…Underfunded Retirement Promises Are Crowding Out
Other Needs
It is
widely recognized that Illinois has the worst unfunded pension liability of any
state. Its five retirement systems had a total of $85 billion in unfunded
liability in 2011, and the figure has increased since then. Dealing with some
of the lowest funded ratios of public pensions in the nation has contributed to
the state’s ongoing fiscal crisis. Illinois’ pension problems were cited by
Moody’s Investors Service when it downgraded the state’s bond ratings in
January 2012, making Illinois’ credit rating the lowest of all fifty states.
However, Illinois has done nothing to reform state employee pensions since that
time, and it is doubtful that anything will happen before 2013…
The
primary cause of the state pension systems’ underfunding is that the state does
not impose the same obligation on itself that it imposes on local governments,
and for decades its employer contributions have been below annually required amounts.
Illinois has planned so poorly that it had to borrow to make its scheduled
pension contributions for FY 2010 and 2011, which were below the ARC amount. State
leaders vowed to make the entire FY 2012 pension payment without issuing bonds,
but as of the development of this report it is unclear whether Illinois has
made its complete pension contributions to all the systems for the fiscal year
that just ended or whether part of the FY 2012 pension contributions are among
the $7.5 to 8.0 billion in unpaid bills that are being carried into FY 2013.
The
Way Pension Costs Are Reported Can Obscure the Problem
Illinois’
pension systems are likely in a more dire fiscal condition than they seem.
Illinois’ three largest pension systems discount future pension liabilities
using an assumed rate of return on investments of around 8 percent. Since the
financial crisis, ongoing economic instability in Europe, and worries of a
double-dip recession, many believe that this assumed rate of return is overly
optimistic. Most state pension systems have exceeded an 8 percent rate of
return over the past several decades, but the rates have been much lower in
recent years.
Lower
discount rates will soon be required in Illinois and other states. Under new
rules approved by the Governmental Accounting Standards Board (GASB) in June
2012, Illinois will be required to report liabilities using “market rates,”
which are typically closer to 5 percent. Although this change will no doubt
have a positive impact by more accurately estimating the level of state
liabilities, it reveals an even more precarious financial position. For
example, “[u]nder the new rules, the Illinois Teachers’ Pension System [TRS],
one of the country’s worst funded, would have shown just an 18 percent funding ratio
as of July 2010.”
Finally,
some state obligations were not reported at all until recently. Since
liabilities for retiree healthcare (“other postemployment benefits” or OPEB)
were only reported after GASB Statement 45 was implemented in FY 2008, long-term
trend data are not available. However, even using only recent reports, it is
clear that Illinois’ OPEB liability is large and increasing more than a billion
per year. Illinois’ Unfunded Actuarial Accrued Liability (UAAL) for other
post-employment benefits was $33.3 billion as of June 2011…
Background
and History
…Illinois’
pension systems date to the 1940s, and since 1970 the state constitution has
protected employees’ benefits. Nearly 80 percent of workers covered by
Illinois’ state pension plans are not eligible for Social Security. In the
1990s, national surveys found that Illinois’ pension benefits were not generous
compared to other states. Offsetting the relatively low benefits, Illinois has
historically provided greater financial support for healthcare benefits to
retirees than most other states and has been one of the few states that
provides and funds disability benefits.
Underfunding
of the Illinois pensions systems dates to the early 1980s. Until that time, the
policy was that the state made sufficient contributions to cover annuitants’
benefits, while the employees’ contributions and investment income were used to
build future reserves. There was no actuarial basis for this system, but it did
sustain the pensions. Fiscal stress in 1981 led Illinois to abandon this
policy. State contributions plummeted in 1982 and 1983 and increased very
modestly for the next decade, although annuitants’ benefits payments grew
dramatically. Between 1981 and 1995, the state’s pension contributions
increased 28 percent, but benefits expenditures increased by a factor of almost
4.5, and unfunded liabilities escalated. In 1995, the funded ratio for the five
systems combined was only 53 percent.
Recognizing
the Problem but Putting Off the Painful Solution for Years
In
1994, Illinois established a plan to bring the pension systems to 90 percent
funding by 2045. This “fifty year plan” has guided the funding of the pensions
up to the present. However, the scheduled contributions are less than the ARC —
also known as “normal cost plus interest” — meaning that even if the state
makes payments as scheduled in the 1995 plan, unfunded liabilities continue to
grow.
This
is another reason why it is hard to see the true picture of Illinois’ pension
problem. Much of the budgetary discussion of pensions in the state is the
“scheduled” payments and few understand the more important concept of the ARC. The
financial condition of the pension systems improved during the late 1990s, as
the booming economy helped increase the five systems’ combined funded ratio to
about 70 percent. But during this time, benefits were expanded as well.
In
2000, the pension systems were relatively sound, but the economic recession of
2000-2003 was disastrous for the systems’ asset values. The funded ratio for
the five systems combined plummeted to 49 percent in 2003. In response, pension
benefits were reduced, the state issued $10 billion in bonds (of which $7.3
billion went to the pension systems), and legislation was enacted allowing a
“partial pension holiday” for FYs 2006 and 2007. Although the intent of
borrowing was to reduce unfunded liabilities, the statute was written such that
the required contributions going forward included the amount of debt service on
these bonds, which reduced the amount actually contributed to the pensions and
worsened the chronic underfunding. The 2006 and 2007 contributions made during
the pension holidays were only about half the amount required based on
actuarial calculations. So the financial condition of the pensions continued to
deteriorate.
In
fiscal years 2008 to 2010, Illinois was required to make larger contributions
to its pension systems to make up for the pension holidays of 2006 and 2007.
Unfortunately, these ramped-up payments coincided with the Great Recession when
the state’s fiscal condition was already poor. During the relatively good
economic times of the late 1990s and mid-2000s, Illinois had not raised taxes.
Rather, the state had relied heavily on borrowing and temporary measures (like
the pension holiday), so it was not well-prepared to weather the recession.
Illinois made its required contribution to the pension systems through FY 2009
but issued pension obligation bonds to cover the payments for FYs 2010 and
2011.
Changing
Pensions in Illinois: Small Strides
Although
Illinois has made significant strides in some areas of its finances, pension
reform has been difficult to achieve. In 2010, Illinois established a two-tier
pension system with reduced benefits for employees hired after January 1, 2011.
This will generate substantial long-term savings but did nothing to reduce the
preexisting unfunded liability. Legislation that would create a third tier in
the form of a defined contribution 401(k)-style plan — and requiring larger
employee contributions if workers opted to keep their traditional pension plans
— did not pass the 2011 legislative session.
Despite
the shortcomings of this particular third-tier proposal, some type of equitable
pension reform is urgently needed. Between FY 2012 and FY 2013, Illinois’
required contributions to the five pension systems increased nearly $1 billion,
and that amount does not completely cover the liabilities incurred during the
year. In addition, Illinois is required to pay debt service for the pension
bonds it issued to cover payments to the systems in FYs 2003, 2010, and 2011. “In
FY 2008, total pension costs, including regular state contributions and
pension-related debt service, took up only 8 percent of General Funds revenue
from state sources, but by FY 2012 these costs had grown to almost 20 percent
of state revenue. By FY 2015, pension costs are projected to take up one-fourth
of the state’s resources.”
Small
strides have also been made with respect to OPEB. Last spring, Governor Quinn
proposed that if employees were to keep their free retirement healthcare, their
annual cost-of-living adjustments (COLAs) would be reduced from 3 percent compounded
annually to the lesser of 3 percent or one-half of the consumer price index,
not compounded. Alternatively, those who wanted to retain their 3 percent
annually compounded COLA would be required to pay a fee (or higher employee contributions)
for their post-employment health insurance. This proposal did not pass, but the
General Assembly did enact limits on state subsidies for retiree healthcare.
Under the new law, employees will contribute to their healthcare premiums based
on their ability to pay.
Serious
Problems Remain
Pension
reform is one of the most pressing issues facing Illinois. Without reform, huge
costs loom for future taxpayers or would-be beneficiaries of state programs
that will be crowded-out. But the magnitude of the problem also means any solution
will include big benefit reductions or cost shifts, so political interests
differ sharply on how to act. The lack of legislative action on pensions has
not been for lack of ideas. In fact, several proposals have been put forth.
Governor
Quinn proposed ambitious pension reforms in April 2012. Under this proposal,
Illinois’ pension systems would be 100 percent funded by 2042. The proposed
reforms included reductions in the COLA, increases in the retirement age, and increases
in employee contribution rates. In addition, the normal cost of pensions of
teachers and state university employees would become the responsibility of the
universities and school districts, rather than the state.
Proponents
of the shift argue that currently school districts can raise teacher salaries
but bear no responsibility for the resulting pension cost increases. Opponents
raise the specter of large property tax increases they argued would be needed
to support teachers’ pensions. IGPA released a plan to reform SURS in early
2012; its principles also could be applied to the state’s other pension systems.
The IGPA proposal would create a hybrid defined benefit/defined contribution system
for new employees. Hybrid systems help balance the pros and cons of defined
benefit and defined contribution plans, allowing retirees to have a guaranteed
income since, in Illinois, most are not eligible for Social Security.
Despite
a variety of ideas and proposals to fix Illinois’ ailing pension systems,
political logjams have halted proposed reforms. The latest legislative session
ended in May without any changes being made to the state employee pension systems.
Governor Quinn called a special legislative session in August to address the
issue, but this session also ended without results. A possible post-election
session may be more fruitful. The November 2012 ballot includes a proposal that
would amend the Illinois Constitution to require a three-fifths majority to
increase benefits under any state or local retirement system.
Because
the state’s resources are limited, some type of reduction in pension benefits appears
inevitable, despite the difficulties in making any type of change. Illinois’
future pension payments are scheduled to grow at rates exceeding the anticipated
growth rates of the state’s revenue sources. Assuming that total spending is
kept within the limits of the state’s revenues, if Illinois makes the required
contributions to its pension systems, serious cuts in other areas of the budget
will be necessary. Pension obligations will continue to crowd out other
spending…
Conclusions and Recommendations
The
recent recession hit Illinois particularly hard. At the onset of the financial
crisis, Illinois was essentially insolvent because it had no reserves; had used
borrowing, time-shifting and fund-shifting devices to balance the budget for
the previous six or seven years; and had shortchanged its pension systems for
decades. Illinois also suffered a crisis of leadership at a time when a strong
and effective governor was needed to make tough decisions to move the state
forward. For these reasons, even at a time when all U.S. states were
struggling, Illinois’ fiscal crisis was one of the very worst.
Make
the Tough Choices Sooner Rather than Later
Illinois
starts with a large structural deficit, an imbalance between sustainable
revenues and existing spending levels. Illinois faces major challenges going
forward due to the aging of the population, rising health care costs, unfunded
pension liabilities, stagnant and eroding revenues, and impending federal
budget cuts. Some of the problems going forward are the consequence of
time-shifting from unbalanced budgets in recent years — debt service costs for
pension obligation bonds, pension payments that were less than the ARC, and
billions in unpaid bills.
The
state needs to recognize that large cuts in many areas of the budget as well as
increases in revenues will be necessary. The default policy if policymakers do
not make the tough choices soon will be two-fold. First, further time-shifting
will make the situation in future years even worse — larger stacks of unpaid
bills and more debt service payments to pay for past gaps. Second, without
deliberate choices as to what to cut or who to tax, cuts will be concentrated
in the “discretionary” areas of spending for human services and education —
programs that have already seen large cuts. We do not offer specific recommendations
for which spending to cut or which taxes to increase, only a few general
observations.
Pension
reform must be a priority. Illinois’ pension systems are crowding out all other
areas of the budget. Without some type of reform that reduces costs going
forward, the systems appear destined for insolvency. Illinois needs to act now
to salvage the benefits of future retirees. Illinois could learn from hybrid
systems adopted in a number of other states.
Medicaid
costs and reforms must be addressed. Illinois should work with the federal
government to control Medicaid costs and implement reforms. “Optional”
treatments such as medications and preventive care can be cost-effective alternatives
to hospitalization, but under the current federal rules these are the first
services to be cut.
Revamp
the State’s Fiscal Toolkit
There
are a number of things that can be done to provide better information on the fiscal
situation and improve the budgetary decision making process:
■ Timely
reporting. Illinois’ budget is typically enacted at the end of May; the
governor’s office should issue a detailed report of the enacted budget within a
month. The comptroller should release detailed reports of actual revenues and
expenditures within six months of the fiscal year’s end so that this information
is available when the next year’s budget is proposed. The private sector
accomplishes this task regularly.
■ Accrual
accounting. Illinois should supplement cash-based budget reports with companion
tables that use the accrual accounting concepts required of year-end CAFRs.
This reporting should include changes in net liabilities for pensions and OPEB.177
Reporting changes in assets and liabilities alongside current cash receipts and
expenditures will expose budget shortfalls concealed by cash-based accounting.
■ Pension
schedules. Illinois should provide annually required contribution amounts (ARC
or “normal cost plus interest”) in the same table as the pension contribution
schedule so that lawmakers and the public can clearly see that even if the
state makes its annual contribution to the systems, unfunded liabilities
continue to grow. Even better would be to show “normal cost plus interest plus
a 30-year amortization of unfunded liabilities” as the benchmark.
■ All
funds, not General Funds. Illinois should reduce its focus on General
Funds-only budgeting and present the total funds budget so that major
expenditure categories such as transportation and major revenue streams such as
the sales tax are fully brought into the budget frame. This would also eliminate
confusion that results when expenditure items are shifted into and out of the
General Funds budget from one year to the next.
■ Transparent
transfers. Statutory transfers between General Funds and other funds (and
between non-General Funds) should be itemized in the governor’s prospective
budget and in reports on the enacted budget. Illinois’ comptroller should
report statutory transfers to and from the General Funds (and between other
funds) on its drilldown website. Currently, only aggregated amounts are
available, making this information impossible to track.
■ Multi-year
forecasting. Illinois should build on the steps it made last year to generate
multi-year forecasts and plans for the total budget (not just General Funds)
that extend at least four years beyond the current budget year. This will
improve the state’s ability to make decisions, which will lead to better fiscal
outcomes. Illinois should make its forecasts available to the public and encourage
outside review.
■ Long-term
planning. Responsible long-term fiscal planning is vital if Illinois is to put
its house in order. Budget forecasts and legislative and public hearings should
be used to develop spending priorities and a responsible long term fiscal plan
for Illinois. Rules and regulations will need to be put in place so that the
plan is not just a recommendation but will be adhered to.
■ Fiscal
notes. Legislation that will have a significant fiscal impact on Illinois
should be accompanied by a fiscal note so that lawmakers can see the price tag
associated with a given policy. Illinois currently has very limited resources available
to make estimates of these costs but this should be a priority for planning and
budgeting.
■ Political
revenue estimates. Illinois needs a non-politicized process for approving
revenue estimates. The General Assembly should either adopt COGFA’s estimates
or establish a consensus process as other states have done.
■ Omnibus
spending bill. Currently, Illinois’ budget is enacted as a series of
appropriations bills rather than a single, coherent state budget. If the total
state budget was enacted as a single omnibus bill, this would facilitate monitoring
and increase transparency. Illinois should establish a real rainy day fund and
use it responsibly. During good times, the state should save automatically and
allow time to replenish the reserve funds after a fiscal emergency ends.
Illinois could learn from successful models of rainy day funds such as those in
Virginia and Texas.
Other
Issues
Tax reform at the state level may
be needed to achieve revenue systems that are adequate and predictable and that
minimize volatility. Illinois’ state sales tax is antiquated and has eroded
over time. Illinois should reform its income and sales tax structures to make
them broader-based, stable, and productive. Illinois should establish procedures for monitoring the fiscal
condition of its local governments and taking early action to help local
governments resolve their fiscal problems. Illinois could learn from
well-established monitoring and early intervention procedures in North
Carolina, New Jersey, Kentucky, Pennsylvania, and Michigan.
Illinois’
infrastructure needs can no longer be ignored. Deferred maintenance is costly in
the long run because problems continue to worsen. Especially problematic is
Illinois’ lack of a comprehensive capital improvement plan that identifies priorities
and establishes repair and replacement schedules for five or ten years in the
future. Infrastructure quality will have an impact on Illinois’ long-term
economic development.
My Commentary:
Illinois' Revenue and Pension Debt Problems (a
Reiteration)
http://teacherpoetmusicianglenbrown.blogspot.com/2012/09/illinois-revenue-and-pension-debt.html
