The state of the State
State pensions' funding: a complicated beast
By MICHAEL KLEMENS
Government does lots of things that are complex and many that are controversial. Issues that seem simple become difficult. Putting money aside for employees' retirement is no exception and has become both complex and controversial in Illinois. Some lawmakers charge that the state is borrowing against its future by underfunding pensions. Pension managers complain the systems are being sustained with record high investment returns that cannot continue. The Thompson administration counters that the fiscal health of state pension systems has and continues to improve. All agree that no retiree is in danger of missing a check, a crisis that would prompt a thorough review of pension funding.
State workers belong to one of five state pension systems. They are the general assembly, judges, state employees, state teachers and state universities retirement systems. The systems receive revenue from three sources. Employees contribute between 4 and 11.5 percent of their salaries. The state makes a contribution. And the systems earn income on their investments. When employees retire, they draw a pension based on final average salary and years of service.
Pensions are complicated beasts. The obligations of the system (its liabilities) are tracked by actuaries (different for each system) who make assumptions about things like inflation, life span and investment returns. The difference between the actuaries' projections of the assets and obligations of the system is called the unfunded liability.
The elaborate system of pensions that Illinois employs has been compared to an insurance policy upon which the employee and the employer (the state) pay. When it is fully paid up (at retirement) the employee can draw on its value for salary. As of today, none of the systems has the assets to meet all its obligations. In June that difference is projected to be $8.6 billion. That is how much money would be needed, if the state were to cease operations, to pay benefits to those who have retired and the benefits earned by those still working who will retire.
Illinois' pension funding has been complicated by inconsistent state funding. Until 1980 Illinois had appropriated annually to the five pension systems the amount actually paid out. That enabled pension systems to invest employee contributions. Then in the 1982 fiscal year Illinois reduced its contribution from 100 to 70 percent of payout and the next year to 60 percent. This year Gov. James R. Thompson proposed, even with $1.1 billion in new taxes, to hold pension funding at the same dollar or percentage amounts as in fiscal 1987, reducing the overall funding below 60 percent of payout. When Thompson's tax hike faltered, he cut another $75 million from pension funding, dropping the level to 45 percent of payout.
6/October 1987/Illinois Issues
Although funding has been measured as a percentage of payout, the key relationship, legislative and executive fiscal experts agree, is the ratio of assets to liabilities. Even with reductions in state funding, that ratio rose steadily since 1975 from 43.1 percent to a peak of 50.2 percent in fiscal year 1981. From then it declined to 48.7 percent in the state's 1984 budget year. Then, sparked by record-high investment returns, it rose to 53.2 percent in 1985 and to 57.1 percent in 1986.
Between 1975 and 1986 assets in the five systems grew $7.2 billion or 313 percent. Over the same period liabilities rose more, $11.3 billion, but at a slower rate of 210 percent. The slower growth rate means that eventually the unfunded liabilities will be eliminated. The issue then becomes: How long should the state take to pay off the accumulated deficit? As is the case with any debt, the lower the initial payments the larger the later ones. The choice becomes, pay now or pay later.
Budget Director Robert L. Mandeville argues that the conditions of the state's pension systems are improving. "We have been improving considerably and are close to full funding," Mandeville says. He claims that the state is not underfunding its pensions as long as the asset to liability ratio is constant or increasing and says he expects the funding ratio to continue to increase. Mandeville suggests that those worried about pension systems do not recognize the impact of the investment-fueled asset growth. The $1.7 billion increase in assets during fiscal 1986 represents eight to 10 years of normal growth. And Mandeville argues that a public pension system can be considered fully funded when its asset to liability ratio equals 65 percent. At that point state government should monitor and simply put in money to maintain that ratio. Pension system managers and lawmakers dispute Mandeville's 65-percent-means-full-funding assumption. Their view of the situation is that huge increases in pension investments, the result of performance in the stock market, have boosted assets and income. At the same time IIlinois has reduced its costs. Michael L. Mory, executive secretary of the State Employees Retirement System of Illinois, says a recession would reverse the situation. And Mory questions whether the members of the system should not have seen some benefit from the investment returns. When the system asks for benefit increases, lawmakers respond that because the present system is not fully funded, more benefits should not be added.
Although funding has been measured as a
Donald E. Hoffmeister, executive director of the Universities Retirement System of Illinois, also disputes Mandeville's contention that 65 percent funding equates to full funding. And he says that cutting state pension contributions amounts to "false economy" because the obligations remain. Hoffmeister praises a study by the General Assembly's fiscal researchers, the Economic and Fiscal Commission: "I think that's the best thing to come out of state government in some time."
The commission's study, released in November of 1986, compared the then current state funding to two alternatives for increasing pension funding. All would require slightly more than $16 billion in state pension spending over the next 20 years and all would reduce the unfunded liability. The commission found that:
• Continuing the state's 60 percent of payout would see first year costs of $429.2 million (7.8 percent of payroll). Over 18 years the appropriation and percent of payroll would increase to $1.4 billion (12.4 percent of payroll) by 2005.
• A five-year phase-in of level percent amortization, would pay actuarily determined normal costs. Initial costs of 451.4 million (8.2 percent of payroll) would increase to $1.2 billion by 2005. As a percent of payroll, the state funding would peak at 10.4 percent in the 1995 fiscal year and remain stable.
• Payment of normal costs plus interest on the unfunded liability would see initial costs of $670.6 million (12.2 percent of payroll). In 2005 costs would be $975.2 million or 8.4 percent of payroll.
Prompted in part by the studies, lawmakers began to address the question. Sen. Dawn Clark Netsch (D-4, Chicago) introduced S.B. 1470, which would use level percent amortization to eliminate the unfunded liability over 40 years. "If you continue to underfund, you are building up liabilities which will come due in later years," Netsch says. She says the problem is a lack of a sensible funding plan. Her bill would cost the state $46 million more than Thompson's original budget. Its passage without opposition in the Senate is taken by Netsch as a sign that the issue is more on the minds of lawmakers.
House approval appears less likely. House sponsor Rep. Woody Bowman (D-4, Evanston) complains that Thompson proposed to continue underfunding pensions, even with his proposed billion dollar tax increase. But neither Netsch nor Bowman thinks the bill will pass this fall, when lawmakers will direct their action toward restoring education cuts.
Why are pensions so tough? Sen. Calvin W. Schuneman (R-37, Prophetstown) questions whether the state is keeping faith with future generations by underfunding pensions, but believes he knows why: "No governor is going to get any mileage out of what they put in pensions." Neither will lawmakers.
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