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Point/Counterpoint - Two Sides of the Pension Debate: llinois Policy Institute

Marc Levine
WUIS/Illinois Issues

In February, Illinois borrowed $3.8 billion and paid a higher interest rate spread than any of the other 49 states. This means the financial markets believe that Illinois is the state most likely to default on its obligations.

In light of the state’s diverse economy and general obligation debt levels, this default risk is entirely explained by Illinois’ insolvent state pension system. 

Given the detrimental impact default would have on retirees, schools, public safety, transportation and other government systems, this default risk must be reduced by reforming the pension system. 

My analysis shows that the principal cause of the pension system insolvency is the explosion in cash benefits payable to state workers and teachers. According to the pension systems’ actuaries, benefits payable over the next 12 years are nearly 2.5 times the benefits paid in the last 12 years.

Benefits then continue growing, eventually soaking up more than one-third of estimated state revenue. According to professors Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester, the present value of those benefits, taking into account employee contributions, appropriate discount rates and future service, is $270 billion. Unfortunately, the pension system has less than $70 billion in assets to meet those obligations, leaving a $200 billion deficit/unfunded liability. The scale of this $200 billion unfunded liability overwhelms the $34 billion state budget. It simply cannot be repaid.

And it gets worse. According to the Illinois Commission on Government Forecasting and Accountability, over the next 12 years, Illinois is scheduled to contribute $78 billion into the pension system, representing more than 20 percent of estimated state revenue. 

But this amount in combination with employee contributions is dwarfed by the unrestrained growth in pension benefits. Illinois pension officials estimate that by 2024, after taxpayers have contributed this additional $78 billion, the pension liability will nearly double and the current worst-in-the-nation ratio of assets to liabilities will not improve. The pension system will be in much worse shape than it is today. 

Over the past 12 years, Illinois has contributed $31 billion into the pension system, compared with employee contributions of about $16 billion. This ratio of 66 percent state support for retirement is far in excess of private sector retirement support, in which employers pay 50 percent of Social Security deposits and typically less than 35 percent of 401(k) contributions. Illinois’ pension funding has been and continues to be substantial.

Pension Chart
Credit WUIS/Illinois Issues
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WUIS/Illinois Issues
Pension Chart

In my opinion, the real cause of the problem has been politicians from both parties promising generous benefits that are out of proportion to private sector benefits and employee contributions. On average, full-time teachers earn $84,000 as they near retirement. Upon retirement, their initial $63,000 annual pension income grows 3 percent annually and, given teachers and state workers can retire as early as age 55, they enjoy this growing income for decades (actuaries estimate about 30 years). 

If a retiring teacher were to purchase an investment annuity from a firm like New York Life or Vanguard to mirror these future pension payments, the value would be in excess of $1.5 million.

Meanwhile, according to the 2011 Retirement Confidence Survey published by the Employee Benefit Research Institute, 81 percent of Americans above age 54 own less than $250,000 in savings and investments. Illinois citizens are coming off a tough decade, with stagnant wage growth, relentless unemployment and a generational bear market in equity and home values.

It is fundamentally unfair for Illinois’ private sector citizens, already worried they will outlive their own savings, to pay higher taxes for the lavish retirement packages of government workers. 

While the pension system insolvency jeopardizes the future of Illinois, it is a more direct risk to the state’s teachers and workers. Teachers pay 9.4 percent of each paycheck into the pension system. In exchange, they are promised future payments. But pension officials pay every nickel of these contributions to current retirees as fast as they receive them. Additionally, pension officials have been liquidating the pension investment portfolio to pay current retirees.

Given the possibility that the pension system will be unable to pay future benefits, the Civic Committee of the Commercial Club of Chicago retained Chicago law firm Sidley Austin to assess the state’s legal liability. Sidley’s opinion was unequivocal: “The state itself is not a guarantor of that obligation.”

With past contributions and assets spent, and in the absence of a state guaranty, current state workers and teachers face the prospect of massive reductions in actual benefits when they retire. Projected employee contributions and realistic state contributions would cover less than half of scheduled benefits.

Younger state workers and teachers had nothing to do with creating the massive liabilities bankrupting the pension system and the state itself; they deserve a better alternative.

Some propose increasing taxes or debt as a solution. Coming on top of the recent 66 percent increase in the state income tax rate, additional tax increases are self-defeating, given the ease of employer exodus and the resulting adverse impact on Illinois economic growth and job creation. With respect to potential state borrowing to pay pension liabilities, financial markets have shut down for sovereign credits such as Greece and Portugal, and they can close to Illinois as well. Paying the highest interest rates of any state indicates a heightened risk of lending markets closing to Illinois. 

We cannot tax our way out of the pension crisis, and we cannot borrow our way out of the pension crisis; we must reform our way out.

Reform opponents either deny the problem exists or blame the state. These are untrue and unproductive. Fixing the pension system requires two steps. First, Illinois needs to stop digging this financial hole deeper by moving all workers into a sustainable system for future retirement benefits.

The private sector has accomplished this by adopting defined contribution 401(k) accounts in which individual workers have their own accounts with their names on them. As many state workers are exempt from Social Security, some minimum benefit guaranty would be necessary. Pension reform legislation SB512, approved by the Illinois House Personnel and Pension Committee last May, would accomplish this, as would reforms enacted by states and cities across the nation. 

But stopping the digging still leaves an estimated $140 billion “legacy” unfunded liability owed with respect to previously earned benefits. The legacy liability can only be reduced through some combination of state taxes and borrowing matched by reductions in previously earned benefits payable to retirees and current workers. This requires either amending the state Constitution’s vague “diminish and impair” language and/or legislation providing existing workers a choice to walk away from their at-risk previously earned benefits in exchange for a guaranteed benefit package going
forward.

Earned benefit reductions may sound harsh but would be modest and far more equitable than the inevitable draconian cuts if reform is delayed.

Pension reform will provide state workers with still generous retirement benefits they can count on and protect current and future generations of Illinois residents from unlimited liability. 
It is the essential policy to restore Illinois economic growth and job creation and return our state to a position of leadership.

Marc Levine is a founding principal of Chicago Asset Funding and a senior fellow in pension and investment policy with the Illinois Policy Institute.

Illinois Issues, October 2011

 

The other side: Illinois Education Association by Cinda Klickna

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