March 6, 2015
Governor Bruce Rauner’s recommended budget for fiscal year 2016 includes a new plan for reducing the State of Illinois’ massive pension costs. As discussed here, the plan could cut the State’s unfunded pension liability by approximately $25 billion and save $2.2 billion on pension contributions from general operating funds in FY2016, according to the budget proposal.
Proposed legislation on the plan has not yet been filed and the actuarial analysis that was used to generate the savings estimates was not released with other budget material. However, the plan’s main features are described in the recommended budget.
The key component of the proposal is a freeze on the State’s more generous level of benefits, which are available to employees hired before 2011. Under the new plan, these Tier 1 benefits would only be paid on service before July 1, 2015. For work after that date, benefits would be paid at the lower Tier 2 level.
In pension terminology, this is known as a “hard freeze.” A hard freeze is when an employer ends benefit accruals for existing employees in a pension plan. As a result, benefits paid under that plan do not increase with additional years on the job or salary increases. In contrast, a “soft freeze,” such as the one that created Illinois’ Tier 2, only closes a plan to newly hired workers.
A hard freeze immediately reduces an employer’s projected accrued pension liability. This liability consists of benefits earned by retired employees; benefits earned by existing employees based on their current salaries and years of service; and the effect of future salary increases on existing employees’ past service. (Many public retirement systems, but not the State’s under current law, also take into account a portion of future service in computing accrued liability.) A hard freeze does not affect benefits already earned by retirees and existing employees. It does eliminate future salary increases from the accrued liability calculation.
The impact of a hard freeze can be seen more clearly through an example involving the Teachers’ Retirement System (TRS), which covers public school teachers outside Chicago. TRS, Illinois’ largest pension fund, provides 2.2% of final average salary for each year of service (under Tier 1, final average salary is the average salary for the highest four consecutive years within the last 10 years).
A 45-year-old Tier 1 member who has been on the job for ten years and has an average salary of $50,000 as of June 30, 2015 would be entitled to a Tier 1 pension of $11,000 upon retirement at age 60. If Tier 1 benefits had continued and the member’s final salary was $150,000, the teacher would have been entitled to $33,000 based only on her ten years of service—plus an extra $49,500 based on the additional 15 years on the job.
After Tier 1 is frozen, all employees would earn new benefits at the Tier 2 level. Tier 2 employees receive annual benefit increases of 3% or one-half of the annual increase in the Consumer Price Index (CPI), whichever is less. Current retirees and Tier 1 workers receive automatic annual increases of 3%. Tier 2 workers’ benefits grow more slowly over time because the annual increase is based on a simple rate, while the benefits of retirees and Tier 1 workers are increased based on a compounded rate. In addition, Tier 2 includes higher retirement ages, a limit on the maximum salary on which a pension is based and a less generous definition of final average salary (the highest average salary in eight of the last ten years of service).
The teacher above would receive a Tier 1 pension of $11,000 based on her first ten years of service and accrue the next 15 years of benefits at the lower Tier 2 level. She could retire at age 60 to receive the Tier 1 pension, with compounded annual increases of 3%, but would have to wait until age 67 to get full Tier 2 benefits.
The actual Tier 2 benefit amount is difficult to determine because the calculation of final average salary is different from Tier 1. The impact of the new proposal on an individual employee in each retirement system would depend on the employee’s age, expected years of service and salary estimates.
It should be noted that many Tier 2 members are paying more than the full cost of their benefits, effectively subsidizing the State by helping to pay down the unfunded liability. As discussed here, Tier 2 TRS members contribute 9.4% of their salary for pensions (the same as Tier 1 members), but the pension benefit is worth 7%.
Besides the freeze on Tier 1 benefits and shift to Tier 2, it would also end State liability for salary spiking (the practice of awarding large pay hikes in the last years of teachers’ or administrators’ careers to boost their pension benefits); lower the effective rate of interest for certain retirement annuity options; spread out over five years the impact of any future changes in assumed rates of return on investment; and achieve 100% funding by FY2045 rather than 90% under current law.
The proposal applies to TRS, the State Employees’ Retirement System, the Universities Retirement System and the General Assembly Retirement System. The Judges’ Retirement System is not affected and the plan would not apply to public safety workers.
Although many private employers have frozen pension plans, hard freezes have been less common for public pension plans due to legal protections of benefits. A hard freeze and future accumulation of benefits at a lower percentage per year of service were part of Rhode Island’s landmark 2011 pension reforms, which are now being challenged in court. New Jersey Governor Chris Christie proposed a pension freeze last month, following a recommendation by a state commission.
Governor Rauner’s pension proposal must be approved by the Illinois General Assembly and is likely to face legal challenges. The legislature passed major pension changes in December 2013 with the minimum votes needed in the Senate and only two votes to spare in the House. The implementation of that law has been blocked by lawsuits; the Illinois Supreme Court is scheduled to hear oral arguments on the law’s constitutionality on March 11.
The Rauner administration believes that the new pension proposal could more easily withstand legal challenges because it does not affect benefits that have already been earned. The pension changes enacted in December 2013 would reduce the annual benefit increases of retirees as well as existing employees. However, labor unions contend that the new proposal also impairs pension benefits in violation of the Illinois Constitution.