I run a Facebook group for pensioners, pensionable workers, and/or their significant others called Golden Albatross/Golden Handcuffs. The group relies on the wisdom of the crowd to answer members’ pension-related questions and/or discuss pension-related topics. From time to time, the group serves up good topics to write about. For instance, I recently exchanged comments about the early retirement penalties built into their pension with a group member. It didn’t appear that the group member understood the reason for these penalties. As a result, I provided a short explanation as to why they did.

Fortunately, the Facebook exchange reminded me of a more in-depth email exchange I had with a reader a few months ago on the topic of early retirement penalties. Since the email conversation was far better organized (and researched) than my Facebook exchange, it seemed like a good candidate for a Pension Couch post. For those that don’t remember, Pension Couch articles are posts created from lightly edited and sanitized email exchanges in which I answer readers’ pension questions. In this instance, I answer McGruff’s (the crime dog from Public Service Announcements in my childhood) questions about the early retirement penalties built into his/her law enforcement pension plan.

McGruff’s Initial Questions

Hello there,

I recently found your Facebook group after hearing about you during a House of FI podcast. I searched the Facebook group for an answer to my question but couldn’t find anything specific to law enforcement pensions.

A little backstory about us…

My better half and I have been law enforcement officers in the suburbs outside of Chicago for the last 11 years. My spouse was a [US] Marine for 11 years before joining their department as well.

A while back, Illinois changed its pension system and went from a Tier 1 (my spouse’s) to a Tier 2 (me-I switched departments in 20XX) pension system.

Under Tier 1, my spouse can retire in 10 years if they want to (age 50) with a full law enforcement pension.

Unfortunately, I am 5 years younger and a Tier 2, which means I have to wait until I am 55.

We have two young kids and are working on the path to FI as well, not banking on our pensions being fully funded at that time. Let’s be honest. It’s Illinois.

There is a subsection in the Tier 2 FOP downstate pension system which states the following:

“If an officer with sufficient credit wishes to draw his or her pension prior to age 55, the pension may be started any time after age 50, but with a resulting decrease in the monthly amount. The decrease is 6% for each year the officer receives pension prior to age 55 (proportioned monthly).”

I asked our pension board at my department. I was told that should I choose to retire early at age 50 (23 years of service with the department), the 6% decrease is permanent, and I would not jump back up to a full pension once I hit the age of 55.

Obviously, if this is true, that is a considerable amount of money over the lifetime of the pension.  We could manage if it was just a temporary decrease from age 50-55, and I would be ok with that.

My questions for you are, do you know anything about the Tier 2 pension system, and is this being interpreted correctly?

I’ve tried to reach out to the IL FOP but have not had much luck. Nobody knows the correct answer.

I appreciate any insight you might give me on this, it’s a confusing pension system, and nobody seems to know anything about Tier 2.

Thank you for your time, and thank you for your service.

Be well,

McGruff

GM’s Response

Hi McGruff!

Thanks for reaching out and joining the FB group. I hope you can learn from the members as much as I have over the past few years. Your question gets to one of the most significant unintended consequences of Defined Benefit Pensions (DBPs) – the early retirement scenario. I’ll provide you with the short answer and the long one, just in case you want to know why your pension is structured that way.

The short answer is yes; in all likelihood, the 6% decrease for each year you retire before age 55 is permanent. My advice is to listen to what the plan administrators are telling you. 

The long answer to why this decrease is permanent is that it is designed to deter pension plan members from retiring early. Think about it in mathematical terms. DBPs create financial incentives for participating members to retire when they fully vest in all the pension plan’s features [at an unreduced rate, typically earned through years of service]. The economic argument for retiring at that moment is that a member can maximize the amount of retirement income they receive (for not working) by drawing upon the pension immediately and living a long life. They can even go and get another job [in most cases], meaning they’d have two paychecks rolling in each month.

This effect isn’t just theoretical either. It is a well-documented unintended consequence of an annuitized retirement payment system [built on years of service]. This means a retirement benefit intended to incentivize workers to stay at the same job for longer created the opposite effect [towards the end of their careers]. Thus, economists and pension administrators had to figure out a way to counteract it.

The solution was implementing penalties for retiring earlier than the ideal retirement age [aka Normal Retirement Age] that the organization wants employees to work through. In your case, that age appears to be 55, and the penalty is 6% for each year that you retire before your department’s ideal age. In the US’s Social Security program (which also had to deal with the same issue), that full retirement age (for most of us) is somewhere around 67 or 68. Still, the early retirement age is 62, with permanent penalties for each year taken before 67 or 68.

As to whether this penalty always existed in your pension plan or was implemented in your system’s Tier 2 revision, I can’t say without some digging around. Maybe you can tell by comparing the provisions of your spouse’s Tier 1 plan to your own. However, make no mistake, anytime you see tiers in a pension system, it means that the first tier is more generous than all the subsequent tiers. Many state and local governments had to implement tier systems as their pension obligations started to boom in the 2000s. At the same time, their tax bases shrank after the dual economic downturns during the same decade (i.e., the dot-com bubble and Great Financial Crash). The bottom line for you is that it doesn’t matter when it was instituted; you’re stuck dealing with the situation at hand. 

I could send you some academic papers on this issue if you’re interested, but I don’t want to assume that level of interest and bore you with the details. Let me know if that’s an incorrect assumption, and I’ll send them your way. In the meantime, I will say that you just identified your Golden Albatross issue/moment. There are resources on my web page (for free) or in my book (not free) that can help you work through whether or not you should stay the entire time or leave early and accept less. However, to cut to the chase, the driving factor for making that decision will be the amount of (fixed) income you and your spouse think you’ll need in retirement. That knowledge will only come with building a detailed retirement plan.

I’m sorry I don’t have better news for you, but I think it’s better that you know the truth. That said, it looks like you are already looking at the situation with the correct attitude since you identified the fact that most Illinois pension systems are underfunded. I don’t know if that’s the case for your specific plan, but you may want to check out the resources at the below link if you need to further investigate your plan’s health. There’s no guarantee that your plan will be listed, but your pension system might be: https://publicplansdata.org/quick-facts/by-state/state/?state=IL  

Finally, I’d like to ask a favor. Would you mind if I take this email exchange, anonymize it, and turn it into a blog post? I think it would help many readers like you learn about early retirement penalties attached to pension plans.

Regards,

Grumpus Maximus (GM)

McGruff’s Response to My Response

Unlike some of my other Pension Couch emails, McGruff actually wrote me back! I thank McGruff for that because a lot of people don’t. Here is what McGruff said:

Thank you for the response. You clarified the confusing jargon quite a bit.

The problem we are running into with the Tier 2 is that nobody is well versed in it, so when there are questions, nobody knows how to answer them.

Unfortunately, unless I win the lottery, it looks like I’ll be staying until 55. It would be financial suicide to retire before then.

I would be interested in any articles you have in regards to this matter too. I’m planning on running for our pension board this year, and I’m trying to gain as much knowledge as possible.

Also, by all means, please feel free to use my example for your website. I know I am not the only one out there in this situation, so if it helps someone else, I’m completely on board with that.

Thanks again and stay safe,

McGruff

GM’s Final Response

McGruff –

Three scholarly articles and one electronic book are linked below, all of which mention early retirement incentives and penalties [built into pensions] in one form or another:

Article: Early Retirement Penalties In Defined Benefit Pension Plans

• • Author(s): Helen I. Doerpinghaus and Daniel C. Feldman

Article: Pension Structure and Employee Turnover: Evidence From a Large Public Pension System

• • Author(s): Goldhaber, Dan; Grout, Cyrus; and Holden, Kristian L

Article: When Do Committed Employees Retire? The Effects of Organizational Commitment on Retirement Plans Under a Defined-Benefit Pension Plan

• • Author(s): Luchak, Andrew A.; Pohler, Dionne M.; and Gellatly, Ian R.

Book: Pension Policy: The Search for Better Solutions

• • Author(s): Turner, John A.

I should’ve mentioned in my previous email that just because there are early retirement penalties in certain plans, it doesn’t necessarily deter all workers from retiring early. I think the Doperinghaus article does a good job of explaining that people in defined benefit plans still retire early (despite the penalties) for a lot of different reasons, not all of which were explored in his article.  

Good luck on running for the pension board! Let me know if you have any more questions. I’ll answer them as my schedule permits.  

Regards,

GM

Links to Research

Some of the journal article links I placed up above may be to paywall sights. A lot of academic journals make their money by charging to read their articles. When I wrote the email, I had access to several academic journal databases through my master’s program. As a result, I was able to read and use the articles for my thesis. That’s how I knew they existed.

You probably don’t have access to journal databases. So, if you really want to read a linked article above, but hit a paywall, try Google Scholar. It works just like Google but links to many journal articles in various locations around the internet, not all of which are behind paywalls. If that’s unsuccessful, then drop me a line, and I’ll try and figure out a way to get you access that doesn’t infringe on copyright issues.

Conversely, the link to the book allows you to download it for free. I won’t say it’s the most entertaining read ever. Still, it’s informative if you really want to understand why modern DBP plans are structured the way they are. Chapter 4 explicitly discusses early retirement incentives and penalties built into modern-day DBP plans.

Retirement Planning Thoughts: Early Retirement Penalties

This email exchange touched on a few crucial issues. The first issue was the penalties associated with retiring earlier than a DBP plan’s Normal Retirement Age (NRA). These penalties are typically permanent (i.e., can’t be changed later) and fixed (i.e., a set amount depending on how many years before NRA a worker retired). They disincentivize workers from the early retirement incentive created by qualifying for an unreduced pension through tenure alone (e.g., a person can retire after 30 years of service no matter their age).

Now, the Facebook group member I referred to at the beginning of this post seemed upset about these penalties because he/she felt they were unfair. That group member specifically wanted to retire early based on reaching a specific tenure and salary level, but the early retirement penalties were too steep. That obviously wasn’t McGruff’s issue because he/she just wanted to know if the penalties were permanent.

As I told the Facebook group member, whether or not the penalties are fair is immaterial. I say that because employers don’t provide DBPs as a “fair” form of retirement compensation. Employers provide DBPs to create employee retention, which I explained at length in Pension Series parts 25, 26, and 27. So, approached from that aspect, the early retirement penalties make sense — even if they suck from an employee’s point of view — because they fix an identified problem in DBPs that messes with retention. Conversely, as I pointed out to McGruff, the Doerpinghaus article explicitly discusses how pensionable workers often retire early regardless of the penalties. So, they’re neither a silver bullet for employers nor completely effective obstacles for employees who want to retire early.

Retirement Planning Thoughts: Staying Until 55?

The other important issue from this email exchange that I’d like to point out is the question of whether or not McGruff needs to stay until 55. McGruff thinks it’s required because doing otherwise would be “financial suicide.” I understand the sentiment because I made a similar statement about my cliff vested military pension. However, now that I’ve studied the issue for multiple years, I’m not 100% convinced that’s the case for McGruff. In my mind, the “stay until 55 question” is best answered through a combination of pension safety analysis, retirement budget planning, and rigorous testing.

Retirement Planning Thoughts: Pension Safety Analysis

For me, pension safety analysis should be an ever-present factor in a pensionable worker’s retirement planning, which is why it was the first entry in the Pension Series. It sounds like it is top of mind for McGruff since he/she mentioned it. However, in McGruff’s case, analyzing the safety of his/her pension isn’t an easy task. As McGruff identified, Illinois pension plans are seriously underfunded. In fact, as a group, they are some of the worst-funded public plans in the US.

That said, Illinois law allows state workers to keep the original pension formula that was in effect when they were hired throughout the remainder of their careers. So, assuming that the historical formulas are more generous than current formulas, whether a current state worker’s pension could ever be legally reduced is in doubt. Now, that’s a lot for McGruff to navigate. Judging the probability that both pensions will come through in full will be difficult. So, I think he/she is on the right path by discounting it but not ignoring it altogether.

Retirement Planning Thoughts: Retirement Budget Testing

How much McGruff decides to discount the pension is up to him/her. That said, the resulting amount of the estimated pension(s) should play directly in McGruff’s retirement budget planning.

Again, in my mind, a retirement budget and a retirement plan are where the rubber really meets the road when it comes to a decision to retire early. The retirement budget considers how much a family will need to spend in retirement monthly (or annually) versus retirement income like pensions and investment distributions. A retirement plan incorporates that information to plot a course to retirement. If the math shows the budget is covered by a pension earned at a certain age and salary, and the budget has been tested rigorously, then McGruff may be able to retire earlier than 55 — even with early retirement penalties. BUT, McGruff won’t know that until he/she builds a retirement budget and tests it.

Fortunately for McGruff (or anyone else looking to build and test a retirement budget), I provide guidance on building and testing pension-related retirement budgets elsewhere on this blog.

Closing Thoughts

Early retirement penalties in pension plans are real, and they can seem draconian for some. Early retirement penalties support the primary purpose of a pension, which is to create employee retention. However, what these penalties do to a pensionable worker’s early retirement planning is really up to that worker’s circumstances.

Like I said in a previous Pension Couch post and my book, sticking around for a higher pension without knowing what that higher amount will/can do for you isn’t much of a plan. Conversely, analyzing your pension’s safety, determining the role the pension should play in a retirement budget, and then rigorously testing that retirement budget can be an effective way to plan for retirement. Once done, a pensionable worker would know (within a certain amount of probability) if the early retirement penalties built into their pension plan really are an early retirement killer.