On pensions: Something’s gotta give
BY TERRY SAVAGE December 23, 2012 6:12PM
Illinois' Thomson Correctional Center. | M. Spencer Green~AP
Updated: May 3, 2013 12:15PM
The State of Illinois cannot print the money to pay the pensions of teachers and other state employees. And there isn’t enough money in the pension funds to generate the promised payments. It’s a simple fact, acknowledged by everyone who can do the math.
Moody’s Investors Services just recently lowered Illinois’ credit outlook to “negative” from “stable.” The state’s $28 billion general obligation debt is currently rated at A2 — the worst credit rating given to any state. Another downgrade would increase the interest rate cost of all state borrowings, adding to our fiscal problems.
Clearly, this is not just a crisis for state employees who hope to retire and live on their pensions. It impacts every Illinois taxpayer, because we will all be asked to pay up. Higher taxes threaten businesses that will look for more tax-friendly states — taking jobs with them. The pension problem hits the education system, making it difficult to recruit and retain good teachers. And it impacts a range of people who count on the state for benefits — from children to seniors, because money diverted to pay pension obligations will come from spending on social programs. Or else, taxes must be raised on incomes or property.
That’s what has business leaders so riled up. Illinois already has one of the highest state tax rates in the country. They know that businesses can and will move out of state if taxes make them non-competitive. The founder of Jimmy John’s sandwich shops has already made the move, on both a personal and business basis. As businesses and individuals who can afford to leave Illinois take action, it further diminishes our tax base and jobs outlook.
Illinois is not alone in having an underfunded pension system. It’s estimated that all states together have unfunded teacher pension liabilities adding up to $325 billion. But Illinois is in the worst shape — with an unfunded teachers’ pension liability of $43.5 billion. The total underfunding for all state pension obligations is $95 billion.
That deficit grows exponentially as the state falls behind. Money that is not in the plan cannot be invested to provide future returns. And, frankly, the estimates of future investment returns seem pretty exaggerated. Currently, Illinois is projecting a 7.5 percent investment return, but in recent years actual returns have been nowhere near that level.
What’s making headlines now is an ongoing fight over who caused this debacle, and who should pay up. Yes, the employees have already been contributing their fair share. And it’s obvious that the politicians are to blame for not making the required contributions. But that’s where we are now.
The choices for the future are stark — but time spent debating blame, and jockeying for position in raising the money is money lost for future retirees. The longer we wait, the greater the eventual cost. Here are the tough choices, or combinations of choices:
♦ Keep the current system for older state employees who are not yet retired — but insist that at retirement they must pay more for medical coverage, or take a smaller annual cost-of-living increase than the current plan promises.
♦ Change the pension system — for current younger employees. Turn it from a “defined benefit” — check-a-month — plan, into something that resembles corporate 401(k) plans, where workers contribute, invest, and withdraw in retirement with no guarantees of monthly or lifetime payments.
♦ Raise taxes to “fill up” the plans now, so future promises can be kept. (The fight will be over who should be taxed and whether the tax should be on income, property or sales.)
♦ Take existing state tax collections away from programs like prisons, law enforcement, Medicaid, and education — and divert that money toward the pension plans.
The problem with the solutions
The choices listed above are guaranteed to create antagonism — but that is how they have been framed in the political debate. If instead you listen to pension experts, there are much more subtle and honest actuarial changes that could be made to put the pensions on a solid footing.
Avijit Ghosh is a pension expert at the University of Illinois, one of four scholars who have just issued an understandable explanation of how those changes could be incorporated — if we could get past the current antipathy. He stresses the importance of acting now before we destroy our state university system — and our state tax base. But he notes that changes must fall within the state constitutional guarantee that pension promises made cannot be rescinded. The report’s suggestions: [The full report is available at http://igpa.uillinois.edu/system/files/A_Time_for_Action_on_SURS.pdf]
♦ Change the calculation for the “annual normal cost” of the required pension contributions. The internal calculation for Effective Rate of Interest has been between 7 to 10 percent. Changing that to 4 percent (a 1.25 percent premium over risk-free long-term Treasuries) would reduce unfunded liabilities by nearly $1 billion, by accruing benefits more slowly.
♦ Converting future benefits to lump sums in defined contribution plans would put the investment burden on individuals — and effectively do away with the mandated 3 percent compounded annual cost-of-living increase for retirees. The study says this is fairer to current employees, who have received little or nothing in the way of raises, while retirees get that 3 percent compounded raise.
♦ Finally, the report suggests that Illinois start taxing income from pensions, annuities, and even Social Security — in order to raise another $1.1 billion each year that could be partly put toward funding state pensions.
No one is going to be happy with these solutions. But it’s time to stop treating this as a political issue and recognize that it is an immediate financial crisis that impacts every Illinois resident. And that the sooner we fix it, the less we will all ultimately have to pay. That’s The Savage Truth.
Terry Savage is the Chicago Sun-Times’ nationally syndicated financial columnist, and a registered investment adviser.