Jane the Actuary Retirement

Forbes post, “Public Pensions And Social Trust”

Originally published at Forbes.com on March 17, 2019.

 

So it seems that I hit the one-year mark of my writing on retirement at this platform, and have still not managed to address some of the topics I wanted to discuss, in particular, questions of what pensions look like abroad and what we can learn from them.  But right now I find myself thinking about international comparisons in another way, around the question of social trust.

Round about a year ago, Megan McArdle, formerly a Bloomberg columnist and now writing at the Washington Post, wrote a series of articles coming out of a visit to Denmark.  Her first, at Bloomberg (paywalled), expresses the gist of the article in its title, “You Can’t Have Denmark Without Danes; What a small, happy country can teach a huge and fractious one. And what it can’t.”  Fundamentally, Demark can do what it does and function as well as it does because of its considerable degree of social cohesion; a sense of cohesion that, to her understanding, was not the result of an expansive welfare state but a precondition for its success.  (She subsequently expanded on this in a series of tweets, though non-subscribers will miss out on what I vaguely recall, from pre-paywall days, to have been an anecdote about losing her wallet and having it returned.)

She subsequently wrote again on the topic of the Danes’ system of disability and the country’s level of social trust at the Washington Post, observing that it has very generous social insurance provision of such benefits as disability income replacement with neither the sort of cheating nor the fears of cheating that you’d see elsewhere, including, yes, the United States, where one periodically sees reports of city workers taking advantage of generous disability pay-replacement and being seen out and about engaging in all manner of activities that indicate their claims of incapacity are fraudulent.

“Social trust” is, well, what it sounds like: How much do you trust your neighbors? And in turn, how trustworthy are they? In a low-trust place such as Greece, people don’t trust their neighbors not to cheat, which in turn makes them more likely to cheat themselves, because why should you stay honest when everyone else is getting away with something? This affects everything: whether people pay their taxes, whether they take benefits they don’t really need, how easy it is to regulate companies. And social trust also works as a productivity booster, because you can do away with a lot of the cumbersome monitoring that is ubiquitous in modern societies — the supervisors who oversee low-level workers, the store clerks who keep an eye on the customers. Every worker who is not making sure that people don’t steal or shirk can be re-employed doing something that actually increases output.

The United States simply doesn’t have that level of trust. And while it would be nice to think that we could get there if companies and government simply stopped acting so suspicious, the fact is that they frequently act suspicious because, well, Americans cheat more than Danes do. (Compare, for example, the American and Danish rates of tax evasion). Moreover, the mutual suspicion that Americans feel for each other restricts the range of politically feasible policies. Even if people aren’t cheating on benefits, if there is a widespread social belief that your fellow citizens might, you will not be willing to support a generous welfare state. (This helps explain why support is highest for old-age benefits in the United States; it’s hard to fake turning 65).

I find myself revisiting this article in light of both my own articles on prospects for public pension reform in Illinois (among others, my own proposal for reform and  my pessimism that Illinois politicians even recognize the importance of pension funding in the first place) and models for improved systems such as Wisconsin’s (and — spoiler alert — there are other systems with risk-sharing elements which I’ll profile soon) as well as the politics around Illinois Gov. JB Pritzker’s proposal for a graduated income tax.  In both cases, any such legislation requires amendments to the constitution Illinois adopted in 1970.  And in both cases, Illinois faces a lack of social trust.

Does a statement about public employee pensions belong in the constitution?  As it turns out, Illinois is only one of two states (the other is New York) with an explicit guarantee protecting future accruals.  (Others guarantee this by means of state supreme court decisions.)  Does it make sense to prohibit a graduated form to an income tax in a state constitution? Illinois, Michigan, and Massachusetts are the only ones which do so.   (North Carolina passed an amendment capping income tax rates to 7% in November 2018; in a peculiar turn of events, this was overturned in a February court decision because of the claim by plaintiffs that the state legislature was invalidly gerrymandered.  The decision is being appealed.)

As the Chicago Tribune reported in 2013, no thought was given in the 1970 discussions to the question of funding those pensions:

In short, state and local governments would be required to keep their pension promises but not be required to sock away enough money to cover payments years into the future. When it came to funding, officials of both parties in Illinois took significant advantage of the escape clause, helping them skate by for decades without having to make politically difficult decisions on raising revenues or cutting services to meet pension obligations.

In May 1971, just weeks before the new constitution would go in effect, an official state pension oversight panel of lawmakers and laymen issued a report warning that the new pension safeguards were a mistake.

The Illinois Public Employees Pension Laws Commission, which no longer exists, said it had opposed the language inserted into the constitution and had asked one of the sponsors to soften it or at least read a statement into the convention record that it wouldn’t preclude “a reserved legislative power” to change benefits in order to keep retirement plans sound.

Nothing came of the request, the report noted.

As it happens, I’m on record in support of removing both these clauses from the Illinois constitution in one fell swoop.

But to raise the issue of a change to the constitution in either of these respects raises fears:  how can we trust the legislature to use their newly-expanded powers reasonably, sensibly, justly?  Republicans will cut the pensions of hapless retirees!  Democrats will recklessly raise taxes!  In comments at my personal website JaneTheActuary.com and via Twitter @JanetheActuary, readers told me that they simply could not believe that Illinois politicians would make the hard political decisions needed to reform pensions, when it would cost them votes and would cost them campaign funds.  And similarly with respect to the proposed income tax amendment, opponents raise objections that this is just Pritzker’s opening bid, but that, once the limits on graduated income taxation are removed, the Democratic supermajority will be unfettered in its tax-and-spending spree.

It is, in the end, the fruit of a long history of corruption in Chicago/Chicagoland and Illinois.  After all, just this past February, the Chicago area was named the most corrupt in the nation, based on its share of corruption convictions.  Statewide, Illinoisians can now breathe a sigh of relief that our past two governors appear not to have been criminals, unlike their two predecessors.  Reforming pensions and instituting risk-sharing mechanisms simply can’t happen if Illinois voters don’t trust that their politicians will seek to make fair decisions.

 

 

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.

Jane the Actuary Retirement

Forbes post, “Three Steps To Fixing Illinois’ Pension Crisis”

Originally published at Forbes.com on Febraury 26, 2019.

 

If this were a clickbait article, I’d have titled it “three easy steps” or “one weird trick” or the like.

But the fact of the matter is that as much as I’ll break down the necessary solutions into three steps, they are not easy.  They are, in fact, difficult, and will require real sacrifice and the expenditure of political capital rather than platitudes, because, however much Gov. Pritzker might wish otherwise, there are no “weird tricks” (asset transfers, re-amortizations, pension bonds) to escape the problem.

But here’s a reminder of the seriousness of the problem, even if Pritzker and his allies think it can be dealt with by accounting games:  an article yesterday from The Bond Buyer, “Why Illinois budget proposal raises new rating concerns.”

 Illinois has faced deeper deficits and its bill backlog has been cut in half from its high of $15.7 billion in November 2017, but it no longer has room for any missteps that could lead to a downgrade.

 Moody’s Investors Service and S&P Global Ratings have the state at the lowest investment grade rating; both assign a stable outlook. Fitch Ratings has Illinois two notches above junk and assigns a negative outlook.

The MMA report warns that the risks associated with the uncertainties over the valuation of asset transfers and the arbitrage gamble on POBs are ideas that “can become gimmicks that pose credit negatives potent enough — scaled to management’s desperation to shape its spreadsheets — to smother the plan’s benefits to the state’s credit profile.”

The article further highlights the ways in which the governor’s proposed can-kicking actions risk bringing the state’s bond ratings down below investment grade.  However much Pritzker, Hynes, etc., might wish it to be otherwise, however much they appear to see funding requirements as nothing more than a nuisance, they should trust that the experts in the matter, who say that it matters vitally, are right.

That being said, here are the three steps.  Not “easy steps.”  Difficult steps.

Step 1:  Provide a benefit to new employees which is both fair, financially-sustainable, and fully funded from Day One.

What does this mean?

To begin with, Illinois is one of 15 states whose teachers do not participate in Social Security.  Neither do state university employees.  (A majority, but not all, of the state employees do participate.)   This needs to change.  However much Social Security has its own issues, all public employees should participate in its basic safety net programs just as the rest of us do.

Next, the retirement benefit provided by the state should be

  • Fixed and defined at the time of accrual;
  • Obligatorily-contributed at that point with consequences as severe as skipping a paycheck;
  • Accrued in an even way over the course of the employee’s career rather than backloaded (see “Pension Plan 101: What Is Backloading And Why Does It Matter?“); and
  • Vested within a timeframe that’s short enough not to impair the ability of job-changers to accumulate retirement income.

Yes, a defined contribution, 401(k)-equivalent plan meets all these requirements.  But that’s not the only option.  Wisconsin’s public retirement system (subject of a forthcoming article) includes risk-sharing mechanisms that accomplish some of these objectives while still pooling risk among participants.  Other proposals exist, as well as a proposed modernized multi-employer plan design (also a now-draft article), with the intention of removing risk from plan sponsors and ensuring that they make the required contributions, when required, while creating risk-sharing and risk-smoothing among participants.

It may also be the case that Tier II employees, hired in 2011 or later, especially teachers who in the current system are actually subsidizing everyone else, want in on the new system, and this can be sorted out as well, not least because over time the decline in the real value of their pensionable pay cap will affect more and more participants.

Step 2:  Reform benefit provisions for existing participants to reduce liabilities in a fair and responsible manner.

This does not mean across the board cuts.  There are a menu of possible options available, which preserve the dollar value of participants’ benefits.

At present, all participants, except those hired in 2011 or later, are guaranteed 3% annual benefit adjustments on their entire retirement income, regardless of the year’s actual inflation.  It should go without saying that the very first benefit reform is to replace the fixed 3% with a true CPI adjustment with a maximum of 3%.  A benefit reform could also include COLA holidays for those employees who have benefitted from the above-inflation increases of the past, to reset their benefits over time, in inflation-adjusted terms, to something resembling what they’d have, absent this generous provision.

In addition, when Rhode Island reformed its pension, they created a cap, so that only the first $25,000 in pension income is COLA-adjusted each year.  Such a cap — which might reasonably be set at the level of a typical Social Security benefit, to mirror private sector employees’ retirement income — would provide protection for retirees at a more sustainable cost for the state.

Here’s another potential benefit reform:  eliminate the generous early-retirement eligibilities and move everyone onto the same retirement schedule as the Tier II employees.  Yes, this will require a commitment by the state to reassign to desk jobs and make appropriate accommodations for arduous-occupation employees who would have simply retired at young ages in the past, but it’s a reform that will eliminate the tremendous disparities between these employees and, well, everyone else.

And finally, the core benefit formula itself is considerably richer than a typical private sector plan ever was, even taking Social Security benefits into account.  If the above changes are insufficient to play their part in shoring up the system, then the core benefit formula might need to be reduced, in a manner that protects accrued benefits; for example, the formula might be the greater of 1.8% per year of service with final pay, or 2.2% per year of service with pay as of the date of the enactment of the reform.

As it happens, there has been a bill filed by Rep. Deanne Mazzochi of Westmont, which proposes to amend the state constitution to enable just these sorts of reforms, with a provision that, per the bill synopsis,

limits the benefits that are not subject to diminishment or impairment to accrued and payable benefits [and p]rovides that nothing in the provision shall be construed to limit the power of the General Assembly to make changes to future benefit accruals or benefits not yet payable, including for existing members of any public pension or public retirement system.

(What specific changes Rep. Mazzochi has in mind I can’t say; these are only my personal recommendations.)

Is Gov. Pritzker championing this proposal?  No, of course not.  But he should.

Step 3:  Deal with legacy debt.

Step one moves future employees into a new system.  Step two moves current benefits from the current overpromised, overgenerous levels to a more sustainable structure.  These two moves eliminate the “pay-as-you-go” mindset which appears to have taken hold, and make it clear that what’s left is legacy debt, and should be treated no differently than any other debt.  That debt will need to be paid off/prefunded over time, in a way that’s fair to future generations without causing undue harm to taxpayers right now.

Will the state raise taxes?  If yes, then the state should choose equitable and transparent methods of doing so, rather than a hidden tax of, for example, selling (long-term leasing) the tollway and authorizing exorbitant tolls.

Will the state issue bonds?  If yes, then those bonds should be used to purchase annuities for retirees in a manner similar to private-sector plan sponsors, rather than promising that the bonds will pay for themselves through investment returns.

In no event should the state simply plan to defer pension funding to some future time of imagined greater wealth, by claiming that money spent now on infrastructure or business-development programs are “investments” which will pay dividends.  Illinois is losing, not gaining population, and it’s wrong for politicians to shrug this off, claim their policy solutions will bring a brighter (and more populous) future, and risk saddling an even-smaller population with larger per-capita debt.

So there it is:  three steps.  Three very difficult but necessary steps.

 

 

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.