Iowa is a great place to retire. After an eight-year phase-out period, Iowa retirees now pay no state income tax on their Social Security income. Retirees also continue to receive a large exclusion of pension income that was first made available in the 1990s. These provisions encourage retirees to stay in Iowa and continue to contribute as volunteers, board members, community leaders, caregivers, mentors, and in all the other ways they contribute to Iowa’s quality of life.
It also reinforces how much has changed in the world of retirement planning since Iowa’s defined-benefit public employee retirement plans were created in the 1950s. Because of these changes, today, many Iowa public pension plan retirees are actually better off in retirement than when they were working. This is an outcome that certainly was never envisioned, but is enormously significant.
The Iowa Public Employees Retirement System (IPERS) was created in the early 1950s, and counts among its 346,000 membership almost all public employees in Iowa (schools, cities, counties, state employees, and others). When this plan and other defined benefit plans like it were created, they no doubt made a lot of sense for the conditions of the time.
For example, people didn’t change jobs much, so they didn’t need portability. Members either made a career of public service or married, so the benefits were weighted heavily to the longest-tenured employees with short-term employees receiving little or nothing. The result today, arguably, is that long-term employees are over-compensated, while those who change jobs (outside the system) more often are not building the retirement savings they need.
Another difference is that in the 1950s public sector pay wasn’t as good as it is today, so back then benefits needed to be higher in order to attract employees. Today, that is no longer the case. At worst, public and private sector wages have evened out (after controlling for higher education levels in the public sector), but public sector health insurance and retirement benefits are still much higher. In fact, public pension benefits have increased substantially since the 1950s even as salaries have caught up.
Another obvious difference is longevity. Today, life expectancy at age 65 is five years longer than it was in the 1950s.
Further, when these plans were first created, investments (of which earnings help pay for benefit payouts) were limited to low-risk fixed income investments, which were well matched with the fact that benefits also had to be paid. Today, most of the portfolios are invested in higher risk equities and alternative investments.This means there’s a lot more risk in the system, and because benefits have to be paid, no matter what, vastly more impact on state and local budgets when the market tanks.
Finally, in the 1950s, Social Security contributions were much lower: 2 to 2.5 percent for the employee, compared with today’s 6.2 percent. Pension plan employee contributions were also lower – for IPERS, about 3.7 percent, while today they are nearly 6 percent. Today, when someone retires, because they no longer have to deduct these sizeable payroll contributions, their post-retirement take-home income feels that much higher.
The cumulative impact of all of these changes on the plans and especially on the pre- and post-retirement comparison is substantial.
We looked at comparisons of pre- and post-retirement net (take-home) income for IPERS members, retiring in fiscal year 2015. These individuals also receive Social Security income. We assumed no other income. It turns out that in our example a 65-year-old IPERS employee with average pre-retirement income who retired in fiscal year 2015 is in a better financial position retired than working, considering differences in required contributions and taxes. Longer-tenured employees do even better.
Sources: IPERS (and Taxpayers Association of Central Iowa estimates based on IPERS data) and Social Security On-Line Benefit Calculator, Age 66 Draw. http://www.socialsecurity.gov/oact/quickcalc/
The “average” reflects people who may have left the system long ago with a short tenure and with relatively low income at the time of separation, although they retired and began to draw benefits in 2015. It is also influenced by the extraordinarily high benefits enjoyed by those with the longest tenure. These longest-tenured employees are even better off in retirement than what is shown above. In fact, an employee who worked more than 30 years with average salary nets 11 percent more take-home income in retirement than working. A 25- to 30-year employee nets 7 percent more in retirement. The average tenure for a 2015 retiree was 21.7 years.
It is doubtful that policy makers intended to create a situation where an employee is financially better off retired than working. In fact, public employees have typically been advised to not rely on Social Security and IPERS alone.
The more favorable tax treatment of retirees in Iowa is yet another reason for a comprehensive review of Iowa’s public employee retirement systems. We would not suggest that retirees should lose what they have already earned, nor what employees are expecting to earn in retirement, especially for those who are close to retirement. However, going forward there should be opportunity to build at least some retirement security for many more employees, while placing what most people would consider reasonable limits on post-retirement net income for those at the top end.
In any case, it’s time for a review to see what kind of plan best fits the world of today and into the future.