Why I Support Illinois Pension Reform but Oppose S.B. 1

Filed Under (Retirement Policy) by Jeffrey Brown on Dec 3, 2013

I am writing this piece the morning of December 3, the first day of a special session of the Illinois General Assembly.  I have little faith that anything I say will shake the legislative leaders from their plan – a delicate political compromised worked out behind closed doors in recent weeks.  But I am taking the time to write anyway because even a small chance of influencing the debate seems worthwhile, given how much is at stake.

I co-wrote an op-ed in the Champaign News-Gazette nine days ago expressing my deep concern about how the proposed reform would affect higher education in Illinois – especially our ability to retain our best people.  Most of my worst fears in that op-ed were realized when the text of S.B. 1 was released yesterday.  In the interim, I was quoted in several news articles as reporters were looking for insight as bits and pieces of information leaked out of Springfield.  In one article, I was quoted as saying that if I had to choose between this reform, and doing nothing, I would do this reform.  That surprised many of my colleagues, so another motivation for this piece is to clarify this statement.

The easy answer is to say that if I had to choose between dying and having both of my legs amputated, I would choose the latter.  But this should not be interpreted as suggesting that I think leg amputation is necessarily a good idea, particularly when equally effective but far less damaging treatments are available.

Similarly, we need pension reform in Illinois.  Doing nothing is simply not an option, at least in the medium and long run.  So I do believe that bad reform may, on net, be better than no reform.  But that assumes bad reform is our only option.

S.B. 1 is bad pension reform because it will lead to an exodus of top intellectual talent from our universities.  (More details below.)

Is it our only option?  From any reasonable perspective – for example, actuarial, economic, financial, etc. – the answer is clearly “no.”  There are many ways to closing the fiscal gap, and S.B. 1 is only one, and particularly flawed at that.

But from a political perspective, the answer is harder.  I worry greatly that this may be our only option, given how dysfunctional our state political system is.  If it really is S.B. 1 or nothing, then I might hold my nose and support it, knowing that universities will have to go to extraordinary lengths to undo some of the extensive damage this will cause.  That would come at a steep price – during the transition, we will lose some of our very best people.  It could literally destroy the pre-eminence that has taken decades for the University of Illinois to achieve.

I am not a political scientist.  But I do understand incentives, and I have followed the politics of Illinois pension reform closely for many years.  And I was struck by a particularly insightful question that one of my politically-experienced and insightful friends asked me: “What leads you to expect that if you could and did kill this bill, that those same politicians would be likely to produce a better outcome the next time?”  (I have edited the question a bit).  My answer is that we should be able to do better. But I am not sure we really can.

Even so, this reform is so poorly designed that, as a pension expert and employee of the University of Illinois, I feel compelled to oppose it.

Because the General Assembly may vote as early as today, I don’t have time to go into a lot of detail or polish my writing.  Nor do I have time to fact check every single detail in this post.  I am writing with a sense of urgency.  I will post corrections later if I find any substantive mistakes.  But here are a number of thoughts on the bill, in the form of a simple Q&A.

First, why does this problem exist?

The answer is easy: for many decades, Illinois did not pay its bills.  Our pensions have been underfunded every single year for decades.  We hid behind flawed government accounting, pension funding “holidays,” and found temporary cover in the rising equity markets during the technology bubble.

-          This is the fault of our politicians.  The problem is bipartisan – Republican and Democrat Governors have underfunded our pensions, and both Democrats and Republicans in the House and Senate have voted to do so.

-          Public workers are not to blame.  They paid their share and were promised constitutionally protected pensions in return for lower salaries.

Why do we need reform?

-          Regardless of whose fault it is, the pension costs are fiscally unsustainable.  We have dug a hole so deep that we have no choice but to partially default on some of our promises.  It is a sad truth.  But it is the truth.

-          We have a pension funding hole that is officially about $100 billion.  But these official statistics drastically understate the problem.  It is only a $100 billion hole if you think we can generate 7.5% to 8% returns on the pension assets every single year without any risk.  No economist believes that.  When valued the way any financial economist would value the liabilities, the funding shortfall is more on the order of $250 billion.

-          Illinois has the lowest bond rating of any state in the country.  This drives up our borrowing costs, and sends a clear signal to companies and entrepreneurs that taxes will be higher in the future.  Few things drive away business more quickly than an unstable fiscal environment.

-          We have enormous structural deficits that show no signs of abating.  Even with the “temporary” tax increase (when the individual rate rose from 3% to 5% of income and the corporate rate increased proportionately), we still are running deficits.  We cannot just keep raising taxes, or we will start an economic death spiral in the state as mobile capital and labor flee the state.

Is it possible to do this in a sensible way?

-          Yes, but it will not be free from pain.  Put simply, there is only one way to solve this – somebody must pay.  The question is how to share that burden equitably.  Taxpayers benefitted for the last several decades by receiving public services at a substantial discount because we borrowed against the pensions to pay for those services.  Retirees benefitted from pensions that were larger than we were paying for.  Unions benefitted from bargaining for greater benefits when it was hard to get salary increases.  Universities and school districts benefitted by not having to directly pay the full cost of their hiring.  Everyone – knowingly or unknowingly – was complicit.  Everyone benefitted.  So everyone should have to share the pain of the solution.

-          No matter how much the Wall Street Journal may wish it to be so, there really is no conceivable way to eliminate the existing unfunded liability right away.  One would have to violate the state constitution by defaulting on 60 percent or more of all benefits that have already been earned by current retirees and current workers.

-          With several other experts, I co-authored a pension reform proposal that outlined Six Simple Steps to reform pensions in a rational way.  It spread the pain, aligned incentives, and solved the state’s problem in the long-run.  Details can be found at the IGPA website.

How would S.B. 1 affect bondholders?

-          Bondholders are clear winners.  Any substantial reduction in pension benefits is great news for bondholders.  After all, they simply care about their debt being repaid, and pensions are competing for scarce dollars.

How would S.B. 1 affect participants in the Self-Managed Plan?   

-          Participants in the Self-Managed Plan are totally unaffected.

How would S.B. 1 affect low income state employees in the Traditional or Portable Plan?

-          If someone close to retirement has earned a pension of $30,000 per year or less, and worked for the state for 30 years, the changes will be small.   Younger workers still many years from retirement will have to work more years before being eligible, and you would not receive the cost of living adjustment in up to 5 of the first 10 years you are retired.

-          All workers would benefit from the 1% reduction in employee contributions.  So given how small the benefit cuts are for low income workers, they may actually come out ahead.

How would medium earning state employees in the Traditional or Portable Plan be affected?

-          By medium earners, I am referring to those with annual salaries from about $45,000 to about $110,000.  In addition to the increase in retirement age, these workers will see a cap on their cost of living adjustment in retirement.  Instead of getting a 3% per year increase on their total pension, they will receive an inflation adjustment only on the first $1000*X dollars, where X is the number of years they worked.  So, for a 30 year worker making above $45,000 per year (which roughly corresponds to a $30,000 pension), you will see smaller future cost-of-living increases.  If you are earning $90,000 per year, and earning a pension of around $60,000 after 30 years of service, you will essentially be getting a cost-of-living increase on only half your pension.

How would high earners in the Traditional or Portable plan be affected?

-          This is where the substantial pain comes in.  The key provision – the one that takes a meat-axe to pensions – is the cap on pensionable salary.  If you earn above approximately $110,000, all future salary increases will be disregarded for purposes of calculating your pension.

-          To see how much this matters:  Suppose you have worked here for 5 years already, and expect a 3% per year salary increase (this is 3% nominal, so if inflation runs 3%, this means you are getting no increase in real terms).  Given the miracle of compounding, this means that your salary will more than double in nominal terms over 25 years.   So if you were to retire after 30 years, you will be getting 66% of your current salary rather than your doubled salary.  This is a 50% cut in pension benefits.

-          This 50% cut is ON TOP OF the reductions from the increase in retirement age and the COLA reduction.  All in all, I have estimated that the total cut could be as much as 65% for some workers.

-          The cut is steeper the more years you have left ahead of you, and the steeper your salary trajectory.

-          Even if you are not subject to the cap now, if your salary grows faster than the cap, you could become subject to the cap later.

-          In present value, this is equivalent to a substantial cut in future total compensation – on the order of 10-15% of salary now and forever.

Is this constitutional?

-          It depends on how the Courts interpret the non-impairment clause.   Under the strictest interpretation, any cut would be a violation.

-          But I continue to think the most reasonable interpretation of the clause is that the state cannot cut benefits already accrued as of the date of reform.  Under this interpretation, the retirement age increase would be a violation, but the other provisions would not be because they apply only to future benefit accruals.

-          It appears that lawmakers want to argue that a 1% reduction in contribution rates will be sufficient “consideration” to offset the benefit cuts, thus making this legal.  That seems absurd to me – a 12% reduction in contributions does not compensate for a 60% cut in benefits.  But I am not a lawyer, so who knows?

What will the long-run impact on U of I be?

-          The university is going to face a tough problem – how to prevent an exodus of top talent without “breaking the bank” already-strained institution.

-          Don’t be surprised if this translates into a long-run reduction in hiring plans as a way to come up with the funds to pay for any attempt to retain existing people.

How will the University of Illinois respond?

-          First, the University is officially opposing the legislation, as it should.

-          Second, University leadership seems well aware that they are going to have to do something to partially offset these changes or we are going to lose our very best people – especially in higher earning units like Medicine, Engineering, Business and Law.  I would anticipate some effort to provide employer contributions to a 403(b), or something similar, to partially offset these changes for those most affected.

What should I do now?

-          Call your lawmakers and ask them to vote no.

-          Then, if it passes, do NOT take any irreversible actions.  Give the Courts time to sort out the constitutionality.  And give the University time to come up with a partial remediation plan.

-          Perhaps talk with a financial planner or advisor about steps you can do to increase retirement savings on your own.

Illinois SURS Pension Reform: A Review Two Offsetting Critiques

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 20, 2013

Earlier this year, I co-authored a proposal with four colleagues to reform the Illinois State Universities Retirement System. My motivation for doing so was quite simple: the fiscal crisis facing the state of Illinois is very real, “doing nothing” is not an option, the politicians seemed to be making little headway on a solution, and the ideas that were under consideration appeared to be driven far more by ideology than by concern about good retirement policy and good fiscal policy.  Given that I have spent the past 15 years of my life developing academic, policy and practical expertise on issues related to retirement income security, I thought I owed it to Illinois taxpayers to make a serious attempt to bring some balanced, centrist thinking into the discussion.  My four co-authors brought exceptional expertise in areas of university administration, benefits design, state and local public finance, and other highly relevant topics.  Together, we proposed six specific reforms to the SURS system.

Our “Six Simple Steps” proposal was subsequently endorsed by the Presidents and Chancellors of all of the public universities in Illinois.  It has also received favorable feedback from many participants and retirees. Over the summer, our proposal gained serious political traction when the bicameral, bipartisan pension committee of the Illinois General Assembly began to treat it as a leading possibility for breaking through the political logjam that had stifled prior attempts at reform.

Now that our proposal – which is sometimes referred to by others as the “Universities Plan” or the “IGPA Plan” – has gained traction, the political knives are coming out on both sides of the ideological divide.  This is not surprising: under our proposal, faculty are being asked to contribute more, retirees are being asked to receive less, the universities are being asked to take on greater financial responsibility for future costs, and the state is being put on the hook for paying down the enormous unfunded liability.  There is plenty of pain to go around.

We did not cause the pain, of course.  The pain was caused by many generations Illinois General Assembly members who failed to behave with even a modicum of fiscal responsibility.  We are just asking legislators, participants, retirees and taxpayers to be honest about the severity of the problem and to take meaningful steps to stop the fiscal bleeding.  But, in a highly politicized environment, with billions of dollars at stake, I am not at all surprised that ideologues and interest groups are pulling out their knives and trying to cut down our proposal.

So allow me to let you in on a little secret – I don’t love our proposal either.  A few aspects of it leave a bad taste in my mouth, in the same way that some life-saving medicines do.  However, I honestly consider to be the best – by far – of a wide range of distasteful options.

Let’s be honest: If I lived in a state where the state government was not dysfunctional, where we did not have strictly binding constitutional constraints, and where we could draw up our pension system from a relatively clean slate, I would NOT design a system exactly like the one we are proposing.  Rather, I would commit the state to a credible funding path; I would raise the normal retirement age to be in line with Social Security; I would fully index benefits to inflation and, if needed, pay for it through downward adjustments to initial benefits; and I would align incentives by making the entities responsible for hiring decisions (e.g., the universities) also be responsible for paying the full benefit costs associated with those hiring decisions.  While I am dreaming, I would also require the state to use accounting rules that transparently communicated the real economic cost of pensions, rather than hiding the true costs behind intellectually flawed government accounting standards.  Then again, if I lived in such an ideal world, we probably would not be facing the worst pension funding crisis of any state in the nation, and our proposal would have been unnecessary in the first place.

But we, the residents of Illinois, do not live in such a world.  Rather, we live in a state where for many decades our political leaders have failed to make good on the state’s most basic financial obligations.  As a result, the time has come for us to take our fiscal medicine: everyone must make sacrifices.  Unfortunately, the very constitutional protections that were intended to protect retirees now prevent us from enacting the most sensible reforms (such as raising the retirement age, which nearly every serious analyst agrees is a good idea): instead, we are forced to use second-best policy tools (such as reducing COLAs) simply because they have a better chance of passing constitutional challenge.  And we live in a state where after several unproductive years of debate, various powerful politicians have made it crystal clear that certain types of reform are political “must haves” and others are “cannot haves,” a situation that further narrows the realm of politically feasible options.

With these and other painful realities in mind, my colleagues and I set out to design a plan that made the best of a truly terrible situation.  We settled on a plan that:

  1. Has a reasonable chance (although not guaranteed) of being deemed constitutional;
  2. Has a reasonable chance of being politically feasible (as demonstrated by the recent support the plan has received from the bicameral bipartisan pension commission);
  3. Will substantially improve the state’s long-term fiscal situation;
  4. Preserves a smaller defined benefit (DB) element to recognize that many public workers in Illinois are not in Social Security, but also creates a defined contribution (DC) account, in an attempt to balance the various strengths and weaknesses of the two types of plans and create a better system than the Tier II system in place for new employees;
  5. Improves the retirement security of new employees through more favorable vesting rules (that are also more closely aligned with private sector practice);
  6. Provides real – if imperfect – inflation protection by linking increases to the CPI, rather than providing an arbitrary annual nominal increase that leads to enormous fluctuations in retirees’ real standards of living;
  7. Substantially increases the likelihood that the state will begin to pay down the unfunded liability, both by reducing the state’s share of future costs and by providing the stakeholders with a legal right to enforce state funding;
  8. Appropriately aligns incentives so that universities bear the full cost of their hiring decisions;
  9. Suggests many other features that attempt to bring some rationality and transparency to a complex and opaque system (such as reducing the hidden subsidy provided via a financially inappropriately high Effective Rate of Interest);

In recent weeks, once it became clear our plan was gaining political traction, two different analyses came out criticizing our Six Step Plan.  There are two things to note about these criticisms:

First, neither critique provides a truly serious alternative that is politically, legally and fiscally realistic.

Second, the criticisms are striking in the extent to which they are mirror-images, taking precisely opposing views to one another.  The first of these critiques was offered by the Illinois Policy Institute.  They criticize our plan for preserving the DB system, not moving fully to a DC world, not eliminating COLAs, not saving enough money, and taking too long to phase in the changes.  The second of these critiques is by a researcher at University of Illinois at Chicago and the head of Keystone Research Center.  They criticize our plan for not preserving the DB system in its entirety, for suggesting the introduction of a DC element, for partially reducing COLAs, for asking the state to pay down the unfunded liability too quickly and for cutting benefits too much.  And, in an amazing feat of mental gymnastics, they also suggest that by reducing  spending the plan will somehow raise costs to the state.

To the extent we were trying to design a proposal in the “sensible center” of this debate, I will take these completely offsetting criticisms as confirmation that we are on the right track.

Here is a brief table summarizing how the two critiques often negate each other, in their own words (followed by my parenthetic and italicized remarks summarizing their view in my own words).

Our Proposal

Illinois Policy Institute

KeyStone Research

COLA: Switch from 3% automatic annual increase to 50% of CPI “The IGPA plan fails to achieve the savings necessary to reform Illinois’ pension system by only partially reducing cost-of-living adjustments, or COLAs”

(in other words, we should completely eliminate the COLA)

“It would undermine the retirement security of Illinois public‐sector retirees, and especially harm those who live a long retirement”

(in other words, we should make no changes to the COLA)

Hybrid DB/DC system for new employees “The IGPA plan takes reform in the wrong direction by maintaining the defined benefit pension system for current workers”

(in other words, we should totally eliminate the DB and have only a DC)

The plan would “be as bad as or worse than Tier 2 because of the

reduction in the defined benefit portion of the plan from a 2.2% multiplier to 1.5%.”  and “DC plans are less cost effective”

(In other words, we should totally preserve the existing DB and not have any DC)

Force the state to pay down the unfunded liability “this plan allows the pension systems and their members to take legal action to compel the state to make the pension payment. Pension guarantees similar to this plan prioritize pension payments above all other government services, jeopardizing funding for those who rely on it the most.”

(in other words, we should not provide additional tools to force states to pay down the unfunded liability)

“This could be coupled with extending the time

taken to get to 100% funding.”

(In other words, we should not actually reduce benefits, but simply stretch the payments over a longer period of time)

Reduces state’s overall cost as much or more than other proposals “Savings this small not only fail to solve the problem, but will also require lawmakers to revisit Illinois’ pension crisis again in just a few short years.”

(In other words, we simply did not slam workers and retirees enough)

“the Universities proposal could result in higher costs to taxpayers”

(In other words, even though they think we are cutting benefits too much, they falsely claim that somehow this risks increasing costs)

I can understand why those who advocate for the smallest possible government would be disappointed with a plan that does not squeeze out even more savings from the pockets of public sector workers.  I can also understand why some public sector workers and retirees would oppose any benefit reduction.  But such extreme views, while potentially useful for advocacy purposes, do not make for good public policy.  The above comparison make it self-evident that these two critiques are attempts to bolster opposing untenable positions: the Illinois Policy Institute would prefer that we decimate retirement security, and the KeyStone group naively acts as if we can solve this crisis without meaningful changes to benefits.  Supporters of both positions will be disappointed with any realistic proposal that actually solves Illinois’ pension problem while preserving retirement security of public workers.

You may not like our plan.  As I noted earlier, I am not in love with it either.  But I still think it is the best idea out there so far.  Very little in the Illinois Policy Institute or Keystone critiques alters my view with the exception of continuing the existing Self-Managed Plan as a voluntary option for some new employees, as suggested by the Illinois Policy Institute, although I do not think it is the best choice for the median employee.

I am totally open to the possibility that better ideas than ours may still be out there – and if either of these two groups (or any other group or individual) have substantive suggestions that are fiscally responsible AND politically feasible AND constitutional AND not unduly harmful to public employees, I would love to hear them.  So far, however, I continue to believe our Six Step proposal is the most serious proposal on the table.

 Prof. Jeffrey R. Brown, 8/19/2013

 (Author’s note: the opinions expressed here are those of the author – Prof. Jeffrey Brown – alone, and do not necessarily represent the views of any of my co-authors or the University of Illinois.)

Why Retirement Plan Tax Preferences are Not as Expensive as You Might Think

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Dec 13, 2012

Retirement plans such as the 401(k) receive favorable tax treatment under the U.S. income tax system.  Historically, this favorable tax treatment was provided to increase individual saving.  Recent research has called the efficacy of this approach into question, suggesting that individual saving rates may not be all that responsive to marginal tax rates.

Last week, I wrote about the danger of drawing the conclusion that tax incentives do not matter and that we should therefore look to eliminate the tax preference for retirement saving.  My focus was on the role that tax preferences play in providing an incentive for employers to offer plans, and to design them in a way that uses behavioral nudges to increase saving.

This week, I want to focus on a different aspect of this issue, the public discussion of which has been misleading – how much this tax preference costs the U.S. Treasury.  My contention is that the cost figures being bandied about (including my own use of the $100 billion figure in last week’s post) are substantially overstated.  The point of today’s post is to note that the amount of revenue that the government would receive by eliminating the preferential tax treatment for retirement saving would be much less than what it might appear.

To understand this, one must understand (1) how retirement plans are treated under U.S. tax law, (2) how the government actually accounts for the foregone revenue, and (3) how the government ought to account for the foregone revenue.  These are complex topics, but some simple exposition is sufficient for seeing the main point.

(1)   How are retirement plans treated under U.S. tax law?  In a nutshell, the income tax on retirement plan contributions is deferred, not eliminated.  This is an important distinction.  If I receive an additional $1000 in cash salary, and I am in a 35% tax bracket, I owe the government an additional $350 in taxes.  If, however, I receive this additional $1,000 in the form of a contribution to a 401(k) plan, I owe no taxes today.  However, I will owe taxes on the money when I withdraw it during retirement.  Of course, there is financial value to deferring my taxes (what we economists call tax free “inside build-up”), but it is not as if the initial contribution escapes the tax system entirely.

(2)   How does the government account for the foregone revenue?  The U.S. Department of Treasury and the Congressional Joint Committee on Taxation prepare annual estimates of what they label “tax expenditures.”  These tax expenditures are basically just an estimate of how much additional tax would be collected if a particular activity went from being untaxed to being taxed, assuming no behavioral response to the tax.  (As an aside, the fact that they do not account for a behavioral response is why they are careful to always note that “a tax expenditure estimate is not the same as a revenue estimate.”)  In the case of retirement plan contributions, they roughly calculate the amount of money being deferred, apply the relevant marginal tax rates to it, and obtain a rough estimate of how much revenue is not being collected as a result of this tax preference.  However, a key point is that they do not estimate this over the entire life of the account, but rather use an arbitrarily truncated time horizon to estimate the effects.

Going back to my simple example: suppose I contribute an additional $1,000 today to a 401(k) plan.  That saves me $350 in taxes today, and costs the government $350 in foregone revenue in the current tax year (assuming I would save the same amount either way).  So far, so good.  But suppose that I plan to pull the money out in 20 years.  I will pay income taxes on the amount I withdraw.  The present discounted value of the tax that I pay in 20 years will likely be less than $350, but it will be much greater than zero.  For the sake of example, suppose it is worth $150 in present value.  If so, then the net gain to me (and the net cost to government) over my lifetime is $200.  The problem is that the government does not use a present value method.  Instead, it looks at just the front end, and thus overstates the value of the deduction.

(3)   How should the government account for tax expenditures?  Ideally, the government would compute these tax expenditures using the “present value” concept just explained.  A number of experts have made this suggestion.  For example, a paper by the American Society of Pension Professionals and Actuaries (ASPPA) boldly states “tax expenditure estimates for retirement savings provisions should be prepared on a present-value basis” because this “would allow an ‘apples to apples’ comparison” with other tax deductions.

What does all this imply?  A paper written by two Treasury Department officials and published in the December 2011 National Tax Journal found that “the long-run NPV cost can be dramatically different if measured using relatively short time horizons.”  The calculations are a bit tricky because one must make assumptions about rates of return, the appropriate discount rate, current and future marginal tax rates, and so on.  And the extent to which estimates differ depends on the time horizon being examined.

But, these caveats aside, the ASPPA study concludes that “the present-value tax expenditure estimates of contributions made in the first five years are 55 percent lower than the JCT five-year estimates and 75 percent lower than the Treasury five-year estimates.”  That is a huge wedge.

How does all this matter for policy?  The fiscal cliff has DC policymakers scouring the four corners of the earth looking for ways to boost revenue without raising marginal tax rates.  One way to do this is to eliminate tax expenditures.  However, some of those tax expenditures exist for good economic reasons, and the provision of favorable tax treatment for retirement saving is one of them.

As noted last week, the elimination of this provision could have serious unintended consequences for the availability of retirement savings programs through employers.  Now add to that the fact that any revenue implications of such a policy change are substantially overstated and what you get is the potential for good intentions (closing the fiscal gap) to lead to bad policy.

Relevant Disclosures:  I serve as a trustee for TIAA, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.

 

A Time to Act on the Illinois State Universities Retirement System (SURS)

Filed Under (Retirement Policy) by Jeffrey Brown on Dec 12, 2012

Earlier this week, I released a report co-authored with Avijit Ghosh and Scott Weisbenner (both of the University of Illinois) and Steve Cunningham (Northern Illinois) that – yet again – tries to make the case for pension reform.  The news release can be found here and the full paper (including a one page summary) can be found here.

In a nutshell, the plan has three components:

1.  Change some of the SURS rules to reduce costs and increase transparency.  This includes pegging the SURS’ effective rate of interest to long-term bond rates.  For my prior musings on this topic, click here to see the blog I wrote on this back in June of 2010, entitled “A Hidden Pension Subsidy in SURS.”

2.  Providing participants with an opportunity to opt out of their automatic annual adjustment (sometimes called the COLA) in exchange for a lump-sum that is calculated to give participants a bit of a “haircut.”  We consider this to be a reasonably fair exchange, especially given its voluntary nature, in sharp contrast to the forced choice that has been proposed in other legislation (for example, see Nolan Miller’s post entitled “The Choice Between Two Unconstitutional Options is Not Constitutional.”)

3.  Expand the Illinois state income tax base to include retirement income.  There is really no compelling economic reason to exempt retirement income from the Illinois state income tax, and this may be the only way to get the retired generation to be able to contribute to solving our fiscal problems.

Whether or not our proposal has an influence on the debates in Springfield is anybody’s guess.  But one thing is clear: absent some time of substantial reform, Illinois is teetering close to a true fiscal cliff, one that will make the Washington DC fiscal cliff look like a small step down.

 

Tax Subsides for 401(k)’s Work, But Not for the Reasons You May Think

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Nov 30, 2012

Earlier this week, the New York Times Economix Blog wrote a piece “Study Questions Tax Breaks’ Effect on Retirement Savings.”  The article summarizes the findings of a fantastic research paper issued by the National Bureau of Economic Research (NBER).  A quick summary of the paper written by the authors themselves can be found here.  The short version is that the researchers used data from Denmark (where much better date is available) to provide evidence that tax subsidies have little effect on overall savings rates.

Their main finding is that “when individuals in the top income tax bracket received a larger tax subsidy for retirement savings, they started saving more in retirement accounts.  But the same individuals reduced the amount they were saving outside retirement accounts by almost exactly the same amount, leaving total savings essentially unchanged. We estimate each that $1 of government expenditure on the subsidy raised total savings by 1 cent.”

The policy implications of their finding are extremely important given the current debate about fiscal policy in the U.S.  After all, if tax subsidies for saving do not actually increase saving, then perhaps we should re-think the $100 billion per year that we forego in tax revenue by exempting retirement savings from the income tax base?  Such a conclusion would be quite tempting to politicians who are desperately seeking ways of raising revenue without raising tax rates.

But I say “not so fast.”  Although I do not disagree with the empirical findings of the study, I strongly disagree with the assertions being made by some that this finding justifies the elimination of the tax preference for 401(k) and other retirement vehicles.

The study itself is an outstanding intellectual contribution, and one that will likely (and deservedly) end up being published in a leading scholarly journal.  I can personally vouch for the high intelligence and research integrity of the two U.S. authors.  Raj Chetty was named a MacArthur “Genius” earlier this year, and is widely expected to be awarded the prestigious John Bates Clark medal sometime in the next 6-8 years.  John Friedman of Harvard is also an emerging research star in the economics profession.

So, the researchers are top notch, the study is extremely well done, and the conclusion is that tax subsidies do not generate net much net savings.  So, why not simply eliminate the tax preference for 401(k) plans in the U.S. and raise a trillion dollars of revenue over the next decade?

Because of the important role of plan sponsors, that is why.

For better or for worse, the employer plays a central role in the U.S. retirement system.  Although there are several reasons that employers offer retirement plans and other employee benefits (e.g., to differentially attract certain types of workers, to help manage retirement dates, to motivate workers, etc.), there is little question that the large tax subsidy  looms very large in their decision to use retirement plans – as opposed to other types of benefits – to achieve these outcomes.

To qualify for favorable tax treatment, employer provided retirement plans, including the 401(k), must meet a long list of “plan qualification requirements.”  These requirements are what provide Congress and regulators the ability to influence the design of retirement plans.

An important example is the set of “non-discrimination rules” designed to ensure broad-based participation in an employer’s plan.  These rules provide incentives for plan sponsors to find innovative ways of encouraging saving by their employees.  Indeed, it is not much of a stretch to suggest that these rules are the reason we have seen the widespread adoption over the years of employer matching contributions, automatic enrollment, automatic escalation of contributions, and numerous other innovations in the retirement plan space that have been shown to increase saving.

The authors themselves note that “automatic enrollment or default policies that nudge individuals to save more could have larger impacts on national saving at lower fiscal cost.”  I agree that behavioral nudges have had an enormous impact.  But in an employer based retirement plan system, the only way to get employers to offer those nudges is to provide them with a compelling financial reason to do so.  In essence, tax subsidies are the nudge for employers to provide the nudge for employees.

Of course, this does not necessarily mean that the existing system should be treated as sacrosanct.  It may be that employers would continue to offer 401(k)’s – along with their numerous savings nudges – if the financial incentive were provided in a less expensive way (e.g., by capping deductibility).  That is a debate we ought to have (hopefully informed by evidence of the same high quality as the NBER study).  My point is simply that any policy discussion should recognize the very important role that employers play as trusted sponsors of the plan, and be careful not to throw out the baby with the bathwater.

Indeed, given that only about half of US workers have opportunities to save through their current employer, we should be looking for ways to encourage more employers to sponsor plans.  If we go after the tax incentives for retirement saving, we must be careful not to inadvertently destroy the plan sponsor infrastructure that is the foundation of retirement security for millions of Americans.

 

Relevant Disclosures:  I am a Research Associate of the NBER (through which the study above was released) and Associate Director of the NBER Retirement Research Center (through which the authors have received some funding for their study).  I am also a trustee for TIAA CREF, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.

The Third “Justification” for a Progressive Income Tax

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Aug 31, 2012

Here is the third in a series of blogs that I started on May 18.  The first was called “Why YOU may LIKE Government ‘Theft’”.  In it, I listed four possible justifications for government to act like Robin Hood, taking from the rich to give to the poor.  The point is to think about whether the top personal marginal tax rate really should be higher or lower than currently, as currently debated these days in the newspapers.

However, perhaps we should also remember what is wrong with government using high marginal tax rates to take from the rich in order to help the poor.  The problem is that a higher personal marginal tax rate distorts individual behavior, particularly labor supply and savings behavior, by discouraging work effort and investment.  Since those are good for the economy, high marginal tax rates are bad for the economy!  In fact, economic theory suggests that the “deadweight loss” from taxation may increase roughly with the square of the tax rate.  In other words, doubling a tax rate (e.g. from 20% to 40%) would quadruple the excess burden of taxes – the extent to which the burden on taxpayers exceeds the revenue collected.

The point is just that we face tradeoffs.  Yes, we have four possible reasons that we as a society may want higher tax rates on the rich in order to provide a social safety net, but we also have significant costs of doing so.  Probably somewhere in the middle might help trade off those costs against the benefits, but it’s really a matter of personal choice when you vote: how much do you value a safety net for those less fortunate that yourself?  And how much do you value a more efficient tax system and economy?

In the first blog on May 18, I listed all four justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, then perhaps a different justification is more appealing.  In that blog, I put off the last three justifications and mostly just discussed the first one, namely, the arguments of “moral philosophy” for extra help to the poor.   As a matter of ethics, you might think it morally just or fair to help the poor starving masses.  That blog describes a range of philosophies, all the way from “no help to poor” (Nozick) in a spectrum that ends with “all emphasis on the poor” (Rawls).

In the second blog on July 13, I discussed the second justification.  Aside from that moral theorizing, suppose the poor are not deemed special at all: every individual receives the exact same weight, so we want to maximize the un-weighted sum of all individuals’ “utility”, as suggested by Jeremy Bentham, the “founding figure of modern utilitarianism.”  His philosophy is “the greatest happiness of the greatest number”.   Also suppose utility is not proportional to income, but is instead a curved function, with “declining marginal utility”.  If so, then a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person.  In that case, equal weights on everybody would still mean that total welfare could increase by taking from the rich to help the poor.

The point of THIS blog is a third justification, quite different in the sense that it does NOT require making anybody worse off (the rich) in order to make someone else better off (the poor).  It is a case where we might all have nearly the same income and same preferences, and yet we might all be better off with a tax system that has higher marginal tax rates on those with more income, and transfers to those with little or no income.  How?  Suppose we’re all roughly equally well off in the long run, or in terms of expectations, but that we all face a random element in our annual income.  Some fraction of us will have a small business that experiences a bad year once in a while, or become unemployed once in a while, or have a bad health event that requires us to stop work once in a while.  To protect ourselves against those kinds of bad outcomes, we might like to buy insurance, but private insurance companies might not be able to offer such insurance because of two important market failures:

  1. Because of “adverse selection”, the insurance company might get only the bad risks to sign up, those who are inherently more likely to become unemployed or to have a bad year.
  2. Because of “moral hazard”, insurance buyers might change their behavior and become unemployed on purpose, or work less and earn less.

With those kinds of market failure, the private market might fail altogether, and nobody is able to buy such insurance.  Yet, having such insurance can make us all better off, by protecting us from actual risk!

Potentially, if done properly, the government can help fix this market failure.  Unemployment insurance is one such attempt.  But the point here is just that a progressive income tax can also act implicitly and partially as just that kind of insurance:

In each “good” year, you are made to pay a “premium” in the form of higher marginal tax rates and tax burden.  Then, anytime you have a “bad” year such as losing your job or facing a difficult market for the product you sell, you get to receive from this implicit insurance plan by facing lower tax rates or even getting payments from the government (unemployment compensation, income tax credits, or even welfare payments).

I don’t mean that the entire U.S. tax system works that way; I only mean that it has some element of that kind of plan, and it might help make some people happier knowing they will be helped when times are tough.  But you can decide the importance of that argument for yourself.

Next week, the final of my four possible justifications for progressive taxation.

U.S. Public Pension Plans are Different (and Not in a Good Way!)

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jun 11, 2012

I have written numerous blogs about the frustration that the financial economics community has with the Government Accounting Standards Board (GASB) rules that govern the way we account for public pension liabilities in the U.S.  The basic problem is that GASB standards do not account for risk in an appropriate way (in fact, they do not really account for it at all!)  Instead, they allow public plans to under-state the size of their liabilities by acting as if they have a risk-free approach to investing money at approximately 8 percent per year forever.

On occasion, someone will ask me if this is really just an accounting issue, or whether it actually has real effects on real-world behavior.  Although I can give countless anecdotes for why it affects real behavior, it is always better when a highly respected and disinterested party can provide rigorous empirical evidence to support the claim.

Well, now we have such evidence.   Just last month, three financial economists (Andonov, Bauer and Cremers) publicly released a rigorous new research paper entitled “Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?”  In this paper, the authors use an international database to look at the asset allocation decisions and discount rate assumptions of both public pension funds and non-public pension funds in the U.S., Canada and Europe.  What is particularly nice about this paper is that it is able to show what outliers U.S. public plans really are.  Not only do they look quite different from corporate DB plans in the U.S., but they also look different from both public and non-public plans in other countries.

Specifically, the authors state that “U.S. public funds seem distinct in that they can decide their strategic asset allocations and liability discount rates largely without much regulatory interference, due to wide latitudes allowed in the currently applicable Government Accounting Board (GASB) guidelines. In particular, these guidelines link the liability discount rates of U.S. public funds to the (assumed) expected rate of returns of the assets, rather than to the riskiness of the liabilities as suggested by economic theory.”  As I have written before, this is an intellectually vacuous approach to discounting.  What I had not fully realized is how unique this mistake is to U.S. public plans.  The authors go on to state that in Canadian and European funds – both public and private – liability discount rates are “typically … a function of current interest rates,” an approach which (assuming the interest rate is chosen appropriately) is much more in line with basic economic theory.

The most striking finding is the impact that this difference in accounting has on real behavior.  The authors find that “in the past two decades, U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities.”  This really is a case of the tail wagging the dog – by allowing an intellectually flawed approach to discounting to be codified in GASB standards, we have provided incentives for public pension fund managers and their boards to over-invest in risky assets.

There are many losers from GASB-induced deception.  Public workers end up with less-well-funded pensions.  Taxpayers end up bearing financial risk without realizing it.  Investors in public debt are given inaccurate information about the size of the pension liabilities.  Isn’t it time that we fix this?

Illinois Public Pension Reform: A Simple but Radical Idea

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jun 4, 2012

After a week of legislative wrangling that had more twists and turns than Hawaii’s famous “Road to Hana,” the Illinois General Assembly failed to come to agreement last week on a pension reform package in time for yesterday’s May 31 deadline.  As a result, they will return to Springfield – possibly this week – for a special session facing an even larger hurdle for passing reform legislation: by Illinois law, bills passed after May 31 require a three-fifths vote rather than a simple majority.

Agreement fell apart over the issue of who should pay for the “normal cost” of future public pension accruals.  “Downstate” lawmakers objected to shifting all of the costs onto school districts, public universities and community colleges on the grounds that this would lead to higher property taxes to fund teacher pensions and do grave damage to the ability of our university system to compete for academic talent.  Once Democratic Governor Quinn agreed to pull this cost-shifting out of the bill, Democratic House Speaker Mike Madigan withdrew his support of the bill.

As I wrote this past Wednesday, one of the grave concerns I have about the leading proposals is that so many of our elected officials seem perfectly content to shift all of the costs onto universities and school districts while maintaining legislative control over the design of the benefits package.  This is a mistake on so many levels.  The separation of responsibility and control is a recipe for fiscal shenanigans.  It is also highly disrespectful of the employer-employee relationship that Bob Rich and I wrote about in our pension reform proposal earlier this year.  

Although I still like the plan that Bob Rich and I put out, it seems clear that the General Assembly has gone another route.  But given that they are stuck on the cost-shifting issue, I thought it might be useful to put forth a more radical proposal that would respect the constitutional constraints, appropriately align the incentives of all the affected parties, respect the employer/employee relationship, and still save the state billions.  Perhaps most importantly from a political perspective, it might overcome the cost-shifting stalemate, because it shifts the costs but offers something very valuable in return.  This proposal would apply to those institutions – such as school districts, universities and community colleges – that, while public, are not part of the state government apparatus itself.  

While “radical,” the idea is deceptively simple.  Here it is in 4 simple steps:

1.       The state agrees to pay 100% of all pension benefits that have been accrued by public sector retirees and current workers as of 7/1/2013.  Whether the state wishes to do this by paying down the amortized unfunded liability, or simply provide the cash as need to pay benefits, is immaterial, so long as they respect the constitutional guarantee and pay it.  Not only does this respect the constitution, but it would also be fair to the generations of workers and retirees who consistently paid their share to the pension fund while the politicians enjoyed their “pension funding holidays.”    

2.       The existing public pension plans – for example, TRS and SURS – are closed to all further accruals as of 7/1/2013.  No new benefits will be earned under any of the plans.

3.       Going forward, each state employer is given 100% autonomy – free from the shackles of state regulation and political interference – to construct a benefits package that is optimally designed for its own employees.  In order to comply with federal law that applies when a state like Illinois opts out of Social Security, each employer would be required to provide a retirement package that is at least as generous as Social Security.  Beyond that, it would be up to each employer to determine the optimal mix of wages, pensions, and other employee benefits that would be required to attract, retain, motivate, and manage the retirement of their workers.  If similar employers wished to joint together as a group (e.g., all community colleges) to provide a common pension plan, or if unions wanted to provide multi-employer pensions funded by a group of employers, they would be permitted to do this.  But if the University of Illinois decided that its needs differed sufficiently from other public universities, they would have the freedom to go their own way.  

4.       The state would agree to a pre-determined, annual “block grant” (basically, an extra appropriation) to each employer that would start out as an amount equal to the “normal cost” of providing pensions, and would gradually decline to zero over a 20-year period of time.  This would slowly shift the entire financial burden of providing pensions from the state to the employers themselves.  

In essence, this plan calls for 100% cost-shifting, but with two critical differences relative to the reform package being debated last week.  First, and most importantly, it accompanies the cost-shifting with a freedom from political interference.  Second, it spreads the cost-shifting out over a much longer period of time (twenty years instead of approximately eight or so) in order to ensure that employers can adapt.

If there is anything I have learned from observing our Illinois state government in action, it is that it cannot relied upon to design a sensible pension package that is fiscally sustainable, credible to employees, and meets the diverse needs of our public employers.  So if they are so eager to get out paying for pensions, let’s take this idea all the way – aside from atoning for their past sins by making good on constitutionally guaranteed promises that they have so far failed to fund – let’s have the state get out of the pension business altogether.  

Doing so would free employers and employees from being subject to the unpredictable whims of the states’ politicians.  And that freedom, it seems to me, is priceless. 

Brief Update on Illinois Pension Reform

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 31, 2012

After last night’s somewhat surprising announcement that Speaker Madigan has agreed to the Governor’s request to remove from the pension reform legislation the provision that would have shifted normal costs onto school districts, universities and community colleges, it now appears that particular provision is dead.  Along with it, it appears that the ability of employers to replace the inadequate Tier II pension (for those hired after 1/1/11) wit a new cash balance plan is also dead.

The main provision of forcing a possibly unconstitutional choice between giving up one’s cost-of-living adjustments after retirement or giving up retiree health insurance, however, is still intact.  As is the provision that would freeze pensionable earnings for those that want to keep their current COLA.  And, rumor has it, the legislature is looking for other ways to save costs as well … so look for some additional benefit changes in the final package.

Also, people who don’t work with compound versus simple growth rates on a daily basis may not realize just how big the COLA changes are.  So here is a simple but useful example.  Suppose someone retires at age 60 and lives until age 85.  Under the current law, they receive 3% COLA each year compounded.  Under the proposed law, they get a 0% COLA for the first 5 years, followed by half of inflation or 3%, whichever is less.  If inflation runs at 3% per year, this is a 1.5% non-compounded (i.e., simple) interest.

This may not sound like much.  But don’t be misled — at age 85, this person’s pension would be 37% LOWER UNDER THE PROPOSED LEGISLATION.  If we compute a present value using a 4-6% nominal discount rate, it is a 20% reduction in lifetime pension payments.  This is why the proposal saves so much money.  It is also why it is pretty clearly an impairment or diminishment of benefits!

 

Three Hard Lessons from Illinois Public Pension Reform

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 30, 2012

The Illinois General Assembly stands on the verge of passing an historic public pension reform.  After many decades of serial underfunding, the legislature and Governor have finally agreed to act.  The news for taxpayers is primarily good: through a combination of cost reductions and cost shifting, the public pension fiscal drain on state revenue is being substantially reduced.  This is welcome news in a state with a fiscal situation as dire as Illinois’.

Although the reform provides substantial cost savings to the taxpayers of Illinois, it also comes at significant costs.  In this post, I want to draw three big picture lessons from this reform.  I will post additional material on more detailed features of the reform in the coming days and weeks.

Lesson 1:  Constitutional Benefit Guarantees Don’t Always Protect Participants

Sensible public pension reform in Illinois has been hamstrung by the fact that we are one of the few states whose constitution contains a clause guaranteeing that retirement benefits for public workers cannot be “diminished or impaired.”  In a well-functioning system, the existence of this guarantee would have two beneficial effects.  First, it would lead to better funding (“we had better fund it, because we are going to have to pay it!”)  Second, it would cause workers to fully value the pension benefits being provided: thus, in a competitive labor market, wages would adjust to reflect the value of the pension, and thus the compensation package would be economically efficient.

But Illinois is far from a well-functioning political system.  Thus, what the constitutional guarantee brought us was: 1) Four decades of under-funding: if benefits are guaranteed, why should workers care about funding?  2) The inability to reform the system in a logical, sensible way. 

The constitutional prohibition against benefit impairment took “off the table” a whole host of sensible reforms, including my favorite: raising the retirement age to qualify for full benefits.  Instead, politicians were forced to play a game of “pension Twister,” contorting policy in all sorts of ways to find a way of cutting benefits that might pass constitutional muster.  Sadly, despite all of these contortions, many of us believe that the Courts are still likely to strike down this reform – on this issue, see yesterday’s post by my colleague Nolan Miller

Lesson 2:  Separating Responsibility and Control is a Bad Idea

The world is full of bad behavior that results when the entity with the power to make decisions is not the same entity that bears financial responsibility for the results.  In the case of Illinois, this issue manifested itself historically through the fact that universities, community colleges, school districts and other public employers were able to make hiring decisions without any responsibility for the pension liabilities that those decisions created. 

Post-reform, we will have a different manifestation of this problem.  The Illinois legislature has – after a relatively brief phase-in period – absolved itself from any further financial responsibility for future public pension accruals.  The funding of all “normal costs” will gradually be transferred entirely to the institutions themselves.  The problem is that Illinois politicians did not also grant these same institutions the power to design and implement their own retirement plans.  In short, the Illinois politicians still get to design the system – the universities and school districts just now have to pay for it.  Although there are a few safeguards being put in place to guard against the most egregious abuses of this new regime, I predict it will not take long for the state to find a way to curry favor with some voting block and pass the cost onto the employers.

Lesson 3:  Public Sector Accounting Rules Really Do Matter

I have blogged extensively about the many flaws of the public pension accounting standards promulgated by the Government Accounting Standards Board (for some examples, see here, here, here and here).  GASB allows public pensions to discount future liabilities with an inappropriately high rate, thus understating the real scope of the problem by ignoring risk. 

Unfortunately, these flawed GASB standards framed the Illinois debate, and in so doing has had the effect of 1) over-stating the extent to which the state is going to do penance for its past sins of historical under-funding, and 2) under-stating the real size of the liability being pawned off on the universities, colleges and school districts throughout the state. 

The hardest hit by this provision will be those employers – such as the flagship campus of the University of Illinois at Urbana-Champaign (UIUC) – that compete in a global labor market for talent.  If UIUC wishes to maintain its position as one of the leading public research universities in the nation, it will have to continue to provide a competitive compensation package: but it will now being doing so with virtually no assistance from the state.  The even worse alternative would be to watch its best and brightest faculty and staff members run for the exits.

Public pension reform was badly needed in Illinois, and our elected officials ought to be congratulated for having the political will to undertake it.  Unfortunately, I fear that they botched the substance of reform. 

Of course, none of this may matter – I still believe there is a greater than 50% chance that the Illinois courts will overturn it. 

Here is hoping they get it right the next time around …