Month: June 2019

Originally published at Forbes.com on June 7, 2019.

Earlier this week, I shared with readers the ill-fated attempt to reform Illinois pensions by requiring local school districts to pay the added costs of their teachers’ pensions when they boost their salaries beyond 3% per year; this measure was slipped into last year’s last-minute budget and removed (restoring the old 6% limit) in this year’s last-minute budget, in a demonstration of the intractability of Illinois’ pension woes so long as the guarantee of future accruals and future increases remains in the state constitution.

As it happens, that’s not the first time that legislators have cobbled together reforms which fail to accomplish their objective.

Readers who are employed by large corporations and have been around for a while likely have experienced the joy of being told that their employer is changing the terms of their retirement benefits program, either switching to a “cash balance” benefit, reducing the generosity of a defined benefit program going forward, being offered the opportunity to switch to a 401(k), or simply being told that the pension plan is being frozen and replaced by a 401(k).  (Have less seniority? Ask your older co-workers.)  From an employee perspective, this might appear to come out of nowhere, but these changes would invariably have been preceded by extensive modeling and calculations by a plan’s actuaries, to calculate the impact on pension accounting and funding requirements and the impact on participants’ projected retirement income.  Yes, even if employees might not like the outcome and even if the results of the calculation were to determine that the new formula’s retirement income, while smaller, was tolerable enough, it remains the case that the actuaries did the math.

But these calculations did not occur in advance of Illinois’ implementation of its two prior reform attempts, the Tier 2 and Tier 3 plan changes to the benefit provisions for new hires.  Each of these was rushed through the state legislature without any consideration of its impacts, and offered short-term gains but at the risk of posing a “pension time bomb” that may turn out to have been no real solution at all.

The Tier 3 changes date to 2017.  The intent was to create a hybrid defined benefit/defined contribution system for new employees, but as Ted Dabrowski at Wirepoints reported in October 2018,

Tier 3 was shoved into the state’s omnibus budget bill back in July of 2017. It was one of the token gifts given to Republicans in exchange for their help in overriding Gov. Bruce Rauner’s veto of the 2018 budget.

Now, nearly a year and a half later, the Tier 3 hybrid plan hasn’t been implemented. And there’s little sign of any action on it. The law that originally created the plan needed lots of fixes for it to work, according to the state’s retirement systems. But the bill that makes those fixes has been stuck for months in the House Rules Committee. That’s where bills go to die.

The Tier 2 system dates further back; it covers all employees hired after 2010.  The precise details of the Tier 2 benefit program differ for each of the 5 state retirement systems (for teachers, state employees, university employees, judges, and legislators), and variations exist for the retirement programs for City of Chicago employees, and other public employees in Illinois, but there were three key changes in the Tier 2 benefits:

• Retirement age and minimum vesting service were increased;
• The Cost-of-Living adjustment was reduced from a fixed 3% per year to half the rate of inflation, and is additive rather than compounded (that is, if CPI is 3% for four years, your original benefit is increased by 4 times 1.5% rather than 1.03 x 1.03 x 1.03 x 1.03); and
• Pensionable pay is capped at a level that sits at $113,645 in 2018, but increase at a rate of half the rate of inflation.  (The legislators, not surprisingly, chose to apply neither this provision nor the COLA reduction to themselves or the judges.)

For the teachers, the impact of these provisions is harshest, especially bearing in mind that Illinois teachers (unlike those of 35 other states) do not participate in Social Security.  Illinois teachers do not vest in their benefits until reaching 10 years of service.  Their normal retirement benefit is not available until age 67; while they are eligible to retire at age 62, their benefit is reduced by 6% per year prior to age 67.  They contribute 9% of pay towards their benefits (though, roughly half the time, their local school district pays the cost as part of their contract), but (unlike the statutory requirements for private-sector plans which require employee contributions) they do not earn interest on their contributions, which comes into play for teachers who leave the state or leave teaching without a full career, and do not vest or have only a small vested benefit.

What’s more, the $113,645 pensionable pay cap may seem generous, but the effect of the below-inflation growth over time are damaging; the 2018 actuarial report uses a CPI assumption of 2.5% and an assumed wage growth of 4% (that is, with seniority- based and other increases stacked on top of this baseline).   What’s this mean?

• In 2018, the cap stood at $113,645, the average teacher’s wage was $71,845 and the average wage for teachers at retirement age (65 and up) was $89, 994.
• In 2027, the cap is projected to grow to $127,088, reaching a level below the average wage for teachers at retirement, which is projected to grow to $128,090.
• In 2035, the cap is projected to grow to $140,367, reaching a level essentially equal to the average wage for all teachers, at $139,946.
• And by 2050, the cap will have grown so slowly relative to teachers’ pay that it will only cover 67% of the average teacher’s salary, and 53% of the average for near-retirees.

All of these items, taken together, mean that the Tier 2 teachers, with their 9% contributions, and using the plan’s valuation assumptions, are actually subsidizing everyone else.  The actuaries calculate what’s called an “employer normal cost” — the present value of the coming year’s benefit accruals as a percent of pay, after subtracting out the employee contribution.  (You can find this on page 83 of the report.)  If you participate in a 401(k) plan with an employer contribution, you can compare these values.

In 2020, the employer normal cost for Tier 2 teachers was -1.75%.  Yes, that’s a negative sign.

Now, that number is a bit unfair, because Tier 2 teachers are younger, on average, than the group as a whole, and as they get older, due to the magic of Time-Value of Money, the value of their annual benefit accruals will increase.  In 2046, the final year of the actuary’s projection, this value improves to -1.04%.  What’s more, this calculation is based on a valuation interest rate of 7%.  If a more conservative bond rate were used (for example, 4%), the total normal cost, and the employer’s share, would both increase — a back-of-the-envelope calculation suggests that the total normal cost would increase by 50%, from 8% to 12%; subtract out the 9% employee contribution and you’ve got an employer normal cost of 3%.  Yes, this is better than nothing.  But, for a plan that’s supposed to be replacing Social Security and providing additional benefits besides, this is not sustainable.

So what’s this mean?

One the one hand, it’s a win for the state’s coffers.  The contribution schedule that is targeted at reaching a 90% funding level in the year 2045 relies in part on the plans’ liabilities growing more slowly than they otherwise would, due to the coming retirements of Tier I participants and the increasing growth in the Tier 2 workforce.  This leads to a bizarre situation in which the state of Illinois contributions, in the short term, do not even exceed the amount needed to hold the plans’ unfunded liabilities steady, yet the funded ratio increases steadily.  Taking all five plans together (page 111 of the consolidated report issued in April), unfunded liabilities that are forecast to reach $136,842 at the end of 2019, continue to climb to a peak of $145,860 in 2026 before finally beginning to decline year by year.  (Other factors are also at play, such as a contribution schedule that’s still phasing in to 50% of payroll, on average across plans.)

But here’s why this situation is called a “time bomb”:  in order for a public pension plan to opt out of Social Security, minimum benefit requirements must be met.  Here’s a News-Gazette report from this past March:

The concern, however, is that Illinois teachers do not participate in Social Security. Federal law allows state and municipal governments to do that, as long as the benefits they pay out are at least equal to what Social Security pays, a law known as the “safe harbor” provision.

But Andrew Bodewes, TRS’ legislative director, told the panel that because of the small cost-of-living increases built into Tier 2, those pensions soon are likely to fail to meet the federal adequacy test.

 “So that means once the Tier 2 teachers are retiring, each and every school district will have to perform a test on that member to see if they get a benefit at least as good as Social Security,” he said. “And if they don’t, they (the school districts) will have to enroll in Social Security. They’ll have to enroll going backwards.”

That means school districts would have to make as much as 10 years’ worth of back payments into Social Security.

That article expressed hopes for reform legislation this year — which, of course, did not happen in the May legislative frenzy, and continues to be deferred.  And, again, improving benefits for Tier 2 employees with no means of modifying the Tier 1 benefits will simply further increase costs.

So it’s a cautionary tale — reform is great.  But for Pete’s sake, do the math first!

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.