Monday, July 24, 2017

Pension Vocabulary: What does "smoothing" mean?

Pension Vocabulary:  What Does “Smoothing” Mean?

One of the elements of the addition of a Tier III in the new law for latest hires in Illinois is a change in how state government calculates the amount of money TRS and other programs will receive from the state government in Illinois for the years going forward: 2018, etc. 

Making common sense of how one might determine what would constitute a required annual contribution is a bit complicated, because that contribution by the State of Illinois to TRS is dependent upon the fluctuating rates of investment returns in the reserves into which we (teachers) all pay. 

Confused?  Believe me, as a retired Language Arts teacher, me too.   But think of it this way:

If the investments in TRS do better than the funds assume (predict) in a current year, the state and local governments can fund pensions with much less tax money, which could be in turn used for services, infrastructure, or citizen benefits. 

However, if the investment returns do poorly, the required annual contributions  by the state will need to increase to meet the needs; and that will crowd out the same programs – the services, infrastructure programs, and citizen benefits mentioned above.

With me so far?

So…if TRS is down 5% this year in investment returns, the state picks up the additional 5% of contribution.  Or if the investment returns are up 3% this year, then the state is able to lessen its payment by the corresponding amount.  Right?

Yes, that is, until a little actuarial gimmick called smoothing is applied to the mathematical reality. 

According to one economist, smoothing is a “actuarial camouflage,” a method to dampen on-book asset volatility.”  The practice is meant to protect the payer from the shocks of sudden changes in market returns (or volatility) in gains and losses during a single year.  So, why not spread the damages or gains over five, or ten, or twenty years to artificially reduce asset volatility? 

Analogy:  I’ll meet with my Doctor later next month.  He’ll be checking my weight carefully again as he does every six months.  Let’s just say that I have a deep and abiding love for good food and paired wines.  And my weight has fluctuated during those times we have met.

 Doctor:  Well, I must tell you that I see you have gained about five pounds despite the last serious talk we had in April.  And you had done so well the time before with a drop of nearly eight pounds.

Me: Yes, you know, Doctor, I think we should smooth the last five years of our appointments.  I calculate an overall average loss of a single pound over our ten meetings.  That’s a hopeful indicator, don’t you think?

Doctor: Does that make you feel better?

When the smoothing is done, it is more likely that the underfunding of pensions will continue as it artificially reduces asset volatility and reduces funding pressures in the short run.  In my case, my assets may look better than they are (pun intended), and the same is true of this engineered value of pension assets and returns.

According to the Rockefeller Institute study on Public Pension Funding Practices, “Funding policies and practices that take a long time to repay shortfalls protect current taxpayers and beneficiaries of government services from sharp and possibly unaffordable changes.  But they create risk that the pension plan will become deeply underfunded and that future taxpayers who never benefitted from past services will have to pay for them.  This is particularly true of the plan suffers a series of shortfalls over several years.” 

Welcome to Illinois.

According to TRS, the original state contribution for TRS expected in fiscal year 2018 – $4.65 billion – will be recalculated.

“TRS must retroactively “smooth” the fiscal effect of any changes made in the TRS assumed rate of investment return over a period of five years.  The “smoothing” applies to assumption changes from 2012 on.  Up until now, the fiscal impact change in the assumed was totally absorbed at one time.  For example, in 2016 TRS reduced its rate of investment return from 7.5% and the result was a $402 million increase in the fiscal year 2018 state contribution to TRS.  Under this new law, that $402 million increase would be phased in over a five-year period.“

The only way it could get any more slippery or worse is if Illinois found a way to short the funding even more.

They did:

According to Mr. Richard Ingram, the executive director of Illinois’ TRS,  Over the last several years state government has taken its responsibilities to TRS very seriously and has paid its legal obligation in full. Still, the legal state contribution for the last several years has been insufficient to improve the System’s long–term finances. State government’s annual contribution is set artificially by law. It is not an actuarial calculation.

As it does every year, for FY 2017 the TRS Board asked its actuaries to calculate two state contributions — the payment calculated under state law and the payment calculated under actuarial practices. Under standard actuarial practices, the state’s annual contribution for FY 2017 should be $6.07 billion.
The calculations set in state law artificially lower the state’s annual funding level. For instance, state law:
   Requires pension costs to be calculated on a 50–year timetable instead of the standard 30 years
   Establishes a 90 percent funding target instead of the standard 100 percent goal
   Requires the debt payments on state pension bonds to be deducted from the total contribution. 
Illinois teachers have always paid their required share and are counting on their pensions to sustain them in retirement. The state has never paid its full share.
The annual contribution is the amount of money required by state law to fund TRS pensions during the coming year, as well as a payment on the System’s unfunded liability, which currently stands at $71.4 billion.”

The inclusion of another Tier by the General Assembly as a laurel to Republicans and Rauner does not fix the hole nearly 80 years of underfunding has excavated.  It provides some relief (like SB7 did) to borrow to pay off debts, once again on the backs of those who paid into their pensions as demanded each and every paycheck. 

Does that make you feel better?

Nope.


Wednesday, July 19, 2017

Future Tier II and Tier III Hires Looking at 401K's

For Future Tier II and Tier III Hires


“We can overturn any law we pass within an hour.”

The most significant and everlasting words I received from a legislator concerning pension reform bills and future promises came back in 2011, when my good friend Glen Brown and I met with Representative Elaine Nekritz in Buffalo Grove area to discuss our concerns about the “pension reform” being pressed by Governor Pat Quinn.

Representative Nekritz was thought to be the probable successor to Michael Madigan before her announcement to retire from Illinois politics this year. 

Back then, as Tier One retirees, we realized the General Assembly – facing an underfunded pension liability after decades of shirking their payments – was about to move to some draconian diminishment of promises made and benefits constitutionally protected.   The bill – SB1 – was not yet fully baked, but it was on it’s way. 

We had an emotional discussion.  One of many more…

We were such idealists.  She smiled when she replied to our question –
“We can overturn any law we pass within an hour.”

On May 8, 2015, the Illinois Supreme Court echoed our hope unanimously.  Article XIII, section 5, stands.  There shall be no diminishment of benefits earned upon the contractual entering of employment as a state employee. 

Earlier Tier Two passed quickly by the General Assembly for those hired after January 1, 2011, and without any real objection by the unions, requiring new hires to work toward a defined pension that is capped at a CPI of about $110,000 and without a compounded cost of living adjustment.  With the caps and the lesser benefits, Tier II workers started paying down much of the debt created by the General Assembly and surrendered nearly 9.5% of their salaries for less than 6% of a return in a defined benefit. 

Glen Brown wrote in January of 2015:

“If Tier II is left alone, it will accomplish its mission. The $61.6 billon TRS unfunded liability will shrink over several decades and eventually be eliminated because the state will pay less to the ever-growing number of Tier II members. In fact, at some point in the future, we estimate that Tier II members actually will help create a surplus of funds for TRS that effectively could eliminate the need for any state government contribution to the System.

“But the core of Tier II – the reduced benefits structure – is a problem the Teacher Recruiting and Retention Task Force will review. The benefit structure is unfair to all Tier II members. Right now, a Tier I member’s pension costs roughly 20 percent of an active member’s salary. Because of the benefit reductions in Tier II, a Tier II member’s pension is worth just 7 percent of an active member’s salary. However, by law, active Tier II members of TRS, like me, pay the same 9.4 percent salary contribution to the System that active Tier I members pay.

“What all this means is that Tier II members are paying the entire cost of their pensions plus an extra 2.4 percent to TRS. That extra 2.4 percent subsidizes the pensions of Tier I members” (https://teacherpoetmusicianglenbrown.blogspot.com/search?q=tier+II)

And now, Tier II pension reserves are calculated to be at 151% funding. 

But now, suddenly,  we have Tier Three. 

Remember: “We can overturn any law we pass within an hour.”

According to the IEA, Tier III offers a positive opportunity to “fix” some of the problems with the Tier II design.  

Among those problems was an unscored bill Tier II passed which did not meet the Federal requirements for a qualified retirement plan or “safe harbor” limit.       

According to IEA’s website, “ SURS and TRS members who first become participants of the pension systems on or after a to-be-determined implementation date (likely no earlier than July 1, 2018) will have the option to:
1) Be in a new hybrid benefit, known as Tier III, or
2) Elect to be part of the current Tier II.”
Elect.  Choose.  Decide to leave the benefits of a promised contractual agreement. This is a form of long-sought-after consideration, wrapped in promises of personal ownership has been part of Cullerton’s olive branch to Rauner and an earlier acceptance by a collective of state workers’ unions. 
“Tier III offers a hybrid plan of a partial defined benefit (pension) and a defined contribution plan (401k or etc.).  While none of this is fully formed yet, those Tier II people choosing to go with the irrevocable defined contribution (401K, etc.) will pay minimally 4% of their salary, but see their pension contributions drop from 9 percent to no more than 6.2 percent. 
“Also, existing Tier II members will have the option of joining Tier III. The retirement systems shall establish procedures for making these elections which, once made, will be irrevocable. The Tier III plan is a combined defined benefit (DB), often referred to as a pension plan, and defined contribution (DC) plan. Under the DB part, the member’s contribution will be no more than 6.2 percent of salary, but may be less depending upon a system’s determination of the annual normal cost of benefits. The member’s contribution drops from the 9 percent of salary required under Tiers I and II.
Entering finally stage right: the 401K style retirement plan.
In 2011, the Civic Committee of the Commercial Club of Chicago urged the adoption of a 401K program for teachers to replace the pension structure currently in place – SB512.  But 401k’s had their birth in the Reagan era: Congress acted in 1986 (during the Reagan presidency) to replace defined benefit plans for federal workers (CSRS) with a less generous defined benefit plan (FERS) and a generous 401 (k) plan called a TSP.  This explicit endorsement by the government from a single type defined-benefit plan to a possible combination of defined-benefit/contribution plan to which employees could elect to contribute amounts of their own choice became the starting point for a fast growing industry in financial investing and personal portfolios for retirement (Employee Benefit Research Institute, 2005).

Makes you wonder who will be managing these teacher investments, doesn’t it?  Maybe Ken Griffin at Citadel? 

Sorry.  Couldn’t resist.

“We can overturn any law we pass within an hour.”

Beginning with the 2020-21 year, all employer costs (normal and any unfunded liability) for a Tier III member will be picked up by the member’s employer and not the state (prior to that date, the state will contribute 2 percent of each Tier III member’s salary to each system with the Tier III member’s employer picking up the rest, if any exists). Under the DC part, the member must minimally contribute 4 percent of salary, while his/her employer must contribute at least 2 percent and could contribute up to 6 percent of salary.
Your future 401K will likely not be protected under Article XIII, Section 5.
 By 2020, the local districts pick up the cost of your 401K savings plan.  The state has no responsibility to engage in any promised compensation for your investments..
I repeat what I warned in 2014:  
Note: Always remember this.  Were the State or Rauner ever able to move public workers to a 401k retirement system, it would not be protected under the Pension Clause.  If the State found that matching contributions to a 401k plus the need for Social Security were too much, the General Assembly could do away with 401k plans altogether. 



Sunday, July 16, 2017

IEA Leader Cinda Klickna Provides Information on SB 42 and Tier III

From Retired IEA Leader Cinda Klickna:
Latest information on Tier III.
1.     Were there pension changes in the new FY 18 State budget?
Yes, there were changes made to pensions in SB 42, one of the three budget bills that make up the FY18 State budget.
2.     How does SB 42 impact pensions?
Within Senate Bill 42, the budget implementation bill, the General Assembly created a third tier for new hires under most pension systems, including State Universities Retirement System (SURS), Teachers’ Retirement System (TRS) and State Employees’ Retirement System (SERS). The Illinois Municipal Retirement Fund (IMRF) is not included. This third tier attempts to fix some of Tier II’s problems. There are several other significant components of the proposal that improved upon the current pension system and several counterproductive ideas that were omitted, for example, a consideration option for Tier I members.
3.     Does the new pension proposal create a third tier?
Yes. SURS and TRS members who first become participants of the pension systems on or after a to-be-determined implementation date (likely no earlier than July 1, 2018) will have the option to:
1) Be in a new hybrid benefit, known as Tier III, or
2) Elect to be part of the current Tier II.
Also, existing Tier II members will have the option of joining Tier III. The retirement systems shall establish procedures for making these elections which, once made, will be irrevocable. The Tier III plan is a combined defined benefit (DB), often referred to as a pension plan, and defined contribution (DC) plan. Under the DB part, the member’s contribution will be no more than 6.2 percent of salary, but may be less depending upon a system’s determination of the annual normal cost of benefits. The member’s contribution drops from the 9 percent of salary required under Tiers I and II. Beginning with the 2020-21 year, all employer costs (normal and any unfunded liability) for a Tier III member will be picked up by the member’s employer and not the state (prior to that date, the state will contribute 2 percent of each Tier III member’s salary to each system with the Tier III member’s employer picking up the rest, if any exists). Under the DC part, the member must minimally contribute 4 percent of salary, while his/her employer must contribute at least 2 percent and could contribute up to 6 percent of salary.
4.     What are the benefits of Tier II or Tier III?
   In both Tier II and Tier III, the cost of living adjustments (also known as COLA), retirement age and years of service are essentially the same.
   The pensionable salary of a member that chooses Tier III is higher than the salary of a Tier II member. It is equal to the Social Security Wage Base — $127,200 in 2017 vs. Tier II being $112,408.42 in 2017.
   Under Tier III, members’ DB contribution decreases to no more than 6.2 percent (so they are receiving equivalent benefit value for their contribution as opposed to Tier II), although each service year is worth 1.25 percent as opposed to 2.2 percent under Tier II.
   In addition to the DB contributions, Tier III members will have the benefit of minimally 6 percent of salary/year going into a DC plan.
   For some employees, depending on anticipated length of service and other factors, Tier II may be preferable to Tier III. For those who don’t want any stock market risk in their retirement, they can keep a strictly defined-benefit plan under Tier II.
   For those who prefer the portability of a DC plan, or see the combined package as preferable, they can opt in to Tier III.
5.     How are Tier 1 participants and retirees impacted by the changes?
The pension legislation has no impact on Tier I members, including retirees. The creation of the Tier III plan does not divert state dollars from TRS or SURS to the defined contribution plan. It requires that the employers fund the defined contribution plan and any liabilities attributable to the DB plan for Tier III members, if any exists.
6.     What impact will this legislation have on local school districts?
For SURS and TRS, the bill contains language that local employers, rather than the state, would be responsible for the employer’s normal and any unfunded liability costs of the defined benefit plan for Tier III employees, plus at least 2 percent of salary for the employer DC contribution. See FAQ 3 above.
7.     Did the IEA support the pension changes?
The IEA and all the unions within the We Are One Illinois labor coalition took a position of neutrality. We knew pension legislation of some kind was going to have to pass for there to be a budget. So, we worked to ensure the unconstitutional consideration model, which had been a part of SB 16 was not included. Additionally, we worked to make sure end of career salary increases which could be used for calculating one’s pension were not reduced from 6 percent to the consumer price index. Such a reduction would minimally have impacted local bargaining.
8.     What role do the systems have in the creation of the DC option?
The legislation requires the systems to implement a DC option for Tier III participants. This option will provide future teachers the ability to invest their retirement savings in mutual funds and other investment options similar to their 403(b) savings plans. The Tier III option will not be available until the DC plan is approved by the IRS.


Cinda 

Bob Lyons Retires from TRS & Provides Perspective Looking Ahead

Bob Lyons’ First Report as Annuitant

I have retired from the TRS Board and I write this today as a fellow annuitant, not as a TRS trustee. This past fiscal year ended on June 30 2017 and  it is my understanding that TRS investments made something above 10% for the year As additional information comes  from TRS holdings in private equity and real estate, it is expected that the gains will only grow. And with TRS funding level firmly above 40%, Illinois is no longer the worst-funded pension state. Illinois has moved up and is now in 48th place, Kentucky 49th at 37.8%, and New Jersey is last with 37.5%. And that is not the only reason to celebrate; Illinois finally has a budget. 
According to the editorial writers and columnists across the state, Governor Rauner was the clear winner except for those that gave the victory to Speaker Madigan. For more than two years Governor Rauner tried to hold the budget hostage: first, for a set of union-busting demands, but in the end for several  measures, such as term-limits, a property-tax freeze, and workmen’s compensation changes that were more popular. In the end while Governor Rauner got nothing for his efforts, he can and will use the tax increase as a hammer against Madigan and company in the 2018 election. One thing is certain: the two years without a budget was a loss for the state. Even with the increased income tax, the state bond rating hovers just above junk. Illinois owes a total of over fifteen billion dollars to everyone it does business with. And the many candidates for governor and the legislature are all in full campaign-mode a year and four months before the election.  The political pundits have already given Illinois claim to be the most expensive campaign in the nation for who will be our governor.
Even without a budget, a combination of courts orders and continuing resolutions had the state of Illinois paying out $39 billion a year, or more accurately a combination of paying, or promising to pay a total of $39 billion. Now the increase in the state income tax from 3.75% to 4.95%, which is an increase of 1.2%, according  to Mike Madigan, or 32%, according to Bruce Rauner, is expected to bring in an additional $4.3 billion in revenue. The rise in the corporate tax from 5.25% to 7% should grow the state’s revenue by an additional $460 million. The bill that gave us the tax increase also allows the state to borrow $8 billion to pay down debt. Normally borrowing to deal with debt is not a good plan, but with some debts paying interest as high as 12% the state can borrow for far less and come out ahead.  In addition, paying off some debts will free up matching grants from the Federal government.
Illinois  needed the tax increases in order to fund TRS pensions. June 28, as the state headed into a third year without a budget, a federal judge ruled that Illinois was out of compliance with previous court orders to pay health care bills for low-income and other vulnerable groups  Judge Joan Lefkow ordered the state to come up with $586 million per month to make immediate payments and to start reducing the $2 billion debt which is owed to health care providers. Without additional revenue, State Comptroller Susana Mendoza would have obviously needed to take the money from somewhere else. The monthly payments from the state going into the pension funds could likely have been taken by Mendoza to help satisfy the judge’s demand.
Over the last several years, following the advice of its own investment people and its outside consultants the TRS Board has lowered its assumed rate of investment return in three steps from 8.5% down to 7%. Each decrease in assumed returns meant that the state of Illinois would need to increase its contributions to the pension fund. The last decrease in assumed returns caused the needed increased contribution from the state to TRS to grow by $402 million. The necessity of these increased payments was not well received by the Governor and the General Assembly and as part of the legislation recently passed TRS must now retroactively “smooth” the final effect of any changes made in the TRS assumed rate of investment in the last five years with 20% being phased in each year over the next five years.  Though the results of this calculation have yet to be announced by TRS,  the estimate is that it could significantly lower the state's FY 18 contribution  and it may mean that the annual payment from the state of Illinois would remain approximately $4 billion, or even less than it was for last year
The FY 2018 budget included changes to the Illinois Pension Code with the creation of a new Tier III.  None of the Pension Code changes enacted on July 6, 2017 affect Tier I members or retired members in any way. There will be no changes to benefits, active Tier I member contributions, or health insurance. Tier III will only affect Tier II members and those teachers yet to be hired only if they want to be a part of it. The optional Tier III calls for a “hybrid” retirement plan of two parts – a life-long-defined benefit pension and a defined contribution plan similar to a 401(K). Details on Tier III still need to be worked out and then the plans will be submitted to the Internal Revenue Service for their approval. It is a shame that that stipulation was not part of the creation of Tier II. Tier II members are paying 9% for a plan that is worth only 6% at best.   Tier I is funded at just over 40%, Tier II is currently funded 151%.
One other change to the Pension Code should be noted. Local school districts will pay for the cost of a member’s pension if the member's salary is equal to or greater that the governor’s statutory salary of $177,412 – only the portion that is equal or over. Also local school districts will be responsible for the “employer contributions” for both the DB and DC plans that will be part of Tier III. For those of you who look ahead and fear the state wants to get out of the pension business, you should know that the billions that Illinois owes to TRS are binds that will not break. They owe it and they have to pay it.
Larry Pfeiffer has taken my place on the TRS Board    E-mail: pfeiff4@gmail.com


 Bob Lyons