Be Careful What You Wish For, Illinois …

Posted by Nolan Miller on May 6, 2011

Filed Under (U.S. Fiscal Policy)

So, the State of Illinois is at it again, talking about reducing pension benefits for current state employees.  Let me get one thing out on the table right from the start:  I believe that the Illinois Constitution is clear on this point: benefits to current employees cannot be reduced.  The plain language of the Constitution is clear, and legal opinions to date support the view that the Constitution guarantees that benefits promised to employees by the Illinois Pension Statute at the time they were hired cannot be “diminished or impaired.”  (Note: I do have ideas for things that can be diminished or impaired without violating the Constitution, but that is a blog for a different day.)

I understand that the state is in a downward fiscal spiral, but that is part of a general problem – for years the state has spent more than it can afford.  Two things.  First, the pension problem is a symptom of that, not a cause.  For decades the state has opted not to make the statutorily required contributions to the public pension systems.  Instead, it has chosen to spend the money on current goods and services or to keep taxes lower than they otherwise would need to be.  There’s nothing wrong with that, but to blame the pension system for the state’s financial problems is like blaming Bernie Madoff’s victims when his Ponzi scheme went bust.  (To be fair, to the extent that state pension systems are overly generous, that’s a problem.  It could be that, due to lack of competition, the strength of labor unions, and difficulty making comparisons for public jobs like police, firefighters and teachers that have no clear private counterpart, state and local employees are overpaid in general and in terms of their pension benefits.  But as I’ve argued before, the best studies I’ve seen show that overall compensation to state and local employees consisting of wages, pensions and other benefits, is pretty competitive with the private sector.)  Second, even if the pensions are overly generous, they are guaranteed by the Illinois Constitution and state employees have held up their end of the contract.  It sets a terrible precedent that the state should be able to ignore its contracts and violate the Constitution when things get tough, especially because the reason why things look so bad for pensions is that the state has not made prudent funding decisions.  It is exactly for this reason that the guarantee is in the Constitution, and “we’ve refused to pay into the pension fund for so long that now there is no choice but to renege on our obligations” seems just crazy, like telling your child that since they didn’t clean up their room for a month you’re going to clean it for them.  It is no way to force a government that has trouble facing fiscal realities to do so.

But, set that aside, and suppose just for a minute, that the State succeeds in breaking its promises to its employees and violating the Illinois Constitution.  Suppose that the current system is replaced by a choice between less-generous defined benefit package (like current pensions but lower benefit and higher cost) and a less-generous defined contribution system, a 401k-like system where employees and the state make contributions to investment accounts that grow or not along with the stock market.  How do we expect state employees to react, given that they had been planning on a more generous retirement package?

  • The decrease in retirement benefits might cause current workers to demand greater compensation, most likely in the form of higher wages.  [Note: I can also come up with reasons why it might not.  For example if current workers think they’re never going to get a dime from the state under the current system, then moving to a system that has a higher likelihood of delivering a smaller payment might actually be a good thing for them.  Of course, wages are unlikely to go down in response.]
  • Decreased faith in the state government as an employer that honors its commitments might make talented people less likely to go to work for the state, or make them demand higher wages if they do.  [Same note as above applies.  Maybe people have so little faith in the state right now that improving their short-term finances would make them more willing to work for the state.  For more on that point, read on.]
  • Good employees with outside opportunities could demand higher wages in order to continue to work for the state.  Again, this could either increase wages or reduce the effectiveness of the current workforce.  To the extent that high wages for stars pull up wages for similar employees, this could put pressure on wages across the board.
  • Even as good employees leave the system, “bad” employees with limited outside opportunities will continue to work for the state.  This phenomenon, which economists call “adverse retention” could result in a rapid deterioration of the quality of the state’s workforce.
  • Mid-career employees that had planned on a more generous pension might postpone retirement.  To the extent that more experienced employees have higher wages, this could result in higher wage bills for the state.  To the extent that some jobs, like police and firefighters, require physical strength that wanes with age, this might result in reduced capability or the need to hire more workers to do the same amount of work.  This is even true in academia, where younger scholars are often more in touch with the latest-and-greatest developments in the field than older ones.
  • If workers lose confidence that the state will continue to fund even the reduced defined benefit  pension system in the future, they may move toward the defined contribution system because in such a system the state is forced to make contributions to the employee’s account every year, so that the employee can start investing that money.  Now, one of the nice things about defined benefit plans from the state’s point of view is that the state has had the option (which it has used) to delay making contributions to the plan in order to use the money for current purchases.  If pension reform drives employees toward defined contribution plans, the state will lose this option.  It will have to come up with all of the cash immediately, and given how bad the state’s financial system is right now, it seems like transforming the pension obligation from a future liability to a need to come up with large amounts of additional cash immediately may actually make the state’s short-term liquidity problem even worse than it currently is.  Sure, it will force the state to adopt a more realistic approach to budgeting, but there will be definite costs to doing so.

There are more, but you get the idea.  Policymakers often focus on the “intended consequences” of a policy change.  In this case, reducing pension benefits will reduce the amount the state has to pay into its pension system.  That’s clear.  Economists, on the other hand, like to think about the “unintended consequences” of policy changes.  In the case of reducing pension benefits, the unintended consequences could include higher wages, later retirements, and a general decreases in the quality of the state’s workforce.  In my mind, the last bullet point above is especially important.  If pension reform pushes workers into the DC plan, the state might find itself needing to come up with a whole lot of cash in a serious hurry.  There are probably more, but what seems clear is that in the rush to find a short-term solution to a long-run problem whose scope is much larger than the pension system, nobody is really thinking about to what extent the unintended consequences of pension reductions could offset the intended ones.