TRS executive director Dick Ingram said the fund’s weak shape is due to decades of underfunding.

CHICAGO — Illinois' largest retirement fund voted to lower its assumed rate of return, casting off political pressure to hold the rate steady due to the burden a change would put on the state's already battered balance sheet.

The board that manages the Teachers' Retirement System voted to lower the rate to 7% from 7.5% based on the advice of its consulting firm Segal. The firm will use the new rate and other assumption changes for the valuation due this fall that will set the state's fiscal 2018 contribution.

If the 7% rate was applied to the most recent valuation, Segal said the state would have owed an extra $420 million on top of its $3.9 billion fiscal 2017 contribution. The fiscal 2018 contribution has not yet been set.

Ahead of the vote, Gov. Bruce Rauner's administration warned a change could have a "devastating" impact on funding for social services and education.

TRS executive director Dick Ingram and the board — including two new members just appointed by Rauner — stressed that the fund's weak shape was due to decades of underfunding.

"The math is unforgiving…..the truth is simple, more contributions now mean lower required contributions later," he said. "Putting off the pain doesn't change the reality…the longer it takes for solutions the more painful and expensive those solutions become."

Ingram took offense at the political pressure and questions raised over the looming vote. He stressed that fund managers and board have a fiduciary duty to the fund and not the state budget.

"While some seem to think otherwise, nothing we are considering today is precipitate or rushed. We are following well-established procedures that are consistent with good actuarial practice and conform with the recommendations of the state actuary," Ingram said.

The state's pension funds routinely revisit various assumptions used in valuations including assumed rate returns, mortality rates, and average salary increase assumptions. TRS previously reviewed rate return assumptions every three years but has lowered that to two.

Friday's action marked the third time in the last four years that TRS reduced the rate. In 2012, TRS lowered the rate to 8% from 8.5 % and then in 2014 lowered it to 7.5%.

Primary drivers behind the change include Segal's recommendation that the projected inflation rate used in calculations be lowered to 2.5% from 3 % and projected returns on various investments.

Segal also factored negative cash flow in its calculations as in some years TRS must pay out more than it takes in further diminishing its assets.

The state actuary also has recommended that the fund consider lowering it assumed rate given economic and industry trends.

The TRS change comes as poor investment returns sparks debate over assumed rates. Moody's Investors Service said in a recent report that lackluster investment returns reported by some of the nation's largest public pension funds signal intensifying fiscal pressure on U.S. state and local governments.

Ingram said if the General Assembly doesn't like the consequences of any board actions it can "override the decision with legislation." Ingram said he was comfortable supporting Segal's 7% recommendation but suggested that the board may need to consider a further drop as soon as next spring.

Ten board trustees supported the change while two abstained from voting. The system is the 37th largest pension fund in the country and serves more than 400,000 members.

While a lower assumed rate of return will spur higher payments to the underfunded pension fund, it comes at a high cost for the state struggling under a backlog of unpaid bills that could soon hit $10 billion and a $5 billion deficit. A political stalemate has left Illinois without full fiscal 2016 or 2017 budgets.

The state's pension contributions — $8 billion in fiscal 2017 — consume a big chunk of the state's roughly $32 billion to $33 billion general fund. Lawmakers previously enacted pension reforms that cut benefits and raised employee contributions but the Illinois Supreme Court voided the changes in May 2015 as a violation of state constitutional provisions that protect benefits from being impaired or diminished.

Lawmakers have said they hope to take up pension reforms early next year. They are expected to exclude retirees while asking current employees to accept changes that would ease the state's burden in exchange for a new benefit. Rauner has also proposed smoothing over five years any changes in assumed return rates.

Headed into the Friday meeting, the board faced pressure not to raise rates. Rauner's senior advisor for revenue and pensions, Michael Mahoney, warned in a memorandum to Rauner chief of staff Richard Goldberg: "If the board were to approve a lower assumed rate of return taxpayers will be automatically and immediately on the hook for potentially hundreds of millions of dollars in higher taxes or reduced services."

Rauner spokesman Lance Trover issued a statement critical of the action. "With less than two hours' notice, Illinois taxpayers including our social service providers and small business owners were just handed a bill for nearly a half-billion dollars," he said.

"While questions remain about the legality of today's action, it further underscores the need for real pension reform in Illinois. The continual need to ask more and more from taxpayers proves yet again the current pension system is fatally flawed and must be changed," he added.

Trover was referring to concerns that were raised over whether the board agenda initially provided adequate public notice that the board intended to take action on the rate recommendation.

TRS' unfunded liabilities increased last year to $62.7 billion from $61.5 billion, though its funded ratio rose to 42% from 40.6% in fiscal 2015, based on the actuarial five-year smoothing. TRS' actual investment return for fiscal 2015 was 3.91%. If the 7% rate was applied to the last valuation, the funded ratio would have been just 39.3%.

The state's collective unfunded obligations stand at $112.9 billion for a 40.9% funded ratio and have ballooned by $86 billion since fiscal 2001, according to the Illinois Commission on Government Forecasting and Accountability.

"The main factors for this increase in unfunded liabilities were actuarially insufficient employer contributions, changes in actuarial assumptions and lower-than-assumed investment returns over five years, along with other miscellaneous actuarial factors," a commission report this year said.

The spiraling liability illustrates the flaws in the payment plan Illinois adopted in 1995, which is supposed to get the retirement system to a 90% funded ratio in 2045.

The contributions, though they are affected by the plans' assumed investment returns, are not tied a formula that would achieve an actuarially required level payment. Under the state funding schedule, the state is required to make contributions as a level percent of payroll in fiscal years 2011 through 2045, following a phase in which began in fiscal year 1996.

The contributions are also required to be sufficient, when added to employee contributions, investment income, and other income, to bring the system to a 90% funded ratio by fiscal year 2045. Each system certifies an annual payment amount in mid-November for inclusion in the next state budget.

Segal's presentation also highlighted how the controversial 1995 schedule — which was the subject of fraud charges brought by federal regulators against the state for misleading bond investor with respect to the state's health — falls short.

Segal officials suggested that using a 90% funding goal is among the schedule's flaws, as unfunded liabilities continue to grow for more than a decade before finally tapering off. If the goal were to reach 100%, the state would face a $2 billion increase in its fiscal 2017 TRS payment at the 7.5% assumed rate, while the payment would be $6.6 to $6.7 billion at 7%.

The lower assumed rate could drive up total state contributions for TRS through the 2045 payment schedule by $8.9 billion based on the last valuation.

TRS is governed by a 13-member board of trustees who include the state superintendent of education, six trustees appointed by the governor, four trustees elected by contributing TRS members, and two trustees elected by TRS annuitants. Rauner filled two vacancies Friday, while one vacancy remains.

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