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

in•cred•i•ble (adjective): too extraordinary and improbable to be believed.

I wrote last week about the Illinois public pension mess and how ceasing to offer fully-paid retiree health benefits might help to address the problem by causing workers to delay retirement.  The reason why such a convoluted route to reducing pension costs is needed is because of the non-impairment clause of the Illinois state constitution, which prevents the state from reducing benefits for current employees.  In short, the non-impairment clause says that membership in a state pension system is a contractual relationship between the worker and the state.  And since contracts cannot be unilaterally renegotiated by one of the parties, the state is in a situation where it would seem to have no way out of its obligation to pay promised benefits to its current and future retirees.

In his proposal to reform the state pension system, Governor Quinn has tried to avoid the non-impairment clause by offering workers a choice.

On the one hand, current workers can keep their current pension plan but lose the right to have future pay increases be included in their final pension benefits and lose the subsidy that the state currently pays for retiree health benefits.  (Now, the first part of this plan clearly violates the non-impairment clause because the formula used to compute final benefits is specified in the Illinois Pension Code and clearly includes future pay raises.  But, that’s not today’s topic.)

On the other hand, employees can accept a significantly less-generous pension plan but maintain the employer subsidy toward retiree health benefits.  (Now, the less-generous pension plan pushes full retirement to age 67, when employees would be eligible for Medicare anyway, so it is unclear how valuable this promise would be to retirees.  But, that’s not today’s topic either.  There is also the real question of whether this would be considered “coercion” by the state.  In the past the Supreme Court of the United States has ruled that an employee cannot be coerced into giving up his pension benefits.  But, that’s also not today’s topic.)

This would be the time to ask ourselves why the non-impairment clause was included in the Illinois Constitution in the first place.  An analysis by Eric Madiar, Chief Legal Counsel to Illinois Senate President John Cullerton, confirms what you might suspect.  Public workers in the state of Illinois were concerned about whether the state would pay the pension benefits that it had promised them.  State and local workers generally receive lower cash wages than their private-sector counterparts, but higher benefits, including more generous pensions.  Thus, when an employee accepts a job working for state or local government, promised future pension benefits play a major role in making that job attractive enough for them to accept.  In light of this it is not surprising that they would be concerned about whether the state could be trusted to pay those future benefits.  This led state and local workers to propose that pension benefits be guaranteed in the Illinois constitution, and this proposal ultimately became the non-impairment clause.

Economists think a lot about commitment.  That is, we wonder about things like how it is that an agent can commit to take an action in the future that is not it its own short-term interest.  Or, we wonder how it is that an agent can be given incentives to take actions today that do not benefit it until the distant future.  Both of these issues arise in the context of pension funding.  In order to induce an worker to take a government job that pays less today, that worker must believe that the state will actually fulfill its promise to pay higher pension benefits in the future.  Similarly, in order for current legislators to cut current spending and use the money to fund future pension payments, there must be consequences.  The non-impairment clause addresses both of these issues.  The highest law of the state guarantees that the state will make the future payments.  This guarantee is so strong that a state that fails to properly plan for these payments will face fiscal collapse – as we do now.  Even in the face of fiscal collapse, the non-impairment clause suggests that pension payments must take precedent over many other payments.  With these promises in place, workers should be confident that the state will fulfill its future obligations.  Ideally, knowing that failure to plan for the future will jeopardize the entire state, legislators will make appropriate funding decisions to avert disaster.

Consequently, the non-impairment clause plays a vital role in the state’s finances.  Over the years it has been used to induce workers to accept a lower wage today in exchange for the seemingly-credible promise to provide higher benefits in the future.  In other words, the non-impairment clause has allowed the state to push the cost of paying current workers onto future taxpayers.  Kicking the can down the road in this manner has been a major tool in the state’s fiscal toolbox.

Let’s think about the role of commitment in regards to Governor Quinn’s proposed choice.  The plan says that those who want to keep their current pension will lose retiree health benefits.  The governor can take away retiree health benefits because they are not guaranteed by the non-impairment clause.  An employee who accepts the governor’s proposal would get a less-generous plan but keep the state’s promise of retiree health benefits.

In order for an employee to voluntarily accept this plan (if they believe that current pensions cannot be impaired), it must be because the employee values retiree health benefits.  But, even an employee who values retiree health benefits would have to believe that, when they retire in the future, the state would actually provide the promised benefits, and would continue to do so even if times were tough.  In fact, when times are tough that’s when people need their pensions the most.  So workers might be particularly concerned about whether a state under fiscal pressure would continue to fulfill their promises.  Sound familiar?

This is where things become a bit tricky for the state.  Times are tough right now, and the state has responded by threatening to take away retiree health benefits.  This has occurred both in the governor’s proposal and in the state legislature, where pending legislation would eliminate the state’s subsidy for retiree health premiums, which amounts to about $7400 per retiree per year.  So, the state is, on the one hand threatening to take away retiree health benefits and on the other hand asking workers to believe that their promise that those who accept the governor’s proposal will continue to receive these benefits in the future.  And, all of this is taking place in a situation that was brought about by the state’s failure to adequately plan to meet its constitutional obligation to pay pension benefits.

This brings us to the big question: Why should workers expect the state to honor its commitment to provide a non-guaranteed benefit when it isn’t even honoring the benefits that it is constitutionally obligated to provide? While the governor’s plan should be commended for attempting to address the pension crisis through asking workers to voluntarily accept a change in benefits, in the end I would be surprised if workers are willing to give up their constitutionally guaranteed pension benefits for an incredible promise to provide health benefits.

Practically speaking, any proposal that asks for voluntary acceptance by workers is going to have to exchange currently promised benefits for some promise of future benefits, and any such promise of future benefits is going to face this same credibility problem.  The state, by finding a way around its constitutional promise of future benefits, may find that it loses the ability to induce people to work today for lower wages and promises of higher payments via pensions in the future.  If workers respond to this by insisting on higher wages today, the state may find itself facing a choice between higher wage costs or lower-quality workers.  Even if the state can find a way around the non-impairment clause, it will not be without its costs.

ADDENDUM (5/30/12):  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.  Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.

Ever since Governor Quinn proposed his plan to reform government employee pensions in Illinois, I’ve been thinking about how to blog about it.  The problem is, my primary opinion is a legal one – that the proposal clearly violates the non-impairment clause of the Illinois state constitution because it threatens current employees with excluding future pay raises from pensionable earnings in contradiction of the “contractual relationship” laid out in the Illinois Pension Code – and I’m not a lawyer.  Better to stick with what I am supposed to know.

So, let’s turn to economics.  While the non-impairment clause prevents the state from reducing pensions, it does not affect other benefits.  In particular, the state would seem free to reduce or remove subsidies for retirement health benefits without running afoul of the non-impairment clause.  New research from by Steven Nyce, Sylvester Schieber, John B. Shoven, Sita Slavov, and David A. Wise suggests that doing so might be a way to lower pension costs.  In short, they show that removing the employer subsidy for health benefits for early retirees would cause people to work longer.  And, when people work longer they contribute more toward the pension fund and draw pensions for less time, improving the overall finances of the pension system.

In the new article, entitled “Does Retiree Health Insurance Encourage Early Retirement,” the authors investigate the relationship between employer subsidies for health insurance to retirees.  The paper begins by noting that many Americans delay retirement until they reach age 65 because employment gives them access to health insurance at far better prices than they could receive in the private market (if such insurance is even available).  When an employer offers subsidized health insurance to those who retire before age 65, it makes it possible for people to retire earlier than they otherwise would.  Using newly-available data, the paper finds that retiree health coverage significantly increases retirements among people in their early 60s.  In fact, when employers subsidize 50 percent or more of the cost of retiree health insurance (as the state of Illinois does), retirements increase by “1-3 percentage points at ages 56-61, by 5.9 percentage points (33.7 percent) at age 62, and by 6.9 percentage points (43.7 percent) at age 63. Overall, an employer contribution of 50 percent or more reduces the total number of person-years worked between ages 56 and 64 by 9.6 percent relative to no coverage.”

What does this mean for the state of Illinois?  Take, for example, SURS, the State Universities Retirement System.  In this system, a worker’s total retirement benefit is limited to 80% of final salary.  This means that, after about 36 years of working for the state, the worker’s pension no longer increases with additional years of service.  Further, state law provides that the state will pay 5% of retiree health premiums for each year of service.  (Importantly, the applicable law is not the Pension Code!)  So, a person who started working for the state at age 25 would, by age 62, be eligible for the maximum pension and free health benefits.

Given this deal, it is no wonder that people choose to retire before age 65.  This costs the pension system, since early retirees do not contribute and they draw their pension for longer.  Removing retiree health benefits would have a significant financial impact on early retirees.  Back in 2006, the most recent data I could find in a quick search, the average health insurance premium for an adult age 60 – 64 on the non-group health insurance market was around $360/month.   A family policy would cost about twice that.  Such policies are usually less generous than employer-provided insurance and feature higher deductibles and coinsurance rates.  So, a near-elderly state employee contemplating retirement might face expected monthly costs of $500 – $700 or more if they had to pick up their own health insurance, and even more if they had a dependent spouse or children.

So, suppose the state were to eliminate retiree health benefits.  Faced with such costs, many people would choose to work until age 65 (or at least until age 63.5 when the COBRA law would allow them to continue to purchase health insurance under the state plan until they become eligible for Medicare at age 65).  And, when people retire later, they draw pensions for less time.

Now, I am not necessarily advocating this, and certainly not across the board.  There are strong arguments why for some government employees – in particular police and firefighters –the physical demands of the job make early retirement reasonable.  For other government employees, such as professors, there is no strong reason why the state should be subsidizing early retirement through providing free health benefits after I stop working.

My broader point is that whatever the state does, and it must do something, it must be done in a way that does not violate the constitution.  While the state cannot touch pension benefits, it is free to reduce health insurance.  And, since retiree health insurance makes retirement more attractive, reducing or removing retiree health benefits would seem to be a constitutional and, based on recent research, effective way to delay retirement, which would improve the ailing pension systems’ finances.

ADDENDUM (5/30/12):  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.  Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.