Pension Mismanagement and the Role of Return on Investment

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Teachers make great scapegoats for legislators and a misinformed public, but once the propaganda is cleared away – it’s incumbent upon all of us to fairly consider the facts.

 

 

Often, we hear about skyrocketing costs to taxpayers caused by inflated public salaries, benefits, and pensions.  Let’s face it, if our legislators didn’t target teachers and other public employees for the Illinois Debt Crisis, they would have to take a scrutinizing look in the mirror.  Teachers make great scapegoats, but how about we consider the facts and make up our own minds about this issue.

 


The Problem

To do this, we need to travel back in “pension-funding time.”   Let’s start at the root cause that created the original 1995 $20B deficit in the state’s five public employee retirement systems:  the State Employee Retirement System (SERS), the Downstate Teachers’ Retirement Systems (TRS), the State Universities Retirement System (SURS), the Judges Retirement System (JRS), and the General Assembly Retirement System (GARS).

The reality behind this $20B shortfall is a structural deficit in Illinois taxing policy, “historically, the Illinois state fiscal system has failed to generate the revenue needed to cover both the inflationary increase in the cost of maintaining public services from year to year and the full employer contribution required to fund pensions. So, rather than cut services, the state usually chose to underfund its employer contribution. Overtime, this chronic failure to make the full employer contribution is the primary reason for Illinois state government’s predicament today, facing the worst unfunded pension liability in the country,” (Center for Tax and Budget Accountability, CTBA).

Problem Number 1:  Illinois legislators did not plan for inflation.

To appropriately address inflation, the state had three options:

A.  Cut Services
B.  Increase revenue by raising income and/or sales tax
C.  Underfund State’s employer contribution

And what option did our legislators select?  Option C.

Anyone who has responsibly and consistently balanced a budget knows expenses must be equal to or less than revenue.  There are two basic ways of doing this:

A.  Revenue is equal to or less than Expenses
B.  Revenue plus Debt is equal to or less than Expenses

And what option did our legislators select to address the 1995 shortfall?  Yes, Option B.

Problem Number 2:  Illinois legislators exacerbated their $20B debt problem.

Anyone who has responsibly accessed credit knows borrowing to cover an expense is feasible ONLY when future expenses can be maintained, or reduced, until debt is covered.

For easy math, let’s suppose  I earn a monthly salary of $100 and my living expenses are $100; yet, my car had a flat and I had to put $25 on a credit card in order to purchase a new tire.

$100 monthly Revenue
-$100 monthly Expenses
$0 – Balanced Budget

Until:  Additional $25 Borrowed + $5 Interest ($30 Debt)

In order to pay for the debt I’ve created, I need to reduce my living expenses by $5 for 5 months in order to pay off the $25 of debt AND I must reduce living expenses by $5 for an additional month in order to pay interest on the $25 I borrowed.

Then:
$100 monthly Revenue (6 months)
-$95 monthly Expenses (6 months)
+  $5 payment on $ 25 Debt + $5 Interest (6 months)
$0 – Balanced Budget = repayment of $30 Debt

Unfortunately,  our legislators didn’t choose either of these reasonable options.  Their ‘fix’ looks more like the scenario below:

$100 monthly Revenue
$100 monthly Expenses
+  $1 payment on $25 Debt + $5 Interest
–  ($1 + $24 Debt + $6 Interest) =  $31 Debt

A responsible ‘fix’ would resemble the following scenario:

$100 monthly Revenue
$80-$90 monthly Expenses
+$10-$20 payment to Savings
$0 – Balanced Budget + Plenty of Money Left Over!

It should be public savings accumulating over time, not public debt.  It is this public savings that should be accessed in times of need or expansion – not public debt, which quite obviously serves the interests of the banking industry but certainly not those of the public!  It’s no wonder the banking industry contributes heavily to political campaigns.

Yes, this representation is simplistic, so let’s look at how our legislators addressed their shortfall.

 


Our Legislators’ Solution

Problem Number 3:  The Edgar Ramp Balloon Mortgage on Steroids

In 1996, the ‘fix’ came with a name, the Edgar Ramp.  The basic premise was to reduce pension payments at the plan’s onset and then steadily increase them over time.  Edgar’s plan didn’t structurally reform pensions; instead, it temporarily pushed the problem off, and left the financial burden for later legislators to address.

 

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In 2015, the Illinois Debt Crisis reached approximately $109B (p 29, 2015 IL Comprehensive Annual Financial Report).

 

An article in Crain’s by Dave Mckinney argues,

“For more than a quarter-century, governors and state legislators, Republicans and Democrats alike, made a series of financially toxic moves in the pension systems for state employees and public school teachers. Proposals to fix the perennially underfunded pensions were based on botched calculations—or no calculations at all—and were driven by misguided rationales that weren’t fully vetted.”

Chan, a Chicago securities defense lawyer and former SEC administrator, describes the ramp as a “balloon mortgage on steroids.  You already know you have a hole. But instead of filling it, you decided to make it deeper.”

Problem Number 4:  Continuation of Flawed Tax System

Overspending on state services is not the cause of the state’s long-term fiscal problems. Rather, the driver has been Illinois’ flawed tax code, which does not comport with the modern economy (p3, CTBA).  Tax revenue hasn’t grown at a rate sufficient to cover the increased cost of delivering the same level of services from one year into the next (p4, IL 2015 CAFR).

  • 2011 – legislature voted to raise individual income tax rate from 3% to 5% and corporate income tax rate from 4.8% to 7%
  • 2015individual income tax rate dropped to 3.75% and corporate rate to 5.25%
  • 2025individual income taxes are scheduled to fall to 3.25% and corporate to 4.8%

Who benefits from these tax breaks … and who doesn’t (statistics from CTBA)?

  • Banks profit from public sector debt.
  • Approximately 54.4% of the dollar value of tax relief from reduction in state’s personal income tax, over $2B of the $3.7B in total cuts, goes to the wealthiest 11.8% of tax filers in IL.
  • Millionaires do particularly well, receiving an average annual tax break of $36,797 per year – 70 times greater than workers having net taxable incomes of $35,000-$50,000 per year or less ($526).
  • Bottom 50% fare particularly poorly, receiving just 8.1% of total tax break.

In 2011, Illinois had the lowest number of state workers per 1,000 residents of all 50 states.  Despite having the 5th largest population, Illinois annually ranks in the bottom 10 states in service spending.

 

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In 2014, over 4 of 5 taxpayer dollars paid as part of the state’s annual pension contribution went to paying down pension debt, not to funding current benefits.

 

CTBA (2009) ‘Debunks’ popular myths regarding the Illinois Debt Crisis:

MYTH:  Illinois has too many public employees.
REALITY:  Illinois actually ranks 49th among the states, next to last in the nation, in number of state employees per capita. Historically, Illinois has not been a high public employee head count state. Instead, Illinois is mostly a grant making state – that is, rather than hire state employees to provide services; Illinois disburses grants to independent providers such as Lutheran Social Services or Catholic Charities, which in turn deliver the service to the public.

MYTH:  Public employee benefits are too generous.
REALITY:  For most Illinois public employees, their pension is all they receive upon retirement (this is true concerning teacher pensions) – fully 78% are not covered by and do not receive Social Security. This is unlike workers in the private sector, who receive both Social Security and private retirement benefits.

MYTH:  Illinois’ current defined benefit system is too expensive.
REALITY:  The ‘normal cost’ of a pension system is the contribution required from an employer to fund the plan’s benefits. The weighted average ‘normal cost’ across all five Illinois pension systems, as a percentage of active members’ payroll, averages 9.13%. The national average for state and local government is 12.5%, placing the normal cost of Illinois’ current defined benefit program far below the national average.

MYTH:  Switching Illinois from a defined benefit to defined contribution system will erase Illinois’ pension debt.

REALITY:  Switching to a defined contribution plan from a defined benefit plan cannot reduce or eliminate any of the unfunded pension liability that Illinois owes to its five public employee pension systems.

The stateʹs duty to maintain pension benefit levels for its public employees is directly mandated in the Illinois Constitution. Specifically, Article XIII, Section 5 of the Illinois Constitution provides, “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 (emphasis supplied).”

Irrespective of the nature of the plans going forward – the only way to address the unfunded pension liability is to find a rational way to pay it. The problem cannot be legislated away. [Although legislators haven’t stopped trying, even after the IL Supreme Court ruled legislation as unconstitutional – discussions regarding the transfer of pension responsibility to the local level are currently taking place]

MYTH:  Placing new public sector employees into a defined contribution system would save the state money.
REALITY:  A switch to a defined contribution plan for new employees would not save the state of Illinois money. In fact, a switch to a defined contribution system would likely increase costs; defined contribution systems have significantly higher annual administrative costs than fully funded defined benefit systems.

According to the Investment Management Institute, the operating expense ratio for defined benefit plans averages 31 basis points (31 cents per $100 of assets); the average for defined contribution plans is three to six times higher, at 96 to 175 basis points.

To put that in context of the Illinois pension systems, the administrative costs of a defined contribution system would in all likelihood cost taxpayers anywhere from $275 to $610 million more annually than the state’s current defined benefit systems.

 


 

Compounding the Problem

Problem Number 5:  Decline of Returns on Investment (RoI)

Mitch Vogel, former President of the University Professionals of Illinois, IFT Local 4100, and former member of the State Universities Retirement System (SURS) Board of Trustees, explains, “When our pension funds were created, it was under the constitutionally-mandated assumption that the funding would come from a so-called ‘three-legged stool’:

1) the employee
2) the employer (the State of Illinois)
3) returns on investments made by duly-appointed pension boards”

He asserts, “When it comes to funding Illinois’ public pension systems, we have done our part.  Our elected officials have not, and they’re overwhelmingly to blame for the funding problems the systems face.”

He then points out, “Some experts have estimated that [pension] systems would be holding billions more in assets today if state lawmakers and City of Chicago officials hadn’t declared years of pension “holidays” which underfunded the system, at a time when the ROI was in double digits, no less. Had the required payments been made during this lucrative time, just imagine how the systems would have flourished.”

 

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Collectively, our three largest systems – the Teachers Retirement System (TRS), the State University Retirement System (SURS), and the State Employee Retirement System (SERS) – hold more than 75 billion in assets. In addition, the Chicago Teachers Pension Fund (CTPF) controls more than 10 billion in assets (p10, IFT’s Union Link).

 

Additionally, “In an attempt to compensate for the lack of state funding, our pension boards have diversified and developed more investment options. For example, the less risky Fixed Income funds, which previously accounted for the majority of the investments, now account for only 1/6 to 1/5 of total holdings. Real Estate has grown to almost 10% of the portfolio.  And the largest growth has been in Equities (U.S. and international).”

 

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While pension systems across the country are divesting from risky hedge funds, here in Illinois we are increasing, and even initiating, additional hedge fund investments. The American Federation of Teachers recently published research which shows that the only ones who really benefit from these types of assets are the investment managers who sell them.


Problem Number 6:
  Political Interference

Vogel contends there is cause for two concerns:

  1.  There appears to be a strategy to solve the underfunding problems by increasing our investment risks.
    These risky funds, which charge fees as high as 20%, require less oversight by the Securities Exchange Commission (SEC) and other watchdog groups. Yet SERS has allocated 8.4% of its funds to these investments, which lost 5.7% of their value.
  2. Governor Rauner’s political interference is additional – and serious – cause for alarm.
    Through his personal appointments, the Governor has changed the composition of our pension boards – for the worse.  Immediately upon taking office, Rauner removed Marcia Campbell, former IFT Secretary-Treasurer, from the TRS pension board.

In an even more blatant move, last year the Governor appointed Sandy Stuart to the TRS Board. Stuart is the former Illinois Republican Party finance chairman who gave more than $150,000 to Rauner’s gubernatorial campaign and more than $1.5M to Republican candidates or conservative super-PACs on the state and federal levels.  His family foundation has also donated more than $100,000 to groups like the Illinois Policy Institute and the Manhattan Institute, which oppose defined-benefit public pension plans.

Also, on the Illinois State Board of Investments, Rauner’s newly-appointed members voted to replace its investment consultants.  The new consultant and board members immediately changed policies and asset allocations, resulting in large fund losses compared to previous years and the other state pension boards.

The decline of RoI by the TRS pension fund due to unsuccessful investments in riskier hedge funds supported by new Rauner appointees to the pension board is an important issue for everyone, not just teachers.  The less Illinois pension funds gain through investments, the more costs that land at the feet of the taxpayer.

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