Jane the Actuary Retirement

Forbes post, “Counting Chickens Before They’re Hatched: Will Illinois Botch Pension Consolidation?”

Originally published at Forbes.com on November 14, 2019.

 

Not much more than a month ago, Illinois Gov. JB Pritzker’s task force released its report recommending that asset management at the 650-odd pension funds be consolidated, while leaving benefit administration (and jobs, and decision-making about disability-eligibility) to the local entities.

And when Illinois doesn’t drag its feet on making changes due to inter- or intra-party squabbles or the desire to avoid making any hard choices, when its politicians think they’ve found a free lunch, they rush headlong into it. The Chicago Tribune reported last night that

“The Illinois House voted overwhelmingly Wednesday to approve Gov. J.B. Pritzker’s plan to consolidate nearly 650 local pension funds for suburban and downstate police officers and firefighters.

“The measure, which was approved on a bipartisan vote of 96-14, now goes to the Senate. If that chamber approves the bill before adjourning Thursday, it would hand another victory to Pritzker after he accomplished nearly all of his legislative priorities in the spring.”

Now, the fundamental concept of consolidation is entirely reasonable – as it is, the smallest of pension plans see lower asset returns because of investment restrictions and comparatively high expenses, which should be solved with consolidation. In the best case, they should see returns of as much as 2 percentage points higher in a consolidated system due to economies of scale.

But Ted Dabrowski and John Klingner at Wirepoints point to a serious concern not being reported elsewhere, an additional boost in benefits:

“[I]t makes sense to pool the funds of the 650 pension plans in an attempt to increase investment returns and lower transaction fees. Everything else equal, not doing so would be irresponsible.

“But the consolidation bill being debated on the floor today isn’t just about consolidation of fund assets. It’s also become a vehicle for changes to pension benefits, with increases for Tier 2 public safety workers. Pensions are the biggest issue that the state faces – and lawmakers are about to make significant changes with no debate as to their merits and no public actuarial analysis calculating their cost.”

More specifically, the bill – by means of deleting two words and changing two numbers – changes the averaging period for Tier 2 worker (hired 2011 and later) from 8 years to 4 years, and modifies the pensionable pay cap increase rate from half of CPI to the full CPI (with a maximum of 3%). (See page 73 of the Amendment 5 text.) This latter change in particular remedies an element of Illinois pensions which would otherwise, over time, have a particularly harsh impact as the real, inflation-adjusted level of the cap declines from year to year.

And I’ve written repeatedly that Tier 2 benefits for all Illinois workers need reform. But, as Dabrowski and Klingner write,

“For sure, benefits for Tier 2 workers – those who started work after January 2011 – will at some point have to be fixed. We’ve written about that in the past. It’s a real mess.

“But this bill is not the place to do it. If Tier 2 is changed, it should be part of a dedicated pension reform bill that fixes all the funds at once, not snuck in as part of unrelated legislation.

“Supporters of the Tier 2 reform in the bill argue that the costs of the increased benefits – estimated at some $70 to $95 million over the first five years – are covered by the expected higher investment returns generated as a result of consolidation.

“But higher returns aren’t guaranteed by the bill. Yes, the consolidated funds will be able to take more risks in the stock market – but those greater risks can lead to better returns or bigger losses.”

The pair also point out that this sets a precedent for simply increasing Tier 2 generosity in other systems without any sort of funding. What’s more, this was done without any concrete analysis of the degree to which the various Tier 2 benefits – for teachers, state and municipal workers, and public safety worker statewide – are in violation of Social Security’s “safe harbor” laws, analysis which has never taken place for any of these benefits.

Now, I myself should acknowledge that in my prior article on the pending consolidation, I was perhaps overly excited by the task force’s acknowledgement of this issue, so as to not recognize at the time the danger of pairing the consolidation with a benefit enhancement.

But the folks at Wirepoints are right – this has the potential from going from a success story to yet another cautionary tale of Illinois’s bad governance.

UPDATE:

As of this (Thursday) morning, the State Senate has now approved the pension consolidation bill. However, as the State Journal-Register reports, various Republican Senators did object to the Tier 2 enhancements, and specifically, the lack of analysis:

“The cost of those changes is estimated at $75 million to $90 million over a five-year period.

“‘I have not found any taxpayer who wants to enhance pension benefits,’ said Sen. Jason Barickman, R-Bloomington. ‘The IRS has not told us we have to do this.’

“He also said the estimated cost of the enhancements did not come from an actuary and thus may not be accurate.

“’We are going to continue to pass enhancements without knowing how much they cost,’ he said.

“’It’s a classic Springfield solution that has led to underfunding of pensions across the board,’ added Sen. Dale Righter, R-Mattoon. ‘Increase benefits, but not put in place any mechanism to require contributions to increase. The difference is going to be made up by a savings figure given to us by the governor’s Office of Management and Budget.’”

There are also two ways in which the cost of these enhancements is not as simple as a liability increase figure.

In the first place, all these pension systems are placed on a funding schedule to reach 90% funding at some point in the 2040s or 2050s, varying by plan. But the Tier 2 liabilities will become an ever greater share of the liabilities, so the relatively small portion of the liability attributable to them in 2019 is not a meaningful measure of the long-term impact of restoring the benefit reductions for new hires.

In the second place, the “savings” due to increased investment earnings will not be shared by all police and fire plans uniformly; plans for larger cities will gain less because they are now in a better position than the smaller-asset plans. This means that the rationale that “we’re just applying some of the increased investment revenue to fund better benefits” only works for those smaller plans, rather than all plans statewide.

So good job, Illinois – in confirming you still don’t have your act together.

 

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, ” More Cautionary Tales From Illinois: Tier II Pensions (And Why Actuaries Matter)”

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.