Four ways Illinois can fix the Pension Crisis: But which will be chosen?

The Illinois pension system (TRS, SURS, etc.) has been in crisis for a number of years. In TRS’ Spring 2016 report, they reported that the pension system is 42% funded to meet its outstanding liabilities. It’s been around this number for at least the last five years. In being at this number, it is one of the top five WORST funded pensions in the country, but it is also one of the largest in the number of members it serves.

So how does this 42% become 52, 62, 72, or even 82%? Before I explain this, it should be noted that I didn’t include anything above 82%. The reason for this is due to how a pension is funded and what liabilities it includes when calculating it’s funding percentages.

Trouble ahead

 

When a pension looks at how much money it needs to pay out, it calculates benefits needed for all of its members who are retired over their entire lifetime, labelled as its outstanding liabilities. While the amount needed for this in the TRS system is over $100 billion, an annual amount of $6 billion is all that is needed to make sure everyone receives their benefits. If TRS were to have $100 billion in funding – allowing it to meet benefits for decades in advance – it would be considered to be an overfunded pension and a waste of teacher’s and taxpayer’s dollars. The fine line between what is an underfunded and overfunded pension is a thin one, but one that Illinois has not been close to in a long while.

There are four ways (that I see) that Illinois could bring up the funded liability percentage – some quicker fixes than others, some impossible to control, and others requiring changes to the Illinois constitution. None of these fixes are easy or quick to implement but they would change the system as we know it, making it better for all. While I’m not advocating for one over another, it should be noted that change does need to be made in order for the Illinois pension systems to survive.

It should also be noted that while some of these changes directly impact teachers and their benefits, the problem has resulted due to the corruption of the Illinois Governor’s office and its state representatives.

 

Introducing a Tier 3 system

Every teacher in Illinois who taught before January 1, 2011 is on the Tier 1 system. This allows for teachers to retire with 35 years of service or at the age of 60 and receive a pension of 75% of their average salary in the highest four years out of the last 10. By making a contribution of 9.4% of their paycheck each period over their career, they are guaranteed that amount under state law.

For any teachers who started working after January 1, 2011, they are in the Tier 2 system. Drastically different from Tier 1, a teacher now has to work until they are 67. Their salary in determining their pension is capped at the same level used by Social Security, so a pension for highly compensated staff will never go beyond a certain threshold. There are a variety of other detrimental changes when compared to Tier 1, but the funding percentage still remains the same (9.4%).

The only reason Tier 2 was allowed is that it changed benefits for teachers not currently employed (as the law was made prior to 2011). The Illinois Constitution expressly forbids changes be made to a current pension system where workers are currently employed.

If things do not change, will we see a Tier 3 system, and what further changes will that entail?

 

Here are some thoughts:

  • Reduce the 9.4% funding percentage to match Social Security (6.2%).
  • Utilize the Social Security formulas to calculate a final pension benefit, causing a maximum monthly pension of $2,639 (like Social Security).
  • Implement an annual increase to the pension tied to the Consumer Price Index, as is done with Social Security. (A similar benefit is in place for Tier 2, but it does match the rules for Social Security).
  • Change the pension calculation to include not four (Tier 1) or eight (Tier 2) of the last ten years, but look at the average salary over a teacher’s full career. This would lead to a smaller benefit but one that is representative of career earnings, not cherry-picking the highest, most recent salaries.

While any changes made of this nature would take a while to see an impact, it would be a step in the right direction to increase the funding percentage. The major downside to this is it would make teaching an even more unattractive career to pursue for financial reasons, and teachers may look to more financially-stable states to pursue their career.

 

Increased taxation

Illinois currently has a 3.75% income tax, varying levels of sales tax from 6.25% to 11%, and effective real estate taxes of around 2.25%. In real estate taxes alone, it is the second most expensive state in the country behind New Jersey.

Source: WalletHub

 

For the state to catch-up with the missed contributions and “I-O-U’s” it’s made over the years, there may need to be an increase in tax revenue to cover the increased contributions. This increase in tax revenue – which is hard to come by in any state – may come from increased taxation of its population or a cut in services offered by other government entities.

No-one is in favor of this approach. Private-sector workers will feel the pinch, as will teachers. While their pension won’t be adjusted, they’ll have to pay more in income taxation to receive the same benefit. Other citizens, having seen in the media how generous some TRS pensions can be, will be up in arms that they are paying more to keep those benefits going. This is ignoring that an average Illinois teacher’s pension is close to $40,000, and that they pay more into the system than a comparable Social Security-covered worker.

While Illinois has tweaked its state income tax in the past (it has been 5% in recent years), I do not think increasing the taxes on Illinois residents will have a major part to play in solving the pension crisis. The pension deficit is too large for a marginal increase in income taxes to make a difference.

 

Buy outs

A recent proposal that’s being floated is that TRS should buy out tenured and vested teachers of their pension obligation. This would lead to teachers receiving a lump sum and then self-managing their retirement plan through the state – an option which is already proving popular in the SURS plan.

While this would relieve a long-term burden it would create short-term havoc with the pension structure. The way the TRS pension is funded is that current teachers contribute an amount to pay for retired teachers’ benefits. It shouldn’t happen that way, but as the pension is severely underfunded, it’s working out that way. As it sounds, the pension system is looking more like a Ponzi scheme as the funding level gets lower – the pension needs employed teachers to pay into the system to keep it afloat. Should state government increase and raise the funding level, this scenario will change, but for now it stands as stated.

If the pension system were to provide payouts to certain teachers, then that teacher’s salary contributions would no longer be going into the general pension fund. This would take away current funding but bring down a future long term liability of paying that teacher a pension.

There also seems to be some short-sightedness into how much it would cost to pay a teacher to leave the pension plan. Currently a teacher earning $75,000 and then receiving full pension benefits at retirement (75%), will receive $56,250 in their first year. If a payout was to be made at retirement, then a lump sum equivalent to provide this income would be $1.1-1.4 million, assuming a 4-5% withdrawal rate on this amount (See what the “4% rule” is here). For a plan that is only funded 42%, it would be hard to come up with these kinds of numbers and keep the plan in solvency. Additionally, any teacher accepting a lower number than this would be short-changing themselves of funds they would receive throughout their retirement.

One way that lump sum benefits may work is for teachers on lesser tenure / service credit. Their buyout will be smaller (as their salary and service credit is smaller) and they can still utilize a self-managed plan to build up an ancillary benefit.

This plan does fall down once you have more than a handful of teachers taking advantage of it. The more teachers that move out of the pension program, the more funding is reliant on the government, and the lack of consistent funding is what got Illinois in trouble in the first place. Any buyouts would need to be structured over a number of years so that new teachers coming into the pension system would be able to make up for lost contributions of those accepting buyouts.

While I am in favor of a self-managed plan, the heavy reliance on government funding to make it work will make any educator nervous that they’ll get what they have been promised.

 

A change in Illinois’ constitution

The main way that a fix to the pension system will be made is a change to the Illinois constitution. This method has been targeted in recent proposals, but no bills have gathered support in the Illinois House of Representatives. This route would take the longest amount of time, and be the most contested, but would enable the pension plan to be fixed quickly and remain viable for the most amount of members.

A change to the plan with a change to the constitution would affect the most teachers – certainly all those who are working, with the potential of affecting those who are retired. While I severely doubt that retired teachers would have their pension adjusted, a change to the constitution would put everything on the table.

While I am not in favor of any changes, for selfish reasons pertaining to my family and clients, I am not naïve enough to think the system can remain as it is. For that reason, I hope a change in the constitution can be made, changes be swift, but that everyone can move on knowing that their pension will not be subject to review or attack again in the future.

 

What change makes sense?

If I had my way, a change in constitution would only change the way the pension is calculated. Instead of cherry-picking high earning years in the final years of a teacher’s career, the pension formula would reflect that of a corporate structure. A teacher’s entire career earnings would be averaged and then this number used to provide an annual pensionable amount. This would bring down every teacher’s pension, whether working or retired, (although retired educators should remain exempt) but be more in line with a realistic pension amount, and fall in line with pension calculations as seen in the corporate world.

I know my opinion will not be popular with the teaching community – as they have held up their end of the bargain – but I want every teacher to have peace that they will receive a pension, even if it is smaller than they hoped or had been told.

 

How do I address this issue with clients?

As you may know as a reader of this blog, I provide personal financial advice to educators around the country, primarily in Illinois. I welcome conversations from people to see if I can be of help in their situation.

For clients who are in a state with a troubled pension plan, I explain how the plan is funded and what shortfalls it has. I will then show them what happens to their financial plan if their pensions benefits were to take a 25-50% cut. Most of the time it’s not pretty, but it will spark discussion to see if what they are preparing for or expecting out of retirement is realistic. We discuss if a pension were to be cut, what changes would take place in their plan, how drastic would these changes be and how would it affect their long-term stability. I take it to the extreme with pension cuts as I can’t foresee what will happen in the future, and a discussion of the worst case scenario often takes the “sting” out of it. When it’s in the open, the fear dissipates, even though the realization may not be comfortable. I don’t think a 25-50% cut will happen, but “preparing for the worst and hoping for the best” is a far more helpful way to live life than not preparing at all.

If you’d like to see what your situation looks like with pension cuts and what you’d need to change to make sure life became “livable” again, maybe we should talk? Email me at dave@financeforteachers.com to set up a time to get to know each other.