Courtesy of the Illinois Policy Institute. Merle
House Speaker Mike Madigan and proponents of the temporary pension “fix”
enacted last week promised taxpayers that it would immediately reduce the
state’s unfunded pension liability by about $20 billion. But despite these
promises, the credit rating agencies have indicated that they would be waiting
for actuarial analyses before making any decisions on how the new law will
affect Illinois’ worst-in-the-nation credit rating.
They’re wise to wait. It turns out that somewhere between $6 billion and $8
billion of Madigan’s promised reduction is solely the result of accounting
Part of the “fix” Madigan’s bill offers is to eventually move to what’s
called the “Entry Age Normal” cost method for calculating how much the state
should be contributing to pensions each year. That’s actually a good idea. This
new accounting method helps make the pension ramp a little less steep. It’s also
required by the new pension accounting rules promulgated by the Governmental
Accounting Standards Board.
But here’s the problem: switching to this new accounting method actually
increases the state’s unfunded liability by approximately $6 billion to $8
billion in the short term, because it attempts to spread the costs over the
course of employees’ careers, rather than having them back-loaded like we do
So how do you make up for that increase, when you’re trying to reduce the
state’s unfunded liability? Do you incorporate more comprehensive reforms to get
that debt under control? Not if you’re Madigan.
Instead of addressing that increase, the pension bill simply delays
implementing the accounting change until fiscal year 2016. This means that the
state gets to pretend that at least $6 billion to $8 billion of the pension debt
simply doesn’t exist for now. But when the new rules take effect in 2016, that
pension debt is added back to the books. Instead of cutting $20 billion off the
unfunded liability as promised, it looks like Madigan’s bill only really cuts
$12 billion to $14 billion.
Actuaries for the state’s largest pension system recommended against delaying
the new accounting rules. As they noted, the gimmick is being used to “maximize
the amount of liability reduction,” even though 25 percent to 35 percent of
that liability reduction will be added back to the pension debt in just a few
The rating agencies have already begun cracking down on state and local
governments for using gimmicks to paper over their true pension debt.
Are lawmakers seriously hoping they’ll overlook this one, especially when our
own actuaries are highlighting it?
What is the normal cost?
The normal cost is the present
value of all benefits expected to be earned in a particular fiscal year. Each
additional year of work brings with it additional pension benefits. The normal
cost represents how much money should be set aside, today, to earn enough
interest to pay out the cost of this year’s benefits when they come due. The
normal cost implicitly assumes that all assumptions about mortality rates,
investment returns, etc. are correct. Actuaries can calculate the normal cost in
multiple ways, depending on what kind of funding schedule is desired. Illinois
currently uses the Projected Unit Credit method, but will transition to the
Entry Age Normal method in 2016.
What is the Projected Unit Credit cost method?
Projected Unit Credit cost method attempts to fund pension benefits with each
additional year of service credit. Each additional year a government employee
works increases the annual contribution the state must set aside to fund
pensions under this method. Costs increase as the employee gets closer to
retirement, because the state will have less time to earn interest before
retirement and because benefit accruals are larger the closer to retirement an
individual gets. This creates a back-loaded funding scheme or payment ramp for
each employee’s annual normal cost. The higher the assumed discount rate, the
steeper the payment ramp.
What is the Entry Age Normal cost method?
The Entry Age
Normal cost method attempts to reduce the pension ramp and fund pensions at a
more level amount throughout the working careers of employees. This method
allows the state to contribute a normal cost that is a level dollar amount or a
level percentage of payroll over the course of an employee’s career. It appears
that Illinois plans to keep the normal cost as a percentage of payroll, meaning
that it will remain a payment ramp, though it will not be as steep as under the
Projected Unit Credit method. However, because the amortization of the unfunded
liability accounts for most of the state’s annual pension contribution and it
will also remain as a percentage of payroll, the payment ramp will likely remain
nearly as steep as it is today.
Imagine a teacher in downstate Illinois. After
30 years in the classroom, she retires at age 60 with a starting pension of
$60,000, a little below average for the typical career teacher in Illinois. Over
the course of her career, her salary increased steadily at an average of 3
percent per year, and she didn’t receive any pension spiking raises in her last
few years on the job. Let’s assume that the pension funds were able to earn 8
percent on its investments each every year and will continue to earn 8 percent
for the rest of her life. And let’s assume that her life expectancy is exactly
the same as the average person her age in the private sector.
Under the Projected Unit Credit cost method, the normal cost would total just
more than $3,000 for her first year on the job. But the normal cost for her
final year teaching would total a whopping $28,000. On the other hand, if the
state used the Entry Age Normal cost method to keep contributions level as a
percentage of payroll, the normal cost for her first year teaching would be
roughly $5,000, increasing to nearly $12,000 by her final year of teaching,
tracking her salary increases of 3 percent per year. By somewhat leveling out
the payment ramp, the total normal cost paid over the course of her career would
drop by nearly 30 percent. Making contributions on a level-dollar basis would
produce even higher long-term savings.