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Illinois Pension-Funding Mess Offers No Easy Solutions
With lawmakers scrambling to reform the state’s cash-starved pension system after a court setback, hybrid plans could be in the offing.
As state and local pension systems across the U.S. struggle to find solutions to their underfunding woes, the last place theyll find hope is Illinois. Thanks to a recent court ruling, lawmakers in that state have gone back to the drawing board in the search of a fix for its cash-strapped retirement system, which may be the nations most troubled.
Taken together, the five state-funded Illinois pension programs are only 43 percent funded, short a staggering $105 billion of what they owe current and future retirees. Standard & Poors and Fitch Ratings rank Illinoiss creditworthiness last among all 50 states, citing the pension mess and broader budget woes.
In late 2013, when state lawmakers passed legislation reducing the future benefits of workers and retirees who entered one of four of Illinois's five state-funded systems before January 1, 2011, many of them spoke about it with equal parts self-congratulation and relief. At the time, they calculated that with the legal changes the states pension plans would be fully funded no later than 2044.
But in May the Illinois Supreme Court threw out the reform law, declaring it unconstitutional. The states constitution has one of the strictest stances in the nation on pensions: It states that membership in a pension system represents a contractual relationship whose promised benefits shall not be diminished or impaired. Only Alaska and New York also constitutionally protect past and future pension rights.
This legal protection means that Illinois cant rein in its pension liability by, say, reducing the annual cost-of-living increase that workers in the system will receive when they retire a step that the 2013 legislation attempted and many other states have successfully taken. Of the 17 states that shrank their cost-of-living allowances, 12 have faced court challenges, according to the Center for Retirement Research at Boston College. The courts have ruled in ten states and upheld the cuts in all but three of those: Illinois, New Jersey and Oregon.
Whats unusual about Illinois is that the constitution specifically says that a pension benefit shall not be impaired, and the Supreme Court has read that literally and said you cannot touch it, says Keith Brainard, research director for the National Association of State Retirement Administrators, a Lexington, Kentuckybased nonprofit whose membership comprises directors of the countrys public retirement systems.
As a group, Illinoiss public plans probably have the lowest funding in the U.S., notes NASRA research manager Alex Brown. But Brown adds that he cant say so with certainty, because funding ratios are reported by system, not by state. Of the five U.S. public retirement systems with the worst funding levels for the 2014 fiscal year, three are in Illinois, according to the Public Plans Database, which is maintained by NASRA, the Washington-based Center for State & Local Government Excellence and the Center for Retirement Research.
One big reason for Illinoiss problems is that for decades its General Assembly has failed to approve funding for its pension systems, even as employees kept up payments. Skipped payments by the state account for roughly 40 percent of the current shortfall. As a result, Brainard cautions against seeing the Illinois debacle as part of a larger systemic weakness among state pension funds, or even as continued fallout from the recession. Theyve got this unique combination of a very strict constitutional protection and an experience in which they have egregiously underfunded their benefit levels, he says. Its the two things in place simultaneously that have put them between a rock and a hard place.
This uncomfortable situation is yielding proposals that some call creative; others, far-fetched. Republican Governor Bruce Rauner successor to Democrat Pat Quinn, who signed the 2013 pension reform legislation believes the solution is for state voters to accept a constitutional amendment clarifying the distinction between currently earned benefits and future benefits not yet earned, his press secretary said in an e-mailed statement. Such an amendment would make way for legislation moving current workers to a lower-paying benefit plan, whereas benefits already earned would remain untouched.
But State Senator Daniel Biss, a Democrat, calls a constitutional amendment a red herring. Not only would it be difficult to find enough support among voters, Biss tells Institutional Investor, but the change may not have the desired impact. The Illinois constitution as it currently exists activates the contract clause of the U.S. Constitution to protect pension benefits, he explains. Even if you subsequently repealed the Illinois protection, you dont un-activate the U.S. Constitutions contract clause. I think its a mistake to go down that path.
Biss favors the strategy underpinning the other main proposal currently on the table before lawmakers, put forward by Illinois Senate president and fellow Democrat John Cullerton. This proposal latches onto an aspect of contract law called consideration, which Cullerton says would allow benefits to be reduced as long as employees agree to the revisions and receive something in return. He suggests that workers choose between not having pay increases factored into their pensions (in exchange for an annual 3 percent compounded cost-of-living increase in retirement) and counting pay increases (and receiving scaled-back cost-of-living increases that are not compounded). Cullerton has stated that he figures his plan would save Illinois $1 billion a year, which critics point out is not nearly enough to dent the states current pension deficit.
Once the pension liability is tamed through some combination of tax increases, expansion of the tax base, state funding cuts and other legislative measures, Illinois will probably join the U.S. public systems that have devised a hybrid defined benefitdefined contribution plan for new employees. Although hybrid systems can take many forms, they are defined-benefit-like in that the value of retirement accounts cannot be reduced, and the assets and liabilities are pooled and professionally invested; they also resemble defined contribution plans because to some extent their benefits rely on market returns. Governor Rauner has said that he favors such a hybrid.
There has been a trend among states to establish hybrid plans as an element of pension reform, NASRAs Brainard says. It would not surprise me to see Illinois establish some form of a hybrid retirement benefit.