Illinois Issues: The Great Pension Chasm

A 1917 report conducted on the Illinois pension system revealed bad news. After a pension-focused trip around the globe, with studies on such nations as Great Britain, New Zealand, and Austro-Hungary, it got to crux of the matter:

“The general condition of the pensions operating under the laws of Illinois may be correctly described as one of insolvency. That is to say, viewed from the standpoint of sound finance and of having the necessary reserves to carry out the payment laws, there are immense deficiencies in the existing funds.”

Though the language would sooner be found in an episode of Downton Abbey, the reality for Gov. Bruce Rauner and the 100th General Assembly sounds much the same but is far worse now. Rauner has made pensions and other pro-business reforms so central to his administration, his critics say it’s at the expense of a state budget.

But some of those same critics, led by Senate President John Cullerton, are using a new pension reform idea in the Senate’s so-called “grand bargain.” It’s an attempt to get the state’s first budget in place since Rauner entered office.

Now Illinois is $130 billion away from having its pension systems fully funded.

The bulk of that debt is not the cost of the employee benefits the Better Government Association found a handful of public employees enjoy, copious retirement benefits well into the six figures — but the vast majority do not.

Photo Credit: Abraham Lincoln Presidential Library and Museum

Rather, the debt is the standing legacy of the 100-plus years of missed opportunity. Those contributions that Illinois never made could’ve sat in investments and banks, accruing interest and returns — namely the world’s postwar boom that has only lately started to subside. Public employees are in the political crosshairs through no fault of their own.

“I know it’s convenient for certain interest groups and certain politicians to blame this on greedy unions, but it’s not. It’s a bipartisan lack of foresight,” says Bob Secter, director of investigations at BGA.

Lately the whole idea of pensions seems to be cursed. In the book Retirement Heist, Wall Street Journal reporter Ellen E. Schultz details how in the 1990s and 2000s, large American corporations like General Electric held such large assets in their retirement funds, they started to look for ways to legally remove them from protected pension accounts and into the company’s bottom line. The newfound profits went to shareholders and executive bonuses.

Since then, retirement plans in the private sector have shifted over to 401(k)-style “defined contribution plans.” Most large companies match contributions their employees make, but after that the income retirees ultimately receive depends on how much the individual decides to set aside, and of course, what happens in the stock market and other investments

Illinois and other states, on the other hand, still operate under the older 20th-century social pact between employer and employee.  When a worker gets hired by the state or school district, they enter into a contractual agreement that includes a guaranteed retirement benefit — payments that continue until you die.

The laws that dictate corporate pensions are not the same as those that cover Illinois’ public pensions. Yet they have led to existential crises of both systems —  in completely inverse ways.

In the private sector, companies legally had to contribute annually to pension funds, but they could change the terms of the agreement. Once a loophole opened up the chance to convert pension money into revenue, it was off to the races.

For Illinois, it has to pay out benefits that were agreed to when an employee was hired, but there is no legal mandate to make sound annual contributions to the fund. The state can short the fund every year while passing a complete budget. And it has. Almost every year since the days it could compare plans with Austro-Hungary.

The hole is so unfathomably deep, past General Assemblies have tried various strategies to cut the promised benefits. Twice now, the Illinois Supreme Court has struck them down. The reason goes back to the difference between those all-but-extinct corporate pensions and the threatened public ones.

In the private sector, when you get hired for a job you’re entering into a contract. That contract says you will start with “x” salary, you will be eligible for “x” benefits offered, and other workplace policies — attire, speech, what’s expected of you to fulfill your position. But, either side at any point could change or cancel the contract. Employers can’t renege on anything you’ve already earned, but nothing you get in the future is guaranteed. Your health care contribution can change — if you don’t like it, you can quit and find another job.

The slyness of GE and other companies featured in Retirement Heist got employees to agree to forgo the benefits they already earned by taking a buyout instead.

Photo Credit: Northwestern University's Pritzker School of Law

Max Schanzenbach, a professor at Northwestern University’s Pritzker Law School, says the Illinois Supreme Court has removed the state’s retirement systems almost entirely from traditional contract law. 

For agreements between most American employers and employees, future benefits and salaries that haven’t been earned yet by the employee are not guaranteed. “There’s been no promise or exchange made that would be a contract,” Schanzenbach says.

However, in California, Arizona, and Illinois, he says that “for whatever reason, [those] courts have interpreted similar provisions to protect not just accrued benefits but to actually freeze in place the benefits you were promised as of the date of your employment,” Schanzenbach says.

Critics complain it doesn’t make sense the state can’t cut benefits, while it can add to them.

Laurence Msall, president of the Civic Federation, a government watchdog group in Chicago, doesn’t believe the intent of the law is that “whenever the General Assembly adds any benefit to somebody’s pension, it could never be a mistake and go back and change it. That it was going to be the one area of state law that is not subject to correction by the General Assembly seems a little extreme.” 

Photo Credit: The Civic Federation

The Illinois Supreme Court has ruled the pension clause of the Constitution means what it says: “Any pension or retirement system of the State, any unit of local government or school district, or any agency ... shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

Why does the state’s Constitution include such strict, locked-in language for pensions? At the 1970 Constitutional Convention, delegates were aware of a persistent problem in Illinois. Pension funds were suffering, and police and fire unions led a fight to protect their benefits. In the 1930s, when New York state was faced with the same problem, it established a new clause that made sure New York was stuck with the benefits it had promised. Under the threat, the state got its act together and shored up pension payments.

Illinois delegates took the language from New York with the hope that if it worked there it could work anywhere.

Of course, it didn’t work

There was a plan made in 1995, when then-Gov. Jim Edgar sought to tackle the problem with a new funding structure to fix the problem within 50 years. Conveniently, the beginning years fell below the recommended contributions from accountants. Though there was now a plan in place, the General Assembly ignored the guillotine it was raising over itself. Shortly after Edgar left office, the prescribed contribution levels jumped, and became too much for Illinois revenues to cover.

The governor and legislature tried to reduce benefits twice under former Gov. Pat Quinn. In 2012, the Democratic governor tried to lower the subsidies the state was providing for some retirees’ health insurance plans. The state Supreme Court shot it down, saying benefits can’t be impaired or diminished, and those subsidies were indeed a benefit.

Then, lawmakers swapped Quinn’s scissors for an ax and tried to curtail benefits across the board. The hope was the Court’s seven justices would agree that the state was so broke the General Assembly had no choice.

They did not. Instead justices unanimously issued a sweeping rebuke of Springfield’s cry of a “fiscal emergency.”

“The law was clear that the promised benefits would therefore have to be paid, and that the responsibility for providing the State’s share of the necessary funding fell squarely on the legislature’s shoulders. Accordingly, the funding problems which developed were entirely foreseeable. The General Assembly may find itself in crisis, but it is a crisis which other public pension systems managed to avoid and ... it is a crisis for which the General Assembly itself is largely responsible.”

Under Gov. Bruce Rauner, Quinn’s temporary income tax increase expired. The problem on the revenue side grew worse.

But, with the state nearly two years away from the last time it had a real budget plan, Cullerton is proposing a tricky solution for pension reform as part of the “grand bargain.” It’s called the “consideration model.”

Photo Credit: NPR Illinois

Cullerton has backed the consideration model for several years as a way to lower the state’s liability and meet the Supreme Court’s strict standards at the same time. The conceit of the model is this: if the Court does indeed take state employee benefits as a contract, then a contract it shall be.

“Typically a contract could be modified if both sides agree. And the modification under very traditional contract law has to be supported by an exchange or a consideration,” Schanzenbach says. Traditional contract law looks a lot more like the employment agreements in the private sector where nothing is set in stone.

If one side wants to change the agreement, they can, so long as the other party agrees. If one decides later they don’t like the deal after all, the other side can point to the deal and say there was an exchange — I got something, and in exchange you got something. If you don’t like what you got, sorry. A deal is a deal. That is “consideration” in the American legal system.

Cullerton’s pension reform takes that idea and says a change can be made to the pension as a contract, and as long as there’s an exchange, it’s not being diminished or impaired. A deal is a deal, and consideration is enough. Even if it’s not necessarily a win-win, the exchange makes it valid.

The version of the consideration model currently in the Senate purports to create an exchange by providing two options to every individual Tier 1 employee who has not retired yet. Any hire before 2011 falls into Tier 1. Judges, who have their own system, and the State Employees Retirement System (SERS) are not included. That leaves the three remaining state retirement systems: the Teachers’ Retirement System (public schools), the General Assembly Retirement System (past and current legislators) and the State University Retirement System (public university employees).

In Option 1, workers agree to a smaller annual bump in benefits. Before 1994, the yearly increase was a simple 3 percent adjustment to base pension levels to account for rising living costs (or it matched inflation if that was a higher number). That was changed to a 3 percent bump with compounded interest — meaning, you would have that cost-of-living adjustment (COLA) being applied each year to a bigger and bigger base. Under this option, the compounded interest component disappears, and the model looks like the 1994 change never happened.

Option 2: You decline Option 1, and you keep to the current pension formula as is — BUT — all the raises you receive from here on in are not included in your final base. The salary on which your pension is based is frozen.

If you’re an employee, you don’t like either option because they both mean a smaller pension. But the consideration model says, yes, benefits can’t change once you’re hired, but salary raises are not a guaranteed benefit. Therefore, they don’t have to apply to the wage base on which your pension is calculated. 

The five retirement systems’ main defender is John Shapiro of the Chicago firm Freeborn & Peters. His primary argument says two bad options for employees don’t create an exchange. “There’s nothing voluntary or bargained for in the options offered to the employee. Each would eliminate a constitutionally protected benefit,” Shapiro says.

Shapiro doesn’t say raises are a benefit, but he does argue that promised benefits rely on them. “I don’t think anybody would question that an employee’s rate of compensation is one of the most — and arguably the most — important component in determining an initial amount of a pension in retirement. The expectation of public retirement fund members is that their respective pensions will be based in large measure on their highest final average salaries.”

In Cullerton’s corner is Eric Madiar, a former chief legal counsel in the Senate. Madiar’s writings say in Option 1, you’re not forcing employees to take a cut because they can choose to decline. If they decline they enter Option 2, which is not technically a cut because even though raises are part of pension formulas, they’re not a guaranteed benefit. So, as a state worker, while you may expect your highest salaries to be counted toward your pension, you cannot expect those raises.

Madiar contends a 1952 New York state court decision says that a government employer does not grant pensionable raises “unconditionally.” To Madiar, that is a precedent for Illinois’ justices that raises are indeed not a guaranteed benefit.

If the state Supreme Court continues to view the pension clause at face value — that it means what it says and says what it means — Shapiro believes the case ends there. Even if raises alone are not guaranteed, they’re baked into the way pensions are calculated, and those are guaranteed.

In February, Cullerton presented this latest version of the consideration model for a Senate vote. The measure failed, but Cullerton said he expects to bring it back for another vote.

For Cullerton, the proposal is a major chip in the negotiation to finally get Illinois a budget. It is one of the carrots Democrats are offering to Rauner in exchange for getting the state back on track. Cullerton claims the model would save the pension funds $1 billion a year. But, will it ever take effect?

As the Supreme Court spelled out, the health of the retirement systems ultimately is the responsibility of elected officials. But, the political cost to divert state money from elsewhere in the state budget to repair the damage done over 100 years is just about impossible to imagine such as the millions of dollars school districts alone would lose for a generation of children.

“The most straightforward manner would be the least palatable to politicians, which is simply to raise your taxes and pay for the problem,” says Secter. “As long as you have the power to tax, you have the power to fix the problem.”

The Supreme Court’s 2015 ruling essentially said the same thing.

Tax increases are what generations of lawmakers avoided. One could argue Illinoisans enjoyed an artificially low tax rate and left their descendants with the problem. It’s as if a couple adopted an adorable bear cub, and once they died, their children inherited a 700-pound Grizzly.

It’s hard to make up for so much lost time. The tax increases in Cullerton’s package, as politically volatile as they are, wouldn’t be enough. Experts who study pension systems are beginning to worry the forecasts on investment returns and demographic data are out of whack, and even the best-funded systems like those in Wisconsin could one day be in danger as well.

Some union-backed Democrats have acknowledged the reality that public employees will have to swallow some level of disloyalty. After generations of incompetence, the chance to get what they were promised is just another casualty in the post-American 20th Century era. The private sector was first, and many voters don’t seem to think public employees should escape the same fate.

Illinois Issues is in-depth reporting and analysis that takes you beyond the headlines to provide a deeper understanding of our state. Illinois Issues is produced by NPR Illinois in Springfield.