From The Economist print edition www.Economist.com
IT WAS a proud moment for Illinois this week, as the state’s favourite son became president. At home, though, matters are more depressing. The impeached governor, Rod Blagojevich, has much bravado and little authority. And, like dozens of other states, Illinois faces a budget deficit. Moreover, another problem is in the offing.
The state’s five pension funds are looking pasty. Illinois has $54.4 billion of unfunded pension liabilities, with just 54% of the assets it needs to pay for future promises to its workers; 80% is the proportion experts usually consider adequate. These figures, the most recent available, are from June 2008. Since then, they have probably got worse.
Other states face similar woes. A sample of 109 state pension funds lost $865 billion, about 30% of their value, between October 2007 and December 2008, according to the Centre for Retirement Research (CRR) at Boston College. In Illinois the state treasurer, Alexi Giannoulias, wants to streamline the pension funds; he hopes a bill will be ready this month or next. But the funding gap will not be filled easily. The short-term outlook is bleak in Illinois and elsewhere. Pension problems only add more uncertainty.
State and local governments’ retirement plans differ greatly from those in the private sector. In 2006, according to the CRR, over 60% of private workers with a retirement plan relied on a defined-contribution scheme such as a 401(k) account. Workers bear the risks of the market; many cheer when their accounts rise, but watch in anguish as they plummet. State and local workers, however, should be more calm. In 2006 80% of them relied on defined-benefit plans, which pay a pension based on wages and years on the job. The employer, not the worker, weathers market turmoil. What is more, public pensions are often protected by a state’s constitution, as in Illinois.
Before the financial collapse most states were moving towards full funding. In the CRR’s sample of pension plans, about 60% had funding ratios of at least 80% in 2006. The problem then seemed to be health-care liabilities, which states usually pay for out of general revenues rather than invested trust funds. The financial mayhem, however, has put pensions back in the spotlight.
Private defined-benefit plans are under most pressure. Firms, thanks to a law passed in 2006, face strict rules for shoring up their obligations. States have more leeway, but many will have to pump more money into their pension funds to offset losses on the market. Some states have been more battered than others. The value of America’s biggest pension fund, the California Public Employees’ Retirement System, shrank from $253 billion at the end of 2007 to $181 billion in November 2008. Trouble descended on cities as well. Philadelphia’s pension fund lost 23% of its value in 2008, according to the city’s controller.
Illinois’s pension funds were skimpy even before the crisis. “The big-picture problem for Illinois has nothing to do with markets,” explains William Atwood, director of the state board of investments. “It has to do with policymakers’ decisions to allocate money to places other than pensions.” After years of starving its retirement systems, in 1995 the state adopted a plan to ensure that its ratio of assets to liabilities reached 90% by 2045. But this was scuppered by generous new benefits for workers and lax payments to the funds themselves. Meagre returns have not helped. In June 2008 the state’s five pension funds had $64.7 billion in assets. At the end of October they had $50.5 billion.
Mr Giannoulias’s plan would consolidate the five funds, improve their management and protect them more effectively from corruption. In the past Tony Rezko, a convicted former fund-raiser, tried to use the teachers’ fund for extortion. The treasurer’s plan might help the funds’ performance, says Laurence Msall of the Civic Federation, a watchdog, not least because investment professionals would oversee them. However, says Mr Msall, the plan “will not solve Illinois’s dramatic underfunding of its pensions”. Mr Giannoulias thinks his proposal will save up to $82m a year. The state is due to pay over $4 billion to the pension system in the next fiscal year. Illinois now faces a deficit of at least $2 billion.
Illinois could follow a few other states and pass reforms for new workers. Kentucky’s changes include setting a minimum retirement age. New employees in Kansas must give a bigger share of their wages to the retirement fund. But current workers’ pensions are protected by law. Past promises remain a heavy burden.
The extent to which states raise their own payments to pension funds depends on the stockmarket. Most funds value their assets over several years, so the effect of one year’s dip is spread over time. Still, the CRR estimates that to return funding levels to those of 2007 by 2010, the rate of return on market assets would have to be 52% each year. To return to 2007’s levels by 2013, the yearly return would have to be 18%. “Taxpayers”, explains the CRR’s Alicia Munnell, “will have to ante up.” The main question is when, and how much.