Inflation could significantly raise costs for some public pension systems

Higher rates of inflation impact the purchasing power of pension benefits for retirees and could boost the cost of providing benefits for some state and local governments. Since public pension systems use a variety of different methods to insulate retiree benefits from inflation, its impact varies by system. Many public pension plans provide either fixed cost-of-living adjustments or ones that vary with the Consumer Price Index (CPI) but are capped, meaning that there is a limit to the adjustment. These caps are useful for limiting excessive spikes in unexpected costs in years when there is high inflation. Consumer Price Index caps for state and local cost-of-living adjustments generally range from 2% to 5%, but there are some exceptions. Public pension plans with high caps, or no caps at all, face the risk of sharply increased actuarial liabilities if high single-digit inflation persists or reaches double digits.

The state of Alaska’s pension plans for its public employees and teachers—closed to new members since 2007—have some unusual COLA provisions. Retirees who remain within the state receive a 10% increase to their pension checks each year, which is intended to encourage them to remain in Alaska after retiring. The cost of this benefit is not, however, impacted by inflation.

Alaska’s exposure to high inflation primarily comes from the pension benefits it offers to retirees who have moved out of state, which actuaries assume will make up 40% of Alaska’s retired teachers, 35% of retired peace officers, and 30% of other retirees. These employees receive cost-of-living adjustments based on changes in the CPI, with some limitations. For example, retirees under the age of 60 receive half the change in the CPI or 6%, whichever is less. Older retirees receive 75% of the change in CPI or 9%, whichever is less.

Alaska’s current actuarial assumption is a 2.5% inflation rate, so the state’s actuarial liabilities are estimated based on the expectation that younger out-of-state retirees will receive a 1.25% COLA while their older colleagues who have moved out of state will receive 1.875%. Based on current inflation rates, it now appears that the actual cost of cost-of-living adjustments will surpass Alaska’s expectations for the time being.

The risk of unexpected costs to Alaska is limited by the fact that variable cost-of-living adjustments only apply to 30%-40% of retirees (those that move out of state) and the pension plans were closed to new entrants 15 years ago. It is of note, however, that the Alaska state legislature is considering re-establishing a defined benefit system, along with the legacy cost-of-living adjustment benefit, for new retirees.

Another state with relatively high cost-of-living adjustment caps is Connecticut. State employees retiring after Oct. 1, 2011, are eligible for COLAs of 7.5% if inflation reaches 12%. Municipal employees can receive up to 6%, as can teachers (but the latter are only eligible for the maximum COLA if the retirement system has a return on assets of 8.5% or greater). With Connecticut’s pension systems using an assumed inflation rate of 2.5%, they face the risk of significant unexpected costs from an extended bout of inflation.

While no state system examined by the National Association of State Retirement Administrators (NASRA) offers an uncapped cost-of-living adjustment, at least one local government system does so. The San Antonio Fire and Police Pension Fund (SAFPPF) offers COLAs equal to the annual change in CPI to employees who retired before Oct. 1, 1999, and 75% of CPI change to those who retired thereafter. Effective January 2022, the pre-1999 retirees received a 7% COLA and the later retirees saw a 5.3% increase.

The system’s most recent actuarial valuation used an inflation assumption of 3%. Based on this and other assumptions, including an assumed rate of return of 7.25%, the system’s actuary estimated that its assets (at market value) covered 91.7% of its liabilities. With inflation potentially heading even higher in 2022, SAFPPF will likely face significant costs which it has not prepared for due to its uncapped COLA structure.

The three public sector employers discussed here are the exception rather than the rule. The vast majority of state and local pension systems have fixed cost-of-living adjustments or adjustments that are capped at 5% or less. But persistent inflation would increase employee and retiree demands for COLAs that provide a greater level of purchasing power protection. Adding these inflation protection benefits without spending decades saving up beforehand is expensive and is a clear example of offloading compensation of previously provided services on current and future generations of taxpayers, making it poor policy. 

Most public retirement systems have established policies to limit annual cost spikes from cost-of-living adjustments during inflationary periods, but prolonged inflation would likely foster political pressure to add on additional promises to protect retiree benefits. That being the case, the wide impacts of inflation extend even to the funding of public post-employment benefits.