Thursday, October 25, 2012

From the “Report of the State of Illinois' Budget Crisis Task Force”

…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)

Illinois Pension Reform Is without Legal and Moral Justification

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