Are the WEP and GPO “Fair”?

Like many teachers, the first time I heard about the Windfall Elimination Provision (WEP) and Government Pension Offset (GPO), my first response was, “That’s not fair!” Why should my Social Security benefit (by WEP) or Social Security Survivor’s Benefit (by GPO) be reduced simply because I worked as a public employee and earned a pension benefit? As with many things, once I learned a bit more I realized that the issue was a bit more complicated and nuanced than I first thought. The following are some brief thoughts about the WEP and GPO (but please realize these are complicated topics and this will not be a thorough exploration of either of them).

First, a reminder. When Social Security was created (in 1935), it was designed to be part of a “three-legged stool” to provide “economic security” to folks when they could no longer work. Those three legs were a company-provided pension plan (still relatively new at that point but very popular, even though many folks didn’t have one), Social Security (Title II portion), and the person’s own savings. It was never designed to be perfect, or to provide for a “comfortable” retirement as we think of it these days, but to alleviate poverty and suffering in old age.

“Security was attained in the earlier days through the interdependence of members of families upon each other and of the families within a small community upon each other. The complexities of great communities and of organized industry make less real these simple means of security. Therefore, we are compelled to employ the active interest of the Nation as a whole through government in order to encourage a greater security for each individual who composes it . . . This seeking for a greater measure of welfare and happiness does not indicate a change in values. It is rather a return to values lost in the course of our economic development and expansion . . .”

Franklin D. Roosevelt: Message of the President to Congress, June 8, 1934.

The Windfall Elimination Provision (WEP) is a provision of the Social Security rules that can reduce (but not eliminate) your Social Security benefit if you are eligible for a pension and did not pay into Social Security during the time you were earning that pension. This most often affects public employees (like teachers) in states where the pension plan is designed as a Social Security replacement plan. This is true of Colorado PERA and many other state plans, but not all state plans – some teachers pay into both their pension plan and Social Security simultaneously. For states where teachers pay into both, their pensions are typically much lower because they are designed to supplement Social Security (and the contributions they and their employers make to the plan are typically much lower). In states like Colorado where the pension is a replacement plan, the pension benefits are larger (as are the contributions), because the assumption is that you will not be receiving any Social Security, so therefore your pension – along with your savings – must be enough to live on in retirement.

Similarly, the Government Pension Offset (GPO) can reduce or eliminate Social Security Survivor’s Benefits. Some folks are eligible for Social Security benefits earned by their spouse if their spouse dies first, but if your pension (again, only if you also didn’t pay into Social Security simultaneously) is large enough, it can reduce or even completely eliminate those survivor benefits.

On first blush, this seems to be very unfair. Many teachers (and other public employees) work enough (typically forty quarters = 10 years of wages) under Social Security covered employment while in high school, college, and before, during and after their teaching careers to earn a Social Security benefit. If we pay into the system just like everyone else, why should our benefits be reduced simply because for some part of our career we also paid into another system? As it turns out, there is actually some really good logic behind this (although not everyone will agree), so let’s briefly take a look.

The first thing to keep in mind is that as long as you qualify for a Social Security benefit, WEP can reduce but not eliminate it. The maximum your benefit can be reduced by WEP is $480 per month (in 2020) and the reduction cannot exceed 50% of your pension benefit. Second, if you have 30 or more years of substantial Social Security covered earnings, WEP won’t affect your benefit at all. (If you have less than 30 years, the more years you have, the lower the WEP reduction is.) You can use this calculator (you have to enter in your yearly Social Security earnings) to estimate your benefit, or visit Open Social Security (where you enter in your PIA as calculated by Social Security).

So why does this provision exist? It’s because Social Security does not pay the same percentage of replacement income to everyone. Because it is designed as “social insurance” and to alleviate “poverty and suffering” in old age, it pays a higher percentage of one’s career average indexed earnings if you make less money, and a lower percentage if you make more. You can download the latest report (pdf) from Social Security, but the replacement percentage can be as high as 78% (for very low earners) to as low as (27% of the maximum Social Security covered wage, currently $142,800) for very high earners, with most folks earning in the 35-45% range.

Because of the way the formula is constructed, many folks who receive a public pension get treated like a very low wage earner and therefore get a higher benefit, even though they were not a very low wage earner. For example, let’s say you have eleven years of Social Security covered earnings and therefore qualify for a Social Security benefit. But those eleven years were mostly low-wage years, years you worked part-time in high school and college, and maybe summer jobs as a teacher. The Social Security formula then takes those eleven years of low earnings and adds in another twenty-four years of $0 earnings, as your benefit is based on your average indexed monthly earnings over the highest 35 years of earnings. To the formula, you look like someone who has made poverty level wages your entire life and, as a result, the formula will spit out a very high replacement percentage of those artificially low earnings.

The WEP formula simply tries to adjust that so that you earn a fair replacement percentage based on the wages you actually earned under Social Security. So while it feels like you are getting “penalized” for being a public employee and earning a pension, what’s really happening is that the WEP is trying to “adjust” for you getting a larger Social Security benefit than was designed.

GPO works the same way, except applied to your possible survivor benefit (survivor’s benefits were added in 1939, they were not part of the original Social Security Act) from your spouse. Survivor’s benefits were designed for families where only one spouse worked (paid work), or one spouse earns vastly more than the other. If the high earner dies first, the survivor’s benefit is designed to support the spouse who didn’t work for pay or worked for low wages. (Back in the day, this was often the stay-at-home Mom who worked very hard at home raising the family and running the household, but didn’t get paid to do that work. That still applies some today, but also includes stay-at-home Dads as well as folks who earn a lot less than their spouse or perhaps stay home for a few years.) Again, the formula for the survivor’s benefit incorrectly sees you as a low wage earner and spits out a higher benefit than intended, so the GPO tries to adjust for that.

There has often been legislation proposed to repeal the WEP and/or GPO, but it typically doesn’t get very far, both because of the faulty formula it is trying to adjust for and because of the impact on the federal budget. Right now there is legislation (pdf) before Congress that attempts to modify the WEP formula as there are cases where it adjusts incorrectly, and that has a much greater likelihood of passing (it also has a hold-harmless clause so that they use whichever formula – old or new – gives you the higher benefit).

While not everyone will agree, I generally think the WEP and GPO are fair to public employees in the context of how Social Security was designed and is implemented (especially if the formulas are adjusted by legislation to fix any incorrect adjustments). It’s a separate discussion whether pension plans as well as Social Security, Medicare and other safety-net programs are adequate in the first place.

Fees Matter: Vanguard, PERA, TIAA and MetLife Comparison

Inspired by some of the work Ben Johnson has been doing, I decided to revisit two posts I’ve previously done on the retirement plans (401k/403b/457) available through Littleton Public Schools and Douglas County Public Schools. (Note that the expense ratios are slightly lower now than when I wrote those posts.)

It’s probably worth reading at least one of those posts for context, but I basically compared the fees you would pay for investing in PERA’s 401k/457 plan with those you would pay in the other vendor offered (TIAA for LPS, MetLife for DCSD). In this post I thought I’d take that a step further by showing the compounded effects of those fees over time, as well as throw in a comparison to an IRA at Vanguard.

Important note: IRA’s have much lower contribution limits than 401k/403b/457 ($6,000 vs. $19,500 if you are under the age of 50), so you can invest much more each year into your workplace plans. And there are also income limitations on whether you can contribute to an IRA, whereas there are no income limitations on 401k/403b/457 plans. And don’t forget the behavioral aspect – some folks need to have the money taken directly from their paycheck otherwise they won’t ever end up investing it.

So I created this spreadsheet to illustrate the impact of fees over time. Like all spreadsheets of this nature, it is based on many assumptions and those assumptions may be incorrect. Feel free to make a copy of the spreadsheet and change any of the assumptions you wish. For example, for the return on different asset classes, I put in the long-term compounded average return, but many folks think those will be lower in the future, so feel free to adjust. You also can adjust your asset mix between the different asset classes (I kept it fairly simple by limiting to US Large Cap Stocks, US Small/Mid Cap Stocks, International Stocks, US Bonds, and a Target Date fund choice.) Make sure the asset allocation mix adds up to 100%!

You can also change the initial amount you have invested (currently $0 in my examples) and the amount you are adding to your investment each year (currently $6,000 in my examples). You should not change the fees charged by Vanguard, PERA, TIAA or MetLife (unless you are reading this enough in the future that those have changed as well), nor the columns that keep track of your running totals with each vendor. Note that the fees for each are based on the lowest-cost fund offered within each asset class with each vendor.

You can change any of the numbers that are in cells with a purple outline, leave the rest alone.

So, let’s look at some selected results. First, what if you had an aggressive, all-equity allocation of 40% Large Cap, 30% Small/Mid Cap and 30% International? This is what it look like after 10 years:

As you can see, investing at Vanguard is going to get you the best overall return, and investing with PERA is going to be a better choice than either TIAA (LPS) or MetLife (DCSD).

How about after 30 years?

Wow. You’d have over $110,000 more in Vanguard than with MetLife, and over $90,000 more if you choose PERA over MetLife. And if you take it out to 50 years (think starting when you are 22 and not withdrawing until age 72 when you have to start taking Required Minimum Distributions):

Almost $1.5 million more in Vanguard than in MetLife, $1.2 million more with PERA than MetLife. (Note that these numbers get even further apart with contributions that are greater than $6,000 per year, although the percentage differences will be the same.)

Okay, well what if you just chose a Target Date fund (which is the default option in your 401k/403b/457 plans, and a good, simple choice for lots of folks) and put 100% of your money into that? Here’s after 10 years:

Note that here PERA is actually ahead of Vanguard due to the lower expense ratios on their Target Date funds, but both Vanguard and PERA are still doing much better than TIAA or MetLife.

30 years?

50 years?

Play around with the assumptions in the spreadsheet, including the asset mix that most closely reflects your desired asset allocation. But no matter what mix you choose, Vanguard and PERA will come out the best (usually Vanguard as the best, with PERA only if you go with just a Target Date fund). TIAA will come in a distant third, and MetLife a very distant last place. (And keep in mind that the negotiated fees with TIAA and MetLife are actually pretty good compared to many folks’ 403b choices around the country.)

And yet many employees in LPS and DCSD choose TIAA and MetLife. Why? Perhaps because a sales rep contacted them and was kind, concerned, and “helpful”. Perhaps because they think they can choose investments and “beat the market”. Or perhaps they just chose without much knowledge.

So, now that you know a bit more, what changes might you make with your investments? In general, if your adjusted gross income is not too high (varies depending on Traditional vs. Roth, and increases slightly each year), opening up an IRA at Vanguard is going to be your best choice to fund first (this is assuming you are disciplined enough to invest the money when it doesn’t come directly out of your paycheck).

If you max that out (remember, IRA’s have much lower contribution limits each year), then fund your PERA 401k or 457 next. In LPS, I would choose the 457 over the 401k, as it’s a bit easier to access the money before age 59.5 (unfortunately, DCSD has not chosen to offer the PERA 457), but otherwise the 401k and 457 are essentially the same.

If you are able to max out your personal IRA and your 401k or 457, then you can invest in the one you haven’t yet, as the 401k and 457 are different “buckets” and they each have their own, separate contribution limit (note that the 401k and 403b draw from the same contribution “bucket”). This means that in 2021 if you are under the age of 50 (if your income isn’t so high that you can’t contribute to an IRA), you can contribute up to $6,000 to an IRA, $19,500 to a 457, and another $19,500 to a 401k, for a total of $45,000. If you are 50 or older, you get “catch up” contributions, which gives you an extra $1,000 for your IRA and $6,500 for both the 401k and 457, for a total of $59,000. (And, depending your plan, there may be special catch up contribution provisions in your last 3 years of work that can let you contribute even more.) Keep in mind that for all of these you have the option of doing a Traditional (pre-tax) contribution or a Roth (post-tax) contribution, which is a complicated and entirely different conversation.

As always, feel free to reach out with questions (or comment below).

PERA: It’s Even Better Than You Think

pera

Most Colorado (public school) educators know that Colorado PERA is a “good” retirement program, especially compared to Social Security, but often they don’t know just how good it is. Fully exploring this topic is beyond the scope of this blog post, but let me briefly hit some of the highlights.

As part of SB 14-214, the the state of Colorado commissioned three independent studies of Colorado PERA, two of which are particularly relevant to this discussion. The Milliman Retirement Benefits Study, released in January of 2015, looked at how Colorado PERA’s benefits fit into the larger picture of total compensation, and was designed to evaluate the value of PERA compared to other retirement packages offered by other states and by private companies. The executive summary states,

The state’s total retirement compensation package is equivalent to 15.7% of pay (15.4% defined benefit and 0.3% retiree health), relative to the market median of 14.7% (combined sources: defined contribution, defined benefit, social security, and retiree health)

Basically, this says that as part of a total compensation package, Colorado PERA is just above the median benefit paid by states and private companies.

The second study, the Gabriel, Roeder, Smith & Company Plan Design Study is a bit more in-depth and relevant to this discussion. The purpose of this study was to compare Colorado PERA’s plan design and, specifically, the costs and effectiveness of PERA, as compared to other retirement plans offered in the public and private sectors (including the one that affects the most people, Social Security). Again, from the executive summary,

This study found that the current PERA Hybrid Plan is more efficient and uses dollars more effectively than the other types of plans in use today.

When the study was presented to the State of Colorado’s Legislative Audit Committee, GRS officials told members,

Colorado’s largest public employee pension system is the most efficient and effective a state could have.

Those are important pieces of background to know, especially when the legislature is in session and various bills are offered regarding PERA. But I want to point out some specific features of Colorado PERA that are particularly relevant to you from an investment and financial planning perspective.

Colorado PERA represents over 500,000 members which provides some significant advantages to you in terms of economies of scale and in terms of investment returns. Because PERA is so large, it is able to both invest at low cost and to invest in areas that are not available to you as an individual investor. Because they are a large, institutional investor, they are able to negotiate investment fees that are lower than what you can typically achieve on your own. They can also invest in areas such as real estate and private equity that are not available to you as an individual investor. Both of these help PERA achieve higher returns (at the same level of risk) than most individual investors.

Perhaps even more importantly, however, is the fact that PERA is the ultimate long-term investor. As an individual, you have a “life-cycle” to your investments. Typically as you get older and then eventually when you are retired, conventional wisdom indicates that you should get more conservative with your investments because you don’t have time to “recover” from a market downturn. But because PERA pools money from over 500,000 members, and because they are essentially investing in perpetuity, in many ways PERA can invest like each one of those investors is an unchanging 35-year old.

While PERA does have to deal with cash flow issues in order to pay benefits, and they certainly have to manage risk and particularly be concerned with sequence-of-returns risk, overall they can truly invest for the long term. Which means that even as you get older, PERA doesn’t have to adjust its investments based on your age, they continue to invest as if you were 35. This allows them to stay fully invested for the long-term at an appropriate level of risk that will generate good long-term returns.

In addition, once you do retire and start drawing your PERA benefits, those benefits are guaranteed for life, including a 2% annual increase to help cover inflation. (Note: that 2% applies to those hired before 2007, and can temporarily decrease following calendar years that PERA investments lose money, which does happen, but not that frequently. For those hired after 2007, it could also be 2%, but it’s a bit more complicated.) Let’s use a specific example to put that into perspective.

The median PERA retiree earns about $35,000 per year in benefits. There’s a rule-of-thumb in financial planning circles called the 4% rule which says that, based on historical results, people can typically withdraw 4% of their investment balance each year to live on and still expect their money to last until they die. While not perfect, the 4% rule is pretty robust, which means that the $35,000 per year in our example equates to about $875,000 in savings. Many career educators will likely qualify for a much higher benefit, maybe $55,000 a year or more, which equates to $1.375 million in savings.

Now, this is a very rough equivalency, as an investment balance using the 4% withdrawal rule has a decent chance of actually growing over time, which means you could leave a healthy inheritance, while your pension income ends when you die (or when your beneficiary dies if you take Option 2 or 3). But I think it still gives you a rough idea of the incredible value of your PERA pension. It really does allow teachers to become millionaires by the time they retire (and multi-millionaires if you invest your own savings wisely).

There’s one other important aspect of this that I think many Colorado educators may not notice. Because this pension income is guaranteed, in many ways you can think of your PERA pension as the fixed income (bonds) portion of your portfolio. This means you can invest your other retirement savings (401k/403b/457 – I’ll write a post soon on retirement savings plans) more aggressively than folks who don’t have a pension plan like PERA, which can ultimately generate a lot of increased wealth and therefore financial security. (I will write a post soon on investment “risk” and how “aggressive” investments are not necessarily more risky for the long-term investor.)

This is one of the main reasons why I think it’s unfortunate that many Colorado educators don’t really start thinking about PERA until they are close to retirement. In reality, the fact that you have PERA as your retirement plan should affect your financial planning from the first day you begin PERA-covered employment. (This is also one of the reasons I decided to start Fisch Financial – after talking with colleagues over the years about PERA, I realized how little many of them have thought about how PERA should affect their financial planning.)

So, how good is PERA? It’s great in-and-of-itself, but it also allows you to be more successful with the rest of your investments as well. Please consider incorporating the affordances that your PERA benefit allows you in the rest of your financial planning.