By: Mark Glennon*
It’s truly absurd that actuarial assumptions have become a mortal issue for Illinois state and local government, but that’s where our defined benefit pension system has left us.
The most impactful assumption is the rate of return pensions will earn on assets they have. The typical assumption of about 7.5% is universally ridiculed by financial economists. Why have overly optimistic assumptions persisted? In Illinois in recent years, that answer has been pretty clear: Pension trustees — both those appointed by politicians and public unions — wanted to hide the scope of the problem. And public unions in Illinois appeared content to rely, instead, on the state constitutional pension protection.
It’s not so simply anymore. Can-kicking accomplished this way is now under fire. Political pressures and strategies on all sides are shifting, and the fiduciary obligations of trustees limit how much assumptions can be manipulated. Evidence came in the recent decision by TRS, the Illinois teachers’ pension, to drop its rate from 7.5% to 7.0%. That small change will result in a staggering automatic increase of $400 to $500 million in the required annual contribution to the pension (unless the statutory contribution schedule is changed). Further evidence came in the changes to Chicago’s police and fire pensions passed earlier this year in Springfield.
Governor Rauner was widely reported to have lobbied against the move by TRS. Predictably, criticism ensued that he was engaging in the same can-kicking he usually rejects. Comments and emails here, too, questioned his thinking. Why not take the rate down to where it really should be — something like 1.5% to 2.5%? That would shine the light on just how doomed the system truly is and finally spur some real action, many thought.
I’m inclined to agree with that approach. A drop like that would roughly double the official unfunded liability. It would be truthful and would be the mother of all wake-up calls that the situation is hopeless. One way or another, the pensions won’t be paid anyway, and nobody would have the guts to try to force the colossal tax increase that would be needed to cover it. Sooner is better than later for Armageddon.
In Rauner’s defense, he would probably argue there’s no sense asking taxpayers to put more money into a broken system. (I have no personal insight into his or his staff’s thinking or strategy on this topic, and he certainly doesn’t communicate it well in public.) “Just don’t fund them” is indeed the only strategy left for reformers in light of an impossible legislature and courts: Spare the taxpayers now and hope for real reform later.
But there’s no automatic tax increase resulting from lowering the assumption, and the annual contribution scheduled could be lowered by statute. The union-funded Center for Tax and Budget Accountability has long advocated “reamortization,” which is little more than putting off funding. Why not take them up on that?
There’s another big obstacle to artificially propping up the assumed rate of return. Pension trustees are fiduciaries for the pension, not for the state or taxpayers. Regardless of how harmful something may be to the state, they will be inclined to go along with the growing pressure from actuaries, accountants and other critics to lower the rate in an attempt to collect more funding.
Now, there’s a case to be made that the fiduciary duty has limits. In the private sector, once a company enters the “zone of insolvency,” its board of directors is no longer a fiduciary for just shareholders — it’s obligated to look out for all claimants. Maybe the same principle should apply here. Maybe pension trustees should start recognizing a duty to minimize the government’s liability. However, that’s entirely untested, to my knowledge, and I would not count on trustees accepting it.
Turning to union and Democratic thinking on this, they had no objection to TRS dropping their rate. More interesting, however, is their support for the changes Springfield made earlier this year on Chicago’s police and firefighter pensions.
You may recall this Spring when the General Assembly passed SB777, which lowered the near term contributions to those pensions and implemented a new ramp up. Rauner vetoed it, calling it a can-kick, which it clearly was, but the legislature overrode his veto.
Why did unions and Democrats support that can-kick?
Because the new law contains an incredibly harsh automatic funding provision. Chicago property taxes will automatically increase — no vote in the City Council or General Assembly necessary — to cover the new contribution ramp. That ramp gradually increases until 2020 when an ARC-like, whatever-it-takes amount will be taxed. The law also provides that any revenue from a Chicago casino would go to those pensions.
What will that mean for assumptions? Unions and Democrats who control the boards of trustees effectively will be setting the tax by setting the assumptions. They will have every incentive to pick the most pessimistic assumptions possible in order to force the largest possible tax increase. And the actuary who calculates all this apparently will be one they can pick. SB777 says the pension itself or the Department of Insurance can pick the actuary.
The bottom line is that reformers will have a tough time opposing return rate decreases. Unions and Democrats are losing their reluctance to do so, probably because they’ve gotten worried about government’s ability to honor the underlying pension obligation when the pensions run dry. Expect to be asked to make larger pension contributions.
*Mark Glennon is founder of WirePoints. Opinions expressed are his own.