By: Tia Goss Sawhney, DrPH, FSA, MAAA*
In the October 9 gubernatorial debate between Governor Quinn and Bruce Rauner. Gov. Quinn said he deserves credit for making Illinois’ full pension payment each year he’s been governor — something his predecessors didn’t do.[i] While Gov. Quinn deserves credit for making full pension payments when, in fact they have not always been made in the past, what exactly is a full pension payment?
You may be surprised to learn that fiscal year 2013’s full payment of about $6.0 billion was nearly $3.5 billion less than what was required to simply hold the end of fiscal year 2012 pension debt level where it was, even if all else went as expected. In other words, the “full” payment was less than 2/3rds of the payment necessary to maintain the debt status quo.
To understand how this can happen, you need to understand a bit about pension plan payments. There are two components to a pension plan payment. The first component is the “normal cost”. It is more intuitively called the “current year cost” as it is the cost associated with the pension benefits earned by the active (working) plan participants that year. The second component of the payment is for the amortization of any pension debt (unfunded actuarial accrued liability). The full payment, referenced by Gov. Quinn, is the total of the employer’s portion [ii] of the normal cost and the scheduled amortization payment.
You are probably already familiar with amortization payments as your mortgage is an amortization payment. So are other loan payments, such for your car or student debt. A typical amortization payment has two components: the amount necessary to pay the interest on the debt and at least a bit more that is used to “pay down” the principal of the loan. If you have a level 30 year mortgage, your initial payments will be almost all interest. But, as the little bit more that you pay reduces the loan principal, the interest component of your payment decreases and the principal portion increases. By the end most of your payment is principal.
Therefore the full payment referred to by Gov. Quinn is the sum of the employer normal cost, interest cost, and principal reduction payment.
With apologies for bringing back memories of high school this can be shown with some simple equations:
Given: Full Payment = Employer Normal Cost + Amortization Payment
And: Amortization Payment = Interest Cost + Principal Reduction Payment
Therefore: Full Payment = Employer Normal Cost + Interest Cost + Principal Reduction Payment
For fiscal year 2013 the employer normal costs for the various state plans were $1.9 billion, the interest cost was $7.5 billion, and the state made payments of $6.0 billion (see this link). With extra apologies to those memories of high school, we can put these values into the last equation and “solve for” the principal reduction payment:
Values: $6.0 = $1.9 + $7.5 + Principal Reduction Payment
Therefore: Principal Reduction Payment = $6.0 – ($1.9 + $7.5) = $ –3.4
The negative sign associated with the $3.4 billion principal reduction payment is not a mistake. The full payments that Gov. Quinn made in fiscal year 2013 fell $3.4 billion short of the amount necessary to reduce the principal on our pension debt. Full payments the other years also fell well short of reducing principal. With full payments the Illinois pension debt is expected increase. [iii] This is known as “negative amortization”. [iv]
The negative amortization occurs because, unlike the typical mortgage, Illinois debt is not being amortized on a level payment basis. Instead the State, via legislation, directs the actuaries to calculate the full payment as a level percentage of the expected active plan participant payroll for the next several decades – a payroll that the actuaries assume will increase over time. The math associated with an increasing payment is such that today’s payment does not need to be sufficient to cover today’s normal costs and interest costs – the principal can be allowed to grow with the expectation that higher payments in the future will ultimately pay the principal.
While increasing or “back ended” payments are often referenced in the Illinois pension debate, the presence and level of negative amortization is far from readily apparent. It was not apparent to me until pulling the numbers. Many of Illinois’s local plans are also negatively amortizing.
Is negative amortizing legal? Yes. The Illinois legislature sets the law with respect to the amortization of Illinois pension debt, including the local plans. If the legislators want to negatively amortize, they can. Whereas, Gov. Quinn has, unlike his predecessors, made full pension payments, he has, like his predecessors, benefited from legislation that increases pension debt even in the “good” years when full payments are made and the plan experience is consistent with actuarial assumptions.
Should negative amortization be more prominently disclosed, perhaps in the actuarial valuation? I think so. Some actuarial reports do disclose negative amortization, at least for the year just ended, except it isn’t clearly labelled as such.[v] Other reports typically have the necessary data elements necessary for calculating negative amortization. The elements can be hard to find, however, as they may be scattered and variously labeled. Finding negative amortization typically requires a good working knowledge of public pension plans and actuarial terminology. There is no requirement for negative amortization to be prominently disclosed. The Actuarial Standards Board recently considered and rejected requiring actuaries to specifically disclose negative amortization. [vi]
Finally, we need to consider that what hasn’t yet been paid, has to be paid tomorrow. Even under pension reform, most of what hasn’t been paid will still need to be paid.
The amortization schedule assumes every-increasing pension payments. Yet our state is considering a significant tax decrease. Furthermore, even though the pension payments are calculated as a level percentage of expected payroll, reducing future state payroll does little to mitigate the challenge. Since the pension debt is with respect to pension benefits already earned, reducing future payroll simply means the interest and principal payments as a percentage of payroll will have to increase.
*Dr. Sawhney is a qualified health insurance actuary employed by the Illinois Department of Healthcare and Family Services. As such, she is an active participant in the State Employees’ Retirement System (SERS), a highly underfunded Illinois plan.
The opinions expressed are solely her own. She has produced them on personal time and equipment. While she is an actuary and Illinois public pension stakeholder, she is not a pension actuary. She may be reached at firstname.lastname@example.org.
[i] Crain’s summary of the debate: http://www.chicagobusiness.com/article/20141010/NEWS02/141019999/quinn-rauner-tangle-on-economy-pensions-in-first-debate
[ii] Employees also contribute to normal cost.
[iii] Unexpected events, such whether a plan earns the expected investment return, also increase and decrease pension debt. I am limiting this discussing to the impact of expected events, including scheduled plan payments on the debt. In a future article we will discuss that some “unexpected” events are more expected than others.
[iv] Here is one of many links describing negative amortization: http://www.thetruthaboutmortgage.com/negative-amortization-loan/
[v] In Illinois the SERS/Judges/GA actuarial valuations labels the negative amortization for the year just ended as “Expected increase in UAAL”, the TRS actuarial valuation labels it as “Employer cost in excess of contributions”, and the SURS does not calculate the negative amortization and the interested user must find the necessary data elements.
[vi] See Actuarial Standards of Practice (ASOP) 4: Measuring Pension Obligations as found at http://www.actuarialstandardsboard.org/asops.asp. The introduction to the new ASOP 4 that will be effective at the end of 2014 specifically notes that a requirement for disclosure of negative amortization was considered and ultimately rejected.