Illinois Public Pension Plan Underfunding ... A Case Study

Illinois apparently can't get its act together with respect to what needs to be done about its current unfunded public pension liability of ~$85 billion. Probably because the politicians don't know what to do or how to explain what they've done to dig the hole they're in today.

And my guess is that they certainly don't want to tell the good citizens of Illinois in painful detail what happened to create the mess that exists today. If the politicians and public sector union leaders didn't actually defraud the citizens over the years, at least they engaged in what in effect was a "pay-go" Ponzi scheme of sorts. Not unlike Social Security and other federal programs, for example.

An intergenerational pay-go system in action for a society that's getting older demographically. In other words, a train wreck happening in slow motion perhaps, but happening nonetheless.

And unfortunately, today's Illinois mess involves both good people (teachers, police, fire fighters and other government workers) who've been promised things that haven't been paid for as well as citizen taxpayers (good people, too) who weren't told about the real costs of  the promises made on their behalf by their "public servants."

Public sector union leaders and public sector officials bargaining on behalf of the taxpayers have really blown it this time. And they are afraid of what people will do if they discover the truth---throw the bums out, in other words. My hope is to help spread that truth in a non-partisan manner and without taking sides. Except for taking the side of all of We the People, as always.

Thanks again to my friend Sid from Illinois for keeping me up to date on what's NOT going on about dealing with this huge issue in Illinois.  Lawmakers derail pension deal says this in part:

"Shortly before 11 a.m. Thursday, Rep. Daniel Biss voted in favor of a plan to fix Illinois’ public-employee pension systems. It was a Republican plan, and Biss and his fellow Democrats on the House Pension Committee didn’t like it; but it was better than letting one of the nation’s worst pension problems fester.

Three hours later, Biss found out through Twitter that his party leader, House Speaker Michael Madigan, planned to vote against the bill when it came up in the last hours of this spring’s legislative session.

That’s when the wheels started falling off.

What had looked like an acceptable response to an $85 billion pension problem was now in trouble. Within hours, the sponsor announced he couldn’t pass the legislation and the session would end with no decisions on the state’s most pressing financial problem.

Gov. Pat Quinn says he’ll call legislative leaders back to Springfield within the next week to resume the search for an answer, but tensions remain high after a week of bitter words, clashing agendas and unclear motivations. Both Madigan and House Republican Leader Tom Cross are pushing their own solutions, while strategizing how to protect not only their constituencies but a rank and file who don’t want voters to blame them for the failure.

“I’m heartbroken,” Biss, who was deeply involved in negotiations, said Friday, summing up a general feeling among legislators. “It’s a silly word to use about a pension bill, but I feel immensely let down. I really want to solve this problem.”

Exactly why the pension negotiations failed remains unclear."

Discussion and Analysis 

The issues with public sector pension plan funding are nationwide but generally misunderstood. We'll use the specific example of Illinois as our case study in an attempt to bring greater clarity to this overall sad state of affairs throughout America. Illinois is not an exceptional case. It's actually and unfortunately a lot like several other states and the federal government as well.

So political amateur hour is alive and well in politics, and that's the nicest thing that can be said about the ugliness of the funding status of our public pension plans. To believe that it's not amateurish politically would be to ascribe the worst of intentions to politicians. And although I do believe that most people in politics are primarily there to serve themselves, even I don't believe that the "public servants" intended to create this huge mess of a pension debacle for public employees and taxpayers, respectively. They just didn't know what they were doing.

How It Happened

Illinois simply didn't fund its obligations over the years. That's the beginning of the decades long "pay-go" story which was never told. {For that matter, social security and many other federal and state entitlement programs operate on the largely fictitious pay-go system for entitlement programs as well.} To understand what happened, we don't have to know much about pension funding, actuarial assumptions, investment returns and such. Just know that promises made and then enhanced over time while no funding was in place combined with inflation to create a deadly combination financially. Add in the demographics of getting older, and it's easy to see how we arrived at our current sorry state of affairs. Nobody was minding the long term store, in other words. Short term-itis prevailed far and wide across our fair land, including the Land of Lincoln.

We'll do our very best in coming posts to explain all this as simply as possible, but not more simply than that, to anybody who's interested and able to read. We'll follow strictly the KISS approach to what most believe is a most complex subject---funding future public pension promises.

My view is different in that most complex subjects can be reduced to "simple" if the effort is made to do so, both by the "explainer" and the "explainee." Here we go.

KISS #1

Rule of 72--- This rule means simply that if we multiply the average annual long term rate of return on funds invested by the number of years they will be invested, we'll know how long it takes to double our money. As I understand it, Illinois uses a rate of return assumption of 8.5%. This means invested funds would double in less than 9 years. The actuaries probably assumed a mix of 60% stocks and 40% bonds and a return on stocks of 10+% and a return on bonds of 5+%. Hence, stocks at 10% x .6 = 6% and bonds at 5 x .4 = 2%. 6% + 2% = 8%.  Close enough for horseshoes.

Inflation--- Illinois provides a 3% cost of living adjustment (COLA) annually to pension recipients. Thus, if invested funds don't earn at least 3% annually, there will be insufficient money available to pay the COLA without dipping into the fund balance.

That said, no contribution = no fund balance. Illinois didn't contribute its share for several decades and simply ignored funding the promises it had made.  

Thus, if Illinois had funded its promises, invested funds would have grown over the years, thereby funding the promised payments. However, there apparently was no money contributed or invested by the state.

And when union negotiations raised the benefit promises from time to time, the amount of the total past unfunded promises grew.  This is called unfunded past service benefits. Think of it this way. A works for ten years and the state funds its promises to A each year. Then in year #11 the state raises its promise to pay A more for all the years A worked previously in addition to future service. This new promise creates a new liability for past service and should be funded in one lump sum unless credit for future pension promises is only for future service. In that event, no past service unfunded liability would be created.

But since it appears Illinois didn't fund properly for either past or future liabilities, the best guess is each time benefits were raised, another deep hole was dug for past service in addition to the new hole being dug for future service.

That's enough for now to at least provide a rough idea of the overall problem. We'll cover it in more detail along with other related issues in future posts. There are no easy answers. That's probably why the Illinois politicians continue to hope they'll wake up and somebody will have solved it for them. But, of course, that ain't gonna happen.

Summing Up

If Illinois is underfunded by $85 billion, that $85 billion amount still assumes a certain rate of return on future investments. In fact, that $85 billion could be as high as $300+ billion, depending on the rate of return assumptions used, future funding and then the actual investment returns on the amounts actually contributed. 

Illinois needs to hope for private sector earnings growth and stock appreciation to come to the rescue so that their pension investments in stocks will earn outsized returns in coming years. By the way, the rest of the nation needs to wish for that very much, too. It's about the only way out of the mess we're in. 

So funding and investment returns over time tell the tale--always.

If the fund earns 8.5% or 2%, there will be an enormous impact on the amount of money available to pay future benefits. {For the sake of simplicity, we'll use 8% in comparison with 2% -- a factor of 4.}

Using the rule of 72, at a 2% rate of return, it will take 36 years to double our money. But at 8%, it will only take 9 years. That's because 2 x 36 = 72 and 8 x 9 = 72 as well.

So the key to all this is twofold: how much and how long money is invested; and what rate of return that money earns over time.

Illinois invested zero and earned zero over the years. And to add insult to injury, if inflation averaged 4% annually the past 36 years, that $1 of 36 years ago will require $4 today to achieve the same purchasing  power. (4% annual inflation rate x 18 years = 72 or one doubling each 18 years) (1 grows to 4 in 36 years because 2 doubles in 36 years at 4% = 4). Thus, $4 today = $1 36 years ago.

Inflation is a killer. Unfunded promises are a killer. Pretending money is being invested by not disclosing to taxpayers what has been promised on their behalf but not funded borders on fraud.

That's the danger of allowing government to continue to use the cash method of accounting. That's how they ignore future liabilities. How nuts is that?!

This is not a Republican or Democrat problem of recent vintage. It's a very real bi-partisan problem that has been building for many decades. And it's not a government worker versus a taxpayer problem either. It's a political and public sector union leader created problem.

And it's not an Illinois problem either. It's a national problem. And since we learned these tricks of entitlement accounting from the Europeans, that makes it somewhat a global problem.

We'll go deeper as we go along. Maybe we'll even do some good along the way. 

We'll sure try. Meanwhile, let's hope the politicians in Illinois and elsewhere do, too.

Thanks. Bob.