Pension reform reaches the 2-minute warning
By Jeffrey Brown and Avijit Ghosh
The two-minute warning has sounded on pension reform, and legislators are calling for "Hail Mary" passes in the hope of finally defeating the fiscal problem created by the underfunded public pension system. Unfortunately, many of the bills treat pension reform as nothing more than a cost cutting exercise. In contrast, the winning strategy is a thoughtful solution that makes the pension system fiscally sustainable, strengthens the ability of universities to compete in a global labor force, and respects the retirement security and the constitutional rights of employees.
Current legislative proposals, such as those that freeze pensionable earnings or arbitrarily cap cost-of-living adjustments, unfairly penalize participants for the state's failure to make required annual pension payments over many decades. However, there is no escaping the fact that the state cannot get out of its current fiscal morass without reducing the cost of pensions. Pension payments are crowding out investments in other priorities, including investments in higher education.
Over the last year, we and our colleagues have offered a number of proposals to reform the State Universities Retirement System (SURS); ideas that are also applicable to the other pension systems. We urge legislators to consider these and other reasonable proposals.
Any meaningful reform package must contain four ingredients: measures to shift responsibility for future normal costs; a credible plan to pay off unfunded liabilities; steps to reduce overall pension costs; and a new improved program to replace the Tier II system for new employees.
A consensus seems to be emerging on reasonable approaches to the first two tasks. A number of university presidents and community colleges have agreed to the idea of paying a portion of the annual cost for their employees as long as the burden is transitioned over time and state appropriations are not cut simultaneously. In addition, a coalition of labor organizations has suggested increasing employee contributions in exchange for the legal right to enforce pension payment by the state. These costs shifts will decrease the state's normal cost payments by approximately 50 percent over the next 15 years and 100 percent thereafter.
There will be little confidence in the pension system without a clear plan for the state to make up for past underfunding. This is the state's obligation, and the state's alone. Our proposal would require the state to commit to a payment schedule that steadily improves the funding ratio of SURS, calculated based on a straight line amortization of the current unfunded liabilities. Importantly, under our proposal the state shall be contractually obligated to pay the full amount of its obligations. Compared to other proposals under consideration, these commitments reduce the state's cost while also setting the pension system on a path to full recovery.
The third ingredient — measures to reduce pension expenditures, rather than just shifting the funding burden from one entity to another — is the most difficult and controversial. Many proposals have targeted the automatic annual adjustment of the retirement annuity, which is often referred to as a cost-of-living adjustment (COLA). The current provision guarantees an annual compounded increase of 3 percent annually, making this provision both valuable to retirees and very expensive to the state. Many pension reform bills would reduce this, such as by requiring retirees and current employees to choose between lower levels of increase or forego access to state-provided retiree health care. Others limit the annual increase to $750 or postpone increases for five years.
We have proposed instead to replace the 3 percent annual increase with an annual compounded increase equal to one-half of the consumer price index (CPI). On average, this will save the state money, especially in times such as now when inflation is running low. But this step is also better for employees because it provides more meaningful protection against high inflation — an essential feature of any good pension system. Because it provides valuable inflation insurance in exchange for the lower average increase, we believe this policy would be constitutionally permissible and it would create a better retirement program. The annual cost of the SURS pension program can also be reduced by rationalizing administrative rules for calculating the rate of interest used to determine a range of benefits, refunds and service credits that is set each year by the SURS board and the state comptroller. These steps and changes to COLA will reduce SURS' $19.3 billion unfunded liability and annual costs by amounts equivalent to that of bills currently under consideration.
The final ingredient is to improve retirement security for new and recently hired employees by replacing the current Tier II program with a "hybrid" plan. The plan would integrate defined benefit and defined contribution components into a single retirement program to balance the pros and cons of each system individually. Because SURS participants do not receive Social Security benefits, a smaller defined benefit plan will provide retirees with a meaningful income floor. Above this, retirement security will be further enhanced by a defined contribution plan, funded by both employee and employer contributions. It will also improve vesting features to increase our ability to compete with peer institutions. The cost to the state will not increase relative to the Tier II program, and these costs will shift to the universities and colleges over time.
The time for action is now, but it must be enlightened action. Yes, we need to reduce costs. Yes, we need to adjust cost-of-living increases. But, in the final analysis, reform must create a secure retirement system that will allow universities to continue to recruit the best and brightest individuals from across the globe. The long-term viability of the state depends on it.
Jeffrey Brown and Avijit Ghosh are professors at the College of Business, University of Illinois at Urbana-Champaign. The opinions expressed reflect their personal views and are not necessarily those of their institution.