Paying for Tomorrow

Public retirement systems are vastly underfunded, and the fix is quite simple: Costs must either be reduced to solve the problem or deferred to postpone the problem.
by | July 12, 2006

When Rod Blagojevich began his first term as governor of Illinois in January 2003, he had a host of priorities he wanted to address: improving schools, investing in the state's underfunded infrastructure, increasing access to health care and so on. There was only one problem: A few months into office, he learned that the state's public employee retirement system was staring at an unfunded liability of $43.1 billion (with a funding ratio of under 50 percent).

If things continued on their path, annual state payments into the system would have to jump from $1 billion in 2006 to $4 billion in 2013 and $16 billion in 2045. "Unless we reform the way we fund our pensions," explained the governor, "we will never eliminate the structural deficit that takes money away from education, from health care, from law enforcement, from parks, and from everything else we care about."

Illinois has a lot of company. More than 87 percent of state pension systems are underfunded, dwarfing the much-publicized corporate pension problems. In New Jersey alone, state and local public retirement systems are underfunded by as much as $35 billion. Meanwhile, the bill for paying future medical benefits for state and local employees who retire could top $1 trillion. And the problem will only get worse with the impending huge wave of baby boomer retirements.

So what's to be done?

Some experts say the solution is to transition public pension systems from defined benefit to defined contribution 401(k)-style retirement programs. While this may be the right thing to do for the long term, it's unfortunately not a solution to managing today's near-term runaway retirement costs. Reason: Governments must phase in defined contribution pension plans gradually as new workers enter the system, meaning they may not see significant relief for 20 to 30 years. In fact, thanks to transition costs, defined contributions would likely increase costs in the near term.

So if that's not the answer, what is? From an actuarial perspective, the "solutions" are quite simple -- costs must either be reduced to solve the problem or deferred to postpone the problem. And continuing to defer the problem to future generations is both unfair and irresponsible.

That leaves one option: reduce costs. This brings us back to Illinois. Facing one of the most underfunded public pension plans in the country, resulting from decisions made long before he took office, Blagojevich has methodically gone about taking out costs and liabilities from Illinois' five state retirement systems.

Loopholes and abuses have been curtailed. School districts, for example, had routinely approved generous salary increases for teachers in their final years of employment, producing inflated pension amounts that became the responsibility of state taxpayers when teachers retired. No more. School districts must now pick up the tab for pension increases triggered by pay raises in excess of 6 percent.

Another big cost driver in Illinois was expensive special benefits once reserved for police officers for risking their lives in the line of duty, which over the years had somehow spread to one-third of all state workers. Eligibility for these benefits was cut back to those they were originally intended for: public safety workers.

To avoid making the same kinds of mistakes again that got Illinois into the trouble it's in now, the governor convinced the legislature to mandate that all future benefit enhancements will expire after five years unless they are renewed by the governor and the state legislature. In addition, every future benefit increase is required to have a dedicated revenue source.

Illinois offers important lessons for other states and localities embarking on fixing their pension systems. The first is to gain a firm understanding of your current pension situation. What are your real pension costs? How big is the problem? If your fund is only 65 percent funded, say, you'll first have to stop the bleeding. Once that is accomplished, you can focus attention on longer-term reforms.

Second, involve stakeholders. Pension reform often involves difficult and politically sensitive changes. Involving political officials, business leaders, labor unions and other stakeholders helps build support and buy-in for these initiatives.

Once reform proposals are developed, you'll need a broad education campaign to explain their value to constituents. Illinois state officials launched an extensive communications campaign to promote the governor's pension-reform plan. They met with most members of the state legislature and with union representatives. They also met with almost every major newspaper in the state and sent letters to teachers and other retirement plan participants.

Third, while it's true that public-pension-plan underfunding is a financially driven crisis, it should not be viewed purely through a financial prism. Pension issues cannot be divorced from their impact on talent acquisition and management. The underlying plans are, after all, "employee benefit" plans that were designed, even if flawed, to attract, retain and motivate talented individuals to seek and remain in employment. All financial decisions are also human-resource decisions that may have significant workforce consequences.

Lastly, Illinois teaches us that few of the pension-reform options are painless. Indeed, all of them demand strong political leadership and the willingness to confront entrenched interests. Yet, the stakes are too high to ignore -- and the time for action is now.

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