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311-139 Tough Choices for the Illinois Pension System

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lower of: 75% of an employee’s average salary over his or her last few working years, or 2.2% multiplied by the number of years employed by the State multiplied by an employee’s average salary over his or her last few working years.2

Plan employees and the State of Illinois contributed to the plan in order to finance the eventual payments owed to retirees. These contributions were pooled and invested by each retirement system. The trustee of each retirement system, not the employees themselves, was responsible for the asset allocation of its pool, which was to be invested so that the system could make monthly payments to retiring employees.

The Illinois pension systems had been chronically underfunded; there were not enough assets in the pension systems to pay their liabilities—the present value of the obligations to future retirees. In 1950, an actuary for the TRS declared the system’s funding “unsound” and reported that TRS had assets to back only 23% of the future liabilities owed to employees.3 According to the actuary, the State of Illinois was not making yearly contributions to its pension systems in an amount large enough to finance future payments to eventual retirees—largely as a result of the lax accounting standards of the time.

Accounting standards for state and local municipalities were set by the Government Accounting Standards Board (GASB), a private, non-profit organization. GASB’s generally accepted accounting principles (GAAP) were not federal laws, nor was the SEC allowed to enforce them. However, many states such as Illinois mandated compliance of their pension plans with GASB. Until 1986, GASB had not required states to make contributions to their DB plans based on their future retiree claims, only that they make the payments required for current retirees. In 1986, states were finally required to report the total unfunded balance (the portion of the liabilities not funded by existing assets) and an actuarial estimate of the total pension liabilities called the Pension Benefit Obligation (PBO). Although pension disclosures had improved, GASB had not required governmental pension systems to make additional payments other than those immediately due to retirees in the current period.

In 1989, the Illinois legislature made its first attempt at pension reform by endorsing a plan that called for the full funding of the PBO over 40 years after an initial seven-year phase-in. However, there was no continuing appropriation to finance pension contributions, so the State did not implement the funding plan.4 In 1994, the Illinois legislature passed a similar law with continuing appropriations and required the State to make annual contributions to the pension according to a schedule that was designed to achieve a 90% funded ratio by 2045.5 At the time the 1994 law passed, the funded ratio (the ratio of the assets divided by the net present value of the pension liabilities) was estimated at 52%.6 Exhibit 2 shows the proposed funding schedule according to the 1994 law.

While the funded ratio had been lower than 52% historically, Illinois legislators felt that they had to pass a funding law, because the State could not look forward to the positive demographic trends it had experienced in the past. The total population of the State had grown by 20% from 1970 to 2000, which meant that there were more taxpayers and employee contributions to fund the pension plans.7 But the State’s growth rate was expected to decrease over the foreseeable future. As Exhibit 1 shows, there were currently 2.7 employees for every retiree. However, with baby boomers retiring and with the average remaining service life of employees at only 17 years, this ratio would certainly decline.

The 1994 law allowed for a slow ramp up of state contributions to the pension plans; as a result, the required payments were low from 1995-2000, a period during which the State was running budget surpluses due to strong economic growth. Despite the positive fiscal situation during these years, Illinois only made the payments required by the 1994 law. Nevertheless, because of the rise in

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Tough Choices for the Illinois Pension System 311-139

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equity markets in the late 1990s, the state’s funded ratio had risen to 74.7% by 2000. (See Exhibit 3 for the funded ratios for the years between 1983 though 2009).

The recession of 2001 and the concurrent decline in equity markets caused the state’s pension situation to deteriorate—resulting in a 48.6% funded ratio by the end of 2003. Additionally, the administrations of Illinois governors Edgar and Ryan had approved an increase of roughly $5.8 billion in benefits to state workers between 1995 and 2003. Of this increase, $2.25 billion came through changing the way that retirement payments were calculated—by basing retiree payments on an employee’s salary in his or her last year, rather than on the average salary in their last four employed years. Next, in 2003, the State allocated $2.4 billion to its employees in the form of an early retirement initiative, which was not funded. Initially, the program was expected to add only $622 million to the unfunded balance. However, the formula was altered whereby retirees in “high stress” jobs were given a higher percentage of their later year’s earnings than the historical rate, and roughly one-third of employees were deemed to be in “high-stress” positions. Finally, the State waived the penalty associated for state employees who retired before the age of sixty. Historically, every year that a state employee retired before sixty meant a 6% decrease in monthly pension payments. With this penalty waived, workers were incentivized to retire early—thus adding to the costs of the pension systems and reducing employee contributions.8

One reason that retirement benefits were expanded for public employees, despite the troubled fiscal situation of the State, was the collective bargaining agreements in place in Illinois. Under legislation passed in 1984, the State mandated collective bargaining between state employers and their employees. In Illinois, collective bargaining was mandated only for the subjects of wages, hours and the condition of employment, although issues such as class size, teacher measurement, and worker safety could be brought up in negotiations. Any grievances between the employee union and the employers were delegated to the Illinois Education Labor Relations Board, which arbitrated the decision as long as both parties behaved in “good faith.” Illinois teachers were allowed to strike under the 1984 statutes if four conditions were met—the employees were represented by a bargaining agent, contract mediation had failed, the Teachers’ union had notified the district it planned to strike, and the union had not submitted unresolved issues for arbitration.9

Since the unions had a well-centralized structure and their leaders were aware of the nuances of collective bargaining agreements, they often succeeded in negotiating higher contractual payments from local school boards. Additionally, since public sector employees represented a huge voting block for the Democratic Party, the state’s political leadership was receptive to increasing benefits. The Illinois Teachers’ union was extremely effective relative to unions in other states. For example, a study by the National Education Association in 2008 showed that, while twenty-six states saw declines in real wages for teachers over the last thirty years, Illinois teachers’ salaries rose by 3.8% in real terms. As a result, Illinois ranked fifth among all states in average teacher salary in 2008.10

Prior Attempts at Pension Reform

Pension Bonds

By 2003, the Illinois legislature and Governor Rod Blagojevich recognized the necessity of advance funding the pension systems and put forward a variety of proposals to deal with the problem. Governor Blagojevich authorized the State to issue $10 billion dollars of pension obligation bonds to help finance some of the balance of the unfunded PBO. Such bonds allowed Illinois to take advantage of GASB’s accounting rules in order to fund its pension plan.

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311-139 Tough Choices for the Illinois Pension System

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In 1995, GASB adopted Statement No. 25 which provided guidance to municipalities on how they should account for their pension liabilities. Under GASB’s rules, government units were allowed to calculate the net present value of their pension liabilities using a discount rate based on the expected return of assets, instead of the interest rate on US Treasury bonds as required for corporate pension plans. By using the higher discount rate based on the expected asset return, the net present value of liabilities was lower, visually improving the funded status of the plan. Illinois used an 8.5% rate to discount its pension liabilities, a rate that reflected its expectations about its long-term investment return. This was much higher than the interest rate on 10-year US Treasury bonds of 3.5% in 2003.11

Pension bonds were general obligations of the state, which meant the interest and principal payments on the bonds were ultimately backed by the state’s taxing authority. These bonds were typically highly-rated and paid a low interest rate; for example, the 2003 pension bond had an annual coupon of 5.0%. If the State earned the expected return of 8.5%, then it would save money: it would receive 8.5% from its investments, yet pay out only 5% to bond holders. Because of this 3.5% difference between the interest rate on the new pension bonds and the projected 8.5% return on the invested bond proceeds, the State was able to realize $860 million in immediate “savings”12 if plan investments could meet the 8.5% hurdle rate. If the plan investments could not achieve this hurdle rate, however, eventually the State would have to make up for the shortfall by contributing more to its pension systems.

Of the $10 billion dollars in proceeds from the pension bonds in 2003, only $7.3 billion was actually used to reduce the historic underfunding of the Illinois pension systems; the other $2.7 billion in proceeds was used by the State in 2003 and 2004 to make its annual pension contributions. From 2003 to 2007, each retirement system garnered double-digit investment returns. However, due to the sharp decline in equities during the financial crises in 2008, the average return for the five-year period from 2003-2008 was 1.7% for TRS, much lower than the 8.5% hurdle rate.13

Other Reforms Proposals

Thus, although the 2003 issuance of pension bonds improved the fiscal situation of the Illinois pension systems, they were still underfunded. In 2005, Governor Blagojevich established a Pension Commission whose goal was to make recommendations to ensure pension solvency. The Commission made the following proposals:

1. No increase in benefits without a funding source identified to pay for the new benefit;

2. Limit pay increases in the final year of employment before retirement since this is the basis of calculating monthly payments;

3. Eliminate the money purchase pension option for new hires (a limited DC plan that was eligible to a small minority of employees);

4. Limit automatic annual pension increases for new hires to 2%;

5. Limit employee groups eligible for the Alternative Retirement Formula—i.e., “high-stress” positions;

6. Increase the employee contribution rate to state pension systems;

7. Increase state contributions to its pension systems by 1% per year;

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Tough Choices for the Illinois Pension System 311-139

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8. Issue pension bonds after above initiatives are in place with all proceeds going to fund the pension systems; and

9. Study the effect of switching to a defined contribution plan for all new state employees.

Governor Blagojevich accepted most of the Commission’s recommendations, except for #6 requiring employees to contribute more to their pensions and #9 shifting to a defined contribution plan for new employees. These two proposals were strongly opposed by the public unions in Illinois. The General Assembly did pass a number of these recommendations, including capping end-of- career salary increases and limiting new hire eligibility in the alternative program. But the General Assembly rejected the proposal to increase the retirement age to 65 for employees who had worked between 8 and 30 years for the State due to strong opposition from the public sector unions.

In order to garner support for the above recommendations, the General Assembly approved a pension holiday for 2006 and 2007, which allowed the State not to fund its pension systems according to the 1994 law. Specifically, the General Assembly lowered the required pension contribution for 2006 and 2007 by $2.3 billion, while requiring higher payments in 2008-2010 to make up for the shortfall. In addition, the General Assembly shifted some of the burden of future increases in benefits from the State to the local school districts. For example, the 2006 law required local school districts to pay for the actuarial cost of pension increases for any salary increases over six percent that were used to determine final average salary calculations.14

All of these reforms were limited by a constitutional provision to the effect that benefits could not be lowered for current retirees and possibly current state employees. According to Article XIII, Section 5 of the Illinois Constitution:

Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.

In 2008, Illinois was obligated to make contributions of $2.6 billion to the state’s pension plans. At that time, Governor Blagojevich sought to lease the Illinois Lottery to investors for $10 billion in cash, and to allow the new issuance of $15.9 billion in pension obligation bonds. All proceeds were supposed to be used to reduce the unfunded liabilities of the Illinois pension system. However, the General Assembly rejected these proposals largely due to the political scandal that was engulfing the governor. On December 9, 2008, he was arrested by FBI agents for a variety of corruption charges including soliciting bribes to select the U.S. Senator to fill President-elect Obama’s vacated seat.

Pension Crisis of 2009

After the impeachment of Governor Blagojevich, Lieutenant Governor Pat Quinn was sworn in as governor in February of 2009. In a month, he was expected to issue his budget for Fiscal Year 2010 despite very weak equity markets and a severe national economic recession.

The recession of 2009 was hitting Illinois particularly hard because of the State’s heavy reliance on manufacturing, construction and retail. For Fiscal Year 2009 (July 2008 – June 2009) and Fiscal Year 2010 (July 2009 – June 2010), Illinois’ economy was expected to contract by 1.8% and 3.3% of GDP, respectively. The latest jobs report in January 2009 showed a state unemployment rate of 7.9%, which was expected to increase to 9.7% over the coming year. As a result of the downturn, state tax revenues were expected to be $27 billion in both FY 2009 and FY 2010, down roughly 9% from peak revenues in fiscal 2008. However, the State was scheduled to spend $31.5 billion and $34.3 billion in

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311-139 Tough Choices for the Illinois Pension System

6

FY 2009 and FY 2010, respectively, leading to combined deficits of $11.6 billion. These projected deficits ran afoul of Article VIII of the Illinois Constitution, which stated: “Proposed expenditures shall not exceed funds estimated to be available for the fiscal year as shown in the budget.”15

The state’s pension systems were in a particularly dire situation due to the financial crisis. Under the 1994 funding law, the State had to make a $3.9 billion contribution for FY 2010. (See Exhibit 4 for the state contributions required for fiscal years 2010-2045). 16 The total unfunded liability of all the state’s pension systems was $73 billion, an amount that had increased almost $20 billion as a result of stock market losses in 2008 and 2009.17 These losses left the Illinois pension systems with an expected funding ratio of 50.2%, the worst in the country.18

Some critics believed that the 50.2% ratio understated Illinois’ problems. In accordance with GASB, Illinois discounted its future liabilities on the expected return of its assets, which Illinois assumed to be 8.5%. But the long-term rate on highly rated Illinois bonds was actually much lower. Discounting Illinois’ pension liability at this actual long-term rate meant the underfunding of the state pension system would be more than $200 billion.19

Other critics of GASB’s accounting rules noted that they allowed state pension plans to use the actuarial value of their assets based on an average of the fair market value of a plan’s investments over a three to five-year period. Illinois had been one of the few states to report the actual fair market value of its plan assets as of the relevant date. However, in early 2009, the State changed its accounting approach so that the reported actuarial value of its pension assets was based on the average values over the past five years in an attempt to smooth the 22% losses achieved thus far in FY 2009.

More broadly, these critics argued that the higher discount rate allowed by GASB created troubling incentives for public pension plans to invest in risky assets. For example, the Teachers’ Retirement System of Illinois, the largest pension plan in the State, had roughly 74% of its assets invested in equities, private equity, hedge funds, real estate and commodities—with only 22% in fixed income.20 Exhibit 5 shows the asset allocation for the Teachers’ Retirement System of Illinois. Corporate pension funds, on the other hand, had traditionally relied on a large proportion of assets allocated to fixed income products. According to a study based on 2008 data, the TRS has the fourth riskiest investment portfolio among all public pension funds in the country, with 81.5% of its investments considered risky.21

TRS had also invested heavily in derivatives; its outstanding notional amount of derivatives reached almost $2 billion dollars as of 2008. According to Dale Rosenthal, an associate finance professor at the University of Illinois-Chicago, “if you were to have faxed me the balance sheet [of TRS of Illinois] and asked me to guess who it belonged to, I would have guessed, Citadel, Magnetar [hedge funds] or even a proprietary trading desk at a bank.”22 TRS had generally sold derivatives on a variety of products like credit default swaps, interest rate swaps, and options on interest rate swaps called swaptions. In other words, TRS had sold insurance in a large bet that these products would not go down in value or default in exchange for yearly payments. According to an article published by Northwestern University, “a large part of TRS’s international-based interest rate swap positions are linked to the Brazilian Interbank Deposit Rate and Euribor in a bet that inflation would stay low in Europe but rise in emerging markets.”23

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Tough Choices for the Illinois Pension System 311-139

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Potential Reform Options

Luckily, for Governor Quinn, a Democrat, both the Senate and the House of Representatives were firmly in his party’s control—holding 63% of the seats in the House and 59% in the Senate.24 However, the Teachers’ Union was a major contributor to the Democratic Party and any legislative action to reduce pension benefits would be met with fierce political resistance. The state of Illinois had hired consultant Alexander Dhanraj in order to help draft proposals that would address not only the immediate funding needs of the Illinois pension systems, but also their long-term solvency.

Dhanraj thought of a variety of measures to reform the pension systems. First, the State could issue pension bonds similar to the ones in 2003. Second, the State could change the asset allocation of the pension systems to try to achieve higher returns. Third, the State could increase revenues through taxes or contributions. Finally, the State could alter the liabilities of the pension systems directly by reducing the benefits to some employees.

Pension Bonds

As in 2003, Illinois could issue pension obligation bonds and invest the proceeds in the assets of the pension systems—immediately increasing the funded ratio. The estimated interest rate of this pension bond ranged from 4-7% depending on the size of the issue.

There were many who argued against issuing any pension obligation bonds. In their view, an underfunded pension is a liability of the State and therefore the issuance of a pension bond just changes the accounting from being off-balance sheet to on-balance sheet.25 More practically, if the State issued pension bonds, the yearly interest payments on these bonds would have to be paid to investors and could not be altered by state law. In other words, the sale of pension bonds would turn a “soft” obligation into a legally binding commitment.

Proponents of issuing a large amount of pension obligation bonds (e.g., $20 billion) thought that the State should use the proceeds to take advantage of the dislocation in the capital markets. The benefits of a pension bonds depended on how the assets were put to use. For example, the 2003 pension bond originally looked like a great idea since the pension’s investment portfolio performed well from 2003-2007. However, given the decline in the portfolio in 2008, the decision to issue pension bonds seemed counterproductive. As Girard Miller, a senior strategist for retirement investments at a consulting firm, said, “[Pension bonds] should only be issued during recessions or during the early stages of economic recovery, when stock prices are depressed.”26 With current equity markets

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