A Modest Proposal to Reform Illinois Pensions

Posted by Jeffrey Brown on Jan 24, 2011

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy)

Illinois faces a challenging fiscal future.  Even with an enormous 67% increase in marginal tax rates (from 3% to 5%), Illinois does not have a sustainable long-run fiscal plan in place.  Decades of under-funding our pensions is part of the problem (though certainly not all of it).  And while we can argue all we want about who is to blame, it is an undeniable fact that the unfunded pension obligations are a substantial part of the fiscal mess that lies before us.

Most of the rhetoric on this issue has devolved into finger-pointing: “it is those lavish public pensions” versus “no, it is the irresponsible politicians who failed to fund them.”  Rather than adding to the argument about blame, I would like to suggest a way forward.  This is only a very rough conceptual outline – you will see there are no numbers attached.  And I should also be quite clear that what I am about to suggest does not “solve” our pension funding problem.  But it could help, so here goes:

First, three observations:

1.        We must begin by recognizing that there are two highly inter-related issues, both of which must be addressed.  The first issue is that we face a large fiscal challenge that, mathematically, almost seems to require that we find a way to reduce future pension obligations.  The second issues is that we face a human resources challenge – that at least in some parts of the public sector, we need to provide a compensation package that makes it possible to attract and retain the right kind of employees with the right kind of skills.  We cannot simply “cut pensions” without implications for our ability to compete in the labor market.  So the trick is to “fix” our budget problem while maintaining our ability to attract the professors, teachers, and other professionals that we want in the public sector.  Too often, the debate ignores this second part, implicitly (and mistakenly) suggesting that we can just slash pensions without any adverse consequences.

2.       The public defined benefit (DB) model, for all its strengths (e.g., inter-generational risk-sharing, retirement income security, cost efficiencies from pooled investments, etc.) also has some fundamental flaws, the most important of which is that it is far too easy to play financial games at the expense of future generations of taxpayers.  The list of budget gimmicks is far too long to enumerate here, but the gist of it is that we often end up growing our future liabilities in return for small short-term gains and then use accounting gimmickry (much of it blessed by the Government Accounting Standards Board) to hide the real costs to taxpayers.  Even if we did not face yawning budget chasms, citizens ought to be alarmed by the poor governance engendered by this system.

3.       The private sector 401(k) model – which is sometimes suggested as a replacement for public DB plans – is also deeply flawed.  As underscored by the recent recession and financial crisis, the existing 401(k) system is woefully inadequate when it comes to providing good tools for financial risk management.  There are mountains of empirical studies documenting the lack of financial literacy in the population and the resulting biases and mistakes that people make when forced into a “do-it-yourself” retirement system.  A few examples – inadequate savings rates, too little diversification, chasing past returns, failing to insure against the risk of outliving one’s resources, and many more.

So, what do we do?  Here is a modest proposal to get the conversation started:

1.        For future workers, we have already scaled back the public DB.  But I say we go even further.  For starters, let’s think about cutting the DB pensions in half.  But in recognition of the fact that we need to remain competitive in the labor market, please read on …

2.       Then, let’s supplement the DB pension with a fully-funded, income-oriented, Defined Contribution (DC) system.  I am not talking about a private sector 401(k).  I am talking about a sensibly designed, mandatory savings program that automatically diversifies people into low cost funds at appropriate savings rates, and that automatically convert into guaranteed retirement income as one approaches retirement.  For example, TIAA-CREF annuities, (DISCLOSURE:  since 2009, I have served as a Trustee of TIAA), which provide low cost investment options and opportunities to convert into lifetime income annuities.  This is akin to what Orange County California did last year – which you can read more about in Roger Ferguson’s op-ed in the WSJ last week.  They reduced their DB plan and supplemented with an income-oriented DC plan.  Importantly, this plan was supported by government officials and the unions.  Unlike the typical 401(k), this approach would manage risk more effectively, and thus would still provide valuable retirement benefits to public sector workers.

3.       For existing workers covered by the constitutional non-impairment clause:  since we probably cannot force them to take a lower benefit, we give them the voluntary option to switch to this same hybrid DB/DC pension.  But with two tweaks:  (i) We announce that the decision is voluntary, but that the default option is that they will be switched to the new system.  Those who wish to remain in the old system would be given a fixed period of time (say, 3-6 months) to fill out the paperwork (or the online form) to state their desire to stay in the old system.  A huge literature in psychology and economics suggests that many people will go with the default.  (ii) When determining the “price” at which we will convert future DB promises into DC contribution, we use a high discount rate that reflects the subjective political risk associated with the benefits.  This is key to this proposal saving the state any money, since the conversion of DB to DC, by itself, does not create any savings.  So let me say a bit more — in essence, we know that a lot of workers are concerned that they will never get their full DB benefit.  So this provides an opportunity to make a fair, voluntary trade – you get a guaranteed contribution to your DC account – which you will then own and which will be protected from the State – and in return, you accept a small “haircut” on the size of this contribution.  Yes, it would be a benefit “cut” relative to the currently promised but under-funded benefits, but numerous studies from the U.S. and abroad suggest that people would be willing to accept such a haircut in return for no longer having their future benefits reliant upon the ability of the State of Illinois to finance their DB pension.

4.       How do we deal with the “transition cost?”  To be clear, this approach would reduce the long-run obligations of the state.  But it would also require that – in the short-run – the state come up with more cash in order to fund the DC plans while still making good on DB promises to existing retirees.  How do we handle that?  A few ideas:

a.       Spread the contributions to the DC tier (that are payment for the reduced DB) over several years

b.      Don’t be afraid to issue debt to finance this.  Keep in mind that this would not represent a net increase in indebtedness – we would simply be exchanging implicit debt (to pensioners) with explicit debt (to bondholders).  Indeed, with the higher discount rate, the *total* debt (implicit plus explicit) would go down.

This obviously leaves a LOT Of details to be worked out.  But the system would have several advantages over the status quo. A few of the big ones are:

1.        It imposes funding discipline.  The state would be legally required to make its DC contributions going forward.

2.       It maintains a focus on the retirement income security of participants.  It is true that, with the “haircut”, the DC would not cover 100% of the reduction in the DB benefit.  But it is also true that the participant would no longer have to worry about leaving the entirely of their retirement income security in the hands of Springfield.

3.       If I am correct that many participants would be willing to accept a reduction in expected benefits (relative to the full DB benefits) in return for no longer being subject to the political risk that Illinois defaults on its DB obligations, then it has the potential to save money.  (But let’s be clear – there is no free lunch here!  The cost savings only come from people accepting a smaller expected benefit in exchange for reducing the political risk to their benefit).

Any takers?

16 Responses to “A Modest Proposal to Reform Illinois Pensions”

  • Frank Goudy says:

    Mr. Jeffrey Brown,

    Illinois has a $15.5 billion welfare health program known as Medicaid. Ity has grown astronomically. Even illegals are on it through the AllKids program. Non-citizen immigrants can and do qualify, while we citizens who worked for the state for 30 years are the Whipping boys and girls. Nearly 39% of the Medicaid programis OPTIONAL and not required by the state of the FEDS (2008 data)

    We have capital projects that are smell of bad prok and some $300 million in continuing appropriations allocated to private unviersities inthe state.

    Our schools are estimated to have at least 100,000 illegal aliens and perhaps another 100,000 anchor babies in them. At $10K per child , you can do the math.

    But you, like so many others in the political and business establishment, focus only on state employees and their pensions.

    Do us all a favor and examine the ENTIRE STATE BUDGET for a change. It will be enlightening for you as well as the state as a whole.

    Any response?

  • Jeffrey Brown says:

    Sure Frank. I have two responses.

    The first is that the proposal I outlined would be voluntary for anyone currently employed by or retired from the state. If you do not like the deal, you would not have to take it. This is simply an attempt to perhaps save the money by offering some participants the opportunity to trade-in some of the political risk in exchange for a slight reduction.

    Second, the fiscal hole that we face is absolutely enormous. What I am suggesting would make only a small dent in it. So we need need to seriously analyze and consider EVERY program in this state, including all of the ones you refer to, in addition to thinking creatively about pensions – and we ALSO need to think about many more ideas in addition to the ones you and I have suggested.

  • Retired says:

    Sigh….. A “voluntary” program…. i.e. take this reduction or the chances that the state will default on your payments will be even greater since we can single out even a smaller minority and thus even easier to pick on. Sounds more like a threat to me. Go pick on those who don’t contribute and huge pork barrel/special interest/wastes of money.

  • Jeffrey Brown says:

    Yes, I hear you Retired. But the risk that they might find a way to default on payments is a risk that exists with or without a voluntary program to have a partial DC. One of the keys, however, to it being a hybrid system is that they # of people would not be smaller – everyone would still be in the DB. They would just have part DB and part DC. so at least if the state defaulted, people would still have something to fall back on.

  • Jim says:

    Jeffrey, why would your plan legally require the state to fund the new DC plan any more than past and current law requires funding the pensions systems? The GA has routinely ignored the laws on funding with impunity. Past behavior suggests only moving state employees into Social Security would truly force this state to pay its share, not that I would advocate for Social Security per se. It’s just the observation that only the Feds seem in a position to “make” this state do the right thing.

  • Jeffrey Brown says:

    Hi Jim,
    Thanks for the comment. When individuals participate in a defined contribution plan, the plan sponsor is legally required to make the contributions, otherwise they are in violation of the employment contract. This is much different than a DB plan, in which the legal responsibility is to pay benefits *in the future* with no obligation to pre-fund it now. If the state failed to make a required contribution to a DC account, employees would have grounds for a lawsuit, unlike the DB situation in which the Illinois supreme court has ruled that participants have no right to funding (only to the eventual benefit).
    There is, however, a related concern. Which is that the need to make the DC contribution means that any shortfall is more likely to fall on the remaining DB. So while the DB might be a smaller fraction of income for those in the hybrid plan, the risk to the DB portion could be even greater. The question – on which we can only speculate – is whether the TOTAL risk to the TOTAL pension (DB+DC) goes up or down. I think it would go down, but there is n way to prove this conjecture …
    Jeff

  • Frank Goudy says:

    Mr. Brown,

    Basically your approach is a closet blackmail plan for existing employees- do this or else we will screw you later anyway. And no matter how you try to sugarcoat that is what it means.

    I am a retired worker so your plan for existing workers does not affect me.

    Now, I hope you are aware of the program cuts I have advocated for Medcaid have been proposed in a joint legislative committee which consisted of 3 Democrats and 3 Republicans.

    The plan to ask immigration status was nixed by the Democrats on the commttee. The plan to address the optional expenditures was also discussed and nixed by the Democrats on the committee. And since the Democrats control the GA that is the end of that story. Not trying to be partisan but that is just the way it is.

    So these expenditures involving billions of dollars are off the table. So where does that leave us. Of course, attacks on pensions and state employees health care.

    By the way, Shoenberg is already on the attack about employee health care costs- but if anyone can show me where he is addressing the huge costs I have talked about, well, tell me about it.

    If anyone has enough sense to connect the dots and see the political winds they will see that not going after Medicaid will lead to disaster for public employees. That is reality.

    Your approach is to be good little boys and girls and bascially surrender- and that is what it amounts to in the final anlaysis.

    As far as deporting illegal aliens, no way either party wants to address that. And if we don’t, we are again leaving ourselves with no effective financial ‘comebac’k’ showing other alternatives.

    Your approach only gives ammunition for one area of the budget to be considered. A method that far too many will consider to be easy to do without other than cosmetic financial cuts.

    I have been around a long time, I have been on AFT negotiating teamns for a university, I have been actively involved in state politics over the years.

    I know what I am talking about.

    Your approach, as it addresses only pensions, is a Trojan Horse for public employees.

  • Frank Goudy says:

    Sorry I had a typo on Schoenberg’s name. I spelled it without the “c”,

  • Jeffrey Brown says:

    “Closet blackmail” is a pretty strong term for a guy who is just trying to think outside the box and break through the log-jam on a thorny issue that nobody else seems to want to address in a comprehensive way.

    I don’t take it personally though – I understand that as a retiree from a public system, you feel you paid your dues, and just wanted the state to make good on its part of the deal. As in the Social Security debate, I am quite sympathetic to the view that we should protect those already-retired or near retirement. But it strikes me as completely ludicrous that we cannot even have a conversation about changing retirement benefits for some 25 year old just because he has been in the system for a year? That is borderline insanity from a fiscal perspective.

    And I also understand (and appreciate) your point that we need to have a broader conversation about spending that goes beyond pensions. But let’s be honest – if you want to cut spending, you have to look where the big money is. And like it or not, pensions are one (not the only one, of course, but one) of those areas.

    Also, I must say that I find it ironic that pension participants say it is “not fair” to have public employees and pensioners share in the burden associated with our underfunded pension, but that it is somehow “fair” for today’s taxpayers to have to foot the bill for public services that were provided but not paid for decades ago – back when many of today’s taxpayers were not even born or did not yet live in Illinois.

    Just food for thought …

    By the way … do you know what is driving much of the projected costs of Medicaid in the years ahead? Long-term care expenditures for the functionally impaired elderly who exhaust their resources (if they saved at all) and end up on Medicaid to pay for care.

  • Craig Pence says:

    Jeffrey,
    You said, “…I find it ironic that pension participants say it is “not fair” to have public employees and pensioners share in the burden associated with our underfunded pension, but that it is somehow “fair” for today’s taxpayers to have to foot the bill for public services that were provided but not paid for decades ago.” You seem, though, to find no fault with the notion that we pensioners, whose earned benefits were misappropriated for more than 20 years and used for exactly these kinds of expenditures, should not now collect them. In my case, the state SAVED the 7.65% social security tax it (and all employers) pay into social security, by promising instead to pay 8% into my state retirement system. It was this almost costless 8% benefit that you seem to think I should now in part lose.
    FYI, since the state saved the social security tax it would have had to pay on my earnings, I have not participated in social security and will not draw social security nor medicare benefits. You say, “Do you know what is driving much of the projected costs of Medicaid in the years ahead? Long-term care expenditures for the functionally impaired elderly who exhaust their resources (if they saved at all) and end up on Medicaid to pay for care.” You seem, sir, to be quite happy to see me, and retirees like me who trusted Illinois to honor its promise to provide our earned pensions and medical insurance upon retirement, relegated to exactly such a state.

  • Craig Pence says:

    I must also comment on your proposition to allow for “voluntary” conversion from DB to DC. You say, “A huge literature in psychology and economics suggests that many people will go with the default.” Setting aside the ethical considerations associated with such manipulation of the gullible and aged, once these conversions occur who will be left in the DB plan and how will it be funded? Won’t DB participants be, in essence, FORCED into the DC plan you offer them so graciously, simply because it cannot be sustained once the young, the frightened, the vulnerable leave? You then say, “When determining the “price” at which we will convert future DB promises into DC contribution, we use a high discount rate that reflects the subjective political risk associated with the benefits. This is key to this proposal saving the state any money, since the conversion of DB to DC, by itself, does not create any savings.” Sir, it is clear that you understand that using a HIGH discount rate results in a LOW present value, or price. So not only will DB participants be forced into the DC plan, they will also be forced to take a large loss (giving up a long stream of relatively high DB payments in exchange for a rock-bottom present value). You then have the used-car-salesman’s gall to say, “So this provides an opportunity to make a fair, voluntary trade – you get a guaranteed contribution to your DC account.” Did the terms “fair” and “voluntary” stick a bit in your throat as you voiced them into your computer’s microphone? I suppose not, since you then have the nerve to admit the theft you are proposing, and praise the plan for being such an easy heist to carry out: “it would be a benefit “cut” relative to the currently promised but under-funded benefits, but numerous studies…suggest that people would be willing to accept such a haircut in return for no longer having their future benefits reliant upon the ability of the State of Illinois to finance their DB pension.” Why not just use a gun?

  • Jeffrey Brown says:

    Craig,

    You are way off base when you state that I “seem quite happy to see (you) relegated to exactly such a state (i.e., long-term care).” I am sorry if you feel this way, so nothing could be further from the truth. I realize that this issue is deeply personal for many pensioners, and that people often react more strongly through the internet than they would in person.

    So let me be clear — just like with the debate over Social Security, I believe that people who are already retired and receiving benefits should be largely left alone (there are a few exceptions, such as technical corrections to the CPI index in the case of Social Security, but for the most part, I think existing recipients should be protected).

    You, my own father (who is himself a public pension recipient), and millions more of you made your retirement plans under a perfectly reasonable expectation of receiving the benefits you had been promised. Further, having already retired, you have far fewer options for absorbing a benefit cut. Essentially, you would have little choice but to cut your consumption. That would be a pretty poor policy to take the axe to those benefits.

    What I had in mind in my “proposal” what not that we would switch current retirees, but that we would switch people like me – current employees who are still a reasonable distance from retirement and who have plenty of time to adjust our behavior. I am in my early 40′s – if I know *now* that my future pension would be cut, I have many ways that I can adjust. I can save a bit more each month, I can choose to stay in the workforce another year, etc. In short, I have time to adjust.

    So in contrast to the very strong case for protecting benefits for current retires (and those near retirement), I see NO good rationale for not being able to change benefits for people in their 20s, for example. Do you really believe that just because some 23 year old has worked in the system for 1 year that the taxpayer has to guarantee the existing pension rules for the next 40 years of this person’s employment, and for another 30 or 40 years thereafter while he or she is retired? Seems absurd on its face.

    So, a longer and more careful description of my proposal (which is tough to provide in the space constraints of a blog) would more carefully explain several features, including: (1) fully protecting existing annuitants, (2) nearly-fully protecting “near annuitants” (say, those within 5-10 years of retirement age), and (3) making the change for younger participants. There are many variants on this. For example, rather than base it on age, one could consider both age and years of service.

    I appreciate your willingness to post comments and engage on this issue. Although I would appreciate it if you would tone down the attempts to impugn my motives or question my concern towards pensioners. I am among those that would like to see a bit less vitriol and a bit more reasoned debate over these important public policy issues. Indeed, that is the whole reason I spend time on this blog.

    Have a nice weekend.

  • Jeffrey Brown says:

    I will ignore your inappropriate final comment about guns – in a post-Giffords world, I think we need to be more careful throwing around phrases like that in our discussions of public issues.

    You raise a valid concern about the use of default options – indeed, I am co-authoring a paper right now using data on the SURS system to point out that people can indeed be harmed when they are automatically enrolled or defaulted into a plan without adequate information. Given my response to your last point, I think I should at least limit the default option to younger workers. I agree it would be a terrible idea to do this for retirees and those near retirement. There has been some interesting work recently about age-varying defaults. So one could imagine defaulting everyone under 40 into the hybrid, and defaulting those over 40 in the existing system. (Just an example).

    To be honest with you, for younger workers (those in their 20s and 30s), I would be quite happy to just impose the hybrid system. But I am assuming that the constitutional protections will bind and therefore that we must do it voluntarily. Thus the idea of the default option.

  • Frank Goudy says:

    Mr. Brown,

    I hope you noticed that I have documented that about 39% of MEDICAID costs are OPTIONAL and not required by the FEDS. That is $billions- even of state GRF And that was in FY08. Blago expanded the program since then.

    I hope you noticed that 70% of the ALLKids program goes to the children of illegals.

    So yes, I have documented real cost savings.

    And those cost savings seemed to be systematically ignored. It always comes back to pensions.

    They are huge but you have never mentioned this type of info and data in your writings. And the GA also ignores it. I was told that these items did come up on a joint committee but that one particular political party would purposely not address them. Guess which one.

    I wonder why so many want to ignore this?

  • Tom says:

    While I understand the plan…what of the people that are 5 years from retirement? Do they have to work longer, too? After working 28 years in a prison…I can’t see me wanting to work for another 10 years. It seems to me the real issues are gross-underfunding by the State for decades…I’m paying close to $500 a month into the pension system…I’ve served over 20 years…I’m not asking for more than I am entitled.

    Frankly, it’s atrocious to me that the VERY IDEA of welching on our retirement benefits is even being discussed…I’m not blaming you, of course…just the ugly trends that have been set by the latest in conservative attack ploys…which, of course, have transcended political parties and have influenced even “blue” states like Illinois…or are at least attempting to do so.

  • Jeffrey Brown says:

    Tom – you are absolutely right that the reason we are in this mess is primarily (but not exclusively) because of decades of underfunding by the state. No question about it.

    However, the data also suggests that are benefit package is generous/expensive one to provide, so I don’t think it totally crazy that we should be having a conversation about what pensions ought to look like going forward. Regardless of how we got here, the state does not have enough money to do everything it is doing and pay what it needs to pay to bring pension funding up to snuff. We have already raised tax rates, and if we do much more of that, we won’t have much of a tax base left …

    To your question, however, my basic view is that the closer you are to retirement, the less we ought to mess with your benefits. Maybe “leave alone” those already in retirement. Make tiny changes to those a few years away, and much more substantive changes for those that are much earlier in their careers.