Illinois pensions cut investment expectations

Move will cause unfunded liabilities to rise

Monday, November 01, 2010

Illinois' unfunded pension liability, already the worst in the nation, is expected to spiral to even higher levels because the financially desperate funds are revising their investment goals downward.

The funds are desperate on more than one front. They are not getting their monthly contributions from the state on a timely basis. And those delays are forcing them to sell fund assets at an annualized rate approaching 10 percent to pay benefits to retirees. The one-two punch is deflating their bottom line.

Now, as much as it hurts during an already painful time, the funds are coming clean, acknowledging that conditions have made it impossible to hit their investment targets. Three of the five funds officially ratcheted down their investment return targets in the past two weeks, which will increase the state's pension costs in the next fiscal year and beyond.

"We keep having to transfer money out to pay benefits, and it's a … drag on returns," said William Atwood, executive director of the Illinois State Board of Investment, which manages the assets of three funds. Investment results have been hurt by the low-interest-rate environment as well.

The pension funds' investment returns, together with contributions by the state and employees, are used to fund retiree benefits now and in the future. So when investment returns lag, the unfunded liability level rises and the state must fork over more to compensate.

The Illinois State Universities Retirement System and the Illinois State Employees' Retirement System, two of the three largest funds, each reduced their assumed annualized rate of return to 7.75 percent, from 8.50 percent, while the much smaller Illinois Judges' Retirement System lowered its goal to 7 percent, from 8 percent.

The Illinois Teachers' Retirement System, the largest fund, is standing pat for now. The Illinois General Assembly Retirement System, a very small fund, has not made a change yet, but its board may consider the issue next month.

For the university pension fund, the change will push its liability level up by $2.4 billion, or more than 8 percent, to $30.1 billion, which in turn will reduce its funded level to 40.24 percent, from 43.75 percent. And the state's annual contribution will rise by nearly $100 million, or more than 11 percent, to $980 million, according to William Mabe, executive director of the university pension system.

"I think this is a more accurate picture of the state of the economy and our liabilities," he said. The 8.5 percent assumption was viewed by some observers as quite aggressive, with most state funds around the country using targets closer to 8 percent.

The state employees' and judges' funds have not finalized figures on how the changes will affect their liability levels and the state's contributions, but administrators estimate they will rise by 8 to 10 percent, said Timothy Blair, executive secretary for both funds.

The rising price tags for Illinois taxpayers come as the Illinois Senate is set to reconvene Thursday, at Gov. Pat Quinn's request, to consider whether to borrow to meet annual pension obligations once again. The state would issue bonds for up to $4.1 billion in state contributions to the five funds in fiscal 2011, which began July 1.

The move was approved by the House on May 25 but was not called for a vote in the Senate becauseDemocrats were not able to get the full support of their ranks needed for a three-fifths majority, and theRepublicans were not willing to step in.

Some observers say not much has changed in the intervening time.

But if the state does decide to borrow again, it will come atop more than $13 billion in previous borrowing for annual pension obligations, a portion of which ended up getting skimmed off for operating expenses during the tenure of former Gov. Rod Blagojevich.

The bond issue could come in lower than $4.1 billion, perhaps closer to $3.7 billion, due to cost savings from the pension overhaul plan adopted last spring that cuts benefits to new employees, said John Patterson, a spokesman for Senate President John Cullerton, D-Chicago.

While the recent steps by the pension funds to adjust their investment returns won't affect this year's state contribution, they will hike costs in fiscal 2012, which begins July 1, 2011.

A spokeswoman for Quinn acknowledged the additional costs but said the governor pushed for the funds to lower their assumed rate of returns in order to paint a more accurate picture of the state's unfunded pension liability.

"This is the fiscally responsible thing to do and should help with the state's bond rating," said Kelly Kraft, the governor's budget spokeswoman. She added that last spring's reforms should cut pension liability by $220 billion over the next 35 years.

A number of observers applaud the funds' lowering of investment expectations but say the scale of the state's pension problem remains vastly underestimated.

While the state estimates its unfunded liability will approach $80 billion this fiscal year, Joshua Rauh, an associate professor of finance at Northwestern University's Kellogg School of Management, thinks a more accurate figure is nearly double that.

When the state pension funds project how much they will owe retirees, or their liability, they convert the sum into today's dollars, figuring those dollars will be invested and provide annualized returns in line with the fund's stated investment goals, most of which are in the vicinity of 8 percent.

Rauh believes the state should peg its plan, instead, to risk-free returns such as those provided by Treasury bonds. In assessing the liability levels of the state's three biggest funds last year, he used a range of rates, from 2.7 percent to 4.5 percent.

"You can't pretend you can get 8 percent without risk," Rauh said. "It's asking future generations to come up with payments when the stock market does poorly, and that's a time when they are hurting the most."

The Civic Committee of the Commercial Club of Chicago, which has been pushing for deeper pension cutbacks, agrees with Rauh's assessment.

"By understating the problem, the legislature has been able to justify underfunding the pensions, which has caused the problem to get worse each year," said R. Eden Martin, president of the not-for-profit organization.

The pension funds say they hit their investment targets over the long haul, though they acknowledge the returns of the past decade have been weak, both because the decade began in a frothy 2000 and because the markets plunged in 2008.

The Illinois Teachers' Retirement System, for instance, saw annualized returns of 3.72 percent in the past decade but hit 8.6 percent over the past 25 years, just a hair over its target of 8.5 percent, said Dave Urbanek, a spokesman for the system.

Rauh's projections "deliberately undercut the revenues that pension systems would create through investments," Urbanek said.

The teachers' system, the largest of the five, only reviews its assumed rate of return every five years, and that review will not roll around again until 2012, he said.

The fund isn't happy about having to sell off assets to make monthly payments, but because of its size, it has more room to maneuver, he said.

"We have had an unfunded liability problem since the 1950s, and the Teachers' Retirement System is still in business," Urbanek said.