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