Center for Business & Public Policy
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I am writing this piece the morning of December 3, the first day of a special session of the Illinois General Assembly.  I have little faith that anything I say will shake the legislative leaders from their plan – a delicate political compromised worked out behind closed doors in recent weeks.  But I am taking the time to write anyway because even a small chance of influencing the debate seems worthwhile, given how much is at stake.

I co-wrote an op-ed in the Champaign News-Gazette nine days ago expressing my deep concern about how the proposed reform would affect higher education in Illinois – especially our ability to retain our best people.  Most of my worst fears in that op-ed were realized when the text of S.B. 1 was released yesterday.  In the interim, I was quoted in several news articles as reporters were looking for insight as bits and pieces of information leaked out of Springfield.  In one article, I was quoted as saying that if I had to choose between this reform, and doing nothing, I would do this reform.  That surprised many of my colleagues, so another motivation for this piece is to clarify this statement.

The easy answer is to say that if I had to choose between dying and having both of my legs amputated, I would choose the latter.  But this should not be interpreted as suggesting that I think leg amputation is necessarily a good idea, particularly when equally effective but far less damaging treatments are available.

Similarly, we need pension reform in Illinois.  Doing nothing is simply not an option, at least in the medium and long run.  So I do believe that bad reform may, on net, be better than no reform.  But that assumes bad reform is our only option.

S.B. 1 is bad pension reform because it will lead to an exodus of top intellectual talent from our universities.  (More details below.)

Is it our only option?  From any reasonable perspective – for example, actuarial, economic, financial, etc. – the answer is clearly “no.”  There are many ways to closing the fiscal gap, and S.B. 1 is only one, and particularly flawed at that.

But from a political perspective, the answer is harder.  I worry greatly that this may be our only option, given how dysfunctional our state political system is.  If it really is S.B. 1 or nothing, then I might hold my nose and support it, knowing that universities will have to go to extraordinary lengths to undo some of the extensive damage this will cause.  That would come at a steep price – during the transition, we will lose some of our very best people.  It could literally destroy the pre-eminence that has taken decades for the University of Illinois to achieve.

I am not a political scientist.  But I do understand incentives, and I have followed the politics of Illinois pension reform closely for many years.  And I was struck by a particularly insightful question that one of my politically-experienced and insightful friends asked me: “What leads you to expect that if you could and did kill this bill, that those same politicians would be likely to produce a better outcome the next time?”  (I have edited the question a bit).  My answer is that we should be able to do better. But I am not sure we really can.

Even so, this reform is so poorly designed that, as a pension expert and employee of the University of Illinois, I feel compelled to oppose it.

Because the General Assembly may vote as early as today, I don’t have time to go into a lot of detail or polish my writing.  Nor do I have time to fact check every single detail in this post.  I am writing with a sense of urgency.  I will post corrections later if I find any substantive mistakes.  But here are a number of thoughts on the bill, in the form of a simple Q&A.

First, why does this problem exist?

The answer is easy: for many decades, Illinois did not pay its bills.  Our pensions have been underfunded every single year for decades.  We hid behind flawed government accounting, pension funding “holidays,” and found temporary cover in the rising equity markets during the technology bubble.

-          This is the fault of our politicians.  The problem is bipartisan – Republican and Democrat Governors have underfunded our pensions, and both Democrats and Republicans in the House and Senate have voted to do so.

-          Public workers are not to blame.  They paid their share and were promised constitutionally protected pensions in return for lower salaries.

Why do we need reform?

-          Regardless of whose fault it is, the pension costs are fiscally unsustainable.  We have dug a hole so deep that we have no choice but to partially default on some of our promises.  It is a sad truth.  But it is the truth.

-          We have a pension funding hole that is officially about $100 billion.  But these official statistics drastically understate the problem.  It is only a $100 billion hole if you think we can generate 7.5% to 8% returns on the pension assets every single year without any risk.  No economist believes that.  When valued the way any financial economist would value the liabilities, the funding shortfall is more on the order of $250 billion.

-          Illinois has the lowest bond rating of any state in the country.  This drives up our borrowing costs, and sends a clear signal to companies and entrepreneurs that taxes will be higher in the future.  Few things drive away business more quickly than an unstable fiscal environment.

-          We have enormous structural deficits that show no signs of abating.  Even with the “temporary” tax increase (when the individual rate rose from 3% to 5% of income and the corporate rate increased proportionately), we still are running deficits.  We cannot just keep raising taxes, or we will start an economic death spiral in the state as mobile capital and labor flee the state.

Is it possible to do this in a sensible way?

-          Yes, but it will not be free from pain.  Put simply, there is only one way to solve this – somebody must pay.  The question is how to share that burden equitably.  Taxpayers benefitted for the last several decades by receiving public services at a substantial discount because we borrowed against the pensions to pay for those services.  Retirees benefitted from pensions that were larger than we were paying for.  Unions benefitted from bargaining for greater benefits when it was hard to get salary increases.  Universities and school districts benefitted by not having to directly pay the full cost of their hiring.  Everyone – knowingly or unknowingly – was complicit.  Everyone benefitted.  So everyone should have to share the pain of the solution.

-          No matter how much the Wall Street Journal may wish it to be so, there really is no conceivable way to eliminate the existing unfunded liability right away.  One would have to violate the state constitution by defaulting on 60 percent or more of all benefits that have already been earned by current retirees and current workers.

-          With several other experts, I co-authored a pension reform proposal that outlined Six Simple Steps to reform pensions in a rational way.  It spread the pain, aligned incentives, and solved the state’s problem in the long-run.  Details can be found at the IGPA website.

How would S.B. 1 affect bondholders?

-          Bondholders are clear winners.  Any substantial reduction in pension benefits is great news for bondholders.  After all, they simply care about their debt being repaid, and pensions are competing for scarce dollars.

How would S.B. 1 affect participants in the Self-Managed Plan?   

-          Participants in the Self-Managed Plan are totally unaffected.

How would S.B. 1 affect low income state employees in the Traditional or Portable Plan?

-          If someone close to retirement has earned a pension of $30,000 per year or less, and worked for the state for 30 years, the changes will be small.   Younger workers still many years from retirement will have to work more years before being eligible, and you would not receive the cost of living adjustment in up to 5 of the first 10 years you are retired.

-          All workers would benefit from the 1% reduction in employee contributions.  So given how small the benefit cuts are for low income workers, they may actually come out ahead.

How would medium earning state employees in the Traditional or Portable Plan be affected?

-          By medium earners, I am referring to those with annual salaries from about $45,000 to about $110,000.  In addition to the increase in retirement age, these workers will see a cap on their cost of living adjustment in retirement.  Instead of getting a 3% per year increase on their total pension, they will receive an inflation adjustment only on the first $1000*X dollars, where X is the number of years they worked.  So, for a 30 year worker making above $45,000 per year (which roughly corresponds to a $30,000 pension), you will see smaller future cost-of-living increases.  If you are earning $90,000 per year, and earning a pension of around $60,000 after 30 years of service, you will essentially be getting a cost-of-living increase on only half your pension.

How would high earners in the Traditional or Portable plan be affected?

-          This is where the substantial pain comes in.  The key provision – the one that takes a meat-axe to pensions – is the cap on pensionable salary.  If you earn above approximately $110,000, all future salary increases will be disregarded for purposes of calculating your pension.

-          To see how much this matters:  Suppose you have worked here for 5 years already, and expect a 3% per year salary increase (this is 3% nominal, so if inflation runs 3%, this means you are getting no increase in real terms).  Given the miracle of compounding, this means that your salary will more than double in nominal terms over 25 years.   So if you were to retire after 30 years, you will be getting 66% of your current salary rather than your doubled salary.  This is a 50% cut in pension benefits.

-          This 50% cut is ON TOP OF the reductions from the increase in retirement age and the COLA reduction.  All in all, I have estimated that the total cut could be as much as 65% for some workers.

-          The cut is steeper the more years you have left ahead of you, and the steeper your salary trajectory.

-          Even if you are not subject to the cap now, if your salary grows faster than the cap, you could become subject to the cap later.

-          In present value, this is equivalent to a substantial cut in future total compensation – on the order of 10-15% of salary now and forever.

Is this constitutional?

-          It depends on how the Courts interpret the non-impairment clause.   Under the strictest interpretation, any cut would be a violation.

-          But I continue to think the most reasonable interpretation of the clause is that the state cannot cut benefits already accrued as of the date of reform.  Under this interpretation, the retirement age increase would be a violation, but the other provisions would not be because they apply only to future benefit accruals.

-          It appears that lawmakers want to argue that a 1% reduction in contribution rates will be sufficient “consideration” to offset the benefit cuts, thus making this legal.  That seems absurd to me – a 12% reduction in contributions does not compensate for a 60% cut in benefits.  But I am not a lawyer, so who knows?

What will the long-run impact on U of I be?

-          The university is going to face a tough problem – how to prevent an exodus of top talent without “breaking the bank” already-strained institution.

-          Don’t be surprised if this translates into a long-run reduction in hiring plans as a way to come up with the funds to pay for any attempt to retain existing people.

How will the University of Illinois respond?

-          First, the University is officially opposing the legislation, as it should.

-          Second, University leadership seems well aware that they are going to have to do something to partially offset these changes or we are going to lose our very best people – especially in higher earning units like Medicine, Engineering, Business and Law.  I would anticipate some effort to provide employer contributions to a 403(b), or something similar, to partially offset these changes for those most affected.

What should I do now?

-          Call your lawmakers and ask them to vote no.

-          Then, if it passes, do NOT take any irreversible actions.  Give the Courts time to sort out the constitutionality.  And give the University time to come up with a partial remediation plan.

-          Perhaps talk with a financial planner or advisor about steps you can do to increase retirement savings on your own.

Earlier this year, I co-authored a proposal with four colleagues to reform the Illinois State Universities Retirement System. My motivation for doing so was quite simple: the fiscal crisis facing the state of Illinois is very real, “doing nothing” is not an option, the politicians seemed to be making little headway on a solution, and the ideas that were under consideration appeared to be driven far more by ideology than by concern about good retirement policy and good fiscal policy.  Given that I have spent the past 15 years of my life developing academic, policy and practical expertise on issues related to retirement income security, I thought I owed it to Illinois taxpayers to make a serious attempt to bring some balanced, centrist thinking into the discussion.  My four co-authors brought exceptional expertise in areas of university administration, benefits design, state and local public finance, and other highly relevant topics.  Together, we proposed six specific reforms to the SURS system.

Our “Six Simple Steps” proposal was subsequently endorsed by the Presidents and Chancellors of all of the public universities in Illinois.  It has also received favorable feedback from many participants and retirees. Over the summer, our proposal gained serious political traction when the bicameral, bipartisan pension committee of the Illinois General Assembly began to treat it as a leading possibility for breaking through the political logjam that had stifled prior attempts at reform.

Now that our proposal – which is sometimes referred to by others as the “Universities Plan” or the “IGPA Plan” – has gained traction, the political knives are coming out on both sides of the ideological divide.  This is not surprising: under our proposal, faculty are being asked to contribute more, retirees are being asked to receive less, the universities are being asked to take on greater financial responsibility for future costs, and the state is being put on the hook for paying down the enormous unfunded liability.  There is plenty of pain to go around.

We did not cause the pain, of course.  The pain was caused by many generations Illinois General Assembly members who failed to behave with even a modicum of fiscal responsibility.  We are just asking legislators, participants, retirees and taxpayers to be honest about the severity of the problem and to take meaningful steps to stop the fiscal bleeding.  But, in a highly politicized environment, with billions of dollars at stake, I am not at all surprised that ideologues and interest groups are pulling out their knives and trying to cut down our proposal.

So allow me to let you in on a little secret – I don’t love our proposal either.  A few aspects of it leave a bad taste in my mouth, in the same way that some life-saving medicines do.  However, I honestly consider to be the best – by far – of a wide range of distasteful options.

Let’s be honest: If I lived in a state where the state government was not dysfunctional, where we did not have strictly binding constitutional constraints, and where we could draw up our pension system from a relatively clean slate, I would NOT design a system exactly like the one we are proposing.  Rather, I would commit the state to a credible funding path; I would raise the normal retirement age to be in line with Social Security; I would fully index benefits to inflation and, if needed, pay for it through downward adjustments to initial benefits; and I would align incentives by making the entities responsible for hiring decisions (e.g., the universities) also be responsible for paying the full benefit costs associated with those hiring decisions.  While I am dreaming, I would also require the state to use accounting rules that transparently communicated the real economic cost of pensions, rather than hiding the true costs behind intellectually flawed government accounting standards.  Then again, if I lived in such an ideal world, we probably would not be facing the worst pension funding crisis of any state in the nation, and our proposal would have been unnecessary in the first place.

But we, the residents of Illinois, do not live in such a world.  Rather, we live in a state where for many decades our political leaders have failed to make good on the state’s most basic financial obligations.  As a result, the time has come for us to take our fiscal medicine: everyone must make sacrifices.  Unfortunately, the very constitutional protections that were intended to protect retirees now prevent us from enacting the most sensible reforms (such as raising the retirement age, which nearly every serious analyst agrees is a good idea): instead, we are forced to use second-best policy tools (such as reducing COLAs) simply because they have a better chance of passing constitutional challenge.  And we live in a state where after several unproductive years of debate, various powerful politicians have made it crystal clear that certain types of reform are political “must haves” and others are “cannot haves,” a situation that further narrows the realm of politically feasible options.

With these and other painful realities in mind, my colleagues and I set out to design a plan that made the best of a truly terrible situation.  We settled on a plan that:

1. Has a reasonable chance (although not guaranteed) of being deemed constitutional;
2. Has a reasonable chance of being politically feasible (as demonstrated by the recent support the plan has received from the bicameral bipartisan pension commission);
3. Will substantially improve the state’s long-term fiscal situation;
4. Preserves a smaller defined benefit (DB) element to recognize that many public workers in Illinois are not in Social Security, but also creates a defined contribution (DC) account, in an attempt to balance the various strengths and weaknesses of the two types of plans and create a better system than the Tier II system in place for new employees;
5. Improves the retirement security of new employees through more favorable vesting rules (that are also more closely aligned with private sector practice);
6. Provides real – if imperfect – inflation protection by linking increases to the CPI, rather than providing an arbitrary annual nominal increase that leads to enormous fluctuations in retirees’ real standards of living;
7. Substantially increases the likelihood that the state will begin to pay down the unfunded liability, both by reducing the state’s share of future costs and by providing the stakeholders with a legal right to enforce state funding;
8. Appropriately aligns incentives so that universities bear the full cost of their hiring decisions;
9. Suggests many other features that attempt to bring some rationality and transparency to a complex and opaque system (such as reducing the hidden subsidy provided via a financially inappropriately high Effective Rate of Interest);

In recent weeks, once it became clear our plan was gaining political traction, two different analyses came out criticizing our Six Step Plan.  There are two things to note about these criticisms:

First, neither critique provides a truly serious alternative that is politically, legally and fiscally realistic.

Second, the criticisms are striking in the extent to which they are mirror-images, taking precisely opposing views to one another.  The first of these critiques was offered by the Illinois Policy Institute.  They criticize our plan for preserving the DB system, not moving fully to a DC world, not eliminating COLAs, not saving enough money, and taking too long to phase in the changes.  The second of these critiques is by a researcher at University of Illinois at Chicago and the head of Keystone Research Center.  They criticize our plan for not preserving the DB system in its entirety, for suggesting the introduction of a DC element, for partially reducing COLAs, for asking the state to pay down the unfunded liability too quickly and for cutting benefits too much.  And, in an amazing feat of mental gymnastics, they also suggest that by reducing  spending the plan will somehow raise costs to the state.

To the extent we were trying to design a proposal in the “sensible center” of this debate, I will take these completely offsetting criticisms as confirmation that we are on the right track.

Here is a brief table summarizing how the two critiques often negate each other, in their own words (followed by my parenthetic and italicized remarks summarizing their view in my own words).

I can understand why those who advocate for the smallest possible government would be disappointed with a plan that does not squeeze out even more savings from the pockets of public sector workers.  I can also understand why some public sector workers and retirees would oppose any benefit reduction.  But such extreme views, while potentially useful for advocacy purposes, do not make for good public policy.  The above comparison make it self-evident that these two critiques are attempts to bolster opposing untenable positions: the Illinois Policy Institute would prefer that we decimate retirement security, and the KeyStone group naively acts as if we can solve this crisis without meaningful changes to benefits.  Supporters of both positions will be disappointed with any realistic proposal that actually solves Illinois’ pension problem while preserving retirement security of public workers.

You may not like our plan.  As I noted earlier, I am not in love with it either.  But I still think it is the best idea out there so far.  Very little in the Illinois Policy Institute or Keystone critiques alters my view with the exception of continuing the existing Self-Managed Plan as a voluntary option for some new employees, as suggested by the Illinois Policy Institute, although I do not think it is the best choice for the median employee.

I am totally open to the possibility that better ideas than ours may still be out there – and if either of these two groups (or any other group or individual) have substantive suggestions that are fiscally responsible AND politically feasible AND constitutional AND not unduly harmful to public employees, I would love to hear them.  So far, however, I continue to believe our Six Step proposal is the most serious proposal on the table.

 Prof. Jeffrey R. Brown, 8/19/2013

 (Author’s note: the opinions expressed here are those of the author – Prof. Jeffrey Brown – alone, and do not necessarily represent the views of any of my co-authors or the University of Illinois.)

Earlier this week, I released a report co-authored with Avijit Ghosh and Scott Weisbenner (both of the University of Illinois) and Steve Cunningham (Northern Illinois) that – yet again – tries to make the case for pension reform.  The news release can be found here and the full paper (including a one page summary) can be found here.

In a nutshell, the plan has three components:

1.  Change some of the SURS rules to reduce costs and increase transparency.  This includes pegging the SURS’ effective rate of interest to long-term bond rates.  For my prior musings on this topic, click here to see the blog I wrote on this back in June of 2010, entitled “A Hidden Pension Subsidy in SURS.”

2.  Providing participants with an opportunity to opt out of their automatic annual adjustment (sometimes called the COLA) in exchange for a lump-sum that is calculated to give participants a bit of a “haircut.”  We consider this to be a reasonably fair exchange, especially given its voluntary nature, in sharp contrast to the forced choice that has been proposed in other legislation (for example, see Nolan Miller’s post entitled “The Choice Between Two Unconstitutional Options is Not Constitutional.”)

3.  Expand the Illinois state income tax base to include retirement income.  There is really no compelling economic reason to exempt retirement income from the Illinois state income tax, and this may be the only way to get the retired generation to be able to contribute to solving our fiscal problems.

Whether or not our proposal has an influence on the debates in Springfield is anybody’s guess.  But one thing is clear: absent some time of substantial reform, Illinois is teetering close to a true fiscal cliff, one that will make the Washington DC fiscal cliff look like a small step down.

After a week of legislative wrangling that had more twists and turns than Hawaii’s famous “Road to Hana,” the Illinois General Assembly failed to come to agreement last week on a pension reform package in time for yesterday’s May 31 deadline.  As a result, they will return to Springfield – possibly this week – for a special session facing an even larger hurdle for passing reform legislation: by Illinois law, bills passed after May 31 require a three-fifths vote rather than a simple majority.

Agreement fell apart over the issue of who should pay for the “normal cost” of future public pension accruals.  “Downstate” lawmakers objected to shifting all of the costs onto school districts, public universities and community colleges on the grounds that this would lead to higher property taxes to fund teacher pensions and do grave damage to the ability of our university system to compete for academic talent.  Once Democratic Governor Quinn agreed to pull this cost-shifting out of the bill, Democratic House Speaker Mike Madigan withdrew his support of the bill.

As I wrote this past Wednesday, one of the grave concerns I have about the leading proposals is that so many of our elected officials seem perfectly content to shift all of the costs onto universities and school districts while maintaining legislative control over the design of the benefits package.  This is a mistake on so many levels.  The separation of responsibility and control is a recipe for fiscal shenanigans.  It is also highly disrespectful of the employer-employee relationship that Bob Rich and I wrote about in our pension reform proposal earlier this year.  

Although I still like the plan that Bob Rich and I put out, it seems clear that the General Assembly has gone another route.  But given that they are stuck on the cost-shifting issue, I thought it might be useful to put forth a more radical proposal that would respect the constitutional constraints, appropriately align the incentives of all the affected parties, respect the employer/employee relationship, and still save the state billions.  Perhaps most importantly from a political perspective, it might overcome the cost-shifting stalemate, because it shifts the costs but offers something very valuable in return.  This proposal would apply to those institutions – such as school districts, universities and community colleges – that, while public, are not part of the state government apparatus itself.  

While “radical,” the idea is deceptively simple.  Here it is in 4 simple steps:

1.       The state agrees to pay 100% of all pension benefits that have been accrued by public sector retirees and current workers as of 7/1/2013.  Whether the state wishes to do this by paying down the amortized unfunded liability, or simply provide the cash as need to pay benefits, is immaterial, so long as they respect the constitutional guarantee and pay it.  Not only does this respect the constitution, but it would also be fair to the generations of workers and retirees who consistently paid their share to the pension fund while the politicians enjoyed their “pension funding holidays.”    

2.       The existing public pension plans – for example, TRS and SURS – are closed to all further accruals as of 7/1/2013.  No new benefits will be earned under any of the plans.

3.       Going forward, each state employer is given 100% autonomy – free from the shackles of state regulation and political interference – to construct a benefits package that is optimally designed for its own employees.  In order to comply with federal law that applies when a state like Illinois opts out of Social Security, each employer would be required to provide a retirement package that is at least as generous as Social Security.  Beyond that, it would be up to each employer to determine the optimal mix of wages, pensions, and other employee benefits that would be required to attract, retain, motivate, and manage the retirement of their workers.  If similar employers wished to joint together as a group (e.g., all community colleges) to provide a common pension plan, or if unions wanted to provide multi-employer pensions funded by a group of employers, they would be permitted to do this.  But if the University of Illinois decided that its needs differed sufficiently from other public universities, they would have the freedom to go their own way.  

4.       The state would agree to a pre-determined, annual “block grant” (basically, an extra appropriation) to each employer that would start out as an amount equal to the “normal cost” of providing pensions, and would gradually decline to zero over a 20-year period of time.  This would slowly shift the entire financial burden of providing pensions from the state to the employers themselves.  

In essence, this plan calls for 100% cost-shifting, but with two critical differences relative to the reform package being debated last week.  First, and most importantly, it accompanies the cost-shifting with a freedom from political interference.  Second, it spreads the cost-shifting out over a much longer period of time (twenty years instead of approximately eight or so) in order to ensure that employers can adapt.

If there is anything I have learned from observing our Illinois state government in action, it is that it cannot relied upon to design a sensible pension package that is fiscally sustainable, credible to employees, and meets the diverse needs of our public employers.  So if they are so eager to get out paying for pensions, let’s take this idea all the way – aside from atoning for their past sins by making good on constitutionally guaranteed promises that they have so far failed to fund – let’s have the state get out of the pension business altogether.  

Doing so would free employers and employees from being subject to the unpredictable whims of the states’ politicians.  And that freedom, it seems to me, is priceless. 

As I’ve said before, I’m not a lawyer.  But, since the Illinois House Democrats have decided to move into incentives, why not?  The details of the pension reform proposal that passed an Illinois House committee today are still vague, but here is a write up about it.

Simply put: the proposals currently under consideration in which members are offered a “choice” between options, as currently constructed, are not constitutional.  Here’s why.

The Illinois Constitution says that membership in a state pension program is a contractual relationship the benefits of which shall not be diminished or impaired.

Any contractual relationship has to have, well, a contract.  In this case, the terms of the contract are spelled out in the Illinois Pension Code.

The Illinois Pension Code specifies the way in which pension benefits will be calculated.  The details are slightly different for different pension funds, but I’ll talk about the part that pertains to Tier I participants in the State Universities Retirement System (SURS).  In particular, the amount of the retirement annuity is specified in Section 15-136 of the Pension Code.  Here it is:

Rule 1: The retirement annuity shall be … for persons who retire on or after January 1, 1998, 2.2% of the final rate of earnings for each year of service.

That seems pretty clear.  The “final rate of earnings” is defined in Section 15-112.  For a person who first becomes a participant before Jan. 1, 2011 (i.e., Tier I participants), the final rate of earnings is defined as:

For an employee who is paid on an hourly basis or who receives an annual salary in installments during 12 months of each academic year, the average annual earnings during the 48 consecutive calendar month period ending with the last day of final termination of employment or the 4 consecutive academic years of service in which the employee’s earnings were the highest, whichever is greater. For any other employee, the average annual earnings during the 4 consecutive academic years of service in which his or her earnings were the highest. For an employee with less than 48 months or 4 consecutive academic years of service, the average earnings during his or her entire period of service.

That also seems pretty clear.

One more excerpt from the Pension Code.  This one has to do with annual cost of living adjustments (COLAs).  From Section 15-136

The annuitant shall receive an increase in his or her monthly retirement annuity on each January 1 thereafter during the annuitant’s life of 3% of the monthly annuity provided under Rule 1, Rule 2, Rule 3, Rule 4, or Rule 5 contained in this Section. The change made under this subsection by P.A. 81-970 is effective January 1, 1980 and applies to each annuitant whose status as an employee terminates before or after that date.

Beginning January 1, 1990, all automatic annual increases payable under this Section shall be calculated as a percentage of the total annuity payable at the time of the increase, including all increases previously granted under this Article.

This part of the Pension Code also seems clear: COLAs are to “include all increases previously granted under this Article.”  In other words, COLAs compound rather than being based on the original amount of the annuity.  And, COLAs start the January after retirement.

So, let’s review.  The Illinois Constitution says that membership in a pension system is a contractual relationship. The terms of that contract are given by the Pension Code, and the Pension Code specifies the way in which final pension benefits should be computed.  In particular, it specifies that the final rate of earnings is average earnings over the final 4 years of service, or the 4 consecutive years in which earnings were the highest.  Thus, the Pension Code states that future pay raises will be included in future pension benefits.  The Pension Code also states that COLAs are to begin immediately after retirement and be computed on a compound basis.

So, let’s return to the “choice” that would be offered to members of the pension system under the proposal.  Details are sparse, but the basic choice to be offered to members will be:

(A)  Keep the current pension plan, but give up the state subsidy for retiree health benefits and having future raises be included in pension benefits, and

(B) Keep the state subsidy for retiree health benefits, but receive a less generous cost of living adjustment (COLA) where annual increases are based on the pension payment at the time of retirement rather than the most recent year’s pension.  That is, the COLA is not compounded over time.  Further, the COLA will not kick in until 5 years after retirement or age 67, whichever comes first.  There is also language in at least the governor’s proposal that will limit the COLA to a simple 3% or ½ the increase in the consumer price index, whichever is lower.

Now, supporters of this approach claim that is constitutional because it offers participants a choice.  This claim is invalid.  While a choice might be constitutional, in order for this to be the case, it must be that one of the options does not impair or diminish the benefits of the current pension system.  This is not true here.  Option (A) denies members their contractual right to have the final annual rate of earnings be based on their highest 4 years of earnings, which would include future raises.  Option (B) denies members their contractual right to have COLAs be 3% compounded each year.  Since both options impair and diminish the benefits of the pension, if members are forced to make a choice between A and B, their pension benefits will necessarily be reduced.

Constitutionally speaking, two wrongs don’t make a right.

Consequently, to me it seems clear that the proposals are not constitutional.  Given that so many of our legislators are backing these proposals, there must be an argument for why the proposal is constitutional.  I can’t see it, though.

ADDENDUM (5/30/12):  This isn’t a post about whether it is right or fair to reduce retiree health benefits (it isn’t), but rather whether it is constitutional (it probably is).  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  The state also does not contribute to Social Security, so state workers who retire are also not eligible for Social Security (unless it is by virtue of having worked for another employer).  Obviously, removing employer-sponsored health benefits and reducing the COLA is going to expose retirees to substantial new risks, and the proposal becomes much more complicated and controversial in this case.

I have released a paper today that proposes a new plan for the State Universities Retirement System.  Co-authored with Robert Rich, the Director of IGPA, the paper proposes a hybrid system that would be partially funded by both workers and universities. It contains several components that reflect some of the ideas that have been publicly discussed by state leaders in recent weeks.

 The proposal has four basic components: 

1) Create a new hybrid retirement system for new employees that would combine a scaled-down version of the existing SURS defined benefit plan with a new defined contribution plan that would include contributions from both employee and employer; 

2) Peg the SURS “Effective Rate of Interest” to market rates; 

3) Redistribute the SURS funding burden to include a modest increase in employee contributions and new direct contributions from universities, thereby reducing state government’s burden on state government; and

4) Align pension vesting rules with the private sector, which would decrease the years new employees hired after January 1, 2011 would need to work for their pension benefit to be vested.

The plan is intended to substantially reduce state expenditures on public pensions, while still providing a reasonable source of secure retirement income to university employees. 

Click here to read the full paper.

Readers of this blog know that I have written several posts over the past 2 years about the mis-use of “expected returns” as a discount rate for public pension liabilities.  It turns out, this issue even has risen to the attention of Bill Sharpe, Stanford Professor and winner of the Nobel Prize in Economics for his contributions to financial economics.   Don’t worry – this is not a difficult technical piece.  It is a cartoon – and I highly recommend it.  You can watch it by clicking here.   It shows the absurdity of acting like future liabilities are smaller just because the assets are invested in a diversified portfolio.  Enjoy!

The use of “default options” (i.e., an automatic decision on behalf of individuals who fail to make an active choice) has been shown to exert a strong influence on individual behavior in a variety of settings.  Perhaps nowhere has this effect been more powerful than in the arena of retirement savings, where default options have been shown to dramatically increase participation in 401(k) plans and savings rates and to provide better portfolio allocations.

The widespread use of default options, however, has also been accompanied by a deeper understanding of when default options are appropriate tools for improving individuals’ well-being, and when, in contrast, default options are potentially harmful.

The State Universities Retirement System (SURS) of Illinois has, for approximately 12 years, defaulted new employees into the Traditional Defined Benefit pension plan if they fail to choose a retirement plan within six months of employment. Along with my University of Illinois College of Business colleagues Anne Farrell and Scott Weisbenner, I surveyed nearly 5,000 SURS participants who joined the system between 1999 and 2007 to better understand who defaults, why they default, and the implications of defaulting rather than actively choosing a plan.

Some key findings of the research include the following:

• More than half of survey respondents who accepted the default option cite information problems or decision complexity as a primary reason for defaulting.
• One in five respondents believe that because the Traditional defined-benefit plan was selected as the default option, that plan must have been the best option.
• Over one-third (35.2%) of respondents who defaulted into the Traditional plan would choose a different plan if given the opportunity to do so at the time of the survey.  This is more than double both the fraction of individuals who made an active choice who would like to change plans (15.5%), and the fraction of individuals who made an active choice of the Traditional plan who would like to change plans (14.0%).
• Individuals who both defaulted into the Traditional plan and would like to choose a different plan if given the opportunity are substantially more likely to cite information problems.

There are numerous implications of the research, including:

• Because (a) there is no single plan choice that is clearly right for all participants; (b) the choice of retirement plans is highly complex; and (c) plan choice is irrevocable, this is a context in which it is not advisable to rely heavily on a single default option.
• To the extent that the Illinois legislature considers changes to the SURS system, it should consider ways to provide information that enables quality decision-making by participants.  The legislature should not rely extensively on default options to convey such information.
• To the extent that default options are used in the SURS system, consideration should be given to allowing default options to vary by participants’ age or income, or to allowing participants to make a one-time change to their plan enrollments.

Given that the Illinois legislature continues to debate the future of state pensions in Illinois, we think these lessons are timely.

Many public employees and retirees in Illinois are (understandably) extremely agitated by the ongoing discussions about public pension reform in Illinois.  Today, I was forwarded yet another email by someone concerned about recent comments made by Illinois State Treasurer Dan Rutherford. 

In a nutshell, some in the legislature are kicking around an idea to get around the Illinois constitution’s prohibition against “impairing” retirement benefits by offering employees a choice:  pay higher premiums in order to keep existing benefits, or switch into a less generous plan. 

To questions about whether this would or would not violate the impairment clause of the Illinois constitution, there is considerable uncertainty.  Rutherford’s reaction view is (my paraphrase, not an actual quote) – “let’s pass it and then let the Courts sort it out.”

It is obvious why this is not satisfying to public employees – after all, it is their benefits that might get cut, or their contributions that may go up. But setting aside all the questions about what we “should” or “should not” do, I think there is tremendous logic to having the legislature pass a law in order to get a more definitive ruling on what the state “can” or “cannot” do.  Yes, I agree that it is really unfortunate that we may have to pass a law to find out exactly where the limits of the impairment clause are, but that appears to be the hand we have been dealt.  But figuring out where Illinois Courts will draw this line is exceedingly important.

Why?  As I have noted before, when employers provide employee benefits, they are not doing so just to be nice.  They are doing so to attract, retain and motivate employees.  In short, it is one component of the compensation package.  In an environment that is disciplined by market forces, employers will only offer employees pensions if the average employee values the pension at more than it costs the employer to provide.  Otherwise, both would be made better off by paying cash.  As I have also written, however, it is not clear how well this market discipline works for public employees.

The major problem we have in Illinois is that we may be in the worst of all worlds, namely, one in which the pension benefits are indeed fully protected by the constitution, but where the perception of political risk means that employees value them far less then they will actually cost to provide.  If this is the case, then nobody wins!  Taxpayers are on the hook for the full cost, but employees do not value the benefits fully.  So the total cost of providing public services goes up!

We would all be better off to have legal clarity.  If the state courts rule that the benefits are protected, then public employees and retirees can go back to valuing their benefits at full value (which will help with recruitment, retention, and general happiness), and the state can move on to figuring out how else to manage its serious fiscal problems.  If the court rules that forcing higher contributions does not violate the contribution, then we can hopefully have a sensible conversation about what the optimal mix of wages and benefits are going forward. 

Either outcome would be far preferable to the current situation.

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).

Any takers?