Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

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. 

The Illinois General Assembly stands on the verge of passing an historic public pension reform.  After many decades of serial underfunding, the legislature and Governor have finally agreed to act.  The news for taxpayers is primarily good: through a combination of cost reductions and cost shifting, the public pension fiscal drain on state revenue is being substantially reduced.  This is welcome news in a state with a fiscal situation as dire as Illinois’.

Although the reform provides substantial cost savings to the taxpayers of Illinois, it also comes at significant costs.  In this post, I want to draw three big picture lessons from this reform.  I will post additional material on more detailed features of the reform in the coming days and weeks.

Lesson 1:  Constitutional Benefit Guarantees Don’t Always Protect Participants

Sensible public pension reform in Illinois has been hamstrung by the fact that we are one of the few states whose constitution contains a clause guaranteeing that retirement benefits for public workers cannot be “diminished or impaired.”  In a well-functioning system, the existence of this guarantee would have two beneficial effects.  First, it would lead to better funding (“we had better fund it, because we are going to have to pay it!”)  Second, it would cause workers to fully value the pension benefits being provided: thus, in a competitive labor market, wages would adjust to reflect the value of the pension, and thus the compensation package would be economically efficient.

But Illinois is far from a well-functioning political system.  Thus, what the constitutional guarantee brought us was: 1) Four decades of under-funding: if benefits are guaranteed, why should workers care about funding?  2) The inability to reform the system in a logical, sensible way. 

The constitutional prohibition against benefit impairment took “off the table” a whole host of sensible reforms, including my favorite: raising the retirement age to qualify for full benefits.  Instead, politicians were forced to play a game of “pension Twister,” contorting policy in all sorts of ways to find a way of cutting benefits that might pass constitutional muster.  Sadly, despite all of these contortions, many of us believe that the Courts are still likely to strike down this reform – on this issue, see yesterday’s post by my colleague Nolan Miller. 

Lesson 2:  Separating Responsibility and Control is a Bad Idea

The world is full of bad behavior that results when the entity with the power to make decisions is not the same entity that bears financial responsibility for the results.  In the case of Illinois, this issue manifested itself historically through the fact that universities, community colleges, school districts and other public employers were able to make hiring decisions without any responsibility for the pension liabilities that those decisions created. 

Post-reform, we will have a different manifestation of this problem.  The Illinois legislature has – after a relatively brief phase-in period – absolved itself from any further financial responsibility for future public pension accruals.  The funding of all “normal costs” will gradually be transferred entirely to the institutions themselves.  The problem is that Illinois politicians did not also grant these same institutions the power to design and implement their own retirement plans.  In short, the Illinois politicians still get to design the system – the universities and school districts just now have to pay for it.  Although there are a few safeguards being put in place to guard against the most egregious abuses of this new regime, I predict it will not take long for the state to find a way to curry favor with some voting block and pass the cost onto the employers.

Lesson 3:  Public Sector Accounting Rules Really Do Matter

I have blogged extensively about the many flaws of the public pension accounting standards promulgated by the Government Accounting Standards Board (for some examples, see here, here, here and here).  GASB allows public pensions to discount future liabilities with an inappropriately high rate, thus understating the real scope of the problem by ignoring risk. 

Unfortunately, these flawed GASB standards framed the Illinois debate, and in so doing has had the effect of 1) over-stating the extent to which the state is going to do penance for its past sins of historical under-funding, and 2) under-stating the real size of the liability being pawned off on the universities, colleges and school districts throughout the state. 

The hardest hit by this provision will be those employers – such as the flagship campus of the University of Illinois at Urbana-Champaign (UIUC) – that compete in a global labor market for talent.  If UIUC wishes to maintain its position as one of the leading public research universities in the nation, it will have to continue to provide a competitive compensation package: but it will now being doing so with virtually no assistance from the state.  The even worse alternative would be to watch its best and brightest faculty and staff members run for the exits.

Public pension reform was badly needed in Illinois, and our elected officials ought to be congratulated for having the political will to undertake it.  Unfortunately, I fear that they botched the substance of reform. 

Of course, none of this may matter – I still believe there is a greater than 50% chance that the Illinois courts will overturn it. 

Here is hoping they get it right the next time around …

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.

I have written on this blog before about the Government Accounting Standards Board (GASB) rules that allow public pension plans to discount their liabilities using the expected return on plan assets.  This is no small technical matter … discounting in this way has the effect of dramatically understating the true economic value of the unfunded liabilities of public pension liabilities.  This single accounting issue may understate the magnitude of the public pension funding problem by trillions of dollars!

GASB has issued proposed new standards and are in the process of accepting comments from the public.  I submitted my comments last week, and thought I would post a few excerpts here.

“As members of the GASB Board may already know, I have been critical of existing GASB guidelines for the computation of public pension liabilities.  I have a paper in the May 2009 American Economic Review (co-authored with David Wilcox of the Federal Reserve Board) in which we explain the basic economic rationale for the appropriate choice of a discount rate.  Economic and financial theory is very clear that the choice of a discount rate depends on the risk of the cash flows being discounted. 

This is true regardless of whether those cash flows are positive or negative, and whether they are being generated by public institutions, private institutions, or individuals.  There is absolutely no economic or financial basis for discounting one set of cash flows based on the risk of a completely different set of cash flows.  In other words, there is no logic whatsoever for discounting pension liabilities based on the risk of the pension plan assets. 

A simple analogy illustrates this point.  Suppose that at 9 a.m. on January 1, I borrow $100,000 for one year from a bank at an interest rate of 5 percent.  I immediately invest the full amount in a diversified portfolio of risky assets (such as stocks and bonds) that has an “expected return” of 8 percent.  By the time I have completed this transaction at 9:05 a.m. on January 1, how much do I owe the bank?  Naturally, I still owe them $100,000 (ignoring the 5 minutes’ worth of interest).  At this point, I have not changed by net worth at all.  All I have changed is my risk exposure. 

Suppose, however, that I follow GASB-like accounting rules to calculate my net worth.  Because the expected return on my portfolio is 8 percent, I can use this to discount the $105,000 (principal plus 5 percent interest) that I will owe in one year (December 31).  By this calculation, I would now only value the future liability as $97,222.22 (=$105,000 / 1.08), making it appear as if I have created $2,777.78 of wealth out of thin air.    

Of course, if I tried to tell my lender at 9:05 a.m. on January 1 – just 5 minutes after closing the loan – that they should allow me to give them $97,222.22 and cancel my $100,000 debt, they would look at me with great puzzlement!  And for good reason – I owe them $100,000 now, or $105,000 in one year, regardless of what I do with the funds in the interim!  The transaction just described is absurd from the financial perspective.  But as illogical as it seems, this approach closely mirrors the approach that has been taken by GASB in the past and that is still embedded in the proposed new public pension accounting guidelines.

The fundamental problem is that the use of “expected returns” as a discount rate is a largely a meaningless concept unless it is also accompanied by a discussion of, and accounting for, the accompanying risk.  

The most straightforward way to do this is to discount pension liabilities based on the risk characteristics of the pension cash flows.  For example, for the accumulated pension obligation (ABO) for a public pension in a state with strong constitutional guarantees against the impairment of retirement benefits, it would be appropriate to use a rate close to the risk-free rate.  In other cases – such as states where pension benefits can be easily changed by the legislature and where the likelihood of change is correlated with broader economic activity – a higher discount rate should be used.  In either case, what must determine the discount rate is the risk profile of the liabilities and NOT the expected return on plan assets.

In the exposure draft for the new rules, GASB seeks to replace the “expected return on plan assets” discount rate with a “blended rate.”  This blended rate is a combination of the expected return on plan assets for the funded portion of the liability and a muni-bond index for the unfunded portion.  Unfortunately, there is no theoretically coherent rationale for the proposed approach.  Indeed, though this approach could be viewed by some as a “compromise,” the result produces an even less coherent outcome than existing policy. 

There are several fatal flaws to the proposed approach, including:

1. There is no clear question to which the proposed measure is the right answer.  Indeed, it is difficult to think of any outcome of interest that is meaningfully described by the output of a cash flow discounting exercise that uses the blended rate as described in the proposed rules.

2. Funded status is not a sufficient measure of the risk of pension liabilities.  To be sure, it may be one such factor – at least insofar as one believes that participants in underfunded pensions are more likely to experience future benefit reductions – but it is far from a sufficient statistic.  Therefore, it is an insufficient basis on which to evaluate the risk of the liabilities. 

3. Even if funded status were a sufficient measure of risk (which it is not), the proposed GASB rules have blended the discount rates in the wrong proportions.  If funded benefits are less risky than unfunded benefits, then the funded benefits should be discounted at a lower rate, and the unfunded ones that should be discounted at a higher rate.  The proposed GASB rules turn this logic on its head, and the result is inconsistent with accepted procedures for risk adjustment.

 4. Even if one wished to calculated a blended rate to account for differential risk based on funding status, the “expected return on plan assets” is not the right rate to use for the “risky” portion of benefits — unless the risk of the liabilities just so happens to correspond exactly to the risk of the asset portfolio, which is highly unlikely.  For example, if  liabilities are discounted using the expected return on a 60/40 equity/bond portfolio, this is equivalent to saying that the distribution of benefit payments to DB pension participants is just as risky as investing in a 60/40 portfolio.  I suspect that few DB plan sponsors intend for their plans to be so risky, and fewer participants believe that their public pension is intended to be so uncertain.

 5. The proposed rules provide an unattractive and dangerous incentive for plan sponsors to take on more investment risk than is optimal.  If plan sponsors invest in a risker portfolio, they will then be able to “justify” a higher expected return under GASB rules.  Indeed when they are permitted to use a higher expected return, they can show a larger share of their liabilities as being “funded.”  This, in turn, also reduces the fraction of their liabilities that will then be discounted using the muni-bond index.  In short, public pensions may be tempted to invest in a riskier asset portfolio in an attempt to shrink the reported size of their unfunded liabilities.    

6. There is a good conceptual argument for using state or municipality’s bond returns as a discount rate for a public entity’s pension liabilities, at least to the extent that pension obligations and bond obligations bear comparable credit risk.  However, this rate should reflect the risk of that particular state or municipality, rather than some aggregate index.  More generally, different states and municipalities should use different discount rates when the risks of their pension obligations differ.      

Because of these and other flaws, I believe it would be a mistake to adopt GASB’s the new proposed discounting rules.  Instead, GASB should adopt standards that based discount rates on the risk of the liabilities.”

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?