Pensions v 401(k)s: An Illinois Case Study
Illinois’ pension liability is estimated to stand at more than $130 billion. The reason behind Illinois’ ever-growing pension liability is one of debate. Some attribute the deficit to legislators voting on pension bills they didn’t fully understand. Others argue that politicians chose to kick the pension ball down the road to avoid raising taxes or cutting spending on their watch. Still others, like Illinois Governor Bruce Rauner, argue the structure of the pension system itself is to blame: employees change jobs as a way to qualify for more than one pension and many seek raises in their final years as that guarantees them higher payouts during retirement
While there is much debate about the cause of the deficit, its existence is certain. Despite being in the top 1/3 of the nation’s wealthiest states, Illinois has one of the most poorly funded retirement systems in the country. Illinois has only funded 39 cents for every dollar it has promised to pay out in pensions. The pensions of similarly populated states like New York and Pennsylvania are far better funded, with New York at 89 percent and Pennsylvania at 62 percent, respectively. It is clear that Illinois needs to rethink its current pension scheme. Some groups like Illinois Policy, a conservative think tank, advocate for Illinois to adopt 401(k)s for new government workers, but the idea has not received much traction among state employees. While the traditional debate has been between keeping traditional defined benefit plans like pensions or moving to a defined- contribution plan like a 401(k), there is a lesser explored option as well: the hybrid 401(k)-pension plan. The hybrid plan combines the guaranteed income of a pension while lowering employer contributions with a 401(k).
The Current Pension Landscape
The Illinois government worker pension is a defined-benefit retirement plan that guarantees employees annual benefits commencing upon retirement. Under a defined-benefit plan, both the employer and the employee contribute a percentage of the employee’s salary to a pension fund that is then invested with the expectation of a favorable return to fund the employee’s retirement. The state aggregates the pension investments of each employee into a pension fund managed by investment professionals. Pension plans are structured to provide a guaranteed income throughout a pensioner’s retirement. While the employee contributes a finite amount of her income to the pension fund, the state is liable to pay a fixed pension payment for the duration of the retiree’s life, even if the amount owed exceeds how much is available in the pension fund.
In Illinois, the pension fund for state employees has failed to generate the returns necessary to meet the ballooning pension payouts the state promised to its workers, creating a continually growing deficit of $130 billion. The pension liability has far reaching implications for the state, as it is obligated to find outside funding if the pension fund is unable to cover the payouts. This means that Illinois must make some difficult fiscal decisions in order to keep its pension fund solvent: increase taxes, cut funding for other services, or issue billions of dollars of expensive debt. While cities like Chicago remain attractive to many, Illinois risks scaring off future high-earning individuals due to the looming pension shortfall. Major credit agencies have already downgraded Illinois’ credit rating to just above junk status. In today’s landscape, Illinois taxpayers are contributing $17.3 billion to the state’s pensions while the employees are contributing only $3.2 million. Illinois currently has one of the highest outflows of citizens of any state, and many former residents cited the state’s looming fiscal crisis and high taxes as impetuses for their departure.
To ensure its viability as a place to work and retire, Illinois must consider alternatives to its current retirement system for public employees. In 2015, the Illinois Supreme Court struck down a major legislative push to solve the Illinois pension crisis through reforming some of the current pension system’s terms. The Illinois Constitution prohibits the state from altering the pension plans of previous or current employees, but there is nothing prohibiting altering future employees’ retirement plans. One proposed alternative is to place future state employees in a 401(k) retirement system rather than a traditional pension plan. While adopting a 401(k) retirement system could help curb any future debt accrual, they don’t come without costs.
What’s the deal with the 401(k) option?
While pensions remain common for public sector employees, 401(k)s are growing in popularity among states as an alternative. In a 401(k), the employee contributes a certain amount of pre-tax salary directly into an investment fund, which the employer may or may not match. Each employee contributes only to her specific fund, which is then managed by an investment professional with limited input from the employee. Unlike with a pension, an employee is free to transfer her 401(k) portfolio if she leaves government.
As employees are living much longer than expected, the state’s obligation to compensate employees during their post-retirement years is much costlier than originally anticipated. Under a 401(k), the state has the same commitment to the retirement fund whether the employee lives to be 65 or 105. The 401(k) system lessens the burden on the state and ultimately the taxpayers, as there is more predictability in the fiscal commitment expected of the state. However, the 401(k) ignores the fact that many people are unable to predict how long they’ll need their savings to last, as they can’t predict their lifespan any better than the employer can. The 401(k) requires the employee to take a very active role in the budgeting of his retirement. A move to 401(k)s for future state employees would not be a panacea for the pension liability, but it could help to curb the rate of the state’s ever-increasing promised pension obligations. However, it comes at the cost of a constant, predictable stream of retirement income for state employees.
Unlike a pension program, in a 401(k) the employee usually shoulders the burden of any maintenance fees, not the employer. Additionally, most 401(k)s invest largely in volatile stocks and bonds in order to generate the investment returns necessary to fund an employee’s decades-long retirement. And unlike most pensions, 401(k)s are not insured despite being more vulnerable to market forces. Lastly, the employee has little input in the 401(k) plan design of her employer. Most of these plans are limited in investment options for the employee, so the employee is often inhibited from creating an investment portfolio necessary for a comfortable retirement fund.
What have other states done?
Tennessee and Michigan have both moved away from a traditional pension system for public employees, and instead offer 401(k)s or hybrid 401(k)-pension packages to new workers. Michigan’s financial health greatly improved since it started offering employees the option to select a 401(k) or a pension plan in 1997. Michigan has saved its taxpayers $167 million in costs related to prefunding the benefits and an estimated $2.3 to $4.3 billion in what would have been unfunded pension liability. Michigan employees who opted for the 401(k) attest to enjoying the benefits of the portability of the 401(k), should they move to a new state, as well as the confidence they have in the funds actually being available to them upon retirement so long as the market performs. Tennessee sees the switch to the hybrid plan as a way to curb costs before they become unmanageable.
As of 2013, Tennessee’s state workers, higher education employees, and teachers hired after June 30, 2014 are enrolled in pension-401(k) hybrid plans. A report by the PEW Research Center, shows that the move to the hybrid plan brought cost predictability for employers and flexibility for employees. In this hybrid plan, employees are required to contribute at a rate of 5% as opposed to no required contribution level in the past. As a result of its hybrid format and increased employee contribution requirement, Tennessee has seen a 50% reduction in state contributions since 2010. Employees retiring from the state will have substantial retirement income and those who leave employment can keep their 401(k) savings. The hybrid plan allows the state to react to low returns by providing the option to raise COLAs or require higher employee contributions. In Tennessee, a worker enrolled in the hybrid plan can expect to see a retirement income between 57 and 71 percent compared to 56 percent if enrolled in the Tennessee’s legacy plan, which made 401(k) contribution entirely optional. The hybrid plan allows the state to guarantee some retirement income while lessening the burden to fund pensions on the state and its taxpayers.
An Alternative for Illinois’ Workers
Under a hybrid 401(k)-pension the employee is guaranteed an annual payment during retirement that is paid for by employer-maintained funds. These funds are kept separate from the 401 (k) contributions made by the employee and employer. This option provides the employee with some guaranteed retirement income regardless of how the market performs while lowering the financial burden on the employer. While it is a better option, a move to a hybrid plan also comes with some of the risk s associated with a 401(k). Because these pension payouts would be significantly less than with a traditional pension, the employee will still need a healthy 401(k) to fully fund his retirement.
As of 2015, the federal government and 10 states offered 12 different types of hybrid plans that Illinois can look to for guidance. If Illinois moves to a hybrid system, employees and advocates should ask the state to provide significant contributions to the 401(k). Requiring a minimum contribution from employees can also mitigate concern related to low contributions on the part of the employee. Additionally, the state should provide workers with ample financial literacy and retirement planning resources in the forms of seminars, webinars and one-on-one advising for employees. Another way states can address worries regarding workers making ill informed investment decisions is to limit the number of investment options and providing access to annuity payment programs. If the state provides enough support in the form of guaranteed payouts, significant 401(k) contributions, and financial planning resources, 401(k) hybrids may be a viable and beneficial option for Illinois as it tries to lower its pension liability.