Do Illinois Pensioners and Taxpayers Know the True Value of Public Pensions?

Posted by Jeffrey Brown on Sep 28, 2009

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

Last week I wrote about the (often misguided) debate over the generosity of public pensions in the state of Illinois.  I ended by noting that it was important to further examine how my previous analysis would change once we account for two under-appreciated facts about the Illinois pension system.    

 

The first under-appreciated fact is that Illinois is one of a small number of states that provides an explicit constitutional guarantee against the impairment of pension benefits.  Specifically, Article XIII section 5 of the Illinois State constitution states that: “Membership in any pension or retirement system of the State … shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

 

While Illinois is not alone in providing this guarantee – similar language is included in the constitutions of Alaska, Arizona, Hawaii, Louisiana, Michigan and New York – it should be noted that not all states provide such a guarantee.  In Indiana, for example, the Indiana Court of Appeals (in Haverstock v. State Public Employees Retirement Fund” stated that “pensions are mere gratuities springing from the appreciation and graciousness of the state.”

 

In a paper that I wrote with David Wilcox in the May 2009 American Economic Review, we discuss just how powerful these guarantees have proven to be over the years.  On the basis of that analysis, I am highly confident that Illinois pensioners will receive their benefits.  Unfortunately, with Illinois having one of the worst records of effective governance in the U.S., most other pensioners and participants are not quite so confident.  One way or another, most of them think, the politicians in this state will find some way to renege (at least partially) on these benefits.  (As an aside, what public servants really have reason to be afraid of is that retiree health benefits will disappear – those are not covered by the impairment clause.) 

 

The second underappreciated fact is that the public defined benefit pension plans in Illinois are far too complex for the average (or even the highly sophisticated) participant, taxpayer or legislator to properly value.  There are many reasons for this, but mainly it boils down to the fact that the ultimate benefit depends on a lot of variables that will only be known with certainty many years in the future, such as one’s final average salary.  If that were not complex enough, the legislature has made it even more complicated by having multiple benefit formulas in place.  For example, in the “Traditional” defined benefit plan under the State Universities Retirement System (SURS), participants who joined the system prior to July 2005 received a benefit that was the higher of two approaches.  The first was the standard formula (2.2% times years of service times final average compensation).  The second was a “money purchase” option that essentially kept track of the individual’s contributions, matched them with a state match (at least on paper – we already know the state did not really provide the money), and then credited them with an “Effective Rate of Interest,” or ERI.  Then, at retirement, the “balance” in this largely fictitious account was converted to an annuity using an annuity table that used a rate quite close to the ERI.  If the resulting number was higher than the standard formula, the annuitant gets this higher amount instead. 

 

Confused yet?  If you answered “yes,” don’t feel bad.  Most participants don’t understand all these details.  It is complex stuff that requires a high degree of financial sophistication to truly follow.  If you answer “no,” then let me ask a few extra credit questions.  First, do you know what mean, standard deviation and range the ERI has been in for the last 25 years?  And do you know how the annuity conversion factor compares to market rates?

 

By this point, I suspect very few people know the answer.  Again, don’t feel bad.  I study pensions for a living, and it took me a lot of time and research to find these answers (and, alas, it was too late – by the time I understood all the details, I had already made a sub-optimal pension choice – and it was unfortunately a lifetime irrevocable one!) 

 

Without boring you with details, let me give you a flavor of what I have since learned.  The way the SURS board has historically set the ERI, participants in the DB plan were getting an enormously high return (roughly 8-9%) relative to the risk (as measured by the standard deviation in the ERI, which was tiny over the past 25 years), and this high return was being implicitly guaranteed by the taxpayer.  And the annuity rate?  It is substantially more favorable than even the most attractive private market annuity prices – I’m talking in the range of 50% or more benefits per dollar in the “account,” and in some cases, far more.  These two factors explain why most people retiring from SURS in recent years actually received a higher benefit from the money purchase calculation than the basic formula.

 

What do these two points – the constitutional guarantee and the complexity of the benefit formula – have to do with each other?  Put simply, they have conspired to put an enormous pension funding burden on taxpayers without providing commensurate perceived value to state workers!

 

Let me explain.  As a result of a complex benefit formula that hides the true value of the pensions – combined with the fact that most participants view the DB pension promises as being at some risk of not being honored – means that most public pension participants do not value the pensions at their full economic value.  This fact partially mitigates the point I made last time because this means the “compensating wage differential” will not be dollar-for-dollar. 

 

However, the fact that participants discount their benefits in this way does NOT mean that the state is not actually incurring the full economic costs.  Indeed, the constitutional guarantee means that the states’ taxpayers ARE on the hook for the full economic cost of these benefits.

 

In essence, we have the worst of both worlds.  Public employees are earning a valuable benefit, but because our legislators have (i) created a needlessly complex system, (ii) created a complete lack of confidence in the security of these promises, and (iii) have provided us with a constitutional guarantee that the benefits will be paid, the participants don’t fully value the benefits even though the state bears the full costs.

 

If any private company did this – providing a costly benefit that was valued by employees at less than the true cost to the employer – that company would soon be bankrupt.  But this is Illinois state government.  So, instead, we continue to build up enormous funding liabilities that will simply be passed on to the next generation of Illinois taxpayers.  It may be “business as usual” in Illinois.  But it’s also a real shame.

 

Public servants and taxpayers of Illinois deserve better.

 

5 Responses to “Do Illinois Pensioners and Taxpayers Know the True Value of Public Pensions?”

  • George Devries Klein says:

    That comment about healthcare not being a guaranteed beneift is of concern. My prediction: If the public option for health care psses nationwide, watch for the state of Illinois (and others) to dump their health care plans into the public option and get out of the health care insurance business.

    Perhaps that’s the hidden agenda driving the public option vs co-ops debate in Washington.

  • Andrew Szakmary says:

    I feel that some of your comments regarding the generosity of the money purchase formula are misleading, so let me try to set the record straight.

    With regard to the effective rate of interest (ERI), SURS has in fact NOT been particularly generous in crediting returns to participant accounts. I looked at this issue in depth in a study conducted in 2005. Between 1973 (when SURS first began meaningfully investing in equities) and 2004, the annual return credit shortfall (the difference between SURS investment returns and what was credited to member accounts via the ERI) averaged 1.11% on a geometric basis. Now if I were to update the study through, say, June 2009, given the miserable performance of virtually all investments over the past 18 months, I would probably find that the return credit shortfall has shrunk substantially. However, given that the cumulative shortfall was 27% in June 2004 and that SURS returns through fiscal year 2007 were decent, I strongly doubt that the shortfall has completely disappeared, let alone turned into a surplus. The point simply is that SURS is properly crediting its members with the investment returns it is earning, under the presumption that the State is making the 9.1% of salary contributions that the money purchase formula assumes, in a timely manner. Had the state in fact made those contributions, the money would be there to provide the retirement benefits that the money purchase formula requires.

    As for the annuity rates in the money purchase formula being favorable with respect to private market annuity prices, there are two very good reasons for this. First, interest rates now are at historic lows, and these are obviously reflected in the private annuity prices, but not in the State rates, because the latter are based on an assumed 8.5% annual return. This return assumption, the “prescribed rate of interest” has been fixed at 8.5% since 1973. Yes, people who are retiring right now are getting a good deal, but what about people who retired 5, 10 or 20 years ago when interest rates were much higher? More importantly, what about people who will retire 5-20 years in the future? In the absence of compelling evidence that future interest rates and stock returns will permanently be at historic lows, I don’t see why the 8.5% perscribed rate of interest should be changed, given that SURS has earned annual investment returns close to this figure in the long run. If the rate were to be changed frequently, then plan participants would get drastically different pensions based on the year they retired, which in my humble opinion would be grossly inequitable and would further add to the complexity of the system.

    The second issue in comparing the SURS annuity factors with those offered in the private market is adverse selection. The only people who will sign up for a private annuity are those who are in good health and expect to live (and collect) for a long time; those who have severe health problems are likely to pass up the offer. Obviously, the rates offered in the private market must reflect the fact that, due to this adverse selection problem, the average enrollee will have a long life expectancy. SURS, on the other hand, does not have this issue because all retirees, whether in good health or not, will participate. In any case, SURS does change its annuity factors every 5 years to reflect changes in average mortality of participants; the only thing that has not changed is the assumed 8.5% interest rate. Note, however, that if the rate were to be reduced, the state would have to simultaneously project a much lower investment return in all of its pension plans, and this would make the reported underfunding of the retirement systems even worse!

  • Judith Rossiter says:

    I realize that our state provided health care plans are not guaranteed as our pensions are. I recently contacted my Congressman about the issue of the State of Illinois dumping employee and retiree health plans into a public option if that passes, and what that would do to us. I was particularly concerned about the status of our insurance being the Medicare Supplement policy. Would that supplement still be there for someone on Medicare? Well, I have not gotten any reply and it has been several weeks. So, my concerns are still hanging out there.

  • Jeffrey Brown says:

    Andrew,

    I stand by my statement that the ERI is an above average rate given the standard deviation of it over the past 25 years. Compare that to *any* asset class, and you will find that on a risk-adjusted basis, the rate is extremely high. It is true that the rate is loosely based on a trailing average of what SURS earns, and so it is not strictly a risk-free rate, but the key point is that the participants and pensioners are not subject to the full risk. The variance of this ERI has been minimal over the past 25 years. We talk more about this in a paper I have with Scott Weisbenner. (Sometime I can post the link to it.) In essence, SURS is investing in a diversified portfolio of risky assets, but turning around and paying people a rate as if the portfolio were very low risk.

    The overly generous annuity factor is not due to selection, it is due to the use of the same ERI. This relative generosity was true even before the current low interest rate regime. I understand adverse selection well – indeed, my co-authored paper in the 1999 American Economic Review is one of the sources most highly cited on this point. That, at most, can explain about a 5-10 percentage difference in the payouts, and most likely much less, given that SURS participants are also longer-lived than the average population due to higher education/income than average.

    Jeff

  • Jeffrey Brown says:

    I’ll definitely have more to say about state provided retiree health care in a future post. I am an economist, not a lawyer, but all of the legal experts with whom I have spoken on this issue so far have agreed with the analysis that health benefits are not protected by the impairment clause, and thus are must more at risk of being cut than pensions.