How Are Defined-Benefit Pensions Calculated?

THE VAST MAJORITY of California's public pension systems operate as defined-benefit (DB) plans, meaning that these plans pay a specific pension amount to their retirees each month for life. In total, about 4 million Californians — 11 percent of the population — are members of one or more of the state's 86 defined-benefit public pension systems: 6 state plans, 21 county plans, 32 city plans, and 27 special district and other plans.

Some plans are small and run by a single city or county. Other plans are huge statewide systems. The "Big Three" are the California Public Employees' Retirement System (CalPERS), the California State Teachers' Retirement System (CalSTRS), and the University of California Retirement Plan (UCRP). CalPERS and CalSTRS are the largest and second-largest public pension systems in the country, respectively.

CalPERS is a pension system for 1.68 million current and former state and local government employees and their families (see Figure 1.1). More than 3,000 public-sector employers participate in CalPERS (1,581 public agencies at the city, county, or state level and 1,508 school districts covering the nonteaching employees, such as janitors and office workers). Employees with the twenty-three campus California State University system are members of CalPERS.

CalSTRS serves 868,000 current and retired K–12 and community college public school teachers and their families. About 1,600 employers (school districts, community college districts, and county offices of education) participate.

UCRP serves 253,000 active, inactive, and retired employees of the University of California system and their families. Participating employers include the university's ten campuses, five medical centers, Lawrence Berkeley National Laboratory, and Hastings College of the Law.

Cities and counties have the option of participating in CalPERS and/or CalSTRS, or they can create their own independent pension system.

DB payments for retirees are calculated based on (1) the number of years of service; (2) age at retirement; and (3) final compensation, which is typically the highest annual pay plus special compensation averaged over a 3-year period. There are variations, however, in the number of years used to calculate "final compensation." Some California teachers with 25 years or more of service, for example, can use their highest consecutive 12-month period of pay to calculate final compensation. Making the pension calculations more complicated, a variety of formulas are applied depending on the employer (state, school, or local government agency), occupation (general office, safety, industrial, or police/fire), and the specific terms in the contract between the employer (government agency) and the pension fund.

To illustrate how a pension benefit is calculated, a state employee hired under CalPERS's "2 percent at 55" can retire at age 55 with 2 percent of their final compensation for every year they have worked. If an employee with 30 years on the job, having earned a final compensation of $100,000 a year, chooses to retire at age 55, then that employee will receive 60 percent (30 × 2 percent) of his or her compensation, or $60,000 annually for life.

If this same employee retires at age 63 or older, the "benefit factor" rises from 2 percent to 2.5 percent, meaning that after 30 years on the job, he or she would receive 75 percent (30 × 2.5 percent) of compensation, or $75,000 annually for life. Note that DB "benefit factors" are back loaded, meaning they increase with age and, therefore, reward additional service years at an increasing rate.

Pension calculation formulas can also vary with occupation. For example, some local police officers and firefighters can retire through CalPERS at age 50 with 3 percent of final compensation for every year served. And pension calculation formulas can vary by jurisdiction. For example, Orange County's pension system permits a 2.7 percent benefit factor at age 55 for some non-public-safety workers. The largest group of state workers is under a "2 at 55" formula with CalPERS.

PENSION SPIKING

Most public-sector collective bargaining agreements include automatic annual cost-of-living adjustments (COLAs) or automatic "step increases" for length of time on the job, or both. These features automatically increase base pay used to ultimately calculate pension benefits, and neither is typically available in the private sector. Pension payments to retirees are often increased annually through automatic COLAs as well.

The "special compensation" used to calculate pensions includes overtime pay, unused vacation pay, allowances, and bonuses. To the extent possible, each employee has a strong incentive to bump these up in the last few years of service since these are the years used to calculate pension benefits. This practice is called pension spiking. The fewer the number of years that are used to calculate final compensation the more attractive pension spiking becomes to workers.

Under current federal law, a private-sector pension cannot be based on an average compensation using fewer than 5 years. State and local pensions are exempt from this law; thus, public pensions in California typically use 3 years or less of earnings to calculate pension benefits, making spiking very attractive and beneficial. Very few state workers have yet to retire under an "average-of-three-years" formula — most are less than three years.

Through spiking, lifetime annual pensions for some retired government workers exceed their final year's pay. For example, retired Ventura County Sheriff Bob Brooks receives an annual pension of $283,000. His final salary was $227,600. Former Merced County Sheriff Mark Pazin receives a higher annual pension than he received in pay when working — nearly $200,000 a year. Former San Francisco Police Chief Heather Fong was paid more than $528,000 in her last year as chief, but more than $303,000 of that were payouts for unused sick, vacation, and comp time before retirement. Fong, who left office at age 53, receives a public pension of $277,656 a year for life, a lot more money than she received when working ($187,875).

The California Rule

California's defined-benefit public pensions pay a specified amount to each retiree for life. In what has come to be called the California Rule, public-pension benefits earned by past work performed and future pension benefits are contractually protected in...