by Ben VanMetre
Senior Budget and Tax Analyst
Illinois’ state pension systems are barreling towards
insolvency. Without a complete pension overhaul, Illinois’ five pension systems
may reach their breaking point.
There is only one way to prevent a collapse. Illinois must
shift from defined benefit (DB) to defined contribution (DC) plans.
In a DB plan, an employer pays fixed, regular pension
payments over a worker’s complete post-employment years. The payments are based
on a formula tied to age, years of service and salary.
This means that taxpayers, not the government retiree,
shoulder the investment and funding risks. The employer is obligated to pay the
benefit that was promised, even if the pension fund has contribution shortfalls
or poor market returns. The
employer (the government), and by extension, taxpayers, must make up any
In contrast, in a DC plan the employer and the employee
contribute fixed amounts to the employee’s private investment account. The
amount one receives in retirement is purely a function of what’s in the
investment account at the time of retirement.
Making the shift to a DC plan would certainly change how
retirees manage for their retirements. And while at first glance the DC plan
may look less attractive, current workers under nearly insolvent DB plans should
embrace the DC option.
Economist Scott Beaulier makes clear that
DC plans give individuals ownership over their retirements, enhance employee
flexibility, improve labor mobility and keep taxpayers from dumping money into
severely underfunded DB plans.
Individuals make their own investment decisions in a DC
plan. They shoulder the investment risk. Their retirement benefits are equal to
the amount contributed by both the employer and the employee, plus or minus any
market returns or losses.
But when the employees shoulder the risk, doesn’t this lead
to retirement benefits that may be less generous because of potential market
losses? Well, yes. And that’s the trade-off facing public sector employees.
Let’s consider the other side of this trade-off, though. The
state’s DB plans are unsustainable. The retirement funds may not be there in
the next 10 to 20 years.
Illinois’ five DB plans currently owe more than $630 billion
in projected pension benefits over the next 33 years. There is currently nowhere
near enough money to cover these promised benefits. The state’s pension plans
are dangerously underfunded. Already, the Teachers’ Retirement System in
Illinois is estimated to have an 80 percent funding shortfall.
The benefits from a failed pension system will certainly not
be very generous. The future retirement benefits, then, from the current DB
plans are, at best uncertain.
In contrast, DC plans are, by definition fully funded. This
is a positive. A practical reality is better than a pipe dream.
For public employees, the switch to a DC plan means trading
overly generous promises from nearly insolvent plans for benefits that are less
generous but more secure and practical.
For government officials, the switch represents a stride
towards fiscal prudence in state governance. It would also prevent a disastrous
failure of the state’s pension systems.
And for taxpayers, the switch would ensure a much more
stable fiscal environment in the future.
Unfortunately, we will not see a shift to a DC plan during
Quinn’s special session tomorrow.
Lawmakers may, at best, tinker at the margins.