Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

It was just a matter of time until the comparisons of Illinois to Greece started flowing like the waters of the Agean.  Yesterday I came across this story on CNN/Money entitled “Illinois: Our Very Own Greece.”  Luckily, Businessweek says that things aren’t quite that bad. 

“The statement that any U.S. state is the next Greece, meaning a near default on their bonds, is not based on fact,” said Judy Wesalo Temel, a principal and director of credit research at Samson, which manages $7 billion. “Comparing the Greek debt crisis to state and local governments is not valid and is distracting from the real concerns about budgets.”

While that’s encouraging, I couldn’t help but notice that the article spends an awfully long time explaining why Illinois is not Greece.  So, the message seems to be that, while we are not Greece, we are the state most in need of an explanation why we’re not Greece.

The New York Times ran a long piece last week about Illinois’ budget problems.  We are dangerously close to passing California as the biggest fiscal mess in the country, if we haven’t already.  Virtually everything is scary, but I found this to be most disturbing:

The state’s income tax burden is not terribly high — Illinois ranks in the bottom half of states — and its government is not terribly large. (The budgets in New York and California, per capita, are much larger).

The Tax Foundation ranks Illinois’ total state and local tax burden (2008) as 30^th highest out of the 50 states and Washington DC.  Federal government data (2009) ranks Illinois 22^nd highest in terms of state and local spending per capita, 12^th highest in terms of debt per capita, and 17^th in terms of GDP per capita.   Relative to other states, we have a very large unfunded pension liability, and as Jeff has pointed out, it is probably even larger than the official numbers show.  And, there are reasons to think that the unfunded pension liability is a symptom of the problem rather than its cause.  Unemployment is high here, but arguably our problems predated the current recession.

Which brings us to the big question.  How did we get into the state we’re in?  If we had an unsually high, or low tax burden, then maybe that would be the cause, and moving taxes in the other direction would help.  If we had an unusually large government, maybe trimming the size of government would be the solution.  But, none of these indicators point to why our state is doing so much worse than others.  The Times article suggests the following:

More broadly, Illinois is caught between blue state convictions about social safety nets and a red state aversion to taxes. For years, the Democratic-controlled legislature has passed budgets that are, in effect, in deficit. Lawmakers routinely skip around the state’s balanced-budget law, with few consequences. (Republicans are near monolithic in voting against any tax increases and borrowings. When one broke ranks to try to keep the pension solvent, he was stripped of a committee position, reducing his pay and pension.)

While all eyes were on the public flogging of Tony Hayward on June 17, you may have overlooked something.  A small story in the Wall Street journal titled, “Pension Bombs Need Spotlight”.  It’s the Governmental Accounting Standards Board ”Preliminary Views on Potential Improvements to Pension Standards”.   When you couple this with the excellent article, “Pension Roulette?” by Alexandra Harris at Northwestern’s Medill School of Journalism (a MUST READ) you’ll be able to paint a not so pretty picture. 

First brush stroke; watch the state’s lobbyists try to keep GASB from requiring these changes, for as the first paragraph of the public notice states in part, “The purpose of the document is to obtain comments from constituents on those views before developing more detailed proposals for changes to existing accounting and financial reporting standards”

 Second brush stroke; watch so many exceptions get into the final standards that it becomes (like most financial regulation) a burden for those who play by the rules and a gaping hole that lets the largest violators flow right through. 

Third brush stroke; the State of Illinois’ financial statements become too embarrassing for even S&P, Moody’s, Fitch, et.al.to maintain the current rating. 

Mark Guarino of the Christian Science Monitor published a piece yesterday (“States cap workers benefits to reduce shortfalls: Is your pension fund at risk?”) that discussed the status of state pension funds.  

Most of the article discusses points that I and others have made on this blog before, such as large size of the shortfall, the fact that it is politically difficult to fix, and the State of Illinois’ efforts to reduce costs by cutting pensions on future workers.  

There was one thing in the article, however, that struck me as new and, quite frankly, frightening.  I am not sure if this is purely “academic” (and as an academic myself, I do not use the term disparagingly) or whether this is something that has any real practical potential.  But Amy Monahan of the University of Minnesota law school points out in the article that states have “police powers” which “given them fundamental rights to protect the welfare of their citizens in a crisis, which in this case would allow a legal ‘out’ in providing benefits.”  The use of this power to cut constitutionally protected benefits is an idea that has never been tested in the courts, but even so, there are two aspects of this possibility that are disheartening. 

The first is obvious – namely, that perhaps the constitutional guarantee of benefits may not be as strong as participants would like or expect.  Although, in reality, I think it is still clear that the constitutional provision is still the strongest guarantee that one can find anywhere – stronger than unfunded promises from Social Security, and stronger than underfunded promises from a private employer that are guaranteed by an underfunded PBGC.  So, as scary as it sounds, I am still not inclined to believe it more than an extremely remote possibility.

The second aspect is more subtle, but also more pernicious.  As I have written in earlier posts, in a competitive labor market, the perceived value of future pension benefits serve as a substitute for other forms of compensation.  Thus, the more employees have a perception that the Illinois public pension benefits are not secure, the less value employees will place on those benefits.  As a result, either taxpayers must pony up more cash to pay these employees in another form (e.g., higher wages), or many of them will take jobs elsewhere.  

The worst situation from a state’s fiscal perspective is one in which the benefits are actually inviolable, but that nobody believes this to be true.  In that situation, the states’ total compensation costs go up in the short-run – we have to pay employees more to make up for the perceived risky pension – but do not come back down in the long-run if the pensions actually end up being paid. 

An article on Saturday in the Tribune pointed out the obvious - that there are no easy solutions to Illinois state budget woes.  Lawmakers are not even thinking about how to backfill the enormous pension funding gap that already exists.  Rather, they are spending all their energy trying to figure out how to deal with one piece of it - namely, the $4 billion or so that is due this year.

It reminds me, once again, of former Fed Chairman Greenspan’s remark about Social Security options, and how we only have three options - raise taxes, reduce benefits, or repeal the laws of arithmetic.

The same three options are the only ones on the table for Illinois.  Our ability to reduce benefits is limited.  And as many have pointed out in comments on my prior posts, one can hardly lay the blame for this problem at the feet of the pension participants who paid their share along the way.  That leaves tax increase or borrowing.  But I would hasten to add that borrowing is just a tax increase on future generations of taxpayers.  This being gubernatorial election year in Illinois, I suspect that lawmakers will once again kick this fiscal can down the road …

Last week I made a post indicating that the Illinois pension problem was much worse than it appears due to faulty accounting that is sanctioned by the Government Accounting Standards Board. It was one of the most read posts ever made on this blog, and it received quite a few comments along the lines of “blame the politicians.”

This week, I thought I would make a few observations both about who is to blame as well as who should share in the pain of filling the yawning fiscal chasm that faces the State of Illinois as a result of its enormous structural deficits (an issue that is broader than just pensions – but clearly the pensions play a role).

So, who is to blame?

First on the list – the politicians. Indeed, it is almost too easy to blame the politicians – doing so is like shooting fish in a barrel. But it is easy precisely because it is largely true. For many decades, governors and legislators from both parties found it all too easy to ignore pension funding in order to address more “immediate needs” (or, shall we say, “more politically expedient wants”?)

As I have pointed out in a previous blog, my colleague Fred Giertz did some back-of-the-envelope calculations that showed that – in a world in which (a) past governors and legislatures had made the required funding contributions, and (b) these same politicians had refrained from the temptation to use the better funding levels to promise more benefits to state workers – then our pensions would be ever-so-slightly over-funded. Of course, believing either point (a) or (b) is a bit like believing in unicorns – pleasant to think about, but totally unrealistic.

I could stop this blog right here and have most of the readers of this blog cheer for more. But I don’t think it is entirely fair to stop here, because others are also to blame.

Second on the list – the “keepers of the statistics.” This was the focus of last week’s post – namely, to blame the actuaries and accountants who provide political cover to the politicians by the use of inappropriate assumptions for calculating the liabilities. Roughly speaking, the liabilities in Illinois are roughly double the official reports.  (To be precise, the analysis by Novy-Marx and Rauh indicates that in 2008, Illinois total public pension liabilities were $151 billion when valued using GASB rules, and $288 billion when using a treasury discount rate.  Assets were only $65 billion at the time).  

So even if unicorns existed – that is, even if our past legislatures had funded according to Fred’s calculations and resisted the temptation to increase benefits – the State of Illinois would still only have about half the money it needed to be funded according to an economically sound calculation!

Third on the list – a pension governance system that allowed key parameters of the benefit formula – such as the Effective Rate of Interest (ERI) – to be set by a board (e.g., the SURS Board) whose members have a fiduciary obligation to act only in the interest of pension participants, and thus give no voice whatsoever to taxpayers. I can’t help but think that this is one of the reasons that the (ERI) was set as such a high rate for the past 30 years, leading to a situation in which the majority of retirees under SURS got a higher benefit under the money purchase option than through the traditional benefit formula.

Fourth on the list – participants themselves. Yes, I realize that my readership will not like this. But let’s be honest – during good economic times, public employee unions fought hard – and successfully – for pension benefit increases. Increases that could not subsequently be “undone” due to the non-impairment clause in the Illinois constitution. Despite the fact that, at the time when these increases were enacted, pensions were already underfunded. One cannot really fault the unions for looking out for their self-interest (that is what all economic actors are supposed to do in a market-driven system.)  But I think taxpayers have a legitimate reason to be irked by the fact that the unions and the legislature “negotiated” higher benefits that are locked-in by a constitutional guarantee without considering the full impact and long-term cost of doing so.  Having said this, let me be clear that much of the anti-public-employee and anti-pension rhetoric that we have been hearing lately is misplaced - the vast majority of public employees are simply doing their jobs and want to be paid what they have been promised. But I also think that public employees (yes, I am one too) cannot totally escape our collective responsibility for pushing for more guaranteed benefits without fully accounting for the long-term costs.

So enough of the blame-game. The fact is that our pensions are underfunded. There is a hole that needs filled, and somebody has to share in the pain of filling that hole.

Because many generations of state taxpayers have shared in the gains from our pension deferral, it makes sense that most of the pain should be shared by as broad a base as possible. Thus, fixing this problem through spending cuts and tax increases will have to be the primary solution. But does that mean that participants in our public pension plans should have no responsibility above-and-beyond paying their own taxes? Not necessarily. There is no question that benefits earned-to-date (i.e., accrued benefits) are protected by the constitution. So we don’t need to have that conversation.  For those of you already retired, this means you are totally protected - nobody can or will touch your pension benefits (although health care is another story). 

And we already know that the state plans to cut benefits for future employees that have not yet been hired.  What about benefits not-yet-earned by current employees? I will leave it to the lawyers to sort the interpretation of the impairment clause. But from an economic policy (not a legal) perspective, it seems this is a legitimate issue to have on the table. After all, Social Security benefits (even accrued ones) can be changed by Congress. Defined Benefit pensions in the private sector are exposed to risk (and not fully insured by the PBGC). Why should one particular subset of the nation’s workforce – state and local workers – be immune from sharing in the collective painful decisions we have to make about the size and scope of government?

Having said this, it is equally important to realize that we cannot simply cut future benefits without consequences. Cutting pensions is cutting compensation, and many of our public employers (such as universities) operate in an exceedingly competitive labor market. If we want to continue to attract and retain the very best, we have to compensate them. So cuts in pensions may require spending more money elsewhere (e.g., salaries) in order to be competitive. As I have noted before, I am pretty skeptical of the claims of how much savings such changes can create.  But that does not mean they are not a legitimate policy option to consider.  Sorry, colleagues.

I’m sure this post will generate a lot of discussion. I’d encourage you to post your comments - I always learn from reader responses. But please, let’s keep the dialogue respectful.

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.   

What passes for pension reform in Illinois came with lightening speed in late March. The bill (SB 1946) appeared suddenly and was approved by substantial bi-partisan majorities in barely two days and enthusiastically signed by Gov. Pat Quinn. After some preliminary actions on March 23, the Illinois House and Senate took 71 separate actions on March 24, leading to the final approval of the bill.                  

The bill was widely hailed in the editorial pages of newspapers in the state as well as the Wall Street Journal and by politicians as an important step toward addressing the state’s massive budget shortfall by dealing with the pension piece of the problem – the one that has come to symbolize the cause of and solution to the state’s fiscal woes.

Unfortunately, the pension reform process was seriously flawed on procedural grounds. In addition, the new legislation falls far short of effectively dealing with pension funding problems, not to mention the larger state budget issue. 

In a recent News-Gazette commentary, State Sen. Mike Frerichs, D-Champaign, heralded a new day of openness and transparency in the General Assembly. His Taxpayer Transparency Act (SB 3622), approved by the Senate, would “put an end to the practice of last-minute, secret budgets in Illinois.”   Further, it will mandate “that general revenue spending proposals must be available for public review for four days prior to the General Assembly taking a vote.” 

Overcome by this spirit of openness, the Senate passed pension legislation that few members, not to mention citizens, understood. By comparison, the recent national health care debate was a model of openness and propriety. In fact, two weeks after the legislation was approved, no one in Springfield could give a definitive answer to a number of key features of the bill. There were no significant hearings on the legislation, no real input from the state’s pension systems, and no competent actuarial study before the bill was approved. 

It is surprising how the editorial writers and commentators bought into the reform idea. In a Chicago Tribune commentary, Abner Mikva, an icon of Illinois politics, stated: “Gov. Quinn and the legislature deserve a lot of credit for a pension reform that is a substantial piece of any meaningful fiscal restraint program. More than a faint praise, they deserve a loud hurrah.” It is disappointing that the former distinguished judge, noted for his advocacy of proper and open procedures in politics, would be cheering what transpired in Springfield. 

The faulty process might be forgiven if the results effectively addressed the pension problem.  Instead, the new bill can be viewed as business as usual similar to the so-called reforms of 2003 and 2005, where purported savings to be realized far in the future became the excuse for reduced current funding efforts. 

The pension bill imposes a new dramatically lower second tier by severely limiting pension coverage and pension benefits for new employees. This will differentially impact public school teachers and public higher education employees who are not covered by social security. New retirement benefits will only be partially indexed for inflation, and these adjustments will not be compounded. The result is that a retiree would lose around 28 percent in purchasing power during a 20-year retirement with 3 percent inflation and 50 percent with 6 percent inflation. 

To save state funds, pension benefits for new employees will be based on a fraction of the social security earnings ceiling – currently $106,800 per year regardless of the actual employee’s salary. This too will only be partially adjusted for inflation, which will cause the earnings ceiling for a new employee working 30 years to fall to 64 percent of the social security ceiling with 3 percent inflation and to 42 percent with 6 percent inflation. 

These are only two of several punitive measures that will reduce future pension benefits. The fallacy of this approach is that it assumes that there will be no adjustment necessary in the hiring costs for new employees who are offered drastically reduced benefits compared to current employees. Can new, highly skilled employees be hired with such meager benefits? This can only be done by paying higher salaries to compensate for the lower benefits or through the establishment of supplementary retirement systems to make up for the deficiency. What the state saves in lower pension costs will be partially offset by higher wages and new supplementary benefit costs. 

Rather than using the new pension savings as a means of setting the state on a path to solvency, the new pension bill is used as an excuse for the state to continue its reckless ways by reducing scheduled pensions contributions. What is overlooked in this discussion is that the budget problems facing the state are really the result of excess spending over several decades where deficits have been partially funded by shorting the state’s pension systems. For example, had the state made timely payments (based on actuarial costs of slightly more than 10 percent of payrolls) to the State Universities Retirement System, SURS would be fully funded with assets of around 106 percent of liabilities rather than its actual level of around 50 percent. 

No reasonable observer can deny that pension reform as well as a careful evaluation of non-pension post-retirement benefits such as health insurance needs to be part of a general solution to the state fiscal mess. However, these changes must be accompanied by greater fiscal discipline as evidenced by spending austerity and enhanced revenues. Unfortunately, the General Assembly appears to view its version of pension reform as a substitute for such discipline.

 Giertz is professor of economics at the University of Illinois and an elected member of the State Universities Retirement System Board of Trustees. The views expressed here are his and not necessarily those of these institutions.

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.

In the last few weeks, the lousy funding status of state and local pension plans was back in the news, thanks primarily to a new study released by the Pew Center on the States (click here for a link to the study).

The news is not good.  The study reports that there is a $1 trillion gap “between the $3.35 trillion in pension, health care and other retirement benefits states have promised their current and retired workers as of fiscal year 2008 and the $2.35 trillion they have on hand to pay for them.”  In fact, the news is probably even worse because this study was conducted before the worst of the equity market decline in late 2008.  

For those readers here in Illinois, you probably already know that our state is among the worst.   According to the Pew Study, “Illinois was in the worst shape of any state, with a funding level of 54 percent and an unfunded liability of more than $54 billion.”  Not that any of us are surprised to learn that Illinois is a case study in bad governance …

I’ve written before (here) about why the pension funding hole may be even worse than the official statistics indicate, especially in those states that have constitutional guarantees of benefits.  What I thought I would do today is make a simple point about an important asymmetry in how funding levels affect pension obligations and what this implies about appropriate funding levels and portfolio allocations.

Let me be clear at the outset – I am usually an advocate of fully funding our pensions.  And I wish we lived in a world in which politicians could engage in rational policy-making based on good economics.  This would include providing responsible levels of pension benefits to public employees and properly funding them.  Unfortunately, we do not live in such a world.  So I thought it would be fun to speculate for a moment about what this political reality implies for pension funding.

I’ve read quite a bit about the history of state pension plans over the past few decades.  I believe the following is almost surely true:  in good economic times (rising state revenues, high equity values, more fully funded pension funds), state governments appear much more likely to increase the generosity of pensions.  But in bad economic times (falling revenues, low equity values, larger funding shortfalls), these same states are legally and/or politically unable to decrease the generosity of pensions.    

This assymetry (increasing benefits in good times, but not being able to cut them in bad times) creates a bit of a conundrum for those of us who normally advocate full funding of pensions.  The reason is that the asymmetric political response suggests that some level of under-funding might actually be optimal (at least in a “second best” sense) because it serves as a constraint on further benefit increases!  

In short, we may prefer that our politicians underfund the pension obligation in order to limit the size of the obligation that ultimately needs to be funded.  Rational economic policy would not have to resort to such tactics.  Real economic policy in a political world might need to do so.

I do, of course, realize the irony here.  Namely that bad economic policy – our inability to have a rational, coherent approach to benefits for public sector workers – is serving as the basis for justifying more bad economic policy – underfunding our pensions.  But as the “theory of the second best” points out, in the presence of one distortion, sometimes society is better served by a second distortion that helps to offset the first.