On October 10, 2019, the Illinois Pension Consolidation Feasibility Task Force released its report to Gov. JB Pritzker. The Task Force was charged with studying the possibility of consolidating some of Illinois’ hundreds of public pension funds and providing recommendations to the Governor. The main focus was Illinois’ public safety pension funds — there are over 600 individual funds for police officers and firefighters throughout the state.
The public safety funds range significantly in size and financial condition, and each one currently operates independently with its own board of trustees. Most, however, are underfunded, and the financial health of the funds has long been a concern. This is, in part, because municipalities’ annual pension payments are linked to the finances of the pension funds — as a pension fund’s finances deteriorate, the municipality’s payments should increase. State law requires municipalities’ contributions to be sufficient so that each public safety fund is 90% funded by 2040 (meaning 90% of the liabilities are matched with assets). Because most public safety pension funds are underfunded, municipalities’ contributions are projected to increase significantly over time. The increasing pension contributions are a growing fiscal pressure for municipalities.
Unfunded liabilities for all public safety funds totaled $11 billion as of fiscal year 2017, and between 2012 and 2017 the median increase in unfunded liabilities from year-to-year was nearly $400 million. A policy change that boosts the finances of the pension funds—like consolidation—could reduce municipalities’ required contributions. However, consolidation should not be thought of as something that will resolve the challenge of unfunded pension liabilities or municipalities’ increasing pension contributions.
As part of my work for the Government Finance Research Center, I’ve been studying the public safety funds. My work has focused on municipalities’ annual pension payments and a state law meant to enforce those payments. Trying to assess whether the enforcement law is working is difficult because the 600+ public safety funds operate separately, and no central authority monitors the pension payments. Because of the challenges I’ve encountered that stem from there being hundreds of funds, I was keen to read the Task Force’s report. Below is my summary of it and some important issues that were largely left out of the report. My big takeaway is the report itself is too thin on details to say for certain whether the recommendations are good or bad ideas, or what impact they’ll have at the local level in the short-term.
What Did the Task Force Recommend?
The Task Force has two main recommendations:
- Consolidate the assets of the public safety funds (excluding Chicago and Cook County). More specifically, the Task Force recommends that rather than having hundreds of funds managing their own investments, this should be centralized under two new, statewide bodies (one for police officers and one for firefighters). Importantly, this would be a form of partial consolidation. While the investments would be centrally managed, each fund would continue to maintain an accounting of its own assets and liabilities. The administration of benefits would also still be managed by the 600+ individual public safety pension boards. The Task Force does, however, recommend studying full consolidation further.
- Increase the Tier-2 benefit. Tier-2 is the reduced benefit level for any public employee hired on or after January 1, 2011. The Tier-2 benefit is believed to provide a pension that falls below a minimum threshold required under federal law. To remedy this issue, the Task Force recommends boosting the Tier-2 benefit, specifically by increasing the amount of salary that can count towards a pension benefit and changing how the final average salary (which is used to determine the pension) is calculated. The Task Force also makes recommendations for changing benefits for surviving spouses.
What’s the Financial Impact? Are the Estimates Accurate?
The Task Force writes that consolidation is “the single most impactful step that the State can take to address the underfunding of downstate and suburban police and fire pension funds.” The rationale for consolidating the assets is that doing so would result in better investment returns, which would boost the overall finances of the pension funds. While consolidating the assets is believed to generate savings, increasing the Tier-2 benefit would add costs. In the end, the Task Force believes the savings will outweigh the costs.
The group estimates that asset consolidation would generate an additional $820 million to $2.5 billion in investment returns over the next five years. The savings, according to the report, “could save taxpayers in excess of $160 million on an annual basis.” While any increase in assets will help, the upfront costs of consolidation could be more than additional investment returns in the short-term.
The savings estimate assumes the increased investment returns generate a 1-to-1 reduction in municipalities’ required pension payments. Investment returns are just one component in determining municipalities’ annual pension payments, and there are many other factors and even aspects of consolidation itself that could drive costs up or down. Reduced administrative costs, for example, might also generate savings, but this wasn’t calculated in the report. The Task Force estimates that the Tier 2 benefit changes would cost between $70 million and $95 million per year; however, no information was included as to how that estimate was calculated. Last, whether the recommendations ultimately saves municipalities and taxpayers money will vary on a case-by-case basis, and depends on a variety of factors, including the investment rate assumption, discussed below.
A key reason consolidation is thought to enhance investment performance is that under current state law, there are restrictions on what kinds of investments pension funds can make, depending on their size (see 40 ILCS 5/1‑113 through 113.4). Smaller funds have the least investment discretion and have to have a more conservative investment strategy, and these restrictions can translate into lower investment returns. Under the Task Force’s consolidation recommendation, the restrictions would be lifted, which is believed to result in a higher investment performance. In theory, higher returns could also be achieved without consolidation by simply lifting the restrictions. Importantly though, achieving higher returns hinges on taking on more investment risk and volatility. For example, one of the largest public safety funds, the Joliet Police Pension Fund, had an investment loss of 0.6% in 2015 and a positive return of 12.9% in 2017.
The estimate itself was calculated using the Illinois Municipal Retirement Fund’s and Illinois State Board of Investment’s average rates of return from 2004-2013, both of which were higher than the public safety funds’ average return. This is a rather simple way to estimate the impact of consolidation, and it does not take into account a variety of factors.
One issue is that there are transition costs to consolidating the assets. While the report acknowledges transition costs, no estimate was included. A 2012 report also evaluated the possibility of consolidating the public safety funds’ assets. That report discusses transition costs, and includes more detailed cost and saving estimates. Importantly, transition costs are immediate expenses, while savings occur over the long term. The analysis from 2012 found that under the most likely scenario, “it would take 11 years to break even and begin realizing any cost savings in excess of transition costs” from consolidating the assets of all public safety pension funds. (The Anderson Economic Group released a report on its study of consolidation for the Illinois Public Pension Fund Association in 2018).
How Would Consolidation Impact Actuarial Assumptions?
Consolidating assets has implications for actuarial assumptions, and assumptions play a vital role in determining a pension fund’s finances and municipalities’ annual payments. According to the Task Force, one of the benefits of consolidation is that it would, “Enhance uniformity in setting investment and other actuarial assumptions.” The report is thin on details about this aspect of consolidation, and it’s important to learn more about it to understand how municipalities will be impacted in both the short-term and long-term.
In determining the long-term finances of the pension systems, actuaries use an investment rate assumption. Right now each of the 600+ public safety funds have their own investment rate assumption, and the assumption rates vary from around 5% up to 8%. Moving to a single investment rate assumption will mean some funds’ assumptions will be lowered, while others will be increased.
Changing the investment rate assumption has an immediate and direct impact on unfunded liabilities. Increasing the assumption will decrease unfunded liabilities, while reducing the assumption increases unfunded liabilities. The Chicago Tribune highlighted that the biggest driver behind increases in Chicago’s unfunded pension liabilities in recent years has been actuarial assumption changes. Since municipalities’ annual pension payments are linked to the unfunded liabilities reducing the investment rate assumption increases the required contribution (and vice-versa). When the Teachers’ Retirement System lowered its investment rate assumption the state’s required pension contribution for one year increased by hundreds of millions of dollars. Lowering the investment rate assumption a quarter of a percentage point (from 6.75% to 6.5%) was estimated to increase municipalities’ contributions for representative public safety funds by between 16% and 22% (see 2017 GRS Experience Report, available here) .
The financial implications of changing the investment rate assumption are not detailed in the Task Force report. Figuring out how switching to a uniform investment rate assumption will impact contributions should be carefully studied, and would need to be done for each fund as the impact depends on their individual investment rate assumptions.
Who Will Determine Municipalities’ Required Contributions? Who Will Trigger the Intercept?
In addition to the financial impact of consolidation, it’s also important to understand how the Task Force’s recommendations will impact pension governance more broadly. As previously mentioned, most public safety funds are currently underfunded. State law requires each municipality to pay enough money to its public safety pension funds annually so that each one is 90% funded by the end of 2040. As of 2017, the funds were only 55% funded. Shoring up their finances requires municipalities’ annual pension payments to increase over time.
If a municipality fails to make that payment the pension board can request the Illinois Comptroller to intercept state-sharing revenue and redirect it from the municipality to the pension fund to make up for the shortfall. But municipalities have some discretion in determining the required payment.
Under current rules, municipalities can use one of three different actuaries to determine the payment: 1) one hired by the Illinois Department of Insurance, 2) one hired by the municipality, or 3) one hired by the pension fund. These three actuaries can use different assumptions, leading to three different figures as to what the municipality needs to pay. It is ultimately up to the municipality to choose which of the three numbers to pay. This has led to concern that municipalities can shop for the lowest number, and thereby undermine the long-term finances of the pension funds. The report doesn’t explicitly address whether duties related to determining the required contributions and triggering the intercept would shift to the statewide bodies that would be formed under the Task Force’s recommendation.
So What’s the Takeaway?
The Task Force’s two big ideas — consolidating assets and fixing Tier-2 — each have merit, and as general ideas make a lot of sense. But the report doesn’t have enough information to say for certain whether the Task Force’s recommendations are prudent policy, or how individual pension funds and municipalities will likely be impacted. Legislation based on the recommendations has yet to be introduced, but once it is, more details should emerge that will allow for more in-depth evaluation. When a more detailed proposal is introduced, it will be important to have a thorough analysis of the estimated costs and savings, and their respective time horizons.