Tiers and Fears: Illinois Is Ground Zero for the Public-Sector Pension Crisis

Hundreds of billions of dollars in pension debt are dragging residents -- and government at every level -- under water.

I t seems not only unfair, but also unreasonably costly, to force hundreds of millions of Americans to shoulder a burden that has nothing to do with them.

Only 4 percent of Americans working in the private sector have access to a defined-benefit pension plan as their sole form of retirement security. The rest of us must rely on some combination of 401(k)s, hybrid plans, or Social Security.

Yet the country is sitting on more than $4.7 trillion in public-pension debt at the state and local level.

To understand the problem, look no further than Illinois — Land of Lincoln and home to the nation’s worst state pension problem.

Here, politicians have made promises that they could never afford to keep. This has led to higher taxes, a constantly growing state debt load, diminished government services, and public-sector retirements that could run dry before many workers hang up their hats.

The Prairie State’s pension debt is the worst in the nation relative to the size of each state’s economy. Moody’s Investors Service estimates unfunded liabilities in Illinois’ five state-managed pension systems at $230 billion for fiscal year 2019, equal to about 26 percent of gross domestic product. Moody’s also projects that the debt will grow to an all-time high of $261 billion for fiscal year 2020, owing to investment losses in markets riled by COVID-19.

Many of the toughest problems facing Illinoisans stem from this crisis, leaving their home state at the bottom of too many “best” lists and at the top of many “worst” lists. For example, Illinois is home to:

• The second highest property taxes in the nation, leaving someone with a home valued at the median price of $187,200 paying $4,299 per year in property taxes, according to WalletHub.
• The second slowest growth in home values since the Great Recession.
• The second most debt per taxpayer according to Truth in Accounting, at $52,000 per state taxpayer.
• The “least friendly” total state and local tax burden for the middle class, according to personal finance site Kiplinger.
• The largest raw population decline over the past decade, with the high state and local tax burden the most common reason residents say they want to leave.

The pension crisis is the common factor in this perfect storm of interrelated fiscal and economic challenges. It’s the anchor pulling so many Illinoisans under water, leaving them paying growing shares of their income to fund government retirement benefits. It saddles them with the equivalent of a second mortgage and contributes to depressed home values and a weak economy.

Retirement benefits for government workers are the largest financial burden borne by Illinois state and local governments. Those benefits are set by state law and afforded near absolute legal protection under a 2015 Illinois supreme court decision, interpreting the state constitution’s pension clause.

But rather than offering anyone true protection, the government continues to maintain an unsustainable status quo that endangers the retirement security of public employees and undermines the chance that almost anyone might have to build a financially secure life in Illinois.

Illinois pension benefits — particularly for employees lucky enough to have been hired before 2011 — are a promise that really is too good to be true.

State lawmakers and former governor Pat Quinn scaled some of these benefits back with legislation in 2010 that created a second, lower tier of benefits for employees hired in 2011 and beyond. But virtually all of the outstanding pension debt — along with the financial burden that flows from it — stems from the pension obligations due to “Tier 1” employees.

The Prairie State has five statewide retirement systems: one each for teachers and administrators, higher-education employees, judges, and politicians and state workers in state agencies and boards. In addition, it also has local pension systems for city employees such as police officers, firefighters, and municipal service providers — which carry $115.7 billion in unfunded liabilities, and that’s on top of a level of state indebtedness that “leads” the nation.

For employees hired before the 2010 reforms, so-called Tier 1 workers in state and local systems, employee contributions account for an average of between just 4 percent and 6 percent of the expected lifetime benefits that a “career employee” with the maximum years of service credit can expect to receive. Benefits are sweetened by an annual “cost-of-living” increase of 3 percent each year regardless of inflation, which functions to double the size of a retiree’s initial pension after 25 years.

Average total payouts for these Tier 1 career employees during retirement typically exceed $2 million, ranging from $2.3 million in the Teachers’ Retirement System up to $3.6 million for judges. State workers receive a lower but still generous average of $1.7 million, but that’s because more than 96 percent also receive Social Security.

Lawmakers attempted to scale back growth in these benefits with a modest reform effort in 2013, but, as mentioned above, that law was eventually struck down by the state supreme court. The court rested its decision on a clause in the state constitution that declares retirement benefits to be a contract that cannot be “diminished or impaired.”

Illinois’s courts will only allow changes that affect new workers, declaring the benefits of current workers and retirees off-limits, including even the future growth rate of benefits for work not yet performed.  The court left the legislature free to enact legislation creating yet another tier (in addition to Tier 1 as well as the second tier discussed below). In 2018, the legislature passed a law to create a Tier 3 with an optional defined contribution component as a compromise with Republican governor Bruce Rauner, but there was no required starting date, and this has not been implemented.

Tier 2 state workers hired after January 1, 2011, receive a cost-of-living adjustment equal to half the rate of inflation, must wait (on average) about twelve years longer to retire, face a cap on their maximum pensionable salary, and contribute a larger share of their total benefits from their own pay. In fact, some of these younger workers are forced to subsidize the far more generous pensions of older workers and pensioners. The result is a system of haves and have-nots in state and local government.

Ultimately, the unsustainability of Illinois’s pension obligations places the whole system at risk of insolvency, meaning that the sense of retirement security enjoyed by 1.1 million current and former state employees may well prove to be illusory.

Solving Illinois’s fiscal predicament will involve accomplishing three policy objectives. First, stabilizing state and local government finances to reduce the burden on taxpayers and businesses. Second, freeing up scarce taxpayer resources to invest in the most important and effective areas of spending, such as education. Third, keeping core promises to public workers by replacing the empty promise of the pension status quo with a financially secure retirement system.

These results are achievable while preserving every dollar in existing benefits for current workers and retirees. A “hold harmless” pension reform plan developed by the Illinois Policy Institute would do just that. Reforms such as tying all future retirement benefit increases to inflation, applying the Tier 2 salary cap to Tier 1 pensions going forward, as well as a few other modest changes, could save nearly $2 billion per year and more than $50 billion over 25 years, after which the debt would be fully eliminated and pension spending could shrink dramatically.

Structural pension reform could be enabled by matching Illinois’s constitutional pension protections with the federal government’s “anti-cutback” rule, which recognizes a distinction between benefits earned for work already performed and the future growth in benefits.

This plan, which must be achieved through a constitutional amendment, represents the fairest option for all Illinois residents — taxpayers, government workers, and vulnerable residents who rely on government services.

Revenues lost as a result of the COVID-19 pandemic and measures taken to combat it make pension reform more urgent than ever. Illinois’s credit rating teeters just one notch above non-investment-grade “junk” status. The state faces a $4.8 billion budget deficit for the coming year, and its backlog of unpaid bills is projected to rise to nearly $15 billion by June 2022.

Without pension reform, Illinois will struggle to adequately fund public-safety, education, and essential health and social-service programs.

Hiking taxes or otherwise throwing more money at the current pension system will not solve the problem. Illinois spends more of its revenue on pensions than any other state in the nation but also has the largest gap with respect to what it would need to pay without reform. Voters recognized that income tax hikes are the wrong strategy when they soundly rejected a proposal to raise revenue by switching from a flat to a progressive income tax on the November 3 ballot.

If a rising tide lifts all ships, Illinois is proof that unsustainable retirement debts can sink an entire state. Residents deserve the opportunity to vote on real pension reform. Today, 51 percent of Illinoisans have said they support constitutional pension reform. That decision makes pension reform not only more important, but also more attainable, than ever before.