Method state and local public safety pension systems use to determine payments is contributing to underfunding

January 30, 2020

Method state and local public safety pension systems use to determine payments is contributing to underfunding

Authors

  • IGPA Staff

Note: This article was produced by the Institute of Government and Public Affairs as part of IGPA’s efforts to connect relevant, nonpartisan research and expertise from the University of Illinois System to the public policy discussion in Illinois.

A new report from The University of Illinois at Springfield’s Institute for Illinois Public Finance found that the state’s public employee pension systems and downstate police and fire pension systems are not contributing enough to fund their liabilities, due in part, to the method used to determine how much money is put into plans each year.

The paper, Are Illinois State and Local Governments Contributing Enough to Their Pension Plans to Pay Down Their Debt?, takes a look at some of the assumptions used to determine contributions and how they are affecting the funding levels of pensions in Illinois.

Kenneth Kriz, UIS distinguished professor of public administration and director of the Institute for Illinois Public Finance, said contribution levels are crucial because there are only three levers policymakers can use to try to address pension funding shortfalls: increasing investment returns, decreasing benefit costs and increasing the contributions governments make to the plans.

However, options are limited, at least in the short term, for reducing the cost of benefits or increasing investment returns, said Kriz, who authored the report.

“The third lever, and the one that they can really control a lot, is the contributions they need. So, setting appropriate contribution rates is extremely important,” he said.

Indeed, the Commission on Government Forecasting and Accountability recently cited insufficient contributions and lower-than-expected investment returns, as prime drivers of an unexpected spike in the state’s unfunded pension liabilities last fiscal year. COGFA pegged that liability at $137.3 billion as of June 30th, after Illinois’ unfunded pension liability grew by a half-billion dollars more than initially projected.

Illinois state pension plans and downstate police and fire plans use what is known as the level percentage of payroll assumption for calculating plan costs. Under this assumption, unfunded liabilities are amortized so that the plans expect to pay the same percentage of payroll each year into their pension systems. This is the method most states use, and it assumes that the amount being paid will increase as time goes on and payrolls grow.

Kriz said this method is similar to taking out a balloon-payment loan to buy a house. Under such a loan, payment amounts spike dramatically near the end, when the borrower is paying off the bulk of the principal.

“It may look like governments are contributing enough into their pension plans if you make a huge number of assumptions,” he said. “However, if you use more realistic assumptions, they’re not anywhere close to contributing enough. That means that the payments are going to have to rise dramatically in the future.”

Another method for determining contributions, known as the level dollar assumption, is similar to taking out a traditional mortgage, where each debt payment is roughly the same amount. Using a level dollar assumption would stop governments from pushing most costs off to the future by requiring larger contributions now. That could leave state and local governments with less revenue to spend on other priorities in the short term, but it would also mean that policymakers in the future will likely not be scrambling to make impossibly high contributions.

Kriz compared the problem to trying to run from Springfield to Chicago. “If you run about 10 miles a day, you will be in Chicago in about 20 years. At the current rate, they’re not only not running that 10 miles, they’re headed in the wrong direction,” Kriz said. “It’s like the goal is Chicago, but they’re headed toward St. Louis instead and hoping to make it all up in the last few years.”

Kriz said that increasing contributions now instead of delaying that fiscal pain would be a challenge, and bad budget years would make it even harder. “Obviously, there will be times that running 10 miles a day is going to be difficult. But if you keep skipping out or going the wrong way, you’re never going to be able to run fast enough to cover all that lost ground. We want to be headed toward Chicago at whatever pace is possible, but it’s got to be realistic”

Kriz said there is a potential upside, too. If governments were to opt for a policy that more resembles a level dollar assumption, the cost of payments would be fairly predictable and easier to plan for in the future. If payrolls continue to grow over the years, the contribution would also become a smaller percentage of payroll over time.

Moves to try to improve efficiency and increase returns on investment, like recently-passed legislation to consolidate suburban and downstate public safety pension funds, could help," Kriz said. “It’s a good first step, but it’s not going to get you all the way. Having better investment returns will help plans become better funded, but it’s not a panacea,” he said.

Kriz said consolidations could open up smaller local governments to more volatility as the consolidated fund takes on riskier investments than they have been able to pursue on their own. “If we have a meltdown in the market next year, God forbid, contributions are going to have to rise,” he said. “And so the question comes back to, are governments going to be willing to and able to make increased payments?”

The full report is available in a white paper format on the UIS Institute for Illinois Public Finance’s website.


Research Area: Fiscal Health of Illinois

Policy Initiative: none

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