Illinois has the distinction of having the worst-funded pension plan in America. In addition to a massive funding shortfall, the state also has the lowest credit rating and owes “$10 billion in backlogged payments to vendors, schools, hospitals and charities”. Pension plan payments make up 22 percent of the general fund budget, and in a decade have gone from $1.8 billion to $7.5 billion annually.
That’s why Illinois state legislators are back at the table trying to figure out how to stablize the plans and fill an estimated $100 billion shortfall. Unfortunately, as is the case with all public pension plans in the U.S., the funding gap is grossly underestimated. On a market basis, Illinois’ funding shortfall is closer to $200 billion.
It is this estimation error, based on flawed discount rate assumptions, that lulled governments into skipping payments, bonding contributions, and pumping up benefits during market boom years. In fact, when Illinois tried reforming the pension system in 1994, it began a habit of issuing bonds to fund its pension plans.
This time legislators want to take a serious stab at the problem. They’ve proposed a few things. One is to freeze the Cost of Living Adjustment (COLA) until 2017. This will have the most mathematically dramatic effect. For every one point reduction in the COLA, the liability decreases by 10 percent. It is estimated a COLA freeze could reduce the unfunded liability by $46 billion.
But there’s a hitch. To do anything to reduce benefits for current workers and retirees means confronting this piece of language from Artcile XIII, Section 5 of Illinois’ 1970 Constitution:
Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.
Is the COLA part of the benefit or external to the formula? Other states have less stringent legal protections surrounding pensions. Some courts have found a right to freeze the COLA for retirees. New Jersey will suspend the COLA until 2040. Other states going the COLA reduction route include Rhode Island, Colorado and Minnesota.
To get around this constitutional language, Illinois legislators are proposing to make a deal with workers: take a COLA freeze voluntaritly, or forgo health care benefits. Health care benefits do not enjoy the same legal protection as pensions. Whether this voluntary approach stands up in court remains to be seen.
COLA freezes, benefit cuts, and court cases are likely to continue in states and municipalities. The problem in public sector pensions was built over decades based some fantastical assumptions. Unfortunately, the result is that lawmakers have little incentive to get the accounting right. Until the accounting matches economic reality, lawmakers will find themselves performing pension plan triage in less-than-ideal circumstances.