by Marc Levine, Senior Fellow
Last month Crain’s Chicago Business published an editorial I co-authored with Illinois State Senator Bill Brady that estimated Illinois’s unfunded pension liability to be $210 billion. That shocking number was provided to us by Professors Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester and is significantly larger than the state’s $80 billion liability calculation. This $130 billion difference consists of two pieces; approximately $70 billion for future service and about $60 billion due to the pension systems’ use of economically-invalid discount rates.
An estimated $140 billion of the $210 billion liability represents legacy costs, meaning pension benefits that have already been earned. The remaining $70 billion of the liability is for future service of current employees. Unless the state fires all state workers and teachers tomorrow, this $70 billion additional liability will accrue based on current pension benefits and highly predictable worker retention rates. Only a legislative adjustment will change this. It’s worth nothing the state excludes nearly all of this $70 billion cost from liability calculations (it includes a very small portion due to estimated salary increases).
The remaining $60 billion difference between the Rauh/Novy-Marx valuation and the state’s calculation is explained by discount rates—the rates used to discount the estimates of future benefits that will be paid over the next several decades. Messrs. Rauh and Novy-Marx use a discount rate based on the “risk-free” rate (normally the current yield on Treasury notes). The roughly 3.5% to 4% “risk-free” discount rate represents a more accurate basis for liability valuation than the pensions system’s average 8.25% discount rate because pension benefits are owed to the state workers and teachers regardless of investment performance of pension assets. If the pension system’s investment returns exceed current Treasury note yields than that excess will partially fund the legacy cost. Based on historical equity returns and anticipated pension asset depletion, risk-based investment earnings will cover less than 20% of the legacy liability.
The $210 billion number may be shocking, but it is the correct valuation of our state’s unfunded pension liability and demonstrates the urgent need to enact legislation that allows Illinois to (1) freeze its legacy cost at current levels and (2) adjust existing benefit levels to bring the state’s pension liability in line with fiscal reality.