Illinois faces a challenging fiscal future. Even with an enormous 67% increase in marginal tax rates (from 3% to 5%), Illinois does not have a sustainable long-run fiscal plan in place. Decades of under-funding our pensions is part of the problem (though certainly not all of it). And while we can argue all we want about who is to blame, it is an undeniable fact that the unfunded pension obligations are a substantial part of the fiscal mess that lies before us.
Most of the rhetoric on this issue has devolved into finger-pointing: “it is those lavish public pensions” versus “no, it is the irresponsible politicians who failed to fund them.” Rather than adding to the argument about blame, I would like to suggest a way forward. This is only a very rough conceptual outline – you will see there are no numbers attached. And I should also be quite clear that what I am about to suggest does not “solve” our pension funding problem. But it could help, so here goes:
First, three observations:
1. We must begin by recognizing that there are two highly inter-related issues, both of which must be addressed. The first issue is that we face a large fiscal challenge that, mathematically, almost seems to require that we find a way to reduce future pension obligations. The second issues is that we face a human resources challenge – that at least in some parts of the public sector, we need to provide a compensation package that makes it possible to attract and retain the right kind of employees with the right kind of skills. We cannot simply “cut pensions” without implications for our ability to compete in the labor market. So the trick is to “fix” our budget problem while maintaining our ability to attract the professors, teachers, and other professionals that we want in the public sector. Too often, the debate ignores this second part, implicitly (and mistakenly) suggesting that we can just slash pensions without any adverse consequences.
2. The public defined benefit (DB) model, for all its strengths (e.g., inter-generational risk-sharing, retirement income security, cost efficiencies from pooled investments, etc.) also has some fundamental flaws, the most important of which is that it is far too easy to play financial games at the expense of future generations of taxpayers. The list of budget gimmicks is far too long to enumerate here, but the gist of it is that we often end up growing our future liabilities in return for small short-term gains and then use accounting gimmickry (much of it blessed by the Government Accounting Standards Board) to hide the real costs to taxpayers. Even if we did not face yawning budget chasms, citizens ought to be alarmed by the poor governance engendered by this system.
3. The private sector 401(k) model – which is sometimes suggested as a replacement for public DB plans – is also deeply flawed. As underscored by the recent recession and financial crisis, the existing 401(k) system is woefully inadequate when it comes to providing good tools for financial risk management. There are mountains of empirical studies documenting the lack of financial literacy in the population and the resulting biases and mistakes that people make when forced into a “do-it-yourself” retirement system. A few examples – inadequate savings rates, too little diversification, chasing past returns, failing to insure against the risk of outliving one’s resources, and many more.
So, what do we do? Here is a modest proposal to get the conversation started:
1. For future workers, we have already scaled back the public DB. But I say we go even further. For starters, let’s think about cutting the DB pensions in half. But in recognition of the fact that we need to remain competitive in the labor market, please read on …
2. Then, let’s supplement the DB pension with a fully-funded, income-oriented, Defined Contribution (DC) system. I am not talking about a private sector 401(k). I am talking about a sensibly designed, mandatory savings program that automatically diversifies people into low cost funds at appropriate savings rates, and that automatically convert into guaranteed retirement income as one approaches retirement. For example, TIAA-CREF annuities, (DISCLOSURE: since 2009, I have served as a Trustee of TIAA), which provide low cost investment options and opportunities to convert into lifetime income annuities. This is akin to what Orange County California did last year – which you can read more about in Roger Ferguson’s op-ed in the WSJ last week. They reduced their DB plan and supplemented with an income-oriented DC plan. Importantly, this plan was supported by government officials and the unions. Unlike the typical 401(k), this approach would manage risk more effectively, and thus would still provide valuable retirement benefits to public sector workers.
3. For existing workers covered by the constitutional non-impairment clause: since we probably cannot force them to take a lower benefit, we give them the voluntary option to switch to this same hybrid DB/DC pension. But with two tweaks: (i) We announce that the decision is voluntary, but that the default option is that they will be switched to the new system. Those who wish to remain in the old system would be given a fixed period of time (say, 3-6 months) to fill out the paperwork (or the online form) to state their desire to stay in the old system. A huge literature in psychology and economics suggests that many people will go with the default. (ii) When determining the “price” at which we will convert future DB promises into DC contribution, we use a high discount rate that reflects the subjective political risk associated with the benefits. This is key to this proposal saving the state any money, since the conversion of DB to DC, by itself, does not create any savings. So let me say a bit more — in essence, we know that a lot of workers are concerned that they will never get their full DB benefit. So this provides an opportunity to make a fair, voluntary trade – you get a guaranteed contribution to your DC account – which you will then own and which will be protected from the State – and in return, you accept a small “haircut” on the size of this contribution. Yes, it would be a benefit “cut” relative to the currently promised but under-funded benefits, but numerous studies from the U.S. and abroad suggest that people would be willing to accept such a haircut in return for no longer having their future benefits reliant upon the ability of the State of Illinois to finance their DB pension.
4. How do we deal with the “transition cost?” To be clear, this approach would reduce the long-run obligations of the state. But it would also require that – in the short-run – the state come up with more cash in order to fund the DC plans while still making good on DB promises to existing retirees. How do we handle that? A few ideas:
a. Spread the contributions to the DC tier (that are payment for the reduced DB) over several years
b. Don’t be afraid to issue debt to finance this. Keep in mind that this would not represent a net increase in indebtedness – we would simply be exchanging implicit debt (to pensioners) with explicit debt (to bondholders). Indeed, with the higher discount rate, the *total* debt (implicit plus explicit) would go down.
This obviously leaves a LOT Of details to be worked out. But the system would have several advantages over the status quo. A few of the big ones are:
1. It imposes funding discipline. The state would be legally required to make its DC contributions going forward.
2. It maintains a focus on the retirement income security of participants. It is true that, with the “haircut”, the DC would not cover 100% of the reduction in the DB benefit. But it is also true that the participant would no longer have to worry about leaving the entirely of their retirement income security in the hands of Springfield.
3. If I am correct that many participants would be willing to accept a reduction in expected benefits (relative to the full DB benefits) in return for no longer being subject to the political risk that Illinois defaults on its DB obligations, then it has the potential to save money. (But let’s be clear – there is no free lunch here! The cost savings only come from people accepting a smaller expected benefit in exchange for reducing the political risk to their benefit).