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No, Illinois Hasn't Solved Its Pension Crisis

Forbes Online

Wednesday, June 6, 2018  |  Commentary  |  Elizabeth Bauer , Contributor

Budget--State (8) , Pensions (70)


Opinions expressed by Forbes Contributors are their own.


This one's for my Illinois readers, given that our legislators and our governor have been patting themselves on the back for passing a budget with enough spending generosity and accounting gimmicks to (they hope) make constituents happy.

And among the touted savings in the new State of Illinois budget are three pension items, each of which are claimed to have achieved that holy grail of saving money, passing constitutional muster, and requiring no sacrifice from anyone.  Eh, not so fast.

Here are the details (from capitalfax.com):

Spiking cap

Illinois has long had issues with pension spiking -- with local school boards raising pay for their teachers in the years just prior to their retirement to significantly boost their pension benefits at comparatively little cost to the local school board.  This was partially reined in with a reform law in 2005, but not completely:  back in 2015, the Chicago Tribune reported that the penalties local school districts were supposed to be paying whenever they continued to engage in the practice, were regularly being waived, and in 2017, the Northwest Herald reported that districts were taking maximum advantage of the remaining degree of spiking permitted.

The new bill tightens up spiking more completely with a restriction that only increases of up to 3% can be credited towards pension accruals, which is projected to save $22 million.  Sounds great, and this is ought to be the easiest fix of those available -- with a risk, to be sure, that a retiree may sue with the claim that this cap is too low to take into account reasonable pay increases, and is, hence, an unconstitutional impairment of benefits, or alternatively, that exceptions written into the bill to prevent just such a lawsuit may result in districts gaming the system and thwarting the forecast savings.

Vested Buy-Out

The most straightforward part of the plan is an offer of lump sums to vested inactive participants of the 3 main pension systems, SERS, SURS, and TRS, at the rate of 60% of the present value of the benefits.  These benefits would be rolled over into retirement funds in the same manner as private sector employees roll over their 401(k) benefits upon changing jobs.  Due to the 60% factor and the fact that the interest rate -- the annual accounting cost of the liabilities -- is calculated based on the expected return on assets but that bonds to fund the buyout would be assumed to be issued at a lower rate, the projected savings is $41 million.

COLA Buy-Out

Tier 1 members (that is, the older members who still have guaranteed 3% compounding cost-of-living adjustments) can accept a reduction in their COLA from 3% to 1.5% in exchange for a lump sum benefit of 70% of the present value of the amount of future COLA reduction.  This is projected to save the state $381.9 million.

Bond Issue

To fund the above buyouts, the state will issue $1 billion in bonds.  Students of Illinois budgeting will note that the bond issue is not a part of the budget, but the savings are included.

What's the Catch?

First, the pre-retirement lump sum buyout takes advantage of financially vulnerable people.

The buyout of terminated vested former employees is at terms that are a significant disadvantage to those employees.  Even in ordinary circumstances, the "liability" that the state uses is based on an interest rate equivalent to expected return on assets.  When a private pension plan provides a lump sum payout, they use bond rates, which are lower, and which give workers higher lump sum payouts.  But the program to be offered by the state reduces benefits even further, by taking what would have been (not really) actuarially fair lump sums and reducing them with a 60% factor -- a reduction which would not be permitted in private-sector plans.

This means that the program won't appeal to people who do their math and determine, wisely, that this is a bad deal financially.  But it will appeal to those who are financially vulnerable and need of an extra cash infusion now, regardless of how much retirement income they're sacrificing later.  Now, in the case of Missouri, the average payout was $14,000, which suggests that these were fairly small accruals to begin with, and, heck, one could further justify the whole thing by saying that these benefits were far more generous than these (former) employees "deserved" in the first place -- but, much the same as relying on lottery revenues which prey on the poor,  it's still an ethically questionable method.

Second, the COLA buyout is an invitation to anti-selection.

Anti-selection, for those who are unfamiliar with the term, refers to people gaming the system in various ways.  Do you know that you're in poor health and buy life insurance or health insurance?  That's anti-selection, and that's why life insurers have medical exams to try to catch any health issues, and why health insurers conventionally had restrictions on pre-existing conditions, and why the ACA attempts to mitigate the problem with limited enrollment periods.  With respect to this sort of buyout, anti-selection means that those people who are in poor health and who expect to die early, will be the first ones to take this buyout, boosting the actual average longevity of the remaining group, and raising the actual long-term cost of the benefits.

Now, if this were an actuarially fair buyout, based on a true actuarial value, without the reduction factor or the high interest rate (relative to the corporate world), you might get a diversity of takers, including those who believe their expenses will decrease from year to year, as they reduce their traveling or eating out, for instance, but who want to spend some cash up-front, say, to pay down debts, pay off their mortgage, buy a second home, or the like.  You might get those who think they can do better in the stock market.

But since this isn't actuarially fair, again, this is far more attractive to those who know they'd have not benefitted much from the COLA adjustment in any case.  To be sure, the degree of antiselection is unknown, and may be balanced out by some number of healthy, long-lived people who want to take the cash now (see #1, financially vulnerable people), but it's unlikely we'll see the forecast savings actually materialize over the long term.

Third, it is not yet clear to what extent the calculation of the savings from these buyouts were the result of genuine actuarial analysis versus a back-of-the-envelope calculation.

According to PBS, the state assumed that 22% of eligible employees would take the vested benefit lump sum buyout, based on a similar program in Missouri.  But did they calculate that 22% of employees, across all accrual levels, or did they recognize that employees with smaller accruals would be more likely to take the lump sum?  They also assumed that 25% of new retirees each year would accept the reduced COLA.  But do the actuarial estimates take into account the anti-selection effects?

Reportedly, Rep. Mark Batinick of Plainfield has been pushing this program for several years, and Capital Fax reports that the savings were calculated by the plans' actuaries.  But due to the chaotic budgeting process, no documentation of these calculations are publicly available, and we, as the general public, have no means to assess whether these claimed savings are realistic, or simply a work of fiction that allowed our legislators to claim that they've achieved a balanced budget.

Oh, and, don't forget:  the projected savings is a drop in the bucket compared to the overall $130 billion shortfall.

What do you think?  Have your say at JaneTheActuary.com!