August 2017 | Illinois politicians again go through the motions, enacting pension law changes that don’t address the problem of underfunded public pensions.
In our January 2017 newsletter (“When assuming a ladder won’t work. Time for a reality check on pensions.”), we discussed the problems with actuarial assumptions for defined benefit pension plans.
- A plan of reorganization of the struggling Central States Pension Fund had been rejected by the U.S. Treasury Department because the assumed 7.5% rate of return was found to be unrealistic.
- The Dallas Police and Fire Pension System had experienced a run in pension assets when it allowed retirees to take lump sum distributions and reinvest the money in segregated accounts with a guaranteed 8% rate of return. Investment returns couldn’t keep up with the guarantees.
Meanwhile back in Illinois, the State’s largest pension plan, the Teacher’s Retirement System (TRS), had also been assuming a 7.5% rate of return. Reality intervened in 2016 when the investment return for fiscal year 2016 was 0.1%. The Civic Federation reported that “no major public pension fund in the U.S. had reported FY 2016 returns of more than 1.5%.” 1
The article also reported that the assumed rates of returns for TRS and SERS (State Employees Retirement System) had been reduced from 7.5% and 7.25% to 7.0%, and life expectancy projections had been increased. These factors, along with investment returns below the assumed rate, combined to balloon the State’s unfunded pension liability.
Here is the history of the unfunded liabilities of the 5 state pension funds ($, Billions).
It should be noted that the Federal Reserve’s interest rate suppression started in 2009 and continued through 2016. The associated decreases in expected rates of return have not yet been reflected in the calculation of the present value of pension liabilities. Look out below when this happens.
Illinois budgetary follies and pension legislation
Because of disagreements over how to balance the budget, Illinois did not have one for fiscal years 2016 and 2017. (The fiscal years ended 6/30/2016 and 6/30/2017.) Under threat of the State’s credit rating being downgraded, a fiscal year 2018 budget was approved on 7/6/2017.
Most of the press coverage was about the budgetary impasse. Changes to public pension law were in enacted at the same time in Public Act 100-0023, but they received scant coverage in the media. Here is a summary of key provisions.
Better disclosure of actuarial assumptions
“The Board shall recalculate and recertify to the State Actuary, the Governor, and the General Assembly the amount of the State contribution to the System for State fiscal year 2018 . . . . . . “
“The State Actuary shall review the assumptions and valuation underlying the Board’s revised certification and issue a preliminary report concerning the proposed recertification and identifying, if necessary, recommended changes in actuarial assumptions that the Board must consider before finalizing its certification of the required State contributions.”
“The Board’s final certification must note any deviations from the State Actuary’s recommended changes, the reason or reasons for not following the State Actuary’s recommended changes, and the fiscal impact of not following the State Actuary’s recommended changes on the required State Contribution.”
This sounds like a good try at transparency, but there is a big gap between theory and practice. There is enormous pressure on state actuaries to keep the discount rates used in computing the present value of pension liabilities high. A higher than appropriate discount rate equates to a lower than appropriate present value calculation for unfunded liabilities.
If unfunded liabilities were to balloon, states would face credit downgrades, raising borrowing costs. As a result, actuaries tend to operate as a herd and lag developments in the economy. No one wants to be the person who points out that the emperor has no clothes (or no pension funding).
This lag can be demonstrated by comparing pension plan interest rate assumptions to U.S. Treasury rates from 2001 to 2014. The interest rate assumptions are for the 126 largest public pension plans.2
Here we have long-term bond rates going down by about 50% and pension plan interest rates assumptions barely budge. The change is even more pronounced if the comparison is to 2-year U.S. Treasury rates. Average 2-year treasury rates decreased by 86%.
It should be clear that there will be reductions in the rates used to compute the present values of unfunded pension liabilities. At least the Illinois politicians will be able to point their fingers at the actuaries for leading them astray.
The new law allows for slow motion adjustments to State pension contributions after changes in actuarial assumptions.
“A change in the actuarial or investment assumption that increases or decreases the required State contribution and first applies in State fiscal year 2018 or thereafter shall be implemented in equal annual amounts over a 5-year period beginning in the State fiscal year in which the actuarial change first applied to the State contribution.”
If the State has increases in unfunded pension liabilities as the result of an expected reduction in assumed rates of return, there is a 5-year phase-in period before the increase is reflected in the State’s contribution to the pension funds. This is yet another example of kicking the can down the road. The history of these pensions is that the State never catches up when the funding of contributions is deferred.
Some of the pension contributions of highly compensated employees of school districts will be the responsibility of the school districts, not the State.
“(i-5) For school years beginning on or after July 1, 2017, if the amount of a participant’s salary for any school year, determined on a full-time equivalent basis, exceeds the amount of the salary set for the Governor, the participant’s employer shall pay to the System, in addition to all other payment required under this Section and in accordance with guidelines established by the System, and amount determined by the System to be equal to the employer normal cost, as established by the System and expressed as a total percentage of payroll multiplied by the amount of salary in excess of the amount of the salary set for the Governor.”
In 2016 the State had 63,000 government employees making more than $100,000. 3
|Teachers and administrators||20,295|
|College & university employees||9,576|
|State of Illinois employees||8,640|
|Small town city & village employees||8.817|
School employees (secondary and college) amount to 47.4% of the total.
The idea of forcing financial responsibility for pensions down to local taxing districts should have been done long ago, but using the Governor’s salary as the reference point makes this provision ineffective. Governor Rauner’s salary is set at $177,412 (even though he is currently taking $1/year). This provision in the law looks like it was designed to be ineffective.
High compensation of government employees goes hand in hand with high pension costs. Had the State of Illinois not assumed the liability for funding teacher and university employees’ pensions, budget limitations at the local level would have acted as a brake on salaries and wages.
It should also be noted that the State is not responsible for funding the pensions of Chicago employees or the pensions of small town city and village employees. These claims may be adjusted in bankruptcy as was the case in Detroit.
Public Act 100-0023 will not generate confidence amount Illinois taxpayers that things are moving in the right direction.
- “State of Illinois Pension Contributions to Increase Significantly in FY 2018”, September 9, 2016.
- State of Illinois, Office of the Auditor General, State Actuary’s Report, “The Actuarial Assumptions of that Five State Funded Retirement Systems,” December 2014.
- “Why Illinois is in Trouble – 63,000 Public Employees with $100,000+ Salaries Cost Taxpayers $10B,” Adam Andrzejewski, Forbes.com, July 25, 2017.