Monday, July 11, 2011

What Will Be Illinois' Next Move Regarding Its Public Pensions' Liabilities?

Public Act 88-593 (the 1995 Funding Law) requires the state-funded retirement systems in Illinois to attain a 90-percent funding ratio by Fiscal Year 2045, and the Commission on Government Forecasting and Accountability (CoGFA, March 2011) claims that “any decrease in the 90-percent funding ratio would adversely impact both the State’s credit rating (resulting in higher costs to the State) and the State’s ultimate ability to adequately fund its pension obligations.” (It is important to note that last May, only 15 states had a funded ratio over 70 percent; the average funding ratio overall was 63 percent; the highest funding rate belonged to Wisconsin at 88 percent) (Barclays Capital, May 2011).

Funded ratios measure the portion of a retirement plan’s liabilities covered by assets. According to the Center for Retirement Research at Boston College (CRR, July 2011), “the funded ratio – plan assets divided by the actuarial accrued liability – is a snapshot of the plan’s funding status at a given moment in time.” To look at this in another way, it would mean that a fully-funded retirement system would have enough assets to pay all benefits earned to date to all of its members, both current and retired.

Nevertheless, CoGFA argues that a 90-percent funding ratio is necessary even though an analysis of U.S. state and local government pension obligations from Fitch Ratings (February, 2011) states that a 70-percent funding ratio is adequate when based on a “rolling five-year average of market value of assets,” and one CRR report (May, 2011) finds that on average state and local funded ratios are approximately 77 percent; an earlier CRR report (March 2011) claims that most retirement systems will remain sustainable until 2041, given a rate of return at eight percent and consistent, actuarial-required contributions from both state and public employees. In view of these aforementioned funding-ratio paradoxes, should the State of Illinois decrease its discount rate and, therefore, its funding ratio?

To decrease the funding ratio would mean the State’s contribution would increase to the pension system’s plans. Furthermore, the State believes that its recent pension reform, Public Act 96-0889 or Senate Bill 1946 (the Two-Tier System for new hires in 2011), will enable the State to reduce its contribution “by $71 billion” (CoGFA). (SB 1946 passed on March 24, 2010 to prevent Illinois from being “viewed negatively by the ratings agencies and the market as a whole,” which would have resulted in lowered credit ratings and increased borrowing costs. The State of Illinois needed $100 billion to avoid undesirable ratings and projected that SB 1946 would allow the State to save $100 billion by 2045. Governor Quinn signed the bill into law on April 14th).

Now consider that CoGFA remarks that “adhering to the pension funding schedule set forth by Public Act 88-593 will continue to remain the most significant fiscal challenge for the State of Illinois… The single largest driver of the growth in the unfunded liabilities has been insufficient employer contributions…, insufficient investment returns [and inflation], benefit increases, changes in actuarial assumptions, and other miscellaneous demographic factors” such as salary growth, retiree longevity, and the length of employee service.

Even so, ponder further that in determining actuarial accrued liability, the majority of states use an entry-age method. As stated by the Center for State and Local Government Excellence (May 2008), “the entry-age method recognizes a larger accumulated pension obligation for active employees than the projected-unit credit and generally requires larger annual contributions… Sponsors that opt for the ‘cheaper’ funding regime – namely the projected-unit credit – may be less committed to funding their plans and, therefore, less likely to make the full annual-required contribution.”  Yes, the State of Illinois uses the projected-unit credit actuarial cost method.

Add to this realization that Illinois has adopted asset smoothing (Senate Bill 1292) to determine the actuarial value of its plan assets. (The asset smoothing method uses expected returns on the asset mix and averages both past and anticipated asset values, generally over a period of five years). Now add to this combination the 2008-09 market collapse that significantly reduced the value of all retirement systems’ assets across the country and decades of not fully funding the Illinois pension systems, and one can easily see that the past five years would include profound, negative returns in the State’s assessment of its retirement systems.

The solutions for the current economic situation in Illinois, according to CoGFA, include lowering the assumed rate of investment return and keeping the funding ratio at 90 percent, nevertheless; moreover, this Commission maintains that unfunded plans “require contributions to pay for benefits that are currently being accrued as well as to eliminate the shortfall between assets and accrued liabilities.”

Questions need to be forwarded. Besides Tyrone Fahner and the Civic Committees’ (Illinois Is Broke) recent attempt to compel all current employees into a tier-three defined-contribution plan (and perhaps reap the resultant financial gains) and the State’s attempt to offer tier-two and tier-three systems that would increase the retirement age and cap the maximum salary for benefit calculation for current teachers, will these optional tier systems and the increased contributions for public employees in tier one continue to be the legislative-funding strategy? Will this stratagem entail not only raising the active employees’ contribution rate but adjudicating that the State’s actuarial-required contribution becomes a “statutory” payment each year?

All the same, two important inquiries need to be answered: will any of these changes and contribution increases eliminate the pension debt or unfunded liability, and can the public trust legislators who can easily change the laws that they enact? The answer to both questions is "No."

Finally, two other critical uncertainties remain: will the state's policymakers eventually attempt to reduce or eradicate compounding the annual cost-of-living adjustments and, in the final analysis, will Illinois legislators forsake their sworn oaths to the State and U.S. constitutions and “let the courts decide” whether Article XIII, section 5 of the Constitution of the State of Illinois can be challenged once again? The answer to these questions is more than likely.

-Glen Brown

For further information and opinions regarding these issues, please also read the following posts: "Unfunded Liability and Sustainability of a Pension" (July 5); “SB 512, Illinois Is Broke, and the Chicago Tribune, et al. vs. Your Financial Security” (June 20); “What We Believe We know about the Sustainability of the TRS Pension” (June 10); “Sustainability of the Teachers’ Pension” (June 5); “Defined-Contribution Plan vs. Defined-Benefit Plan” (May 25); “Antedated Court Cases: Challenging the Pension Clause” (May 18); “The public pensions’ funding gap: three questions/three solutions” (May 14); and “Pensions: an Argument Regarding Sustainability” (April 28).

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