CHICAGO – Getting Illinois out from under its formidable pension bind will require its leaders to put aside their penchant for short-term patches in favor of politically painful options like new or higher taxes.

That was a recurring theme during debate over the pension quagmire, potential fixes, and need for stakeholders to work together at the “Navigating Pension Reform in Illinois” conference hosted by the Federal Reserve Bank of Chicago and the Chicago Civic Federation last week.

Rick Mattoon, Senior Economist and Economic Advisor, Federal Reserve Bank of Chicago
"Come up with a binding plan that eliminates uncertainty” about Illinois pensions, said Rick Mattoon, a senior economist at the Chicago Fed.

Presentations on successful pension fixes from stakeholders in Detroit, Atlanta and Arizona – a state where pension benefits enjoy similar constitutional protections as Illinois – offered glimmers of what’s possible while a former Illinois governor said action should come from the top.

The biggest obstacle may be the political will needed for leaders to support measures that the public and labor may find hard to swallow.

The recommendation to the winner of the November election for governor: “Come up with a binding plan that eliminates uncertainty,” said panelist Rick Mattoon, a senior economist at the bank.

Bring stakeholders together and agree to “shared sacrifice,” said panelist Tracy Gordon, senior fellow at the Urban Institute.

Stabilizing the state’s pension system has taken a backseat to passage of a fiscal 2019 budget and the statewide election looms large over this year's legislative session. Incumbent Republican Bruce Rauner faces Democratic nominee J.B. Pritzker, a venture capitalist.

Pritzker has steered clear of offering details on how he would address the state’s $129 billion of unfunded liabilities. Rauner endorses a reform package that would make a small dent in annual payments if it passes constitutional muster. He has also proposed shifting some contributions now covered by the state on to local school districts and public higher education institutions.

The latter would ease pressures on the state general fund but won’t help a system that’s less than 40% funded according to 2017 data.

Pensions are often named as the primary long-term drag on Illinois’ credit profile. The state has little breathing room as two of its ratings are one notch away from junk.

Pension contributions of about $8 billion consume more than one-fifth of general fund spending. Local governments are struggling and looking for direction following Illinois Supreme Court rulings banning efforts to alter benefits. Combined, local and state funds carried $185.2 billion of unfunded obligations in fiscal 2016.

OPTIONS

Bolstering revenue to trim unfunded liabilities offers a path that would win with labor but poses political challenges due to the already high property tax rates in some communities, the hefty sales tax rate in the Chicago region, and recent state income tax rate hikes.

Former Illinois Gov. Jim Edgar and Elaine Nekritz
Former Illinois Gov. Jim Edgar and former state Rep. Elaine Nekritz discussed Illinois pensions at a Chicago conference last week.

“The pension problem creates a special risk. New revenue will have to be used to pay for services already consumed” in the form of accrued unfunded liabilities, according to a presentation by Mattoon.

The state could expand its sales tax to cover services and other goods or begin taxing retirement income. Both have seen little political support so far. The state could expand gambling and legalize marijuana but gaming revenues have been flat and marijuana lacks long-term revenue certainty. The state could impose a financial transaction tax but that could drive some firms out. A shift from a flat income tax to graduated rates, as Pritzker favors, would require a constitutional change.

A statewide property tax has benefits if such a tax is legal because it creates certainty and transparency and would likely be capitalized into real estate values which could prevent people leaving the state to avoid paying for the liability, Mattoon said. But it would prove a hard sell.

A hybrid “tax swap” might offer the best solution with an increase in other taxes going to reduce property taxes, Mattoon suggested. Some limited use of pension borrowing to reduce the amount of property tax revenue needed to fund the pensions could be in the mix.

Others have proposed pension borrowing but the state needs to tread cautiously with its ratings so close to junk. Other groups have suggested re-amortizing the pension funding schedule and perhaps lowering the current 90% target, but such a move could face an investor and rating agency backlash.

While the state can’t cut benefits under its constitution, it could seek labor concessions on wages and other benefits like healthcare costs and dedicate the savings to pensions. In a state where public employee unions hold significant sway, political will would be needed to press labor to compromise.

Panelist Jeff Johnson, president of one of Chicago’s four pension funds, urged leaders to think outside the box on revenue and said the state has “a moral obligation” to make good on its promises.

He fears public backlash against state and local government workers and stresses that it’s in the state’s economic interest to solve its pension troubles. “Pension funds help to fuel our economy,” he said, citing studies that show that every dollar paid in pensions generates $2.21 in economic output.

Federal options have been pitched too. They include direct aid, loans, and guarantees, allowing tax-exempt pension obligation bonds under certain conditions, the introduction of deferred annuities, and a new insurance product offered by establishing a Pension Benefit Guaranty Corporation for the public sector, and expanded access to restructuring options with bankruptcy, Gordon said.

States are not permitted to file municipal bankruptcy and Illinois lacks such a statute for its local governments.

CONSIDERATION

The so-called “consideration model” first pitched by Senate President John Cullerton, D-Chicago, is touted by many, including Rauner, as the state’s best chance at trimming benefit costs without running afoul of constitutional protections.

In 2013, that plan was passed over in favor of House Speaker Michael Madigan’s plan, which would have saved more money by raising employee contributions and cutting benefits. The state Supreme Court struck it down in May 2015.

A revised consideration model asks employees to give up their 3% compounded COLA in exchange for a lump sum payment and a reduction in future contributions.

If an employee accepts, future salary increases count toward the pensionable salary. If not, they don’t.

“Those are the two choices: accept the deal or reject it," said panelist Eric Madiar, now a principal at Madiar Government Relations, who authored the model during his time as Cullerton’s chief legal counsel.

Union lawyers argue the plan won’t pass the pension clause test because with either choice fund members take a hit.

Madiar counters that the state’s contractual obligations on pensions don’t extend to counting raises toward pensionable salaries and cites past Illinois and New York court rulings holding it’s a state’s right to offer raises and count them toward pensionable salaries.

ARIZONA'S EXAMPLE

Illinois and Arizona share similar stringent constitutional benefit protections against impairing or diminishing pensions. Arizona was struggling with rising obligations in its public safety funds due to its compound COLA, dwindling investment returns, and unrealistic estimated return rates. A 2011 package that cut COLAs failed a constitutional test.

A reform package was developed that brought pension funds, local officials, and Gov. Doug Ducey to the table and it passed in 2016. It outlined changes for new hires and capped COLAs. Because the latter impacted current fund members the state turned to voters who in May 2016 approved by 70% a constitutional amendment that permitted the legislative changes.

Sponsors believe it can past Arizona’s contract clause tests if it is challenged in court.

If the government has the inability to pay and reform negotiations have failed or appear impossible, then model guidelines for a constitutional amendment or a legislative public pension funding policy should be considered so that critical services are protected and the tax base needed to service pensions preserved, said panelist James Spiotto, managing director at Chapman Strategic Advisors.

The Civic Federation’s pension reform proposals recommend the General Assembly put a constitutional amendment on the ballot by 2020 clarifying the clause to allow for “reasonable” changes to existing benefits.

Some lawyers warn the amendment path is fraught with uncertainty because the high court could conclude that the state can’t retroactively alter the contractual promise made to retirees and existing employees, which would in turn limit the potential savings from changes.

THE RAMP

Funding holidays, early retirement programs, enhanced benefits, a compounded COLA, and overly optimistic return assumptions contributed to the state’s rising obligations. At the center of the problem is the funding schedule adopted in 1995 to reach a 90% funded ratio by 2045.

Contributions have long fallen short of what’s actuarially needed. Last year’s payment, based on the formula, fell about 26% short of an actuarially determined contribution.

“It wasn’t the final answer but it was a start,” former Gov. Jim Edgar said during another panel discussion in defense of the plan enacted during his tenure. “We got away from it.”

The state settled fraud charges in 2013 with the Securities and Exchange Commission for failing to inform investors of the funding risks tied to the schedule and the impact of several payment holidays.

To stabilize the system a “bipartisan” fix is needed with all parties at the table and it should come from the governor, Edgar said. “The next governor is definitely going to have to address this issue.”

The Pew Charitable Trusts’ latest national state pension report illustrates the depth of Illinois’ strains, although other states are in worse shape.

State funds cumulatively reported a $1.4 trillion unfunded deficit in 2016, up $295 billion from 2015, due primarily to investment returns that fell short and assumption changes. Nationally, funds averaged a 66% funded ratio.

Kentucky and New Jersey are in worse shape than Illinois at just 31% funded with Illinois at 36%, based on 2016 data. California's and New Jersey’s net pension liabilities exceeded Illinois in size.

“Policy makers have options. As well-funded states have shown, combining strong contribution policies with a focus on managing risk and avoiding unfunded benefit increases can help states offer secure retirement benefits in a sustainable and affordable way,” the Pew report says.