University of illinois institute of government and public affairs six simple steps for reforming surs
1Six Simple Steps:Reforming the Illinois State Universities Retirement SystemMarch 12, 2013Jeffrey BrownUniversity of Illinois at Urbana-ChampaignSteven CunninghamNorthern Illinois UniversityAvijit GhoshUniversity of Illinois at Urbana-ChampaignDavid MerrimanUniversity of Illinois at ChicagoScott WeisbennerUniversity of Illinois at Urbana-ChampaignThe ideas, proposals, and opinions expressed by the authors reflecttheir views and are not necessarily those of their institution.The 97th General Assembly ended in January withoutpassing a pension reform bill; leaving the fate of thepension systems in the hands of a new assembly. Butsolving the pension problem will not be any easier forthis group of legislators. The unfunded liability of thestate’s five pension systems grew by over $10 billion sincethe 97th assembly started and now exceeds $97 billion;including a liability of approximately $19 billion for theState University Retirement System (SURS).The task for the new assembly is clear: it must takedecisive action this spring to pass a pension reform billthat creates a path to fiscal sustainability for the pensionsystems. As is well known, at the crux of the “pensioncrisis” is the state’s failure over many decades to makerequired pension payments. That failure has come hometo roost and the state is now required to follow a “pensionramp” to make additional payments to make up for thatpast underfunding. In addition, the state needs to payoff the pension obligation bonds (POB) issued over thepast decade. These payments—at a time when Illinois’economy continues to be sluggish and the state owesbillions of dollars in unpaid bills—are crowding out otherstate funding priorities and posing a major fiscal challenge.What is required at this time is a path to a solution—aplan to stabilize the pension systems. Many legislators,groups and individuals—including us—have offeredsuggestions for reforming the pension systems. Here webuild upon previous suggestions to propose six steps toset the State University Retirement System (SURS) on thepath to fiscal sustainability while ensuring retirementsecurity for participants and honoring the constitutionalguarantee against reducing already accrued benefits.1Detailed discussion of the goals and principles motivatingthese proposals and more detailed discussion of some ofthe proposals presented here can be found in two paperspublished last year by the Institute of Government andPublic Affairs at the University of Illinois.2Our six-step proposal is designed to not only reduce costand bring financial stability to the system but also improvethe retirement program for universities and colleges. Wealso note at the outset that under our proposal, in the long-run (after existing unfunded liabilities have been paid offand after our proposed new “hybrid” system is fully inplace), the state’s obligation for ongoing pension fundingwill be de minimis. Over time, the direct employers—the1While our proposal is structured in the context of SURS—to which all of usbelong—our suggestions are relevant for the other pension systems as well.2Fiscal Sustainability and Retirement Security: A Reform Proposal for the IllinoisState Universities Retirement System (SURS), Jeffrey Brown and Robert F.Rich, February 8, 2012; A Time for Action: Reforming the State UniversityRetirement System, Jeffrey Brown, Steven Cunningham, Avijit Ghosh, andScott Weisbenner, December 10, 2012.i g p a . u i l l i n o i s . e d u
265 universities and colleges who are part of SURS—and their employees will accept the bulk of the fundingburden, as institutions around the country already do. Inreturn, each employer will have much more flexibilityto adapt the basic retirement plan structure to meet itsparticular needs.The steps in our proposal fall into three broad categories.In the first section of the document, we discuss steps toreduce the normal cost and liabilities of the Tier I definedbenefit plan. Next, we focus on how the pension systemshould be funded. Our final step is to institute a “hybrid”systemtoreplacetheTierIIprogramforcurrentemployees.The inadequacies of the Tier II system put Illinois publicuniversities at a serious disadvantage compared to theirout-of-state peers and threaten the continued vitalityof higher education in Illinois; no pension reform planwould be complete without addressing Tier II reform.I. Reducing Costs and LiabilitiesThe first steps we propose would revise how the annualincrease in the annuity paid to retirees and the effectiverate of interest are calculated. These steps will reduce thenormal cost of the Tier I pension program going forwardand also reduce the current liabilities of the system.Annual Annuity IncreaseThe provision of the current pension plan that hasreceived the greatest attention is the automatic annualadjustment to the retirement annuity; typically referredto as the cost of living adjustment, or COLA. The currentprovision guarantees that the retirement annuity increasesat a compounded rate of 3% annually. As we have notedelsewhere, when this provision was introduced in 1990 thestate did not consider the full cost of providing this benefitand increased the benefit without adjusting employeecontributions.3Given the high cost of this provision,it is not surprising that pension reform proposals havefocused on inducing or forcing participants to accept asmaller increase. For example, some bills have suggestedthat retirees and current employees choose between alower level of increase or forego access to state providedretiree health care. Other bills would limit the annualincrease to the first $25,000 of the annuity.There has been little discussion of the fact that ascurrently structured this benefit is not really a cost ofliving adjustment (COLA), since it is not linked to actualinflation rate. It is simply a guaranteed 3% increase inannuity irrespective of whether inflation is 1%, 7%, 10%or -1%. During times when inflation is low—as has beenthe case for some time now—retirees receive a windfall.On the other hand—generous as it may seem now—the3Brown, Cunningham, Ghosh and Weisbenner; op. cit.COLA provision will not adequately protect the retiree’spurchasing power during periods of high inflation.Consider, for instance, the period from 1973 to 1982:inflation was higher than 6% in nine of the 10 years duringthis period and it exceeded the 10% mark in four of thoseyears. SURS retirees would have lost a significant portionof their purchasing power despite what now seems like agenerous benefit provision.The truth is that the current COLA provision offers noprotection against high inflation—which is an essentialfeature of any good pension system. It is for this reasonthat we believe that annuity increases should be linked tosome measure correlated with inflation. Linking COLAto inflation will also reduce the cost of providing theincreases during periods of low inflation. Costs wouldincrease when inflation is high; but the impact of thishigher cost is mitigated by the fact that the state’s tax base,and thus the state’s tax revenue, rises more quickly wheninflation is high. In our view, it would be constitutionallypermissible to reduce the expected average futureincrease in exchange for the valuable insurance protectionthat individuals would receive during periods of highinflation.Effective Rate of Interest (ERI)A little understood feature of the SURS pension system isthe “Effective Rate of Interest” or ERI. The annual interestrate is not mandated by the constitution but is set eachyear by the SURS Board and the State Comptroller. AsBrown and Rich had noted a year ago, the ERI, which iscurrently set at 7.5%, has historically shown very littlevariability.4Thus the ERI established by the SURS Boardhas included a significant risk-premium for what isessentially a risk-free return to the participants. This inessence represents a hidden subsidy in money purchasebenefit calculations, portable plan refunds, purchase ofservice credits and refund of excess contributions.5To eliminate such subsidies the ERI should be pegged to4Brown and Rich, op.cit.5Due to this subsidy the money purchase option is equivalent to a definedcontribution plan in which participants are completely shielded from mar-ket risk yet paid the equivalent of risky market returns. Tier I participantswho started employment after July 1, 2005 are not entitled to benefitsunder the money purchase formula.STEP #1The retirement annuity of current and future retireeswill increase annually by one-half of the unadjustedpercentage increase (but not less than zero) in theconsumer price index-u in the previous twelve months,compounded upon the preceding year’s annuity.
3the yield of long-term government bonds with a smallpremium added. This would be the commensurate returnfor an essentially risk-free asset. At the same time thechange would significantly reduce both the accumulatedliabilities of the system and the annual cost going forward.It is important to note that the lower ERI has no effect on thedefined benefit of 2.2 percent of income for each year of serviceto which Tier I participants are entitled.We also urge that other administrative rules such as thoseused to calculate survivor benefits when annuitizingmoney purchase benefits should be examined with aneye towards increasing transparency and comparabilityto market returns.II. Sharing the Funding LiabilityAs we have stated earlier, at its core, the challenge tothe pension problem is one of funding. Simply stated,the state seems to lack the wherewithal to make therequired payments to the pension system to amortizepast underfunding and fund the annual normal cost. Theannual normal cost is currently shared by the employeesand the state.6Consistent with a number of otherproposals we suggest that the direct employers of SURSparticipants—public universities and colleges—shouldalso contribute toward paying the normal cost. We alsopropose that Tier I employees increase their share of thenormal cost. In exchange for accepting a larger shareof the financial burden, employers and employees willreceive the valuable right to enforce the state’s pensionfunding obligation through the legal system.The pension reform legislations debated by the 97thGeneral Assembly included normal cost shifts aspart of the solution. Although some have suggestedeliminating this provision, we strongly believe that itshould be retained. The provision will not only ease thestate’s financial burden but also appropriately align theincentives of employers to consider the cost of retirementbenefits when making hiring and compensationdecisions. As we have stated elsewhere, the employers6The annual normal cost is the actuarial estimate of the present value ofthe benefits accrued by participants each year.need to have a “skin in the pension game.”7By ignoringpension cost, employers underestimate the true cost oftheir hiring decisions. Cost transfer will also provideemployees greater assurance that the required paymentswill be made in a timely manner. However, to avoidone-time budget shock for universities and colleges, thecost shift should be phased in gradually over a period ofseveral years. In a letter addressed to the Governor andthe legislative leaders, the Presidents and Chancellors ofIllinois public universities agreed to a “limited” transferof normal cost if the state maintained at least the currentlevel of state appropriations to their institutions.8To further ease the state’s funding burden and in thespirit of shared sacrifice, we also propose that employeecontributions to the plan be increased from the current8% level to 10% of pensionable income over a two-yearperiod (for Tier I participants in the traditional andportable plans only). A similar proposal has also beenmade by “We Are One,” a coalition of labor organizationsin the state.9It should be recognized, however, that courtsin some states have ruled against increased employeecontributions without additional benefits, which is whythis proposal must be specifically linked to the grantingof appropriate legal rights to participants to hold the stateaccountable for its funding commitments.An important aspect of pension reform is for the state tofill up the hole left by past underfunding by amortizingthe unfunded liabilities (in addition to funding the state’sshare of the normal cost each year). To instill confidencein the pension system, the state must ensure a steady flowof funds in accordance with an agreed-upon schedule ofpayments. Some have suggested replacing the paymentschedule passed by the legislators in 1995 with onethat achieves 100% funding in 30 years. While this is alaudable goal, what is more important than the 30-yeartimeline is a steady stream of funding at an agreed uponrate and improving the funding ratio steadily.Regular and full payments in accordance with an agreedupon payment schedule that steadily improves thefunding ratio will raise confidence in the system even ifit takes longer to achieve 100% funding. It is important,however, that the payment schedule is calculated basedupon a straight-line amortization of the current unfundedliabilities using a closed amortization period. This wouldcorrect two important deficiencies of the paymentschedule adopted in 1995. First, in contrast to the currentschedule, which concentrates the bulk of the paymentsin the later years—especially post 2035—straight-lineamortization would require equal payments each year.Second, in the closed amortization period method all thecurrent unfunded accrued liability would be paid off in7Brown, Cunningham, Ghosh and Weisbenner; op. cit.8Letter dated May 3, 2012.9http//www.weareoneillinois.orgSTEP #2Going forward, Effective Rate of Interest (ERI) forall purposes, including the money purchase benefitformula, portable lump sum refunds, purchase ofservice credits and returns of excess contribution willbe set to a value equivalent to 75 basis points above theinterest paid by 30-year U.S. Treasury Bonds.
4full by the end of the agreed upon date. Together thesefeatures would increase confidence in the system and alsoreduce overall cost to the state in real terms. Specifically,we propose three funding related steps:III. Revised Retirement Planfor New EmployeesNo pension reform will be complete without rectifyingthe problems in the Tier II plan that went into effecton January 1, 2011. Thus, our proposed final step is toreplace the current Tier II program with a “hybrid” planthat includes both defined benefit (DB) and definedcontribution (DC) components. Integrating DB and DCcomponents into a single retirement program helps tobalance the pros and cons of each system individually. TheDB component provides lifetime retirement security forparticipants, while the DC component, like 401(k) plans,allows participants more control over their retirementresources while controlling liabilities for the state and theemployers.10Our proposed plan will allow universitiesand colleges to compete for talent and improve retirementsecurity for their employees while still reducing the fiscalburden to the state.Below we present some of the salient features of theproposed plan. The features are designed to promoteretirement security including a benefit that cannot beoutlived, mandatory participation, shared financing,shared risks and flexibility for each university or collegeto tailor the program to the needs of its own work force.The retirement plan for new employees will compriseboth a defined benefit plan and a defined contributionplan; all members will be enrolled in both componentsof the plan. The plan will also be available to Tier I andTier II members. If a member with accrued benefit underany existing plan elects to transfer to the new plan, allbenefits earned under existing plan with respect toservice completed prior to the transfer will be preserved.All creditable service already completed under the statepension system shall count for purposes of determiningretirement eligibility and vesting under the new plan.The features of the proposed “hybrid” plan include:a. The defined benefit plan: Upon eligibility forretirement, members will receive 1.5 % of final averagesalary, up to the Social Security maximum taxableearnings level at that time ($113,700 in 2013) for eachyear of service credit earned while they are a memberof this plan.10For a more detailed discussion of the advantages of the hybrid systemsee Brown and Rich, op.cit. See also NASRA Issue Briefs: State HybridRetirement Plans I and II, November 2011 and August 2012,www.nasra.org/resourcesSTEP #3Universities and colleges will contribute up to 6.2%of the pension eligible payroll of their employees tofund the annual normal cost. The cost shift will betransitioned at a rate of 0.5% of pensionable pay peryear for the first eleven years and 0.7% the twelfth year.STEP #4All employees enrolled in the Tier I defined benefitprogram will contribute an additional 2% of paytowards pension cost at a rate of an additional 0.5%of pay a year for the next four years. The additionalemployee contribution will not be included in thecalculation of benefits under the Money Purchase Plan.STEP #5In return for the above cost-shifting, the state shall berequired to amortize the current unfunded liabilitiesof SURS in accordance with a payment schedulethat steadily improves the funding ratio and iscalculated based on a straight line amortization of thecurrent unfunded liabilities with a reasonable closedamortization period. Furthermore, the state shall becontractually obligated to contribute to the pensionsystem each year the full amount of all its paymentobligations. If the state fails to make full payment, thepension system or any of its members may take legalaction to compel the state to make that payment.STEP #6Any new employee who becomes a member of SURSwill participate in a hybrid plan comprising a definedbenefit (DB) and an individual defined contribution(DC) plan. The current retirement plans—Tier II planand Self-Managed Plan—will no longer be offeredto new employees. Any employee who is currently amember of SURS can elect to terminate participation intheir current plan and elect to have retirement benefitsof future creditable service provided under the newretirement plan. The irrevocable choice must be madeduring the six-month period following the effectivedate of the new plan.
5b. Final average salary: “Final average salary” meansthe average monthly salary obtained by dividing thetotal salary of the participant during the 96 consecutivemonths of service within the last 120 months of servicein which the total compensation was the highest bythe number of months of service in that period. Thefinal average salary of participants who have been amember of the system for less than 96 months meansthe average monthly salary during the entire periodof employment. In all cases, only salary below themaximum earnings level specified in Item ‘a’ abovewill be included.c. Self-managed (defined contribution) plan: Eachmember will also be automatically enrolled in a definedcontribution plan established by the system, whichshall offer members the opportunity to accumulateassets for retirement through a combination of memberand employer contributions that may be invested inmutual funds, collective investment funds, or otherinvestment products in a self-managed fund. Theplan must be qualified under the Internal RevenueServices Act and contributions can be made up to themaximum amount allowed by the act. As noted below,this defined contribution plan will be funded by a mixof both mandatory and voluntary contributions fromboth employers and employees.d. Payments: Each employee will be required tocontribute 8% of his or her pensionable salary to theplan each year; based on the Social Security maximumtaxable earnings level at the time. One-third of thisamount shall be credited to the employee’s selfmanaged (DC) plan and the rest towards the cost ofthe defined benefit plan. The employee’s contributionshall be deducted from the employee’s salary and willbe a condition of employment.The state shall be responsible for the remaining portionof the normal cost of the defined benefit component ofthe plan. Consistent with normal cost shift describedearlier (Step 3), the state’s normal cost obligationswill be transitioned to the universities and collegesat the same rate as that described before. In thiscase, however, we expect the state’s obligations to becompletely shifted to the direct employers at the endof the transition period.In addition to funding the normal cost of the definedbenefit portion as described above, universitiesand colleges will also make a mandatory annualcontribution equal to 1% of total pensionable pay tothe DC account of each employee.e. Supplementary DC Contributions: In addition to theabove funding, each university or college will have theflexibility of making additional employer/employeecontributions to the DC plan. This could take theform of additional fixed or matching contributionsby employers and voluntary contributions byemployees. Employers will have the flexibility to varythe contribution amounts in order to optimize theirhuman resource goals related to their own workforcerecruitment and retention needs in a manner consistentwith all applicable laws.f.Vesting: Employeecontributionstotheplan,includingthe accrued rate of return attributable to contributionsto the DC component, shall always be vested with theemployee. State and university contributions to bothcomponents of the plan, including the accrued rate ofreturn attributable to state and employer contributionsto the DC component, shall be vested with theemployee in the following manner: upon completingtwo years of service the member will be vested with20% of the amount. For each additional year of servicethe member will be vested with an additional 20% ofthe amount. Members with six or more years of servicewill receive the total amount.g. Cost of living adjustment: A member’s definedbenefit annuity will increase annually on the January 1occurring either on or after the attainment of age 67 orthefirstanniversaryoftheannuitystartdate,whicheveris later. Each annual increase shall be calculated asone-half the annual unadjusted percentage increase(but not less than zero) in the consumer price index-u,compounded upon the preceding year’s annuity.h. All other aspects of the program includingparameters governing retirement eligibility, penaltiesfor early retirement, disability payments and survivorbenefits will be similar to the corresponding parametersgoverning the Tier II program.IV. Impact of ProposalsAny meaningful pension reform proposal must improvethe financial stability of the system while honoring theconstitutionalguaranteeagainstreducingalreadyaccruedbenefits. The proposal presented here achieves this goal.It reduces the normal cost and the current liabilities ofthe system, shifts the responsibility for paying a portionof the normal cost and then creates a legal obligation forthe state to make timely payments to recover from pastunderfunding and fund the remaining normal cost.Taken together the steps we propose will significantlyreduce SURS’ $19.3 billion unfunded liability as well asthe annual cost of the pension system going forward. Forexample, changing the ERI going forward to 4% is likelyto reduce SUR’s unfunded liabilities by more than 5%.Linking the annual annuity increase to the inflation rate
6will reduce the liability even further. Both steps will alsoreduce the annual normal cost of the pension system.The transition of normal cost to universities and collegesin accordance with Step 3 will reduce the state’s requirednormal cost payments to SURS between 2014 and 2045 bymore than 70%. This is a conservative estimate since it doesnot include additional contributions from Tier I employees;nor does it consider the reduction in normal cost achievedby other the steps of our proposal. Finally, the hybrid planis designed with an eye toward not increasing the cost tothe state in the short term and over time transitioning costto universities and colleges. It also allows each institutionto design a retirement system that best suits its own needs.The plan will help Illinois public universities and collegesrecruit and retain the talent they need.Taken together as a package, the steps we propose willsignificantly reduce the state’s funding obligation toSURS and allow the state to make timely payments tofulfill the remaining funding obligations. This will instillconfidence in the system and sustain it for the long term.V. A Concluding NoteA comprehensive pension reform proposal has eludedIllinois legislators for two years. But delay will not makethe problem easier or make it go away. The package ofreforms presented here offers a credible path to a fair,equitable and feasible pension reform. Now it is timefor action. Each passing day makes the problem morechallenging and threatens the continued excellence ofhigher education in Illinois that has taken generations tobuild. The long run vitality of the state of Illinois dependsupon action now.TheInstituteofGovernmentandPublicAffairs(IGPA)isapublicpolicyresearchorganizationbasedinallthreeUniversityof Illinois campus cities. IGPA’s mission is to improve public policy and government performance by: producing anddistributing cutting-edge research and analysis, engaging the public in dialogue and education, and providing practicalassistance in decision making to government and policymakers. The institute’s work not only advances knowledge, butalso provides real solutions for the state’s most difficult challenges.To learn more, visit igpa.uillinois.edu and follow @IllinoisIGPA.Step Summary Impact1A member’s retirement annuity will increase annually by one-halfthe unadjusted percentage increase (but not less than zero) in theconsumer price index-uReduces normal cost going forwardReduces unfunded liabilities2Effective Rate of Interest will be set to a value equivalent to 75 basispoints above the interest paid by 30-year U.S. Treasury BondsReduces normal cost going forwardReduces unfunded liabilities3Universities and colleges will contribute up to 6.2% of the pensioneligible payroll of their employees to fund the annual normal cost.The cost shift will be transitioned over a 12-year periodReduces normal cost paymentobligations for the state4All employees enrolled in the Tier I defined benefit program willcontribute an additional 2% of pay towards pension cost transitionedover a 4-year periodReduces normal cost paymentobligations for the state5Thestateshallberequiredtoamortizethecurrentunfundedliabilitiesof SURS in accordance with a payment schedule calculated based ona straight-line amortization of the current unfunded liabilities with areasonable closed amortization period. If the state fails to make fullpayment, the pension system or any of its members may take legalaction to compel the state to make that paymentAssures long term funding andamortization of unfunded liabilities6All new employees who become a member of SURS will participatein a hybrid plan comprising a defined benefit (DB) and an individualdefined contribution (DC) planReduces state normal cost paymentsby shifting costs to universities andcolleges. Institutions gain flexibility todesign system to fit their own needs