An Unbalanced Pension Proposal: “Universities” Proposal Would Erode Retirement Security, Weaken Schools’ Ability to Retain Talented Teachers, and Create New Threat to Financial Sustainability of Illinois Pension Funds

Authors: 
Howard Wial
Authors: 
Stephen Herzenberg
Publication Date: 
August 14, 2013

Executive Summary

The “Universities” proposal to alter public employee pension systems in Illinois would significantly undermine the retirement security of teachers and state workers. An estimated 80 cents on the dollar of pension system savings from the plan would be borne by retirees through a reduction in cost-of-living increases over the course of retirement. These benefit cuts would make it more difficult for Illinois public schools and the state to recruit and retain qualified college-educated employees. Additionally, the plan would create a new threat to the financial sustainability of the state’s existing public pension systems, in part by diverting a third of funds contributed by new employees away from defined benefit pension pools to individual retirement accounts. The plan could result in a drop in investment returns on the state’s pension assets with state taxpayers left to make up the difference.

The Universities pension proposal, first advanced in March by Jeffrey Brown of the University of Illinois at Urbana-Champaign and four co-authors, has received increasing attention in recent months. While the details of the Universities proposal address the State Universities Retirement System (SURS), the authors note that “our suggestions are relevant for the other [public employee] pension systems as well.” Thus, the rest of this brief considers the impact of the Universities proposal on all of the main Illinois public pension plans, focusing not only on SURS, but also on the State Employees’ Retirement System and the Teachers’ Retirement System.

This briefing paper uses the following criteria to examine the Universities proposal as a framework for changing Illinois’ three largest pension plans:

  • equity in the sharing of sacrifice among pension system stakeholders;
  • the impact on retirement security of Illinois pension plan members;
  • the ability of employers who participate in Illinois pension plans to attract and retain high-quality employees; and
  • the impact on taxpayers.

We find that the Universities proposal makes some important contributions to the state pension debate. For instance, the proposal endorses a system in which the state makes fixed payments into the pension system (similar to a mortgage). This would ensure that the state does not make contributions that are too small in the next few years, and would steadily improve the pension systems’ funding ratios. The Universities plan, however, also has several major flaws:

  • It would be highly inequitable in its distribution of costs. According to its authors, approximately 80% of the projected savings from the Universities proposal would come from reducing the inflation-adjusted benefits of current and former Illinois employees.
  • It would undermine the retirement security of Illinois public-sector retirees, and especially harm those who live a long  retirement. The Universities proposal would cut the annual Cost-of-living adjustment (COLA) in the Illinois pension plans from a fixed 3% to one half the annual percentage increase in the Consumer Price Index (CPI). Assuming an inflation rate of 3% per year, the Universities proposal would cut in half (from 3% to 1.5%) the annual inflation adjustment to retiree benefits under the Illinois pension plans. This translates into a 31% reduction in pension benefits for 25-year retirees. The Universities proposal would protect the retirement income of Illinois public-sector retirees against inflation only half as much as Social Security benefits are protected against inflation. (Social Security benefits are indexed to the Consumer Price Index.) The deep resulting cut in retirement benefits for older seniors would particularly threaten retirement security for lower-income state workers, for school teachers (who do not participate in Social Security and thus do not benefit from its COLA protection), and for retired Illinois state workers  who did not participate in Social Security during their public employment.

Under the Universities proposal, we estimate that Illinois public sector retirees  who do not participate in Social Security would have inflation protection in their retirement income inferior to the average retirement income inflation protection enjoyed by all but a portion of the richest fifth of all U.S. retirees 65 and over. The inflation protection provided to these Illinois retirees in the Universities proposal would also be as bad as or worse than that in all but two of the other 19 non-Illinois state pension plans across the country (in 10 states) in which pension plan members do not participate in Social Security.

Additionally, the Universities plan would require new employees (and allow existing employees) to  enroll in a hybrid pension plan that combines a smaller defined benefit pension with a 401(k)-style individual savings accounts. The combination of the reduction in the defined benefit and a lower cost-of-living adjustment would reduce retirees’ benefits by more than half (53%) for 25-year retirees compared to current Illinois pension plan participants who joined the system before 2011 (“Tier 1” employees).  On the defined contribution portion of their retirement savings, Illinois public-sector retirees would now bear the financial market, or investment, risk of saving for retirement. Retirees would also risk outliving their savings in the defined contribution portion of the plan — which, unlike the defined benefit portion, would offer them only a lump sum in their investment account rather than an annual payment.  The defined contribution portion of the plan would also likely provide future employees with lower investment returns than the current defined benefit plans and would come with higher fees, further reducing the growth of retirement savings.

  • It would hamper the ability of Illinois public employers to attract and retain qualified college-educated employees, including teachers. Public sector salaries for college-educated public sector workers already trail private salaries for comparable employees (with similar education, experience, and other characteristics). This makes good quality retirement benefits pivotal to retaining talent (as the authors of the Universities proposal acknowledge with respect to higher education).  Especially for Illinois teachers, some of whom could get better retirement benefits in non-teaching jobs in the private sector (from Social Security plus an employer-based savings plan), the deep cut in the pension COLA could make the overall school compensation package non-competitive. This could increase the challenge of attracting and retaining outstanding teachers for Illinois public schools.
  • It would introduce a new risk to Illinois taxpayers.  The proposal would reduce funds going into the state’s existing defined benefit pools and increase the share of defined benefit pension obligations owed to retirees and to older active employees. This could lead plan managers to invest in more conservative and liquid assets, reducing future investment returns for the existing pension plans and increasing the state’s unfunded liabilities, with taxpayers having to make up the difference.

The rest of this brief evaluates in more detail the Universities proposal using our four criteria. In the spirit of “slow and steady wins the race,” we argue in the last section for (a) extending the period of time it takes Illinois to fully fund pensions and (b) making sure that adequate contributions are made in the near term so that the plans begin to move to a sound financial footing.