What about the State of Illinois’ Funded Ratio for Public Pensions and Its Related Issues?

What is a funded ratio?

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), “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, many Illinois politicians (and business leaders who finance and then influence them) believe a 100-percent funding is required even though an analysis of U.S. state and local government pension obligations from Fitch Ratings (2011) stated that a 70-percent funding ratio is adequate when based on a “rolling five-year average of market value of assets.” 

One CRR report (May 2011) found that on average state and local funded ratios are approximately 77 percent. An earlier CRR report (March 2011) claimed 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. (Illinois now has an 8-percent expected rate of return but without any guarantee for fully funding the pensions). In view of this aforementioned information, why are Illinois politicians and business leaders adamant about a 100-percent funded ratio for public pensions?  

To decrease the funding ratio would mean the State’s contribution would increase for the pension system’s plans, even though some state policymakers believe that previous pension reform, Public Act 96-0889 or Senate Bill 1946 (the Two-Tier System for new hires since 2011), will enable the State to reduce its contribution “by $71 billion” (CoGFA).  (Ironically 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 14^th).  

What does the “Pension Ramp” have to do with this discussion?

Public Act 88-593 (the 1995 Funding Law—“Pension Ramp”) 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, 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, however, in May of 2010 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, 2011). We also know the so-called “Pension Ramp” is a major cause of financial instability in Illinois, one that the state’s policymakers refuse to address.

According to the Commission on Government Forecasting and Accountability, “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.  

What does the Entry-age Method used for determining actuarial accrued liability have to do with this discussion?

Moreover, 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, “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.”  Unfortunately, the State of Illinois uses the projected-unit-credit method.  

And what does asset smoothing have to do with this discussion?

Add to this the fact that Illinois has adopted asset smoothing (Senate Bill 1292 in 2011) 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 consider the 2008-09 market collapse that significantly reduced the value of all retirement systems’ assets across the country, and one can easily see that the past five years includes profound, negative returns in the State’s assessment of its retirement systems!

Though the best solutions, according to CoGFA for the current economic situation in Illinois, are said to include lowering the assumed rate of investment return (the state has lowered it) and keeping the funding ratio at 90 percent, this Commission also 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.” 

Three final notes:  “According to the Congressional Budget Office, 80% is sufficient for public sector plans. Private sector plans require 100% because of concerns over bankruptcy or otherwise choosing to go out of business, concerns which do not pertain to the public sector. Yes, plan actuaries still set 100% as the goal because their sole concern is the pension system—they do not give a whit about the state’s responsibility to fund services, pay other debt or existing tax system, all of which matter” (Ralph M. Martire, Executive Director of Center for Tax and Budget Accountability).  

Most states today (60% of them) are funded below 59%. Illinois’ funded ratio has never been above 70%. Furthermore, according to Alicia Munnell, Director of the Center for Retirement Research at Boston College, the distribution of funded ratios for state and local pension plans in 2010 on average were the following: 12% of the state and local pension plans were funded between 35-59%; 48% were funded between 60-79%; 35% were funded between 80-99% and 5% were funded at 100+% (State and Local Pensions: What Now? 2012).

Though no state public pension has to be fully funded (ever), had TRS been fully funded by Illinois legislators throughout the decades, its funded ratio would have been between 80 and 90% today!

(Most of this essay was originally posted on this blog in July 2011).

For more about lowering that funding ratio: Click Here.