Print Friendly, PDF & Email

February 27, 2014 by: James T. Palermo*


Every Illinoisan who follows the news knows our five statewide public pension funds are in terrible condition. According to the Illinois Commission on Government Forecasting and Accountability (COGFA), the unfunded liability of those five statewide funds is approximately $100 billion. More conservative estimates using market based discount rates place the underfunding at closer to $200 billion. Though lesser known and not yet the subject legislative reform, the troubles facing Illinois municipalities are every bit as severe.

ILLINOIS’ LOCAL PENSION PLAN TROUBLES: A WELL KEPT SECRET

Illinois’ nearly 650 local police and fire pension plans are deeply underfunded. According to COGFA, in 2010,  the last year for which compiled data is available, the average funding level was just 54%. Though funding levels look better than the statewide plans, local funded ratios are likely overstated.


Unlike the widely recognized short-funding experienced by their larger cousins, where for years politicians simply ignored the necessary contributions, the short-funding suffered by many police and fire plans goes largely unnoticed. Pension actuaries have broad latitude over the economic and demographic assumptions they use to value plans’ liabilities and necessary contributions. Deliberate over-optimism in assumptions on employee retirement age, mortality, investment return and even the age of the retirees’ spouse can reduce the amount municipalities must contribute to plans each year. Actuaries can win consulting mandates using this discretion to tailor valuations and prescribe municipal contributions to meet the clients’ budgetary and political needs.

 

THE PARADOX OF PENSION GUARANTEES AND LAX PENSION PLAN GOVERNANCE

The Pension Clause of the 1970 Illinois Constitution provides that public pension benefits ‘shall not be diminished or impaired,’ preventing the reduction of benefits without labor’s consent. Intended as a protection from legislative taking of future benefits already earned, the constitutional guarantee may actually weaken the financial security of pension benefits.


Unlike in the private sector, public plans are not covered by stringent ERISA rules requiring IRS oversight of pension funding calculations. In the private sector framework, where the solvency of the pension plan (with limited PBGC backstop) determines its ability to pay retirement benefits, the pension trustees’ financial incentives align with their fiduciary duties to act in the sole interest of plan beneficiaries. Fiduciaries insist on sound, conservative assumptions in the calculation of Actuarially Required Contribution (ARCs) and demand full funding to comply with the law and to assure the plan is adequately funded.


Constitutional guarantees introduce a moral hazard to public sector plan governance. Illinois police and fire pension boards, dominated by active and retired plan participants, may eschew sound funding practice and adopt less conservative actuarial assumptions with the expectation that a future generation of taxpayers will be legally bound to, and capable of picking up the tab for the prior generations’ indulgence. Their incentive? Smaller plan contributions leave more money today’s government including union pay increase, higher end-of-career earnings and ultimately, higher pension benefits.


While seemingly at odds in the pension funding relationship, elected officials, municipal management and labor may actually be willing partners in the actuarial ruse:

• Faced with the alternatives of increasing taxes and fees on a weary electorate, or reducing service or infrastructure maintenance, both political career-killers, elected officials may instruct municipal management to seek the services of an optimistic actuary to reduce current pension contributions.

• Municipal management, seeking labor peace and wage parity with organized labor, can share the faulty assumption bounty with labor by granting more generous contracts to the bargaining units.

• As a reward for balancing the budget and keeping peace with labor, elected officials pay municipal management higher salaries than possible were there no actuarial sleight-of-hand.

• Actuaries who must compete with each other for plan business accommodate the clients’ needs by using optimistic assumptions. They are also quite satisfied to use the minimum standards set by state legislation with respect to actuarial methods and the amortization of unfunded liabilities rather than methods and amortization schedules that would result in higher current contributions.

MUNICIPALITIES NEED TO ACKNOWLEDGE THE TRUE CONDITION OF THEIR PENSION PLANS

Each year the Illinois Department of Insurance (DOI) prepares a Tax Levy Report for each of the state’s police and fire pension plans. Data from 2010 indicate about 55% of police and fire plans, primarily smaller plans, base their municipal contributions on the DOI recommendation. The remaining plans use private actuarial consultants. The private consulting field is very concentrated with three firms consulting more than 90% of the Illinois police and fire plans. Plans are free to base their contributions on either source the DOI estimate or their consultant’s recommendation.


Until 2012,when the DOI published its actuarial experience study the DOI’s assumptions themselves were dubious, basing mortality assumptions on the 1971 GAM table, colloquially called the ‘chain-smokers table’ because it is so out-of-date. Between plans using bad assumptions deliberately and those using them inadvertently, arguably the use of dated assumptions had become institutionalized, with many trustees being unable to recognize actuarial reality.


Table 1 highlights some of the key assumption changes that came out of the experience study:

TABLE 1

Expected Investment Return

Return is lowered from 7.5% to a range of 5.0% for the smallest plans to 6.5% for the largest.  The lower expected return results in higher required contributions

Mortality Table

The 1971 GAM Table is replaced with the more conservative RP-2000 BC Table.  The expectation is that participants will live longer than previously believed.

Age of Spouse

The assumption that the female spouse is three years younger than the male spouse is adopted.  Younger spouses are expected to live longer, requiring larger municipal contributions

Retirement Age

Police officers and fire fighters are expected to retire at a slightly younger age than previously thought

Disability Frequency

The frequency of disability assumption increases.  However, the increase does not result in a meaningful increase to pension contributions.

 

On the whole, changes to the DOI assumptions result in larger unfunded pension liabilities and larger municipal contribution and are in keeping with actuarial standards of practice. Though more costly, the new, higher liabilities are just a recalculation of existing benefits. Benefits have not been made more generous; they’ve become more costly because benefits will be paid longer under the new assumption.


Smaller plans that have historically used the DOI recommendations have already experienced increased contributions. Depending on whether private actuaries’ adjusted assumptions in accordance with the DOI changes, larger plans may or may not have seen their funded ratios fall and contributions increase.


It’s unclear the extent to which Illinois’ police and fire actuaries have adjusted their assumptions to reflect the new DOI findings, only a survey report by the state will reveal this. When the data is finally assembled, we’ll find that Illinois’ local police and fire plans are in poorer condition that we believe today.

WHITHER REFORM?

When the General Assembly takes up local pension reform, it must consider the conditions of the plans using up-to-date assumptions. It can’t solve the pension challenges without knowing the true extent of the funding gaps. A sound measure of unfunded liabilities will be a catalyst for discussion on funding discipline, revenue enhancements, benefit recalibration and municipal cost reductions.


If the hallmark of a well-struck bargain is that all the parties leave unhappy, Illinois police and fire pension reform is primed for a good deal. Taxpayers, retirees, current employees and elected officials will all have much to be unhappy about.


*James T. Palermo, CFA, is a trustee in the Village of La Grange and financial professional working in Chicago. His opinions are his own.

Sort by:   newest | oldest | most voted
wpDiscuz