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

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. 

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.

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.

Last month the Departments of Labor and Treasury issued a Request for Information in order to solicit public comment on ideas related to converting 401(k) account balances into annuities or other guaranteed retirement income streams.  This is a topic about which I have given a lot of thought – indeed, I even wrote a paper recommending that annuities become the “default option” for distributing from 401(k) plans.  (Click HERE to see the paper).

 As I see it, there is a good case to be made for thinking about guaranteed lifelong income as the default distribution option.  My primary motivation is to ensure that individuals have the private sector financial tools available to optimally manage their retirement portfolios in the presence of uncertainty about how long they will live.  Annuities solve this problem by allow one to trade a lump sum of wealth for an income stream that will last as long as you (and possibly a spouse) live.  There are mountains of academic research suggesting that annuities can make people better off by offering a higher level of sustainable consumption, insuring against longevity risk, and so on.

Enter stage right, Newt Gingrich and Peter Ferrara.  In a piece on Investor Business Daily’s website (read it here), they wrote an article entitled “Class Warfare’s Next Target: 401(k) Saving.”  In it, they essentially argue that treating annuities as the default distribution option is somehow a left-wing conspiracy to tax your retirement, force people to buy government bonds, and do other evil things in the name of “class warfare.”  (You can also find it on the AEI webpage and a related post on the conservative blog watch.)

I am extremely puzzled by their hostility towards the general idea.  But before I point out what I do not like, let me point out some valid points they raise:

First, they correctly point out one longer-term risk of a government program that starts out as optional – which is that they can, through the political process, end up paving the way toward a mandate.  There is no question that mandated annuitization would be a bad thing on many levels – it would interfere with individual liberty and choice, it would effectively redistribute resources from the poor (who don’t live as long) to the rich (who tend to live longer), and so on.  So they are right to be concerned about where an optional program will ultimately lead in a political environment – a point that academic economists too often overlook when thinking about optimal policy designs.

 Second, I completely agree with their general dislike of the Ghilarducci proposal to invest in a guaranteed retirement account administered by the Social Security Administration.  Indeed, I could write 20 blogs on all the things I dislike about this proposal, whether it be the absurdly high return that Ghilarducci proposes to guarantee at taxpayer expense (without appropriately accounting for the true economic cost) or the very idea that the under-resourced, overly-bureaucratic Social Security Administration should be expanded into an area that the private sector can run perfectly fine.  

 Third, I certainly cannot quibble with their general ideological distaste for policies that keep “punishing responsibility and rewarding failure.”  As readers of this blog can probably tell, I am an advocate of free market capitalism, and I generally distrust over-reaching government regulation.  

Given all of this, why do I support annuities as a default option?  And why do I disagree with the Gingrich/Ferrara critique?  Here are a few reasons.  I will keep it short so this post does not grow monstrous in size, but perhaps I will return later:

Part of the goal here is to do what conservatives like me generally like – to provide people with more choice, not less.  The idea is to get more plan sponsors to offer annuities as a distribution option from their 401(k) and other DC plans.  Right now, few do so, and so individual participants who want annuity income are forced into the individual market where they don’t get as good of a deal (due to concerns about adverse selection, etc.)

1. We already have a default distribution option from 401(k) plans – in most cases it is to take a lump-sum distribution.  The question is about what type of default option makes the most sense for the most people.  I think the research is pretty clear that most individuals do not have adequate sources of guaranteed retirement income, and that a product that provides guaranteed lifetime income would make them better off.  A lump-sum strikes me as precisely the wrong default option for a retirement plan.
2. What I favor is an optional program.  As I have outlined in my proposal, people would have plenty of opportunity to take an alternative distribution if they want it.  Those who (like me) place a high premium on individual liberty should take comfort in the fact that my proposal would place no restrictions on an individual’s ability to opt out of the annuity if they want.
3. There is nothing in my proposal that forces people to hold treasury bonds or subject themselves to inflation risk, as implied by Gingrich and Ferrara.  Indeed, I am a big advocate of inflation-indexed annuities and/or variable payout life annuities in which the lifetime payouts are linked to an underlying portfolio like those offered by TIAA CREF (disclosure: I am a Trustee for TIAA.)  Plus, an annuity provides what some call a “mortality premium,” which is an extra rate of return in exchange for making the benefits life-contingent.
4. Under my proposal – and under most of the serious proposals I have heard so far – the government (whether it be Social Security Administration or some other agency) would NOT be the administrator of this program.  Rather, plan sponsors could contract with private sector annuity providers – and there is a nice, active, competitive market for such products.

Yes, I am a big fan of free markets.  But only a fool would think that the existing 401(k) system looks like it does because of pure free market forces.  The complicated system we have in place today is as much a creature of government regulation as any program we have.  Indeed, the name “401(k)” itself refers to a section in the Internal Revenue Code! 

As long as we are operating in a world in which government rules largely drive plan sponsor decisions about what kind of retirement plan to offer – and as long as plan design influences participant behavior – and as long as participant behavior drives how well off these participants will be when they retire – then does it not at least make sense to ensure that the basic set of rules be ones that make people’s retirement more secure rather than less?  Especially if we can do it in a way that preserves individual choice?

I respect Gingrich/Ferrara’s healthy skepticism of government.  But sometimes ideology can get in the way of a good idea.  

Last week I wrote about the (often misguided) debate over the generosity of public pensions in the state of Illinois.  I ended by noting that it was important to further examine how my previous analysis would change once we account for two under-appreciated facts about the Illinois pension system.    

The first under-appreciated fact is that Illinois is one of a small number of states that provides an explicit constitutional guarantee against the impairment of pension benefits.  Specifically, Article XIII section 5 of the Illinois State constitution states that: “Membership in any pension or retirement system of the State … shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

While Illinois is not alone in providing this guarantee – similar language is included in the constitutions of Alaska, Arizona, Hawaii, Louisiana, Michigan and New York – it should be noted that not all states provide such a guarantee.  In Indiana, for example, the Indiana Court of Appeals (in Haverstock v. State Public Employees Retirement Fund” stated that “pensions are mere gratuities springing from the appreciation and graciousness of the state.”

In a paper that I wrote with David Wilcox in the May 2009 American Economic Review, we discuss just how powerful these guarantees have proven to be over the years.  On the basis of that analysis, I am highly confident that Illinois pensioners will receive their benefits.  Unfortunately, with Illinois having one of the worst records of effective governance in the U.S., most other pensioners and participants are not quite so confident.  One way or another, most of them think, the politicians in this state will find some way to renege (at least partially) on these benefits.  (As an aside, what public servants really have reason to be afraid of is that retiree health benefits will disappear – those are not covered by the impairment clause.) 

The second underappreciated fact is that the public defined benefit pension plans in Illinois are far too complex for the average (or even the highly sophisticated) participant, taxpayer or legislator to properly value.  There are many reasons for this, but mainly it boils down to the fact that the ultimate benefit depends on a lot of variables that will only be known with certainty many years in the future, such as one’s final average salary.  If that were not complex enough, the legislature has made it even more complicated by having multiple benefit formulas in place.  For example, in the “Traditional” defined benefit plan under the State Universities Retirement System (SURS), participants who joined the system prior to July 2005 received a benefit that was the higher of two approaches.  The first was the standard formula (2.2% times years of service times final average compensation).  The second was a “money purchase” option that essentially kept track of the individual’s contributions, matched them with a state match (at least on paper – we already know the state did not really provide the money), and then credited them with an “Effective Rate of Interest,” or ERI.  Then, at retirement, the “balance” in this largely fictitious account was converted to an annuity using an annuity table that used a rate quite close to the ERI.  If the resulting number was higher than the standard formula, the annuitant gets this higher amount instead. 

Confused yet?  If you answered “yes,” don’t feel bad.  Most participants don’t understand all these details.  It is complex stuff that requires a high degree of financial sophistication to truly follow.  If you answer “no,” then let me ask a few extra credit questions.  First, do you know what mean, standard deviation and range the ERI has been in for the last 25 years?  And do you know how the annuity conversion factor compares to market rates?

By this point, I suspect very few people know the answer.  Again, don’t feel bad.  I study pensions for a living, and it took me a lot of time and research to find these answers (and, alas, it was too late – by the time I understood all the details, I had already made a sub-optimal pension choice – and it was unfortunately a lifetime irrevocable one!) 

Without boring you with details, let me give you a flavor of what I have since learned.  The way the SURS board has historically set the ERI, participants in the DB plan were getting an enormously high return (roughly 8-9%) relative to the risk (as measured by the standard deviation in the ERI, which was tiny over the past 25 years), and this high return was being implicitly guaranteed by the taxpayer.  And the annuity rate?  It is substantially more favorable than even the most attractive private market annuity prices – I’m talking in the range of 50% or more benefits per dollar in the “account,” and in some cases, far more.  These two factors explain why most people retiring from SURS in recent years actually received a higher benefit from the money purchase calculation than the basic formula.

What do these two points – the constitutional guarantee and the complexity of the benefit formula – have to do with each other?  Put simply, they have conspired to put an enormous pension funding burden on taxpayers without providing commensurate perceived value to state workers!

Let me explain.  As a result of a complex benefit formula that hides the true value of the pensions – combined with the fact that most participants view the DB pension promises as being at some risk of not being honored – means that most public pension participants do not value the pensions at their full economic value.  This fact partially mitigates the point I made last time because this means the “compensating wage differential” will not be dollar-for-dollar. 

However, the fact that participants discount their benefits in this way does NOT mean that the state is not actually incurring the full economic costs.  Indeed, the constitutional guarantee means that the states’ taxpayers ARE on the hook for the full economic cost of these benefits.

In essence, we have the worst of both worlds.  Public employees are earning a valuable benefit, but because our legislators have (i) created a needlessly complex system, (ii) created a complete lack of confidence in the security of these promises, and (iii) have provided us with a constitutional guarantee that the benefits will be paid, the participants don’t fully value the benefits even though the state bears the full costs.

If any private company did this – providing a costly benefit that was valued by employees at less than the true cost to the employer – that company would soon be bankrupt.  But this is Illinois state government.  So, instead, we continue to build up enormous funding liabilities that will simply be passed on to the next generation of Illinois taxpayers.  It may be “business as usual” in Illinois.  But it’s also a real shame.

Public servants and taxpayers of Illinois deserve better.