Let’s Review the Creation of the So-Called Tier III Pension Plan

The following is from the Teachers’ Retirement System of Illinois:

July 10, 2017 - In early July the General Assembly approved a new law that significantly changed the Illinois Pension Code by creating a voluntary “Tier III” benefit structure. The law also alters the way the state funds TRS.

The pension code changes are designed to be cost-saving measures for state government and were enacted as part of a $36.1 billion state government budget for fiscal year 2018.

None of the Pension Code changes affect active Tier I members or retired members in any way. There are no changes to Tier I benefits, active member contributions or health insurance coverage.

The new law gives current Tier II members and future Tier II members the option of joining a new “Tier III” retirement plan. After Tier III is implemented, new members will automatically become a part of Tier III unless they opt into Tier II. The optional Tier III “hybrid” retirement plan has two parts – a small life-long “defined benefit” (DB) pension and a “defined contribution” (DC) plan similar to a 403(b).

However, it is unknown at this time when Tier III will be available to members. Before Tier III can be implemented, the plan must be reviewed and approved by the U.S. Internal Revenue Service. It is unknown how long that process may take. The TRS Board will establish the final implementation date of the Tier III plan.

Under the Tier III plan:

Members will make payroll contributions to the pension portion that are based on the cost of their benefits, but no more than 6.2 percent of salary.

• Members will contribute a minimum of 4 percent to the DC portion of the plan.
• Normal retirement age is determined by Social Security. Currently, 67 years.
• The Final Average Salary (FAS) for calculating an initial pension is the member’s average salary during the last 10 years of service. By comparison, the Tier I FAS is the highest four consecutive salaries out of the last 10 years of service and the Tier II FAS is the highest eight consecutive salaries out of the last 10 years of service.
• The automatic annual increase (AAI) is similar to the Tier II AAI – one-half of the previous year’s consumer price index, not compounded. The Tier I AAI is 3 percent annually, compounded.
• The Tier III calculation for an initial pension is Service Years multiplied by Final Average Salary multiplied by 1.25 percent. For comparison, the Tier I and Tier II pension calculation is Service Years multiplied by FAS multiplied by 2.2 percent.
• Local school districts, rather than the state, will bear the primary burden of making the “employer contributions” to both the DB and DC plans in Tier III.
• In addition, the new law makes two changes to how state government calculates the amount of money TRS will receive from state government in fiscal year 2018 and in the near future. It is expected that the original state contribution for TRS expected in fiscal year 2018 – $4.65 billion – will be recalculated. 
1. TRS must retroactively “smooth” the fiscal effect of any changes made in the TRS assumed rate of investment return over a period of five years. The “smoothing” applies to any assumption changes from 2012 on. Up until now, the fiscal impact of change in the assumed was totally absorbed at one time. For example, in 2016 TRS reduced its assumed rate of investment return from 7.5 percent to 7 percent and the result was a $402 million increase in the fiscal year 2018 state contribution to TRS. Under this new law, that $402 million increase would be phased in over a five-year period.
2. In addition, local school districts will pay more of the cost of a member’s pension if that member’s salary is equal to or greater than the governor’s statutory salary of about $180,000. The district will be responsible for paying the actuarial cost of the portion of the member’s pension that exceeds $180,000. 

Also in conjunction with the fiscal year 2018 budget, the General Assembly enacted a 32 percent increase in the state’s income tax, which will raise an estimated $5 billion in new revenue for the state. The individual tax rate will increase, effective on July 1, 2017, from 3.75 percent to 4.95 percent. The corporate tax rate will increase, effective on July 1, 2017, from 5.25 percent to 7 percent (Teachers’ Retirement System of Illinois). 

Commentary on Shifting the “Normal Costs” to School Districts (from August 1, 2012 on this blog):

To transfer the “normal costs” of the Teachers’ Retirement System to school districts is to eliminate the state’s role in providing income retirement security for its public employees. Because “the State has the primary responsibility for financing the system of public education” (Article X, Section 1 of the Illinois State Constitution), one might ask whether teachers are considered part of that “system of public education?”

 “A shift would create a new and large financial requirement for school districts, which would be difficult for many to meet. Moreover, Illinois ranks last in terms of state spending on K-12 education, and school districts are already relying heavily on local property taxes. Shifting the state’s normal cost obligation onto school districts would only mean that an even higher proportion of school districts’ revenue would come from property taxes.

“[Furthermore,] property tax bases would not be sufficient to absorb any shift in the employer normal cost for teacher pensions… School districts are demographically and financially varied, and it would be difficult to impose a uniform normal cost shift on them… Illinois ranks last in terms of state spending on K-12 education, and school districts are already relying heavily on local property taxes… While shifting the state’s normal cost obligations onto school districts may provide some relief to the state’s budget, it will not mitigate these financial obligations and will instead push them onto school districts that, on average, already derive the majority of their revenue from local sources” (The Center for Tax and Budget Accountability, March 2012).

What would be other probable effects? In cash-strapped school districts, of which there are many, teachers would not receive increases in their salaries; many teachers would lose their jobs; student programs would be reduced or eliminated; class sizes would increase; it would be more difficult to recruit, as well as retain and attract, the best teaching candidates… (Education Sector Policy Briefs).

The public school system in Illinois would be jeopardized; the public school teacher’s dignity and guaranteed retirement security would be imperiled, and their students’ right to be taught by the very best teachers available in Illinois would be at risk.

Approximately one-third of the total pension payment is the normal costs; the other two-thirds of the payment is the interest owed on the debt that the state created for not fully funding the pension system for almost six decades. To transfer the normal costs of the teachers’ retirement system to the school districts is to diminish the state’s role in providing income retirement security to its public employees. 

-Glen Brown

Placing Illinois Teachers in Social Security via 401k's (from the Teachers Retirement System):

“Issue: Requiring newly-hired Illinois teachers to become part of Social Security would help ease the burden on TRS, lower the state’s contribution to public pension systems, help ease the long-term financial problems facing Social Security, and create more income stability for retired teachers.

“Discussion: Making newly-hired teachers pay into Social Security and allowing them to be eligible for benefits would affect all current and retired teachers. Illinois teachers have never been part of the Social Security system. Most teachers rely almost solely on a TRS pension during retirement. Active teachers contribute 9.[0] percent of their paycheck to help fund TRS and school districts contribute 0.58 percent of every teacher’s salary to the System. Last year, all told, teachers contributed $917 million to TRS and school districts contributed $155 million.

“For new teachers to become part of Social Security this scenario would mean a mandatory 12.4 percent payroll deduction split evenly between the member and the employer, which in the case of Illinois teachers is school districts and state government. Teachers would still be required to contribute 9.[0] percent of salary to TRS.

“For school districts, the cost of teacher pensions would immediately rise by a considerable amount. Instead of contributing 0.58 percent per new teacher, every district would have to contribute 6.2 percent per teacher. It is estimated that this increased cost would equal $41 million for Illinois school districts in the first year and more than $2.4 billion over 10 years. Plus, districts would still have to contribute 0.58 percent for each participant in the current system.

“Finally, a 1999 study by the General Accounting Office found that adding teachers and other public employers from around the country who are not currently in Social Security would create, at best, a temporary surge in revenue for Social Security. Over the long term, adding teachers to Social Security would only increase the System’s total obligations and deepen the long-term funding problem.”