Posted by Jeffrey Brown on Mar 31, 2010
Filed Under (Retirement Policy)
Illinois pensions are in the news yet again. Last month, the Pew Center on the States reported that Illinois was once again the poster child for everything wrong with the funding of state pensions, noting that we had the worst funding ratio of any state in the country.
Last week, Illinois House Speaker Michael Madigan decided – finally – to take some action. He secured a House vote to change pension benefits for future Illinois state workers. Specifically, this proposal would raise the full benefit age to 67, cap the maximum pension income at a bit over $100,000, limit cost-of-living increases, and so on. In short, the package amounts to benefit reductions for not-yet-hired future state workers.
Why this option? To put it simply, there are only two options for fixing the funding problem.
Option one is increase revenue to the system. In other words, make additional contributions. But this would require that Illinois lawmakers raise taxes or cut other state spending, neither of which is politically popular.
Option two is to reduce the liabilities. But as I have written before, the impairment clause in the state constitution prohibits benefit reductions to existing retirees and existing employees. So the only way to reduce liabilities is to cut benefits for future workers – those that have not yet joined the system. And that is precisely what Madigan pushed through the House.
[By the way, the only “option three” is to, in the words of Alan Greenspan when discussing Social Security, is to “repeal the laws of arithmetic.” I am pretty sure that most state governments would choose this option if they could!]
As a fiscal conservative, I have no real objection to the decision to reduce future liabilities in the way that the House has chosen to do. But two issues that have come up in the debate that I think are worth a bit of analytical clarity.
First, estimates of future savings are almost surely inflated. There are two reasons for this. One is that some of the estimates appear to have simply looked at undiscounted dollar flows, which implicitly assumes a dollar saved in 2050 is the same as a dollar saved in 2020. This is obviously not the case, since a dollar saved earlier has a much higher present value. A second reasons is that – as I have written before – pensions are part of the overall compensation package. If we reduce future retirement benefits, our ability to attract top faculty members, for example, will be reduced unless we increase compensation in some other way. None of the cost savings estimates account for this.
Second, there is clear confusion about the source of the funding problem. Much of the rhetoric around this legislation focused on the level of benefits. The Champaign News-Gazette is a typical example, stating:
“A big part of Illinois’ horrendous budget problems can be traced to the high costs for the lavish pensions many public employees enjoy. They are far more generous than those available to workers in the private sector, and that’s a big reason why state public pensions are underfunded to the tune of an estimated $80 billion.”
This is wrong for several reasons.
First, the real source of the funding problem is not level of benefits. It is the fact the Illinois legislature has consistently failed to make the annual contributions that are called for under standard funding formulas. My colleague Fred Giertz has done some calculations suggesting that if the legislature had made its required contributions every year, the Illinois system would be slightly over-funded, not under-funded. In short, don’t blame the pensioners for the lack of fiscal discipline on the part of our politicians.
Second, the comparison of public pensions to private pensions is misleading. One reason is that the public pension replaces both Social Security and a private pension. Social Security costs roughly 12% of payroll today. Private employers who offer pensions typically contribute several percent more. On that basis, Illinois public pensions are not “lavish.” A second reason is that – yes, I am repeating myself – this is part of an overall compensation package. So any comparison needs to account for the value of all salary and benefits, not just a single piece of it.