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Inflation is taking a substantial bite from the income retirees get from pensions.
Many pensions periodically increase recipients’ payment amounts by offering a cost-of-living adjustment. But those raises are small relative to the 8.5% annual inflation rate in March, the highest in over 40 years.
Some plans, especially corporate pensions, don’t offer any COLA.
Retirees who rely on pension income are losing purchasing power as a result, unlike those who rely on some other income sources like Social Security, whose payments try to keep pace with inflation.
“The real value of that pension will go down,” according to Jean-Pierre Aubry, an associate director at the Center for Retirement Research at Boston College. “It will basically buy less at the supermarket than it used to.”
Take this example: A 1% inflation rate would reduce the value of a $25,000 annual pension benefit 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.
It’s unclear how long the current rate of inflation will persist, though. Some economists think it likely peaked in March and may start to decline in coming months.
The current dynamic is especially acute for former employees of state and local government, such as retired public school teachers, firefighters and police officers.
Nearly 11.5 million people were getting income from a state and local pension in 2020, according to the U.S. Census Bureau.
State and local governments tend to use pensions instead of 401(k)-type plans as their primary retirement plan for workers.
Eighty-six percent of state and local government employees had access to a pension plan as of March 2021, according to U.S. Department of Labor. Just 15% of private-sector workers had pension access. (They are more likely to have access to a 401(k)-type plan, which was available to 65% of employees in private industry.)
Roughly 3 in 4 state pensions automatically provide a COLA to recipients, according to the National Association of State Retirement Administrators. The others rely on ad-hoc action by state legislatures or another governing body.
But the formulas to determine the size of that automatic increase vary considerably. Some peg their adjustment to the inflation rate, typically up to a cap. Others only offer the adjustment when the pension has adequate funding or hits certain investment-return thresholds, for example.
“Very few plans provide 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 U.S., according to the Census Bureau. Local plans are also “all over the map” in terms of cost-of-living adjustments but largely mirror state policies, Brainard said.
Further, 5 million state and local workers (about 25%) aren’t covered by Social Security on their current job, according to the Center for Retirement Research. That means longtime public servants who haven’t had another job that pays into the Social Security system may not get any of that inflation-protected income.
Many of these individuals are in states like Massachusetts, Ohio and Nevada, where government workers don’t pay into Social Security, according to Aubry. That’s true of specific occupations in other states, like teachers in Minnesota, he said.
“It magnifies the role and importance of the [pension’s cost-of-living adjustment], if they’re not getting Social Security,” Brainard said.
Some states throttled back the generosity of their pension COLAs after the Great Recession, Aubry said.
Prior to 2021, inflation had been low for years and pension COLAs had largely kept pace; some were even higher than inflation.
Just one state pension — a plan for police officers and firefighters in Washington state — is keeping pace with the current inflation rate, according to a National Association of State Retirement Administrators report published in June. Its adjustments are fully indexed to the Consumer Price Index, a key inflation gauge. The plan (Washington LEOFF Plan 1) is only available to workers hired before Oct. 1, 1977.
A pension for Vermont state employees is also among the more generous relative to COLAs, according to report data. Its adjustments are pegged to the Consumer Price Index up to a 5% cap.
Others, like the Iowa Public Employees’ Retirement System and a pension for Ohio teachers, don’t offer any adjustment, according to the report. That’s similar to corporate pension plans, which also generally don’t, according to experts.
An Ohio pension board voted in 2017 to reduce the COLA to 0% from 2% in part to maintain the “fiscal integrity” of the plan, the report said. And a pension plan in Kentucky only pays the adjustment when it’s more than 100% funded or if the legislature prefunds it, making payment “unlikely in the foreseeable future,” the report said.
The current inflation trajectory exposes a central tension: While retirees may be falling behind in the short term, offering a more generous adjustment (especially one that’s permanent and automatic) can be expensive. A modest COLA might benefit retirees in the long run by maintaining better financial health of a pension — perhaps offering more reassurance to retirees that the plan will be able to pay the promised benefits.
“It’s no good to have a promise for $1 million if they can’t pay it,” Aubry said. “You want a promise that can be kept.”
Fully indexing state and local pensions to a national inflation rate may be challenging since state finances are more closely tied to the local economy, he said.