Misleading Accounting and Illinois’ Pension Perils

Posted by Jeffrey Brown on May 3, 2010

Filed Under (Retirement Policy, Uncategorized)

My good friend Douglas Elliott, who is now a Fellow at the Brookings Institution, just issued a new paper “The Financial Crisis’ Effects on the Alternatives for Public Pensions. The paper is yet one more in a growing chorus of voices pointing out the significant fiscal woes facing our state and local pensions in the U.S.  And, as I have pointed out before, Illinois is the poster-child for everything that is wrong with the funding status of our public pensions.  

After reviewing the net losses on pension assets, Doug makes the following simple but astute observation:

“The situation is even worse than those figures show on the surface, because pension funds are essentially walking on a treadmill. They need to earn an expected return each year in order to stay standing in place, since the value in today’s dollars of the pensions they have promised to pay goes up each year as those payouts come closer in time. The situation is analogous to inflation. The public pension funds may have lost 15% over two years on a “nominal” basis, but, if their target return was 8% a year , they lost 31% compared to their targeted level of investment value, excluding the effects of contributions and pension payments.”

I have previously noted in this blog that the Government Accounting Standards Board (GASB) allows public pensions to discount future liabilities using the expected return on plan assets.  This approach has no basis whatsoever in financial market theory – indeed, I have yet to meet anyone with a PhD in economics or finance who believes such an approach is correct or sensible.  Actuaries and plan administrators often defend it, but when you dig below the surface, their defense is often rooted in the political or P.R. ramifications of reporting the true nature of the liabilities, rather than in any good economic reasoning.

Let’s bring this home to Illinois.  Specifically, let’s bring this home to the State Universities Retirement System, or SURS.

According to the SURS Investment Update (see page 3 here), the average annual return on the SURS Total Fund over the 10 years ending February 2010 was dismal 3.4%.  But SURS, in accordance with GASB, uses an expected return on assets that is more than double this amount.  Even worse, SURS credits participants in the old Money Purchase option with an investment return that is far greater than this.  Doing so amounts to an implicit transfer from Illinois taxpayers to Illinois pensioners that is above-and-beyond the standard pension formula. 

As we discuss pension reform in Illinois and other states, here are three related points that are worth considering:

  1. We should start with truth in accounting.  Stop hiding behind high discount rates and let’s at least define the size of the problem honestly.  A starting point would be disclosing the size of the public pension liabilities discounted using something more akin to a risk-free rate.  (See here for discussion).
  2. Let’s stop pretending that we can achieve higher returns without taking on higher risk.
  3. Let’s stop making irrevocable transfers from taxpayers to pension participants on the basis of “average” or “expected” returns.  In SURS, that means bringing the Effective Rate of Interest way, way down from historical levels.   

17 Responses to “Misleading Accounting and Illinois’ Pension Perils”

  • John says:

    4. Let’s require that the State pay it’s promised match. If that had occured then this crisis wouldn’t have happened in
    the first place and the pension would most likely have been
    overfunded.

  • Barney says:

    It is time to eliminate those politicians that support this catastrophic finiancial failure. Otherwise don’t expect anything to change.

  • Jeffrey Brown says:

    Thanks John. Yes, my colleague Fred Giertz did some calculations showing we would be overfunded if the State had made its so-called “required” contributions (I wish I could legally escape my “required” tax payments so easily!), SURS would be more than 100% funded according to GASB calculations. However, if we did the calculations using the right discount rate, we would be under-funded today even if the state had made its contributions! In short, this problem is really bad. And, yes, the blame lies with the politicians, not the participants.

  • Jeffrey Brown says:

    Understood, Barney. The blame clearly lies with our elected officials. It is a shame that people are so quick to blame the participants, even though the participants all make their contributions!

  • Joan says:

    Ditto John’s comment. Why am I, as a retiree, blamed for what the previous legislators have neglected, or avoided, or whatever you want to call it, done in not funding the pensions. Why don’t we hold all those people liable instead?

  • Frank Goudy says:

    So how much underfunded would SURS be if the the state had matched its funding and the “right discount” was used?

  • Jim says:

    Don’t overlook the even longer term results of SURS investments, which that particular update doesn’t give. The 3.4% is dismal, but it’s all the result of the recent economic disaster that affected virtually every investor. SURS made huge gains in better times (like most), which further encouraged our brilliant leaders to cut back or eliminate pension contributions. So they got the benefit when times were great but now want to blame the victims when the cycle turned so bad.
    Consider also what would have happened if the state had not opted out of all programs that demand payment, eg Social Security, real health insurance, real annuities that are purchased with a retirees account balance. The choice to “self fund” everything saved huge amounts over the years, but has created the current mess. Illinois has become a black hole economically. Retirees and current employees may want to start investigating Mexico and other non-US locations as the only places they will be able to live out their lives.

  • Jerry Anderson says:

    To your knowledge, Jeffrey, has anyone determined what the impact of the new two-tiered retirement system–whose terms, I believe, will make the “self-fund” option a necessity for our future retirees–will be? Will the resulting fall off of retirement contributions under the traditional plan place the system in jeopardy for current retirees?

  • Subhash Bhagwat says:

    Pointing a finger at discount rates SURS should have used only distracts from the crimes of legislators who failed to hold up the legal commitment to pay the promised amounts to SURS. It was this failure to pay which played the major role in everything that followed, including, I suspect, SURS’ “adjustment” of the discount rate to “made do” with what they were forced to. Citizens of Illinois can not be absolved of their responsibility either because they “enjoyed” the benefits of money that should have gone to SURS. Now it is time to pay up. A significant income- and sales tax increase, is the only answer. This state is facing a 50% deficit on funds that need to be generated within the state directly! How long until the ship sinks?

  • Jeff says:

    Other sources I have seen agree with Jeffrey Brown’s follow up comment that we would be somewhat underfunded using a proper discount rate. However, it would be a relatively moderate and very manageable amount of underfunding and not a major budget issue. It’s this point that drives me crazy when I read articles and reports broadly bashing retirees and would-be retirees. If the state had just paid its portion we wouldn’t be having this conversation. If any private employer fails to pay its portion of employee retirement (i.e. social security) they are potential felons!

  • Mark S. says:

    When I was elected to be a city alderman three times, I had to take an oath of office that required me to uphold the consitution of the United States and the consitution and laws of the state of Illinois.

    It seems to me that if our elected officials of Springfield, who have to take the same oath, have not kept it, they are now in violation of the laws and should be so prosecuted… just a thought…. a good thought.

  • Jeffrey Brown says:

    Thanks for all the comments. I wanted to respond yesterday, but I was on a furlough day (seriously!) and did not want to violate any of the (dumb) rules. :-) A lot of people have made a lot of terrific points in these comments. Rather than address them here, just keep coming back to this blog – as I will surely have more to say in the coming weeks!

  • Pete says:

    Every year SURS declares an investment return percentage. Who makes this decision? I believe we are guaranteed a minimum of 4.5% if I remember correctly. Almost always the number is between 8.5% and 10%, no matter what the market does.

  • Pete says:

    Here’s another question. Employees pay half of the plan costs.
    The State has underfunded SURS, but the state has contributed funds over the years. HOW CAN SURS CURRENTLY ONLY BE FUNDED AT 41% OF LIABILITIES GIVEN THE EMPLOYEE CONTRIBUTIONS? This seems like mismanagement.

  • Jeffrey Brown says:

    Pete,
    Sorry for the delayed response. The SURS Board makes that decision. As for the underfunding problem … there are a number of subleties to the answer. But the shortest response is that the employee ciontribution is not equal to half of the actuarial value of the future benefit costs – it is actually less than half. And this is even taking the actuarial calculations as given – as I have written before, I think they are flawed. So, really, our 8% annual contribution is substantially less than half of the true cost of providing the benefits promised.

  • Craig Pence says:

    Investment returns can be anything you want them to be, depending on the start- and end-times you happen to pick. No one who invested at the height of the dot-com bubble ten years ago has done well over the ten-year period that followed. Note that the rate of return earned on the S&P 500 over this same period was actually a negative figure. SURS’ positive 3.2% looks very good in comparison. Note also that the fund’s average rate of return from 1981 to the present, as reported in the cited reference, is on the order of 10%.

  • Jeff Brown says:

    Craig,
    The broader point here has far less to do with historical returns and far more to do with whether if is financially or fiscally prudent for any entity to guarantee a riskless return backed by a risky portfolio with a similar expected return. The short answer is “no”. This is especially true for future returns – such as the use of the very high interest rate when setting annuity prices. Pensioners have a right to be angry with the politicians for a failure to fund pension promises. But taxpayers also have the right to be angry with politicians for granting high pension benefits through non-transparent benefit subsidies that even participants do not fully understand.