Illinois Running Out of Pension Time?

Mike Riggs of Reason spoke with Illinois Policy Institute's Adam Schuster about how to fix the state's pension debt crisis:

Illinois is running out of time to fix its public sector pension problem. A new report from Moody's Investors Service identified the Prairie State as one of the two most likely to suffer during an economic downturn. Illinois towns and cities are already paring back government services to pay for generous benefits packages for retirees, and Chicago's pension debt alone is larger than that of 41 states. That arrangement can't last forever.

"The worst-case scenario is there's another national recession, which would cause our pension funds to lose a bunch of their assets again," says Adam Schuster of the Illinois Policy Institute. "As the assets shrink, the pension funds go into a financial death spiral. We might end up with some kind of Puerto Rico–style pseudo-bankruptcy or federal bailout. Everybody in the nation is now on the hook for Illinois politicians' irresponsible decisions."

The best-case scenario would involve repealing an automatic 3 percent raise that pensioners receive each year of their retirement and requiring workers to pay more into their own plans. Democratic Gov. J.B. Pritzker would prefer to scrap Illinois' flat income tax and replace it with a progressive tax scheme, which could cause even more people to flee the state. In May, Schuster spoke to Reason's Mike Riggs about the pension conundrum.

Q: If somebody had been paying attention 30 years ago, could they have anticipated this pension problem?

A: Thirty years ago would be just about enough time to stop some of the mistakes. We changed the state constitution in 1970 to add a pension protection provision, which essentially says that as of the day of hire, an employee's benefit formula cannot be changed in any way. So it doesn't only protect benefits that somebody has already earned. It protects the future growth rate of those benefits for life and gives the state legislature no flexibility to change them.

Q: What happened next?

A: In 1990, Illinois implemented a guaranteed 3 percent compounding cost of living adjustment. So a person's pension goes up by 3 percent every year regardless of how much inflation there is in the economy. It basically doubles the size of somebody's pension over the course of 25 years.

We also had a series of governors, both Republican and Democratic, who habitually shorted the system by putting in less than the required contribution. The reason they did that is that the required contributions were unaffordable and never would have been affordable because we overpromised the benefits.

Q: Do Illinois taxpayers know what's going on?

A: I think there is pretty widespread knowledge about the problem, but there's also a defeatist apathy. We've had five straight years of population loss. We're losing our prime working-age adults, and poll results say that the No. 1 reason they're leaving is that the taxes are too high here. And the No. 2 reason they're leaving is job opportunities are better elsewhere, which is related to No. 1.

Q: What do public sector union leaders say about the pension crisis? How about union members?

A: I appreciate that you make that distinction, because I've found there is a huge disparity in how they react to this kind of thing. Union leaders, who are involved in politics and lobbying, are against having this conversation at all. But when I talk to regular rank-and-file union members, they actually think the plan we put forward is a very fair and very reasonable compromise.

Q: What is the short version of your plan?

A: It would amend our constitution so that instead of protecting the future growth rate, it would only protect the pension benefit that somebody has earned to date. So if you retired today, your annuity would be protected, but it would give the legislature flexibility to change retirement ages for younger workers and to change that 3 percent cost of living adjustment, for example.

Q: What happens if Illinois does nothing?

A: I don't know if you followed at all the story of Harvey, Illinois, but it's a South Chicago suburb, and they have one of the highest effective property tax rates in the nation. Even still, their police and fire pensions are so underfunded that in order to make their pension payment, they had to lay off dozens of current police officers and firefighters.

Q: That's what people pay taxes for: government services!

A: Harvey was the canary in the coal mine. Down in Peoria, they've had to lay off municipal workers, people who plow the streets. In Rockford, they're being told they need to sell their city water system. Municipalities around the state are laying off public safety workers today to pay for yesterday's pensions.

Illinois's pension woes are well-known, I've been writing about them for years. It's literally one of of the worst states to live in when it comes to public pensions deficits and cutbacks in public services and hikes in property taxes to make up for growing pension shortfalls.

But it's not alone. As I explained last week, America's public pension funds are falling short of their target returns and as rates plunge and liabilities soar, they're in big, big trouble, especially chronically underfunded public pension plans.

I'm very worried that when the next crisis hits us full force, many state plans will be teetering on the verge of default and only a massive bailout by Congress will save them from not meeting their growing obligations.

Or maybe not. Elizabeth Bauer, an actuary who writes on retirement issues for Forbes recently posted a comment on a modest proposal to solve Illinois's pension woes:

It's easy-peasy, really.

There's a way to reduce the Illinois and Chicago pension liabilities by half, with no constitutional amendment required, no hard political truth-telling or compromises, no cuts at all.

And considering that Chicago's pensions are 23% funded, and Illinois', 40%, this is not a minute too soon.

Here's the scoop:

The basic structure of Illinois' and Chicago's pensions are the same. In general, Tier I employees/retirees, those hired before 2011, receive a pension based on final pay and service with a fixed 3% per year Cost-of-Living Adjustment; whenever inflation is lower than this (the last ten years, it's averaged 1.8%, the last 20 years, 2.2%), they come out ahead, to the extent that some retirees get pension checks greater than any paycheck they ever received. Tier II employees, on the other hand, keep the same benefit formula, but averaged out over a longer period of time, receive pseudo-COLAs at half the rate of inflation, without compounding, and have their pensionable pay capped at a level that (unlike, for instance, the Social Security ceiling) doesn't rise based on average wage growth or even inflation but at half the rate of inflation, so that, to take the teachers as an example, any teacher who earns above-average pay levels will be affected as soon as 2027, based on current inflation projections and average wage data.

Now, the value of any pension without a true CPI-based cost-of-living adjustment will be eroded over time due to inflation, and eroded in very short order in instances of high inflation. And in countries with a history of inflation, employer-sponsored pensions are more likely to include true cost-of-living increases. In some cases, the entire actuarial valuation is done on a "real" basis, evaluating all of the inputs on the basis of "value in addition to inflation" — that is, using the assumed salary increase in excess of inflation and the interest rate in excess of inflation. When both these hold true - true-CPI increases and assumptions all relative to inflation, in principle, neither the liabilities nor the pension benefits' real value are affected by fluctuations in inflation. (Random trivia: in Brazil, the government even issues its bonds on a "real" basis.)

At the same time, back in the spring, the latest buzzword was Modern Monetary Theory (here's an explainer), which was the means by which various progressive politicians promoted the idea that there was an awful lot more room for government deficit spending than appears to be the case; concerns about inflation were waved away with the assurance that the government would be able to tack as needed by increasing tax rates.

You see where I'm going with this, don't you?

If the United States were to hit a period of high inflation rates, sustained over a long period of time, these liabilities would shrink considerably — and I'm not even speaking, snarky photo aside, of hyperinflation. Based on my calculations (and yes, these are real calculations, using real data for this plan collected for another project, not merely back-of-the-envelope estimates, however unlikely the very even numbers make it appear), an inflation rate of 10%, and assumptions for interest rate/asset return rate and salary increases over time which reflect the same net-of-inflation rates as at present, would halve the pension liabilities of the Illinois Teachers' Retirement System.

Sounds preposterous, I know. And admittedly, beyond all the ill-effects of high inflation, individual state governments don't control monetary policy anyway. But is it really any worse a proposal than the idea of selling the Illinois Tollway to a private firm which would do the dirty work of raising tolls so as to indirectly fund the pensions by making the tollway an attractive and profitable purchase? Or more ill-conceived a notion than the notion that public pensions can function perfectly well as pyramid schemes in which each cohort of employees funds their predecessors' benefits?

Or maybe the politicians of Illinois have some better idea? If so, I'm all ears.

I think Mrs. Bauer's argument is actuarial sound but it has more holes in it than Swiss cheese.

No doubt, a period of sustained high inflation over a long period will shrink pension liabilities as interest rates soar.

But what if we have a period of sustained low inflation reverting to a prolonged deflationary era where rates on Treasuries notes fall to zero or go negative? This is my macro scenario and it's based on the reality we are witnessing in many countries outside the US right now.

There's this naive notion that if Bernie Sanders or Elizabeth Warren win in 2020, MMT will rule the day and high inflation will magically reappear over the next decade. I don't buy that for a second. And don't be surprised if neither of them win or if Trump gets re-elected. At this point, it's a crapshoot.

This is why I prefer to live in reality and my proposals for Illinois and other chronically underfunded US public pensions are the following:

• Make all contribution holidays constitutionally illegal.
• Lower discount rate from 7-8% to 6% or lower to reflect real cost of liabilities over long run.
• Adopt Canadian-style pension governance (separate the government from public pensions).
• Adopt conditional inflation protection immediately and never guarantee COLAs, ever.

That last one sounds like I'm all for cutting benefits but that's not the case.

Go back to read a comment I wrote on how the fully funded Ontario Teachers' Pension Plan adopted conditional inflation protection to make it young again.

As public pensions mature, the ratio of retired to active members grows, so it makes sense to temporarily partially or fully reduce cost-of-living-adjustments to bring a plan back to fully funded status.

For retired members, the change to their monthly benefits is minimal for a short period and this ensures inter-generational equity in a plan. If there are more retired than active members, it makes sense they shoulder more of the deficit for a short period.

Once a plan recovers and is fully funded, they can then fully restore the cost-of-living adjustments.

I realize this isn't a defined-benefit plan with full indexing guarantees and more of a target benefit plan depending on the funded status of the plan but long gone are the days of guaranteeing COLAs to public pensions.

Look at Illinois. That guaranteed 3% increase compounding cost of living adjustment (no matter the if the actual rate of inflation is lower) is just insane, a recipe for disaster.

Of course, public-sector unions will fight tooth and nail for this but it makes no sense whatsoever and as Illinois's pension woes grow, so will the exodus from the state. No rational person will want to live in a place where property taxes keep rising as public services keep shrinking to make up for rising pension shortfalls.

Is Illinois running out of time? I guess they can emit more pension obligation bonds to plug the $134 billion pension liabilities and pray stock markets return higher than their return targets over the long run but that's wishful thinking and all it does is kick the can down the road.

If you live in Illinois or another state where public pensions are grossly mismanaged and chronically underfunded, you need to really take note and wonder how bad things are going to get and how it will impact your quality of life.

Below, Sean Carney, head of municipal strategy at BlackRock, and Bloomberg's Flynn McRoberts examine the new revenue plan for the state of Illinois as it faces mounting pension liabilities. They speak on "Bloomberg Daybreak: Americas."

Also, an interview with Mark Glennon, founder and Executive Editor of WirePoints, an online publication focusing on financial and political issues. He shares his views on what he sees as the key issues facing Illinois' financial future, on Governor Pritzker's proposed Progressive Income tax, and on the problems of pension funding.

Lastly, the right-wing Illinois Policy think tank says the state crafted the solution to its pension crisis nearly 20 years ago. That’s when lawmakers passed an inspired retirement plan that gave state university workers an alternative to the traditional pension plan, one that offered more flexibility, portability and individual control.

As I've explained many times, the brutal truth on defined-contribution plans (401 Ks) is they are FAR WORSE than defined-benefit plans, so I would ignore these idiotic policies which are "fairer" to taxpayers. That's very short-term thinking which will only make things worse in the long run.