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