REPRISE: Simple Vs. Compound - What You Need to Know

Update: The latest designs by the General Assembly, Governor Quinn, or those inner-party members who work with Stermer's pension task force are serious attempts to reduce, diminish, impair, or destroy the compounded COLA (cost of living provision) for active public workers or currently retired employees.  

As we head into the Veto Session and the January lame-duck Session, bills before the General Assembly include last spring's SB1673, Rep. Fortner's HB 2604, and Rep. Nekritz's HB 2609 and 2610.  All of them include provisions to eliminate a compounded COLA (cost of living) by coercive choice, participation in a defined contribution plan, or replacement by a simple cost of living. 

The ultimate destructive effects of a loss of the compounded COLA cannot be understated.

A graph (courtesy of Capitol Fax) clarifies the importance of the compounded COLA.  

This chart shows how the 3% compounded COLA is critical to protecting retirees from inflation. "Imagining someone who retired with a $15,000 pension in 1987, the chart shows the amount of their pension in each of the 25 subsequent years under two scenarios: Red is what the retiree has earned under current law, with a 3% annual compounded COLA; green is what they would have earned if the Tier 2 COLA provision had been in place (half of CPI capped at 3%, simple). The purple line shows the amount the retiree would have needed in each year for the pension to keep pace with the actual rate of inflation.

Under current law, the 1987 retiree is today an aggregate $12,000 behind, or 2% less than, the amount required to keep pace with CPI for the period. The benefit has exceeded the real value of the base plus inflation in just 3 of the 25 years. Had the Tier 2 COLA been in effect, the retiree would have lost $111,000 or 20% of the value of the base plus inflation"

(Capitol Fax.com - Your Illinois News Radar » *** UPDATED x2 *** The compounding problem).

"I can't tell you how many people retiring had absolutely no idea of what compound or simple interest was or even how it applied to their retirements..."  - an observaton by a current retiree commenting on the state of other retirees' knowledge.  (Are you kidding? )

Simple Interest and Compounded Interest

(Two Very Different C.O.L.A.s)

Nouns.  Simple interest is a percentage of money (a.k.a. interest) earned on an original (or principle) amount of money.  For example, if you invest $100 at 10% simple interest per year, you will receive $10 at the end of the year on your original $100 investment.  And, with simple interest, you would receive the $10 each next year, and on and on.  In short, you would earn $10 per year for every year you maintained your original investment. 

Compound interest, on the other hand, provides you the percentage on the original amount (principle) plus any earlier earned interest.  In other words, you would earn a return (in this case, 10%) on the original investment plus the interest earned in the year previously.  This difference is as significant as  E = MC2!  

See the chart below for an example:

Original $100 After	Simple Interest	Compound Interest
1 YEAR	$110	$110
2 YEARS	$120	$121
3 YEARS	$130	$133
4 YEARS	$140	$146
5 YEARS	$150	$161
10 YEARS	$200	$259
20 YEARS	$300	$672
30 YEARS	$400	$1,744
40 YEARS	$500	$4,526
50 YEARS	$600	$11,739

(Source: www.financeprofessor.com/introcorpfinnotes/simplevscompound.html)

In other states – let’s take Rhode Island, for example – legislatures are freezing the COLAS where they are; that is, no increases for a period of time in order to make up for their unfunded liability to assure a resultant funding achievement of 80% or 90% or upward.  In the case of Rhode Island, such a freeze will occur for the next nineteen years, bringing current purchase power for retirees down from $52,000 to $39,000 in 2011 dollars.  In Minnesota, a state without a Constitutional provision like Illinois’ Article XIII, Section V, courts have found that the base pension is protected while the COLA is not.  The same was also true in Colorado, where district judge Robert Hyatt proposed that the inflation adjustment could be reduced in difficult economic times, but not the base pension  (www.nytimes.com/2011/07/01/business/01pension.html).  

Originally, the COLA in Illinois became a part of the TRS annuitant’s payment in July of 1969; however, since 1990, retired teachers in Illinois (TRS) Tier One receive a 3% compounded increase annually after attaining their sixty-first birthday.  On the other hand, those in Tier Two (hired after January of 2011) will receive only a simple COLA after retirement.  The annual cost of living increases for Tier Two recipients will be calculated using either 3 percent or one-half of the consumer price index (CPI), whichever is less.  Any increases will be simple, not compounded (www.trs.illinois.gov/subsections/general/history/pdf.).

On the other hand, one must bear in mind inflation does not increase in simple terms.  Increases in inflation are compounded; therefore, the cost of living escalates faster and faster.  The cumulative effect of inflation presents numbers that are sobering and staggering.  From 1980 through June of 2011, thirty-one years, the cumulative effects of inflation reach a bit over 280%.  An item costing you $78 in 1980 will cost you nearly $220 in our current year(www.inflationdata.com).

For this last  year 2011, cost of living benefits for the COLA for Social Security will begin in January of 2012 at the rate of 3.6% (www.ssa.gov/cola/) - nearly ½ percent beyond teachers in Tier One, who are not eligible for Social Security benefits.  Retired Tier Two teachers would receive a 1.8% increase.  Please consider the differences.