, 1977.
A pension for Vermont state employees is also among the more generous compared to COLAs, according to report data. Its adjustments are linked to the consumer price index up to a ceiling of 5%.
Others, such as the Iowa Public Employees’ Retirement System and a pension for Ohio teachers, offer no adjustment, according to the report. This is similar to corporate pension schemes, which also generally do not, according to experts.
An Ohio Pensions Board voted in 2017 to reduce COLA to 0% from 2% in part to maintain the plan’s “tax integrity,” the report said. And a pension scheme in Kentucky only pays the adjustment when it is more than 100% funded or if the legislature pre-finances it, making payment “unlikely in the foreseeable future,” the report said.
The current inflation path reveals a key tension: While retirees may lag behind in the short term, it may be expensive to offer a more generous adjustment (especially one that is permanent and automatic). A modest COLA can benefit retirees in the long run by maintaining better financial health for a pension – perhaps offering more assurance to retirees that the plan will be able to pay the promised benefits.
“It’s no use having a $ 1 million pledge if they can not pay it,” Aubry said. “You want a promise that can be kept.”
Full indexation of state and local pensions to a national inflation rate can be challenging as government finances are more closely linked to the local economy, he said.