Why I Support Illinois Pension Reform but Oppose S.B. 1

Filed Under (Retirement Policy) by Jeffrey Brown on Dec 3, 2013

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

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

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

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

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

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

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

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

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

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

First, why does this problem exist?

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

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

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

Why do we need reform?

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

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

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

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

Is it possible to do this in a sensible way?

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

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

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

How would S.B. 1 affect bondholders?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is this constitutional?

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

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

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

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

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

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

How will the University of Illinois respond?

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

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

What should I do now?

-          Call your lawmakers and ask them to vote no.

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

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

Illinois Public Pension Reform: A Simple but Radical Idea

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jun 4, 2012

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. 

Three Hard Lessons from Illinois Public Pension Reform

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 30, 2012

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 …

The Choice Between Two Unconstitutional Options is Not Constitutional

Filed Under (Other Topics, Retirement Policy, U.S. Fiscal Policy) by Nolan Miller on May 29, 2012

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.

Proposed GASB Pension Discounting Standards: Even Worse than Before?

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 2, 2011

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.”

 

Illinois Teachers’ Pensions Increase Allocation to Alternative Investments in Order to Do the Impossible

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 21, 2011

Just a short note today (which I learned from reading Institutional Investor) to point out that the Illinois Teachers’ Retirement System on April 8 approved a change in portfolio allocation.  Specifically, they are going to increase by 5 percentage points the fraction of the pension portfolio going to hedge funds and private equity.  The increase is coming primarily from a reduction in domestic equities from 26% to 20% of the portfolio.

What I find ironic (indeed, it would be amusing if the stakes were not so high) is the statement by the Chief Investment Officer that they are doing this to “minimize risk and maximize returns.”

There is a major problem with this statement.  Namely, it is impossible to do both.

It is possible to minimize risk, while holding the return constant.  Or one can maximize returns, while holding the risk constant.  Indeed, these are two different ways of – in financial economics lingo – to get to an “efficient” portfolio.

But it is impossible to do both simultaneously.  In financial markets increased market risk and increased expected returns go hand-in-hand.  As Frank Sinatra said about love and marriage, “you can’t have one without the other.”

 

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.