Pension Neutrality: South Dakota
Pensions Policy
Analysis of South Dakota's policies
South Dakota's pension system is based on a benefit formula that is not neutral, meaning that each year of work does not accrue pension wealth in a uniform way until teachers reach conventional retirement age, such as that associated with Social Security.
Teachers' retirement wealth is determined by their monthly payments and the length of time they expect to receive those payments. Monthly payments are usually calculated as final average salary multiplied by years of service multiplied by a set multiplier (such as 1.5 percent). Higher salary, more years of service or a greater multiplier increases monthly payments and results in greater pension wealth. Earlier retirement eligibility with unreduced benefits also increases pension wealth, because more payments will be received.
To qualify as neutral, a pension formula must utilize a constant benefit multiplier and an eligibility timetable based solely on age, rather than years of service. Basing eligibility for retirement on years of service creates unnecessary and often unfair peaks in pension wealth, while allowing unreduced retirement at a young age creates incentives to retire early. Plans that change their multipliers for various years of service do not value each year of teaching equally. Therefore, plans with a constant multiplier and that base retirement on an age in line with Social Security are likely to create the most uniform accrual of wealth.
South Dakota's pension plan is commended for utilizing a constant benefit multiplier of 1.7 percent for service credit earned prior to July 1, 2008 and 1.55 percent for service credit after. Teachers may also calculate their benefit with an alternative formula that uses a 2.4 percent multiplier for credit before July 1, 2008 and 2.25 percent multiplier for credit after, less 80 percent of their total Primary Social Security benefit. Teachers are entitled to whichever calculation is greater. While the multiplier changes, it is not advantageous or disadvantageous to anyone, as it is not dependent on a teacher's total number of years of service; however, teachers may retire before standard retirement age based on years of service without a reduction in benefits.
Teachers may retire according to the "Rule of 85," meaning that age plus years of service equal 85, once they reach the age of 55, while other vested teachers may not retire with unreduced benefits until age 65. Therefore, teachers who begin their careers at age 24 can reach the "Rule of 85" with 31 years of service by age 55, entitling them to 10 additional years of unreduced retirement benefits beyond what other teachers would receive who may not retire until age 65. Not only are teachers being paid benefits by the state well before Social Security's retirement age, but these provisions may also encourage effective teachers to retire earlier than they may otherwise, and they fail to treat equally those teachers who enter the system at a later age and give the same amount of service.
Recommendations for South Dakota
End retirement eligibility based on years of service.
South Dakota should change its practice of allowing teachers whose age and years of service equal 85 to retire at age 55 with full benefits. If retirement at an earlier age is offered to some teachers, benefits should be reduced accordingly to compensate for the longer duration they will be awarded.
Align eligibility for retirement with unreduced benefits with Social Security retirement age.
South Dakota allows all teachers to retire before conventional retirement age, some as young as 55. As life expectancies continue to increase, teachers may draw out of the system for many more years than they contributed. This is not compatible with a financially sustainable system (see pension sustainability goal).
State response to our analysis
South Dakota was helpful in providing information that enhanced this analysis.
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Pensions
Research rationale
In addition to the ways defined benefit pension systems disadvantage teachers described in Goal 4-G, the way pension wealth accumulates in some systems further compounds the inequity. All pension systems use a multiplier to calculate the benefits an individual is entitled to receive based on salary levels and years of service. For example, a pension system may have a multiplier of 2.0. In such case, pension benefits are determined by multiplying average final annual salary by years of service and then multiplying the product by 2.0. Thus, someone working fewer years with a lower final salary would appropriately receive less in benefits than someone with more years of service and/or a higher final salary. However, the multiplier in many pension systems is not fixed; it increases as years of service increase. When a higher multiplier is used, teachers receive even more generous benefits.
Another way that pension benefits are awarded unfairly is through the common policy of setting retirement eligibility at different ages and years of service. For example, in a given state, a teacher with 30 years of service may retire at age 55, while teachers with fewer years of service may not retire until age 62. This means that a teacher who started teaching in this state at age 25 would reach 30 years of service at age 55 and receive seven additional years of full retirement benefits beyond what a teacher that started at age 32 and cannot retire with full benefits until age 62 would receive. A fair system would set a standard retirement age for all participants, without factoring in years of service.
Pension systems affect when teachers decide to retire as they look to maximize their pension wealth.
The year teachers reach retirement eligibility by age and/or years of service, their pension wealth peaks; pension wealth then declines for each year they work beyond retirement age. Plans that allow retirement based on years of service create unnecessary peaks, and plans that allow a low retirement age create an incentive to retire earlier in one's career than may be necessary. For every year teachers continue to work beyond their eligibility for unreduced retirement benefits, they lose that year of pension benefits, thus decreasing their overall pension wealth.
To try to balance this incentive to retire, some states have created DROP (Deferred Retirement Option Plan) programs. DROP programs allow participants to place their monthly pension benefits in a private investment account while still teaching and earning a salary, thus retaining those benefits. These teachers are, in effect, earning their pension and salary at the same time, and often at a relatively young age.
NCTQ's analysis of the financial sustainability of state pension system is based on actuarial benchmarks promulgated by government and private accounting standards boards. For more information see U.S. Government Accountability Office, 2007, 30 and Government Accounting Standards Board Statement No. 25.