The Truth about the State Employees Retirement System of Illinois

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1 The Truth about the State Employees Retirement System of Illinois The State Employees Retirement System (SERS) began in 1944 as a core benefit for state and local employers to use in attracting and retaining employees needed to fulfill critical government duties. Today, the system covers 65,599 members who are currently working and 57,099 retirees, beneficiaries and disabled members who are currently receiving benefits. The plan covers workers at state agencies, as well as those at state boards and commissions. SERS Efficiently Provides Career Employees with Modest, but Meaningful, Benefits SERS provides pension benefits to 57,099 retired and disabled state and local employees and their beneficiaries. The average annual pension for a retiree under the general formula was $22,424 in FY 2009, see page 52, FY 2009 CAFR. The vesting period is eight years for SERS participants hired prior to January 1, 2011, and ten years for those hired on or after this date. This means that, after eight years of service (ten years for the new hires), a plan participant will have the right to ultimately receive a pension benefit regardless of whether the employee remains a member of the pension plan. According to the Wisconsin Legislative Council s 2008 Comprehensive Study of Major Public Employee Retirement Systems, nearly three-quarters of the public plans surveyed require five or fewer years of service to vest; private sector plans also provide vesting after five years. There are two applicable benefit formulas for AFSCME members covered by SERS: the general formula covers most employees, while an alternative formula is available for employees in jobs such as state police officers, corrections security officers, along with other security and investigative positions. 1

2 Both formulas use a service credit multiplier to determine the benefit. The general formula uses a benefit multiplier of 1.67 percent, which is multiplied by average pay and years of service to determine the benefit amount. The multiplier for those covered by the alternative formula is 2.5 percent. The national average for service credit multipliers in public plans is 1.95 percent. SERS members covered by the standard formula are eligible for unreduced retirement benefits after attaining age 60 and completing 8 years of service, or after attaining age plus service of at least 85 years (Rule of 85). They can elect to retire as early as age 55, but their pension benefit is reduced by 6% for every year they retire under age 60. The amount of the pension benefit is determined by the actual number of years of service. An Illinois State employee would have to work for nearly 45 years in state service to earn the maximum pension benefit of 75% of their final average compensation. The notion that Illinois State worker can retire at age 60 with full benefits is false, they are only entitled to the benefits they actually earned based on their years of service. For those State employees hired on or after January 1, 2010, the normal retirement age is 67 and the rule of 85 will not apply. To illustrate, the benefit for a hypothetical 30-year employee with a final average salary of $40,000 would be calculated in the following manner: General Employees: $40,000 x 30 years x service multiplier of 1.67% = $20,040 Alternative Formula: $40,000 x 30 years x service multiplier of 2.5% = $30,000 Employees make substantial contributions from their paychecks to finance their own retirement benefit. Those covered under the SERS Standard formula pay 4 percent of their earnings, but also gave up a 3.0% pay raise in 1998 (through collective bargaining with Governor Jim Edgar) to be allocated to the SERS. So their combined contribution is 7% of pay when the foregone pay raise is properly counted. 2

3 Those Illinois state employees covered by the alternative formula pay 8.5% of their salary for each year they occupy a position that is covered under that formula. Defined benefit pension plans are a more efficient way to finance a secure retirement program for public employees than defined contribution plans, according to a recent study by the National Institute on Retirement Security (see A Better Bang for the Buck). Under defined contribution plans (such as 457 and 403b Plans), most plan participants invest too little, or their investments may provide insufficient returns, thus preventing employees from retiring. A recent study by the Center for Retirement Research shows that the real retirement crisis in our country is the $6.6 trillion gap between current savings and what Americans should have today to maintain their standards of living in retirement (The Retirement Income Deficit, Retirement USA, October 2010). As a result, millions of U.S. workers have already delayed or are likely to delay their retirement date. This can complicate the employer s role, forcing decisions with unpleasant consequences for everyone. Even for those employees who have accrued what they believe may be sufficient savings, there is often little incentive to retire. Defined benefit plans have access to professional investment managers who are trained in developing ongoing, long-term investment strategies that include an optimum mix of growth potential and risk. Participants and taxpayers benefit from the favorable investment performance of pooled pension fund assets, as well as fees and expenses that are significantly lower than those of defined contribution savings plans. The wide range of investment options open to large pension plans, such as foreign and domestic stocks and bonds and venture capital, also improve investment returns. Furthermore, SERS investments are not affected by the retirement timing of a particular employee so the investment horizon never has to be shortened. Plan investments not only help keep costs down for plan sponsors, but are also a critical part of the economic fabric of the state. According to the National Institute on Retirement Security (NIRS), each dollar in taxpayer contributions to Illinois s state and local pension plans supports $5.62 in long-term economic activity in the state, and retiree 3

4 expenditures stemming from state and local pension plan benefits support over 83,611 jobs in Illinois. These figures reflect the fact that taxpayer contributions are, in the long run, a highly efficient source of financing for retirement benefits that ultimately provide income and jobs for others (Pensionomics: Measuring the Economic Impact of State and Local Pension Plans, National Institute on Retirement Security, February 2009). Illinois has not Responsibly Funded SERS Illinois political leaders, including Governors and General Assemblies over the past 30 years have engaged in irresponsible underfunding of the SERS. Appropriations for SERS were often reduced. Pension contribution holidays were taken by the State in some years, while covered workers made their contributions out of each and every paycheck. In several fiscal years when funds were extremely tight, such as FY 2010 and FY 2011, the annual pension contribution was borrowed in the bond market. While SERS received contributions, the State incurred more debt, and it was pension debt even if held by bond holders. In sum, efforts taken since 1996 that purportedly were designed to reform funding practices were inadequate and/or based on wishful thinking. The results of this irresponsible behavior by politicians should not be a surprise to anyone in Illinois who has been paying attention to the plight of the State s public pension funds. As of June 30, 2009, SERS held assets with an actuarial value of $11.0 billion and had accrued liabilities of $25.3 billion. In other words, the fund had 43.5 percent of the money it will need to pay accrued benefits in upcoming years, See June 30, 2010 Actuarial Valuation. (Recent surveys show that the average funding level for large public sector plans is in the range of 70 to 75 percent). It is worth asking how this happened. The major factor is a decades-long failure to make the employer s annual required contributions (ARC), which is generally accepted as responsible funding level. The state has utilized funding formulas that fall far short of the ARC for at least three decades. For instance, the funding statute has required $2.8 billion in 4

5 contributions over FYs , while the Annual Required Contribution (ARC) under GASB 25 would have produced contributions of $4.8 billion (see following table). Year GASB 25 ARC (Mils) % Contributed 2004 $ % , Average 58.9% The problem dates back much further than 2004, too. Below is a brief history of the state s pension funding practices: In FY 1983, then Governor James Thompson proposed a one year partial pension holiday that cut the State s contributions by 56%. This cut, however, continued for the next fifteen years. P.A : Effective August 23, 1989, this Act created a funding plan that would ramp-up state contributions for 7 years reaching a level in 1996 that would pay for the normal cost (the cost of benefit accruals during the year) and amortize the unfunded liability over 40 years. The Governors and general assembly ignored this Act, however, even though the funding levels produced by this formula were well below the ARC. A class action suit failed to force compliance with the law, as the state s Supreme Court ruled that SERS members had no right to force the State to make its pension contributions. That funding plan was modified in 1994 by Public Act , which aimed to provide a level percent of payroll sufficient to have the systems 90 percent funded by However, this new Act perpetuated the underfunding of SERS because the provisions allowed for a 15 year gradual ramp-up in employer contributions, with contributions to reach the required level percentage of payroll in This had the effect of spiking unfunded liabilities over the ramp period, and raising the required percentage of payroll to a level much higher than would have been necessary had the new law required immediate funding at the correct percentage of payroll. 5

6 The pension funding ramp was unsustainable without new revenues. In 2003, the state issued $10 billion in pension obligation bonds in an effort catch-up on funding, only to divert $2.7 billion of that amount to other priorities. PA , the pension holiday Act, further reduced FY 2006 and 2007 contributions by $2.3 billion. A state commission on pension modernization determined that $18.8 billion of the combined $35.7 billion in unfunded state pension obligations (in 2008, before the current downturn) were due to the state shortchanging its contributions. For both fiscal 2010 and 2011, the State is borrowing the entire pension contribution for SERS and the four other State of Illinois retirement systems. This is not a sustainable funding policy. The recent Illinois State Income Tax increase should allow the State to make future pension payments from General Revenues and not from more borrowing. The inadequate funding levels were pushed even lower in recent years, due to the market meltdown that affected all pension plans and other retirement accounts such as 401K plans. The SERS lost $2.9 billion in FYs 2008 and The normal cost (the cost of benefit accruals) of the SERS plan was $363 million in FY 2009, while employees directly contributed $242 million or two-thirds of the cost of benefit accruals (not counting the value of the 1998 raise of 3% that the State was supposed to be investing each year in the retirement system). However, the budgetary costs for the state, going forward, has skyrocketed due to the high cost of paying down the massive unfunded liability. It is the liability cost and NOT the normal cost of the annual benefit accrual that is causing fiscal instability for Illinois State government. Employees have contributed their full required contribution every year. In contrast to the SERS plan, the Illinois Municipal Retirement Fund (IMRF), which has contributions set by certified actuaries and has a guarantee of getting the required contribution 6

7 from all of their 3,000 plus public employers each year, is 83.2 percent funded even after the recent economic/market turmoil. It is important to understand what the funding ratio is, and how it works. This ratio of assets to liabilities is simply a snapshot that captures a plan sponsor s ongoing effort at one point in time to fund its pension obligation; any unfunded liabilities can be made up over many years. If the plan sponsor is consistently making its annual required contribution, its pension plan can have a funded ratio below 100 percent yet still be on track toward full actuarial funding. Plan actuaries project that over the long term SERS will earn an average of 7.75 percent each year on its investments. In some years returns will be below that rate and in others returns will exceed it. When returns are strong and above the actuarial assumed rate, the employer s level of contributions will generally be lower than when investment returns lag the actuarially assumed rate. When returns are less than projected, those actuarial losses are amortized through increased employer contributions. This is one reason why contributions needed are higher than levels needed earlier in the decade. The State Employees Retirement Website notes: Through September 30, 2008, the 10 year return was 5.70% percent annually, while the 20 year and 30 year return numbers were 8.39% and 9.06% annually, respectively. In pension funding, there is a clear relationship between the funding level and the employer s annual budgetary cost. Well funded plans are able to get most of the required revenue from investment returns. When plans have not been properly funded, higher employer contributions are required to make up for past underfunding. Well funded plans cost less because the plan assets earn returns, and these returns are compounded. Poorly funded plans cost more because the employer owes interest on the unfunded liability, and the larger the unfunded liability, the higher the interest cost. Simply put, it is better to EARN compounded interest than to PAY compounded interest. Even with the recent poor investment performance and low funding levels over the past decade, SERS investments have provided 38.6 percent of pension fund revenues since

8 Meanwhile, taxpayers only paid 43.2 percent of the plan s revenues. Workers themselves contributed the other 18.2 percent. Had the plan been funded in a more robust manner over these years, the taxpayer s share would have been substantially lower. Fiscal Year SERS Revenue Sources (in Mils), FY Employee Contributions Employer Contributions Investment Income/(Loss) Total Revenues/(Losses) 1996 $137.2 $146.4 $736.2 $1, , , , , , , , , , , , , , , ,192 Total $2,759 $6,534 $5,844 $15,137 % of Total 18.2% 43.2% 38.6% 100.0% Source: FY 2009 and FY 2005 CAFRs. The ability to provide a large share of retirement benefits with investment returns, while the assets are professionally managed (and with much lower fees than DC plans have), is the primary reason defined benefit plans can provide retirement benefits in a much more efficient manner than 401k-type plans. What Has Been Done to Address These Challenges? As mentioned above, the Governor of Illinois signed public pension bills in 2010 and early 2011 which establish a second tier of benefits in all Illinois public pension systems, 8

9 including SERS, for those employees hired after December 31, Because of the current funding law, which uses a level percentage of payroll to reach the 90% funding target in FY 2045, some significant portion of the savings will be realized in budgets starting this year, even though it will be 30 years before a significant number of those newly hired actually retire. These new State employees (hired after December 31, 2010) will have their benefits reduced in a number of ways, as follows: The normal retirement date will be 67 years of age, with 10 years of service. The minimum retirement age will be 62, with a reduction in the pension benefit of 6% for each year under age 67. The Rule of 85 will not apply to these employees. The period used to calculate final average compensation has been expanded from four years to eight years, which has the effect of reducing the benefit. The COLA for these workers will be inadequate to keep pace with inflation, limited to 50% of CPI not to exceed 3.0%, and applied to the ORIGINAL benefit (that is, non-compounded). Many jobs formerly covered by the alternative formula will be covered by the general formula for new hires into these positions. Places restrictions on double-dipping (returning to work in retirement). Pensionable income is limited to $106,800 per year for new hires. AFSCME believes in a society of opportunity; where all workers not only earn a living wage and can afford to see a doctor when they are sick, but where we all have the opportunity to reach our full potential in our chosen careers and where we all have the opportunity to retire with dignity when our work is done. For decades SERS has provided workers and their beneficiaries with secure retirement benefits. The recently enacted Illinois income tax increase is the first concrete sign in many years that Illinois is taking its responsibility to responsibly fund their pension fund seriously. 9