By MICHAEL D. KLEMENS
State pensions: the truth and the consequences
State government has been cutting corners on putting aside money to pay for state workers' retirements. As a result, for three consecutive years — fiscal years 1988, 1989 and 1990 — the liabilities of the five state-funded pension systems increased more rapidly than their assets. That means that in a time of scarce resources, the state is likely to have to begin spending money for pension payments that it would otherwise have had available for programs. In short, increased pension spending may be yet another fiscal correction that state government must make.
First, a little background. The state makes the employer contribution for five pension systems, the so-called state-funded systems: the Judges' Retirement System of Illinois, the General Assembly Retirement System, the State Employees' Retirement System of Illinois, the State Universities' Retirement System and the (Downstate) Teachers' Retirement System of the State of Illinois. The state also makes a payment to the system that covers Chicago teachers proportional to the payment it makes to the downstate teachers' system.
Besides the payment made by the state, workers also contribute to the pension systems. Employee contributions vary from 4 percent to 11.5 percent, the difference depending upon the plan and whether the worker is also covered by social security.
The third source of income for the state retirement systems is the return on investment of the funds that each system holds. In theory the retirement system takes each employee's contribution and the state's contribution for that worker, invests them and has enough money set aside to pay the worker's pension when he or she retires.
The employee contribution, a fixed percentage of salary, has been the most reliable income source for the systems. Investments were also good throughout the 1980s. For the State Employees' Retirement System the average rate of return from 1981 through 1990 was 12.4 percent. The return ran from a high of 44.1 percent in 1983 to a low of negative 5.2 percent in 1984. The state has not done anywhere near as well by the systems in making its contribution. Unlike the employee contributions, state contributions were not based on salary. Until 1982 the state contribution was the amount that the systems estimated that they would pay out in benefits. In 1982 the contribution was cut to 60 percent of payout. In 1988 the tie to payout was broken, and the state payment has been approximately what the previous year's was.
In 1981 the state's contribution to the five systems was $406 million. In 1990 the contribution was $478 million, an increase of 17.7 percent. In comparison state payrolls rose 77.8 percent over the period from 1981 to 1990.
Revenues to the State Employees' Retirement System are typical. Member (employee) contributions rose from $64.6 million in fiscal year 1981 to 107.9 million in fiscal year 1990, an increase of 70.5 percent.
Member contributions increased each year. State (employer) contributions increased from $96.9 million in fiscal year 1981 to $107.9 million in fiscal year 1990, an increase of 11.4 percent. State contributions hit a low of $61.5 million in fiscal year 1982 and a high of $109.6 million in fiscal year 1987. Investment, income rose from $255.4 million in fiscal year 1981 to $431.2 million in fiscal year 1990, an increase of 68.8 percent. The 1990 figure was the highest for the period; the 1982 investment income of $232.5 million was the lowest.
Figuring out how much money a pension system should have is tricky business. An actuary must make assumptions about how long people will live and what benefit they will receive upon retirement. The actuary must also project what interest rates will be and how much a system can be expected to earn on its investments.
Ideally a pension should be fully funded. That means that it should have assets sufficient to cover the benefits of current
retirees and the portion of the benefits that active (still working) employees have earned to date. For the five state-funded pension systems, the ratio of assets to liabilities improved in 1985, 1986 and 1987. In 1988, 1989 and 1990 this funding ratio declined. Decreased employer contributions by the state will likely cause further reductions in the assets-to-liabilities ratio in 1991 and 1992.
In practice public pension systems are seldom fully funded and do not need to be since it is unlikely that government will go out of business. However, if the unfunded liability — the difference between assets and liabilities — grows too large, the system will require an infusion of cash. Between 1981 and 1990 the assets of the five state pension systems grew $9,2 billion, while the liabilities grew $14.6 billion. That means the unfunded liability grew $5.4 billion.
The issue with Illinois state pension systems is not whether there will be money to pay benefits. The payment of retirement benefits is guaranteed by a provision of the state Constitution. If the state simply wanted to appropriate the money for the pensions based on what would be owed its retirees each year, no pension system would be needed. Under such an arrangement the state would estimate payments, appropriate and spend the money just as it does for state workers' salaries.
The pay-as-you-go approach reduces costs in the short run. However, in the longer run it increases state costs because of interest that would not be earned on the investment of the pension contributions. And, to the extent that pension costs are considered part of the cost of government, the pay-as-you-go scheme shifts current costs to future taxpayers.
A coalition that included the state retirement systems, their retirees and the Illinois Economic and Fiscal Commission (IEFC), the General Assembly's revenue forecasting and debt analysis unit, has argued that underfunding pensions is a form of borrowing and has pushed for increased state contributions. A 1988 IEFC study projected costs for a 20-year period, from 1987 until 2006, under different funding methods. The IEFC study concluded that to continue level funding of the systems would cause problems in the future. Specifically, the agency projected that the judges' system and the universities' system would start to lose their asset base by the turn of the century.
The IEFC report identified a plan to amortize the unfunded liability over a 40-year period as the best alternative. Options rejected by the commission report included continued level funding, payment of interest on the unfunded liability and basing pension contributions on current year's payouts to retirees.
In 1989 Auditor General Robert G. Cronson, in a special analysis of the five state-funded pension systems, endorsed the IEFC's findings. Cronson attributed improvement in the funding ratio (assets to liabilities) in the systems to changes in actuarial assumptions that reduced liabilities. "Recent decreases in pension funding will result in escalating costs and growing unfunded liabilities," the auditor general's report concluded.
In 1989, flush with money following the temporary income tax increase, state lawmakers passed a pension funding plan contained in S.B. 95 (PA 86-0273). The measure called for seven years of phased-in payments to reduce the unfunded liability, then a 40-year amortization of the unfunded liability. Lawmakers provided money to begin the process of paying off the unfunded liability, but they provided less new money than S.B. 95 required.
But S.B. 95 also included higher benefit payments, a feature sought by the retirees who had pushed for increased funding. Beginning January 1, 1990, the pensions for state workers were compounded. Instead of increasing 3 percent of the original retirement plan, the benefits were increased by 3 percent of the current annuity. Retirees began to see interest on their interest. At the same time, survivors and widows began to see automatic 3 percent increases, compounded, in their benefits.
As a result, even though state contributions went up for the state systems, liabilities went up faster than assets. For the State Employees' Retirement System, the increased benefits boosted the unfunded liability by more than $250 million.
The Economic and Fiscal Commission puts underfunding below the levels that would have been required under S.B. 95 at $34 million in fiscal year 1990, $104 million in fiscal year 1991 and $225 million in fiscal year 1992. Through the current year (fiscal year 1992) the IEFC puts the loss to the pensions systems at $407 million below S.B. 95's required levels when lost return on investment is considered.
Continued level funding in fiscal year 1993 will result in $350 million in underfunding, according to IEFC. And by then the total loss, including the lost opportunity to earn interest on invested funds, will stand at $750 million.
"We've been at basically level funding for five years," says Mike Hoffman, IEFC deputy director. The commission's 1988 pension study, the last comprehensive examination of the state's pension systems, identified troubles ahead for the state pension systems under level funding. The report predicted that the judges' system would have to begin to sell assets to make pension payments before the end of the century. It predicted the same problem for the universities' system by 2002.
That was before the enhanced pension benefits in S.B. 95. A vision of things to come was offered this year by the universities' system, which will experience a negative cash flow of $33 million, the first in its 50-year history. That means that state contributions and employee contributions together will fall $33 million short of covering benefits that must be paid. To pay benefits the system has had to take $33 million in investment income that
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it would otherwise have reinvested. "We are losing the power of compound interest," says Dennis D. Spice, executive director of the State Universities' Retirement System. Spice projects that at current rates the negative cash flow will grow to $500 million by 2005.
Spice says that the illusion of not needing stable state contributions was created by the extraordinary investment returns earned by the system in the mid-1980s. His system saw return on investments of 18.6 percent in 1985, 28.6 percent in 1986 and 16.3 percent in 1987. Spice does not expect to see such returns again: "We are not going to see the investment returns of the 1980s."
Spice fears that in the future the system will see second-tier benefits offered to new employees, something that has happened in other states. He insists that should not happen. "There's still time to fix the problem," he says.
Robert V. Knox, associate executive secretary of the State Employees' Retirement System, says that his system's board is most concerned that the state have a goal and a plan for reaching the goal. He knows the problem: "It's just too easy a payment not to make." In the wake of the nonfunding of S.B. 95, plans with longer phase-ins of benefits have been kicked around, he notes.
The IEFC's Hoffman says that the problem will be easier to address the sooner the state starts to tackle it. He says that without full funding, state employees lose the opportunity to see retirement benefits improved. A preliminary IEFC report on pension funding projects insolvency for the General Assembly retirement system by 2008 if level funding continues. The IEFC report also says that under continued level funding teacher universities' and judges' systems would also deteriorate rapidly by 2010. The commission plans to complete and release its report in January.
The pension underfunding prompted a push by annuitants' groups and the systems for higher levels of funding. The Illinois Retirees Legislative Advisory Council (IRLAC) has formed an organization called FIRST (Fund Illinois Retirement Systems Today) to push for better pension funding. Many of the retirees were involved in the push for S.B. 95 and in the wake of its nonfunding are seeking to take pension funding out of the appropriation process. FIRST is pushing to make the funding a continuing appropriation, much like the Refund Fund that pays income tax refunds, with a set percentage of state revenues diverted to paying the state share of pension costs.
The retirees are also seeking increased pension benefits. One push calls for raising the minimum pension payment for retired teachers from $450 to $750. Marjorie Shea, state legislative cochair of the Illinois Retired Teachers Association, says that more than 10,000 retired teachers receive the minimum pension. Those on the minimum pension were teaching when salaries were lower and need the help today. Shea says.
Joan Walters, director of Gov. Edgar's Bureau of the Budget, says that holding state contributions to pensions level as the state did for fiscal year 1992 is not where the administration wants to be. But Walters acknowledges that pension will have to compete with pressing spending demands for eduacation and human services.
Walters is unconvinced that pension funding is nearing a crisis level. "I don't feel like it's so imminent that if we don't deal with it today that it will have an effect in the near future. I don't believe that doomsday is tomorrow."
Walters' problem of determining how much of scarce state general funds money to put in pensions is the same one faced by her predecessors. Throughout, the choice has been to spend money on programs rather than pensions.
When pension funding last rose to the forefront in 1989, lawmakers adopted the reforms in the S.B. 95 pension funding plan; Gov. James R. Thompson signed it in to law. Since then both governors and lawmakers have ignored the law.
The day is coming when state contributions to pensions will have to be increased. That's the truth. As a consequence, as state government enters a period of relatively low growth, constrained by Edgar's no-new-tax pledge, the competition between pensions and other spending demands will be all the more intense.
20/November 1991 /Illinois Issues