To say Illinois faces a hole in funding its public employee pension systems is like saying the Grand Canyon is an impressive ravine or the Mindanao Trench a good-size gully.

Indeed, “hole” is hardly an appropriate word. “Abyss” and “chasm” come readily to mind, with “bottomless pit” not too far away.

One fact seems indisputable: The commitments Illinois has made to provide retirement security for more than 700,000 downstate teachers, state workers and university employees pose the greatest financial challenge the state ever has faced. Consequently, pension reform is expected to be a key issue during the current spring session of the General Assembly.

The dollars can’t be argued. When the books are closed on the current fiscal year on June 30, legislative analysts project the five retirement systems for which state government is responsible will need roughly $131 billion to cover benefits already earned by public workers, with only $46 billion in expected assets to cover the costs, or about 35 cents on the dollar. The other $85 billion represents the unfunded liability, an obligation the state must meet but for which no funding source exists.

Nor can the state walk away from the commitment, as a private sector employer can do through bankruptcy. The Illinois Constitution guarantees that once earned, pension benefits cannot be diminished or impaired. Even if the state were to abolish its public employee retirement systems today, every covered worker would be entitled to the benefits he or she has earned up to the moment the systems disappeared.

How much is $85 billion? Well, it’s roughly three times last year’s total receipts into the state’s main checkbook account, about $29 billion. Or about $6,600 for each of the 12.9 million folks the U.S. Census Bureau says live here. And it’s eight times greater than the comparable figure of two decades ago, when the state’s unfunded liability was slightly more than $10 billion at the end of fiscal year 1990.

Financial experts warn that the continued unchecked growth of the pension debt threatens to reach a “tipping point” beyond which the state won’t be able to reverse a fiscal slide into bankruptcy.

“The radical cost cutting and huge tax increases necessary to pay all the deferred costs from the past would become so large that many businesses and individuals would be driven out of Illinois, thereby magnifying the vicious cycle of contracting state services, increasing taxes and loss of the state’s tax base,” says R. Eden Martin, president of the Commercial Club of Chicago, a civic group.

Martin’s dire prediction came in a minority report to the Pension Modernization Task Force, a panel created last year at the behest of lawmakers to study the issue. In its final report, issued last November, the panel provided a comprehensive overview of the problem but offered no solutions.

Marked differences between members representing business interests and those from labor and its allies prevented the task force from reaching broad-based consensus on what steps Illinois should take to stop the ongoing financial death spiral. But no one contested the chief reason for the huge unfunded liability: For decades, governors and lawmakers from both political parties have chosen to spend available revenues on education, health care and other current programs rather than sock enough away to pay for the pension benefits workers were earning.

The dollars not put into the retirement kitty in turn did not earn any return on investment or compound over the years, so the gap grew even larger. More recently, the recession and near collapse of Wall Street sliced the value of the systems’ invested assets by some $18 billion, more than a quarter, since FY 2008.
 

  “The deadly combination of nearly 30 years of systematic state underfunding of its employer contributions to the pension systems, followed by the cataclysmic decline in asset values caused by the national meltdown in financial markets over the last year, combined to create an all-time high in the state’s unfunded pension liability,” noted the Center for Tax and Budget Accountability, a Chicago-based think tank, in testimony to the task force.

Moreover, over the years, Springfield political leaders have enhanced retirement benefits without providing full funding for the new costs. For instance, in the late 1990s, the formulas by which benefits are calculated were changed to allow teachers, state employees and university personnel to earn larger pensions more quickly, without corresponding increases in member contributions to cover fully the additional cost to the systems.

And in some instances, actuarial projections proved off target. The early retirement incentive program for state workers enacted in 2002 was expected to add slightly more than $600 million to the unfunded liabilities of the State Employees’ Retirement System. But significantly more state workers opted to retire than anticipated, at younger ages and with higher benefits, so the final price tag was $2.4 billion, four times higher than the original estimate.

For many years, the accepted practice was for the state to cover pension system expenditures in a given year, with members’ contributions and investment income used to build reserves for the future, according to a 2007 report by Comptroller Dan Hynes. The policy was abandoned in the early 1980s, though, when economic conditions worsened and state revenues weakened, leading to only modest increases in state contributions even as retirement costs soared.

In 1981, Hynes reported, the state kicked in $406 million, while pension systems spent $431 million. By 1995, the state contribution increased to $519 million, but system expenditures increased to $1.9 billion, according to the comptroller’s report.

The alarming trends caught lawmakers’ attention, and several schemes were devised to increase state contributions incrementally over long periods of time, so that at some future point, the systems’ assets covered at least 90 liabilities, a level that actuaries consider tantamount to full funding.

A plan enacted in 1989 envisioned a seven-year increase in state contributions, followed by annual payments sufficient to cover benefits earned each year and to amortize the unfunded liability in full over 40 years.

At the time, the five systems were funded at close to 58 percent, with assets slightly more than $14 billion and obligations of almost $25 billion.
But the plan — which was not mandatory — faltered when state budget makers ignored its requirements in favor of allocating more dollars to ongoing programs.

The 1989 law was replaced by a new funding arrangement in 1995. That called for a 15-year, gradual buildup in state contributions, followed by annual contributions at a level percent of payroll from 2011 through 2045, at which point the systems’ assets were to cover 90 percent of liabilities. To ensure compliance, the new law made its required annual contributions a continuing appropriation, a provision that mandates the state comptroller to transfer the specified amount to each system even if the budget does not include it.

But the 1995 plan also was seriously flawed. Contribution levels were set too low in its early years to cover the costs of benefits earned each year plus interest on the unfunded liability, the sum needed just to maintain the status quo. Under its funding schedule, the deficit is projected to continue to grow until topping out at $150 billion in 2031, before dropping to $35 billion in 2045, when the systems would be 90 percent funded.

Despite the plan’s shortcomings, the economic boom of the 1990s, coupled with a major actuarial change that listed assets at current fair market value rather than at the initial acquisition cost, helped push the systems to their highest funded level in memory by FY 2000, with some $46 billion in assets to cover about $62 billion in liabilities, roughly 75 percent funding.

Since then, it’s been all downhill, as economic downturns bookending the 2000s prompted lawmakers and Gov. Rod Blagojevich to resort to pension borrowing and pension holidays to free up money for other uses. A $10 billion bond sale in 2003 was used to cover a portion of the 2003 and all of the 2004 contributions under the 1995 law. Two years later, the governor and legislature rewrote the 1995 law to cut some $2.3 billion from required contributions in FY 2006 and FY 2007, and last year Gov. Pat Quinn and lawmakers agreed to sell $3.5 billion in pension notes to cover FY 2010 contributions.

Meanwhile, the systems closed their books on FY 2009 with assets of $48.7 billion and liabilities of $126.5 billion, leaving an unfunded liability of nearly $77.8 billion, for a 38.5 percent funded ratio. 

Facing such numbers, all parties agree something must be done. What, though, is a topic of heated debate.

Business leaders concede that chronic underfunding is the main reason the pension debt has increased more than eight fold in the last 20 years. But they see another major factor at work: pension benefits that are too generous to retirees and too expensive for the state to afford.

“The level of pension benefits provided by the state’s plans generally exceeds those available in the private sector — i.e., available to taxpayers who pay the state’s bills,” the Commercial Club’s Martin contended in his report. “The state’s pension plans must be reformed and made less costly.”

The five systems generally allow employees to retire with full benefits at age 60, a much younger age than allowed in private sector plans, and their monthly annuities are calculated on more favorable terms than those available for private workers. In addition, retirees receive 3 percent compounded cost-of-living increases annually, something virtually unheard of in the corporate world.

Moreover, many private sector employers no longer offer defined benefit plans, in which retirees are promised a certain amount for life, but instead offer defined contribution plans, in which the company agrees to contribute a certain sum each year into an employee’s retirement savings account.

“A substantial disparity thus exists between pension benefits generally available in the private sector and the state’s pension plans,” Martin wrote in the minority report. “This disparity should not continue, for two reasons. First, the state cannot afford it. Second, maintaining such a disparity is unfair to taxpayers — who largely work in the private sector — who must pay higher taxes to support the more generous and more costly benefits provided to the state’s employees.”

Not surprisingly, labor organizations dispute the business characterization of the state’s retirement systems, citing the findings of the task force’s benefits subcommittee, which compared Illinois’ benefits package with those offered by other public employers in four areas: retirement age, employee contribution rates, retirement formulas and cost-of-living adjustments.

“In the four categories that the subcommittee studied, Illinois’ state-funded retirement systems were generally found to be in the statistical median,” members concluded.

In addition, the subcommittee found the normal costs of the state’s retirement systems — the amount needed each year to cover benefits earned that year — to be less than those of neighboring states and of private sector employers, chiefly because almost 80 percent of the workers covered by the state plans are not eligible for Social Security, so the state does not pay a federal tax on their salaries. 

In contrast, private sector employers must pay a 6.2 federal payroll tax to provide Social Security coverage for their workers, and on average contribute 4.4 percent of payroll to 401(k) and other retirement plans, for a total cost of 10.6 percent, compared with state government’s normal cost, which averages about 9 percent of payroll.

Nor does the typical retiree reap a windfall upon leaving his or her job. Annuities for retired state workers average slightly more than $22,000 a year for the 95 percent of retirees eligible for Social Security and about $28,000 for the 5 percent who are not, according to financial reports from the State Employees Retirement System.

The average annuity for retired teachers is about $43,000 and for retired university workers about $29,000. Neither group receives Social Security benefits for its members’ years in public service.

“The level of benefits is modest, comparable to national averages of public employee retirement systems and of our neighboring states,” said Anders Lindall, spokesman for the American Federation of State, County and Municipal Employees Council 31, which represents more than 40,000 state government employees. “And the cost of benefits is not only in line with other states, it’s less than the private sector. The state doesn’t pay Social Security in most cases, and participants make significant contributions to their own pensions.”

Reasonable or not, business leaders insist the state can’t afford the current retirement plans. Some argue the state should dump the guaranteed benefit plans and switch to defined contribution plans for all new hires, and, if constitutionally permissible, for current workers’ future retirement. Advocates concede, though, that the initial costs of moving to a defined contribution plan might be more than the state can handle at this time.

In the alternative, the business community is pushing for setting up a second tier of pension benefits for new employees that would reduce future pension costs to the state and track more closely private sector cutbacks on employee benefits.

Among the changes they’d like to see:

• Raising the normal retirement age to 67 and the early retirement age to 62, in both cases for workers who’ve logged at least 10 years on the job. Currently, teachers can retire at age 60 with 10 years of service, while university workers need only eight service years at age 60. State employees can retire with full benefits under the so-called “Rule of 85” — when an individual’s age plus years of service equals 85 — allowing someone who’s worked full-time since age 25 to retire at 55 with full pension.
• Reducing the annual rate at which employees earn benefits to 2 percent of salary for workers not covered by Social Security and to 1.5 percent of pay for those under Social Security. At present, teachers, university personnel and about 3,000 state workers not eligible for Social Security accrue benefits at 2.2 percent a year, while other state employees covered by Social Security earn 1.67 percent of final average salary.
• Changing the provisions used to calculate benefits to exclude base salary in excess of the Social Security Covered Wage Base — $106,800 in 2010 — and to average pay over eight years, rather than four.
• Limiting the annual cost-of-living adjustment to 3 percent or one-half of the Consumer Price Index, whichever is less, applied to an annuitant’s starting pension amount. Now, the annual adjustment is 3 percent, compounded.
• Reducing the amount new employees would pay toward their retirement benefits by 13 percent to 15 percent, depending on the system.

Business leaders would apply the same standards to current employees for benefits they earn going forward but concede that the courts might decide the change violates the constitutional provision that forbids impairing pension benefits. In that case, they argue, current workers should be required to contribute more for their pensions, an average of 11 percent for those not covered by Social Security and 7 percent for those who are. Currently, workers without Social Security average almost 9 percent, while those eligible are paying 4 percent.
In his budget proposal last year, Quinn embraced similar provisions for a second tier of benefits for new hires and increased contributions from current workers, which he said would reduce the state’s pension liabilities in 2045 by $162 billion. The governor later backed off, though, under withering criticism from organized labor and its allies, and legislation embodying the changes was never called for a vote.

Similar efforts to revamp pension system benefits are likely this spring and may appear attractive as lawmakers grapple with a budget deficit of unprecedented magnitude. But adding a second tier of reduced benefits would provide few immediate savings, according to analysts with the Commission on Government Forecasting and Accountability. “Because the reduction in benefits would apply only to newly hired employees, there is very little change in the total actuarial liability in the near future,” they said in an April report. 

Other policy experts argue that public pensions should not be the scapegoat for what they view as the root of the state’s fiscal problems, an outdated revenue structure that does not track well Illinois economic activity in the 21st century.

“Despite oft-repeated claims to the contrary, the primary cause of the state’s pension funding woes have very little, if anything, to do with the overgenerous benefits, high employee head counts or inflated costs,” the Center for Tax and Budget Accountability told the task force.

“The state’s failure to make its required employer contributions to the five pension systems can be traced to one, simple cause,” according to the center’s analysis: a state fiscal system “that is so poorly designed it, for decades, failed to generate enough revenue growth to both maintain service levels from one year to the next, and cover the state’s actuarially required employer contribution to its five pension systems.”

The structural deficit posed a difficult choice for elected officials over the years: fully fund pensions and dramatically cut services, or skip some of the pension payment and keep as many services as possible, the center said.

“Not wanting to implement dramatic cuts in spending on essential services, the legislature and various governors elected to instead divert revenue from making the required employer pension contribution to maintaining services like education, health care, public safety and caring for disadvantaged populations,” the center argued. “Effectively, the state used the pension systems as a credit card to fund ongoing service operations.”

Because the state’s current tax structure motivates public officials to shortchange contributions to the retirement systems so as to preserve funding for immediate needs, “pension funding reform is not possible without enhancing state revenue,” concluded the task force’s subcommittee on funding.

In theory, state officials could choose to slash spending on other programs to pay down the pension debt, the subcommittee said, “but there is little likelihood that the General Assembly could make such cuts without reducing social services and programs to politically unacceptable levels.”

In addition to calling for new revenue — in essence higher taxes — subcommittee members also suggested state leaders should:

• Consider replacing the current funding plan with “a new, rational payment schedule, one that front-loads costs,” unlike the 1995 law, which allows pension debt to grow for another 20-plus years. 
• Study the feasibility of selling selected state assets, such as the Illinois Tollway, to raise immediate cash for infusion into the retirement systems.
• Examine the possibility of issuing additional pension obligation bonds, but only when market conditions are favorable and only as a debt swap, in which proceeds would be used to refinance a portion of the existing unfunded liability, but not as a replacement for the required annual contribution to cover actuarial normal cost plus interest on the debt.

In testimony to the task force subcommittee, the center proposed replacing the 1995 law with a new long-term plan that would require annual state payments based on a declining percentage of the overall state budget, with a goal of hitting 90 percent funding at the end of the amortization period.
To ensure the state will have the cash needed to meet the new schedule, the center said the state’s tax structure should be revamped by enacting pending legislation (HB 174) that would raise state income tax rates, broaden the sales tax base to include consumer services and increase tax relief to moderate and low-income taxpayers. The measure passed the Senate last May but stalled in the House. Its chances are deemed shaky in an election-year session.

Cut pension benefits? Raise state taxes? Hammer out a compromise with some of each? Perhaps the only sure thing is that the longer lawmakers and the governor wait, the tougher the measures they’ll have to adopt eventually to put the five retirement systems on sound financial footing.

Charles N. Wheeler III is director of the Public Affairs Reporting program at the University of Illinois Springfield. He is a member of the State Universities Retirement System.

Illinois Issues, February 2010