As your pension fund trustee, I am often asked about Tier 2, what it is, and how it differs from Tier 1.
Tier 2- What it is? Tier 2 is a response by the Illinois Legislature to address the chronic underfunding of pension funds throughout the State. The legislation essentially applied to any new entrant, into every Illinois pension system, after December 31, 2010. So if you are a Chicago firefighter or paramedic, and you started on the job in 2011 or later, you are considered Tier 2. You should be reading this and understand what it says.
In my view, there are three major aspects of the Tier 2 legislation that members should be aware.
- The ceiling on salaries when calculating final average salary
- The basis of your initial benefit and the annuity reduction factor (retiring before 55)
- The annual cost of living adjustment (COLA)
- The Ceiling. There is a ceiling imposed on your salaries when your pension benefit is calculated. Tier 2 members will still earn the same salary as Tier 1 employees while employed, but when they retire, their rank and salary won’t matter – if the salary exceeds the ceiling it will be reduced. There is no ceiling on Tier 1 members, the rank and salary they retire at, is the rank and salary the Retirement Board uses to calculate their pension. The Tier 2 ceiling started off at $106,800 in 2011 and increased annually by either the lesser of 1) 3% or 2) ½ of the previous year’s inflation rate. I think the following table explains it best:
2. The Method. The method used by the Retirement Board for determining your initial pension benefit will differ depending on if you are Tier 1 or Tier 2. Tier 1 benefits are typically calculated on the member’s last 4 years of service. Tier 2 benefits are calculated on the last 8 years of service. Because your salary in the last years of your career are typically your highest, it is better to have to salaries closest to retirement used in the calculation. Additionally, if you retire before you reach age 55 under Tier 2 there is a reduction in your benefit that is not imposed on Tier 1 members. The pension code states a member is “subject to an annuity reduction factor of one-half of 1% for each month that the fireman’s age at retirement is under age 55.”
3. The Cost of Living Allowance (COLA). Tier 2 members, when they retire, will have their benefit increased each year based on the lesser of 1) 3% or 2) ½ of the rate of inflation. All Tier 1 members will have their benefit increased each year by 3%.
The following charts will illustrate an example providing a concise illustration of the 3 differences outlined above. In this example we will assume the following about the member and we will calculate it based under both Tier 1 and Tier 2.
- Both members are retiring on 12/31/2020
- Both members are exactly 50 years old
- Both members have 30 years on the job
- Both members were promoted to LT./EMT exactly 4 years before retiring
- The consumer price index (inflation) rate was exactly the same in this previous 10 years before retirement as it was in the 10 years after retirement.
- Assumes Tier 2 has been in existence, for one employee, since the employee started with the CFD
Although the salaries these two members earn over their careers may be identical, the Tier 1 employee’s pension benefit is calculated over the salary he actually earns while the Tier 2 salary is effective capped by the ceiling imposed by the Tier 2 language. You can see by the table that the amounts used to calculate the Final Average Salary is different each year. Additionally, the Tier 2 member’s Final Average Salary is calculated over a longer time period, 8 years rather than 4.
When the pension benefit is calculated the member will be subject to an annuity reduction factor of one-half of 1% for each month that the member’s age at retirement is under age 55. This results in the Tier 2 member receiving only 45% of the calculated average salary. This is the case, even though both the Tier 1 and Tier 2 members both worked the same amount of years, and are the same age. I can only assume the reason for this was to force Tier 2 members to work longer to continue subsidizing the underfunded pension fund.
The cost of living allowance (COLA) is designed to help keep your pension benefit’s buying power at par with inflation. All Tier 1 members will get 3% of their initial benefit added onto their benefit each year. The COLA allowance will vary every year for Tier 2 members, it will never be greater than 3% and never be less than zero; it is a function of the consumer price index (CPI) each year. The Tier 1 member starts to get his COLA enhancement at 55, the Tier 2 member doesn’t receive his COLA enhancements until the age of 60. I applied the consumer price indexes for the previous 10 years to our hypothetical case.
Although the differences in pension benefits between members in the same union is substantial, the members are doing the exact same job during the same time period. The members are the same age, same rank, entered and retired at the exact same time. The only difference that we have assumed here is that we applied the Tier 2 rules against the Tier 1 rules. After ten years of retirement, a Tier 1 member is getting a benefit of $112,830 and the Tier 2 member is getting a pension benefit 55% less at $50,663
So remember, why did the State Legislature put Tier 2 into the pension code? Because the pension funds were underfunded! So when the Local 2 Executive Board continues to state – funding doesn’t matter, your pensions are guaranteed by the Illinois State Constitution – remind them that funding is what caused you to receive a substantially reduced pension benefit. Funding matters!
Timothy McPhillips
Pension Fund Trustee
