The Hidden Economic Logic Behind the “Take it to the Courts” View on Illinois Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 23, 2011

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.

A Modest Proposal to Reform Illinois Pensions

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jan 24, 2011

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?

Why WEP?

Filed Under (Retirement Policy, Uncategorized) by Jeffrey Brown on Aug 23, 2010

One of the most despised provisions of the Social Security regulations is known as the WEP – an acronym for the “Windfall Elimination Provision.”  This provision is poorly named, poorly designed, and poorly understood.  But that does not mean it should be eliminated.  While the Social Security Administration does a truly horrible job of communicating it, the WEP (or something like it) has a legitimate reason for existing.

What is the WEP?  It is a provision in the law that alters the way Social Security benefits are calculated for individuals who work for state and local employers who do not participate in the U.S. Social Security system.  For example, the earnings of employees of public universities and public schools in Illinois – who participate in Illinois SURS and Illinois TRS – are not covered by Social Security. 

Illinois is not alone.  Approximately one fourth of all public employees in the U.S. do not pay Social Security taxes on the earnings from their government job according to the U.S. Government Accountability Office (GAO).  This includes approximately 5.25 million state and local workers, as well as approximately 1 million federal employees hired before 1984. 

However, many of these public employees – including the author of this blog – will still qualify for Social Security benefits, either as a result of switching between covered and uncovered employment at some point in their career or because they simultaneously work two or more jobs that span both covered and uncovered employment.  For example, a teacher in the State of Illinois may spend his summers working in covered employment.  Alternatively, a professor may spend part of her career working at a private university covered by Social Security, and part of her career working for a state university that is not covered. 

If Social Security benefits were calculated as a simple “linear” function of lifetime earnings, this would not present any problems.  If you earned 50% of your lifetime income in Social Security, you would just get 50% of the benefit that you would have earned had all your earnings been covered.  The only thing Social Security would need to know is how much you paid into Social Security.  Whether you have other “uncovered” earnings would be irrelevant.

But Social Security does not have a “linear” benefit formula.  Rather, it is explicitly designed to offer a higher ratio of benefits-to-taxes-paid for low income workers than it offers to higher income workers.  It is designed this way in an attempt to redistribute income from the rich to the poor.

And therein lies the problem.  If Social Security only observes part of a person’s total earnings (e.g., they know someone’s earnings from a summer job, but not their university salary), then they might mistakenly classify this person as a low-income individual, even though they might be a high income individual who just had a small part of their earnings covered by Social Security.  As a result, blindly applying the same benefit formula to this person gives them a benefit that is too high relative to other individuals who have the same total lifetime earnings!  In essence, we would be paying too much to people who only worked a small part of their career under Social Security.      

In order to adjust for this, the Windfall Elimination Provision (WEP) was enacted as part of the 1983 Social Security Amendments.  This provision is meant to downward-adjust the Social Security benefits of affected workers in order to eliminate the “windfall” (a poor choice of words, I am the first to admit!) that arises when, for example, an individual with high lifetime earnings (based on both covered and uncovered earnings) would appear as if he or she were a low earner when evaluated solely based on covered earnings. 

It is easiest to see the problem that would be created if there were no WEP provision in place through an example.  Consider the three individuals shown in the table below.  “Larry” is a very low income worker who works his entire life under Social Security, with an average lifetime monthly earnings of only $500 per month.  Using the 2008 benefit formula, Larry would have a full benefit $450, or 90% of his pre-retirement income.  “Mo” is a higher income worker with all of his earnings covered under Social Security, thus having an average monthly income while working of $5,000.  Under the benefit rules, Mo would have a full benefit of $1891.34, or a 38% of their working life income.  Thus far, this example simply illustrates the “redistributive” nature of the benefit formula, as Larry receives a higher replacement rate than does Mo, owing to the fact that Larry has lower lifetime earnings.

Social Security Primary Insurance Amount If No WEP Adjustment Applied

 

Average earnings covered by SS

Average earnings not covered by SS

Average total earnings

Benefit if SS formula applied to covered earnings

Benefit as % of income if no WEP adjustment

Larry

500

0

500

450

90%

Mo

5000

0

5000

1891

38%

Curly

500

4500

5000

450

90%

 

Now consider Curly, a public employee.  Curly’s total lifetime earnings of $5000 are identical to Mo’s.  Had all of Curly’s earnings been covered by Social Security, Curly would have the same 38%replacement rate as Mo.  However, only 1/10th of Curly’s earnings were in employment covered by Social Security; the rest were in non-covered public employment.  If Social Security applied the standard benefit formula to Curly’s covered earnings without any WEP adjustment, Curly would receive a monthly benefit of $450, equivalent to Larry.  This provides Curly with a ratio of benefits to (covered) earnings of 90%, which is substantially more generous than the 38% ratio provided to Mo, even though Mo and Curly have identical lifetime earnings.  To use the language of the provision designed to address this issue, Curly would receive a “windfall.”  The WEP adjustment is designed to calculate Curly’s benefits differently, so that they end up looking more like Mo’s, since they both have similar lifetime incomes.    

In short, because Social Security is a redistributive program, there is a real need for something like the WEP.  Most people affected by it, however, hate it.  And who can blame them given that SSA does a terrible job of explaining it?  In essence, instead of telling a retiree that “your benefit will be $800,” SSA tells them “your benefit would be $1100, but because of the WEP, it is only $800.”  But for the individual in question, the $1100 benefit is a red herring.  In no way, shape or form is the $1100 benefit a relevant amount to start with.  So SSA’s poor communication and negative framing raises a lot of hackles unnecessarily.  As a result, thousands of letters are written to elected officials every year demanding that it be repealed.  And, every year, bills are introduced in Congress to eliminate it.  And every year, those bills fail as they should.

This is not to say that the WEP is perfect.  Far from it.  I have written more extensively elsewhere that the WEP calculation may be close to correct on average, but it is almost certainly wrong for each individual.  Sadly, it hits lower income individuals harder than it should, and does not hit most high income individuals hard enough.  There is a “right” way to calculate the WEP, but implementing it requires that SSA have a full history of both covered and uncovered earnings, but they did not collect the uncovered earnings in a systematic way until the early 1980s.  As such, we probably have to wait another 10 years before they can implement the fix.  In the meantime, SSA could do themselves and a lot of elected officials a huge favor by taking the time to adequately educate affected individuals on the rationale for this program.

The Laws of Arithmetic and Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on May 17, 2010

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

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

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

Spreading the Blame and Spreading the Pain of Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on May 11, 2010

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

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

So, who is to blame?

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

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

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

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

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

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

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

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

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

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

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

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

Misleading Accounting and Illinois’ Pension Perils

Filed Under (Retirement Policy, Uncategorized) by Jeffrey Brown on May 3, 2010

My good friend Douglas Elliott, who is now a Fellow at the Brookings Institution, just issued a new paper “The Financial Crisis’ Effects on the Alternatives for Public Pensions. The paper is yet one more in a growing chorus of voices pointing out the significant fiscal woes facing our state and local pensions in the U.S.  And, as I have pointed out before, Illinois is the poster-child for everything that is wrong with the funding status of our public pensions.  

After reviewing the net losses on pension assets, Doug makes the following simple but astute observation:

“The situation is even worse than those figures show on the surface, because pension funds are essentially walking on a treadmill. They need to earn an expected return each year in order to stay standing in place, since the value in today’s dollars of the pensions they have promised to pay goes up each year as those payouts come closer in time. The situation is analogous to inflation. The public pension funds may have lost 15% over two years on a “nominal” basis, but, if their target return was 8% a year , they lost 31% compared to their targeted level of investment value, excluding the effects of contributions and pension payments.”

I have previously noted in this blog that the Government Accounting Standards Board (GASB) allows public pensions to discount future liabilities using the expected return on plan assets.  This approach has no basis whatsoever in financial market theory – indeed, I have yet to meet anyone with a PhD in economics or finance who believes such an approach is correct or sensible.  Actuaries and plan administrators often defend it, but when you dig below the surface, their defense is often rooted in the political or P.R. ramifications of reporting the true nature of the liabilities, rather than in any good economic reasoning.

Let’s bring this home to Illinois.  Specifically, let’s bring this home to the State Universities Retirement System, or SURS.

According to the SURS Investment Update (see page 3 here), the average annual return on the SURS Total Fund over the 10 years ending February 2010 was dismal 3.4%.  But SURS, in accordance with GASB, uses an expected return on assets that is more than double this amount.  Even worse, SURS credits participants in the old Money Purchase option with an investment return that is far greater than this.  Doing so amounts to an implicit transfer from Illinois taxpayers to Illinois pensioners that is above-and-beyond the standard pension formula. 

As we discuss pension reform in Illinois and other states, here are three related points that are worth considering:

  1. We should start with truth in accounting.  Stop hiding behind high discount rates and let’s at least define the size of the problem honestly.  A starting point would be disclosing the size of the public pension liabilities discounted using something more akin to a risk-free rate.  (See here for discussion).
  2. Let’s stop pretending that we can achieve higher returns without taking on higher risk.
  3. Let’s stop making irrevocable transfers from taxpayers to pension participants on the basis of “average” or “expected” returns.  In SURS, that means bringing the Effective Rate of Interest way, way down from historical levels.   

Pension Reform in Illinois: Why is everyone cheering?

Filed Under (Retirement Policy) by Fred Giertz on Apr 14, 2010

 

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

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

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

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

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

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

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

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

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

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

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

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

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

  

Misguided Reform Rhetoric Around Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on Mar 31, 2010

Illinois pensions are in the news yet again.  Last month, the Pew Center on the States reported that Illinois was once again the poster child for everything wrong with the funding of state pensions, noting that we had the worst funding ratio of any state in the country.

 

Last week, Illinois House Speaker Michael Madigan decided – finally – to take some action.  He secured a House vote to change pension benefits for future Illinois state workers.  Specifically, this proposal would raise the full benefit age to 67, cap the maximum pension income at a bit over $100,000, limit cost-of-living increases, and so on.  In short, the package amounts to benefit reductions for not-yet-hired future state workers.  

 

Why this option?  To put it simply, there are only two options for fixing the funding problem. 

 

Option one is increase revenue to the system.  In other words, make additional contributions.  But this would require that Illinois lawmakers raise taxes or cut other state spending, neither of which is politically popular.  

 

Option two is to reduce the liabilities.  But as I have written before, the impairment clause in the state constitution prohibits benefit reductions to existing retirees and existing employees.  So the only way to reduce liabilities is to cut benefits for future workers – those that have not yet joined the system.  And that is precisely what Madigan pushed through the House.

 

[By the way, the only “option three” is to, in the words of Alan Greenspan when discussing Social Security, is to “repeal the laws of arithmetic.”  I am pretty sure that most state governments would choose this option if they could!]    

 

As a fiscal conservative, I have no real objection to the decision to reduce future liabilities in the way that the House has chosen to do.  But two issues that have come up in the debate that I think are worth a bit of analytical clarity.  

 

First, estimates of future savings are almost surely inflated.  There are two reasons for this.  One is that some of the estimates appear to have simply looked at undiscounted dollar flows, which implicitly assumes a dollar saved in 2050 is the same as a dollar saved in 2020.  This is obviously not the case, since a dollar saved earlier has a much higher present value.  A second reasons is that – as I have written before – pensions are part of the overall compensation package.  If we reduce future retirement benefits, our ability to attract top faculty members, for example, will be reduced unless we increase compensation in some other way.  None of the cost savings estimates account for this.    

 

Second, there is clear confusion about the source of the funding problem.  Much of the rhetoric around this legislation focused on the level of benefits.  The Champaign News-Gazette is a typical example, stating:

“A big part of Illinois’ horrendous budget problems can be traced to the high costs for the lavish pensions many public employees enjoy. They are far more generous than those available to workers in the private sector, and that’s a big reason why state public pensions are underfunded to the tune of an estimated $80 billion.”

This is wrong for several reasons.

First, the real source of the funding problem is not level of benefits.  It is the fact the Illinois legislature has consistently failed to make the annual contributions that are called for under standard funding formulas.  My colleague Fred Giertz has done some calculations suggesting that if the legislature had made its required contributions every year, the Illinois system would be slightly over-funded, not under-funded.  In short, don’t blame the pensioners for the lack of fiscal discipline on the part of our politicians.

Second, the comparison of public pensions to private pensions is misleading.  One reason is that the public pension replaces both Social Security and a private pension.  Social Security costs roughly 12% of payroll today.  Private employers who offer pensions typically contribute several percent more.  On that basis, Illinois public pensions are not “lavish.”  A second reason is that – yes, I am repeating myself – this is part of an overall compensation package.  So any comparison needs to account for the value of all salary and benefits, not just a single piece of it.

 

 

 

The Real Risk to Illinois Public Pension Participants: Retiree Health Care

Filed Under (Health Care, U.S. Fiscal Policy) by Jeffrey Brown on Oct 6, 2009

I’ve noted in prior postings that public pensioners in Illinois have very little to worry about with regard to their pension benefits.  But now the bad news – they do have reason to be concerned about retiree health insurance.

 

As I stated in a previous post, Article XIII, Section 5 of the Illinois state constitution protects pension benefits.  Specifically, it states:

 

“Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

 

That is about as strong of a guarantee as anyone could hope for in this day and age.  Indeed, Social Security offers no such guarantees.  The Supreme Court of the United States has previously (in 1960) ruled that individuals have no inherent “right” to their Social Security benefits (see Fleming v. Nestor).  Congress can alter them at anytime. 

 

But, the above guarantee is limited to the benefits from the retirement system, such as the Statue Universities Retirement System (SURS) or the Teachers’ Retirement System (TRS).  As much as participants might hope that retiree health insurance is a benefit of the retirement system, I (and, more importantly, most of the lawyers to whom I have posed this question) don’t think this argument would stand much of a chance in the courts. 

 

Of course, even in states that do not have explicit constitutional guarantees, retirement benefits are often protected by a contract clause.  And, yes, Illinois has one of those too.  Specifically, the Illinois constitution states:

 

“No ex post facto law, or law impairing the obligation of contracts or making an irrevocable grant of special privileges or immunities, shall be passed.”

 

I have asked a few knowledgeable legal experts about whether this would apply in the case of retiree health care.  The responses are typically consistent – that while contract impairment provisions are sometimes successful with regard to the terms of a retirement system contract, nobody could point to a case where this provision was successfully applied to benefits under an employment contract because employment contracts, by their nature, are temporary.  If you doubt this, just consider the fact that the University of Illinois changed our contracts for the current year to allow the University to require involuntary, unpaid furloughs!

 

Of course, I am an economist, not a lawyer – and I am certainly no judge.  So this is not to say that retired Illinois public servants don’t have a case worthy of court if the state were to eliminate or substantially reduce their retiree health care benefits.  As has been pointed out to me by others, such a case is certainly likely to be given “an attentive listen” by the courts.  But whether that translates into any actual protection of benefits is anybody’s guess.  If I were a betting man (I’m not), then I would best against it.

 

So should retirees panic?  Of course not.  We should never forget that we live in a democracy, and most politicians know that the surest way to lose the next election is to do something that makes a large voting bloc – especially seniors – angry, motivated and mobilized.  Politically, I doubt the state will do anything so drastic as to eliminate retiree health benefits for existing retirees or those close to retirement.  But even if drastic changes are out, the reality of the dire long-run budget picture in Illinois would seem to dictate that retiree health care will be an area that legislators look to for future savings. 

 

So, I would much rather that retired public servants enjoy their retirement worry-free.  But for those who want something to worry about, then retiree health benefits are worth a lot more worry than pension benefits.

Do Illinois Pensioners and Taxpayers Know the True Value of Public Pensions?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 28, 2009

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Public servants and taxpayers of Illinois deserve better.