I have written before that SURS – the public pension system in Illinois covering most workers in higher education – is a highly complex system, and that this complexity often “hides” some of the generosity of the system from both participants and taxpayers. (I put “hidden” and “hides” in parentheses because SURS does disclose the information – it is just that one needs a pretty high level of knowledge and financial sophistication to make sense of the fiscal implications of what is being disclosed).
Today, I want to talk about one very specific taxpayer “subsidy” to retirees that I do not think many people realize exists. This subsidy comes in the form of excessively-generous annuitization rates.
I will try to spare the unnecessary details, but a bit of detail is required. Individuals in the SURS defined benefit plan have their retirement benefit calculated in multiple ways, and then the participant gets the higher of these amounts. One of those approaches is the “money purchase” formula (which was eliminated for those hired after July 1, 2005). When I was doing some research on this issue a few years ago, I learned that – at least at the time – the majority of SURS retirees were receiving the highest benefit using the money purchase option.
I have written before about the problems I have with the way the Effective Interest Rate is set that is used to accumulate the value in the money purchase calculation, and I will not revisit that accumulation issue here.
Rather, the hidden subsidy I want to discuss today is with regard to how the accumulated account balance is converted into an annuity.
On page 17 of the SURS Traditional Benefit Package guide, it shows that someone retiring at age 65 and 0 months will get $1 per month in income for every $110.40 in accumulated “money purchase” account value. Thus, if your account is calculated to be worth $100,000, SURS will convert that to $905 per month for the rest of your life (=100,000 / 110.404).
For comparison, if one goes to www.annuityshopper.com and look up the price for a single life income annuity with no payments to beneficiaries for a 65 year old male resident of Illinois (as of 6/21/10), you will find that a $100,000 account would buy you only $633 per month in benefits. If you are a woman, it would buy you only $579 per month (because women live longer).
This is an absolutely enormous subsidy relative to private market annuity prices. The SURS annuity conversion rate is 43% higher than the best annuity price available from the private market for men, and a 56% bonus for women.
Now, the sophisticated among you might argue that there are two reasons that SURS can provide better pricing than the market. The first is that SURS does not suffer from adverse selection like in the private annuity market (the phenomenon in which only longer lived people buy annuities, thus driving up the price). But research has shown that adverse selection can account for about a 10% reduction in payouts in the private market. The second reason is that SURS may have lower administrative and marketing costs. These are estimated to be about 5-10% of the value of an annuity in the private sector. So, at best, these two factors can account for about 20 percentage points – less than half — of this difference.
Where does this enormous subsidy come from? It comes from the fact that SURS is pricing these annuities assuming that it will continue to earn about 8% per year in its investments going forward. (That distinguishes it from the use of the ERI to accumulate account balances based on past performance of the SURS funds).
To guarantee 8% going forward is financial insanity. In essence, SURS is promising annuitants the expected rate of return on a stock portfolio, but leaving all the risk with the pension fund (and ultimately either future taxpayers or future pensioners).
Were SURS a private insurance company, pricing annuities in this way would be a pretty good way to ensure a “junk” rating from the rating agencies.
At the bottom of the table on page 17 of the SURS material, it states “this table is determined by the SURS actuary and is subject to change based on the actual experience of SURS.” Because SURS has disclosed that it is subject to change, then SURS ought to be able to invoke more realistic pricing assumptions without violating the impairment clause. Of course, it is probably limited in doing this only for those that have not annuitized yet.
Of course, it is worth noting that the 43% and 56% numbers above would apply only to the income generated under the money purchase approach. In reality, making this change would likely result in benefits being higher under the standard formula (2.2% of final average compensation for each year of service). So the good and bad of it is that neither benefits to annuitants nor the cost savings to the SURS system would be as large as this suggests because the other formula acts as a floor.
In closing, I am not necessarily saying we should cut benefits - I will leave that to the politicians to decide. But if we want to subsidize our annuitants, let’s make a conscious decision to do so and be very transparent about it so that both they and the citizens of Illinois know we are doing it. It is not good for a democracy to hide the subsidy behind actuarial complexity where we can pretend it does not exist.