Research Matters: Julie Roin on "Planning Past Pensions"

Research Matters is a biweekly feature in which a member of the faculty talks about some of his or her latest work and its impact and relevance to law and society.

Julie Roin, Seymour Logan Professor of Law, is finishing up “Planning Past Pensions,” a new work on Illinois’ pension crisis and possible ways to solve it. Illinois has the worst-funded state pension system in the nation, according to the Chicago Tribune and, Roin writes, “a sizeable non-pension related budget deficit.” State revenues do not cover current expenses, let alone generate the additional funds needed to defray pension costs, Roin writes, pointing out that “the state still has a $5.4 billion backlog of unpaid ‘current’ bills.’” The state legislature passed a pension reform bill late in 2013 that Roin said is likely to be held unconstitutional in court. Instead, she suggests “reforms that are legal and that would protect the valid interests of state employees.” The final work has not yet been published, but Roin spoke about the arguments she makes in the article.

Q. Why write about the pension crisis?

A. I’m very interested in government finance. My specialty is federal income tax, but I also do some state and local finance, and the last couple of pieces I wrote were about Chicago’s parking meter lease and how I believe that all these privatization deals have been a form of secured borrowing. Underfunding of pension plans is just another form of borrowing. It has the problems of borrowing and particularly of not admitting you’re borrowing when you are borrowing. It understates the cost of services, it leads to terrible problems down the road when, oh gee, you actually have to make these payments that you’ve promised to make. The money’s got to come from somewhere.

Q. So why is Illinois such a mess?

A. Illinois is an especially dysfunctional state. It has been dysfunctional at a fiscal level for many, many years, just as Chicago has been dysfunctional. Its politicians are afraid to tell their constituents how much it actually costs to run the government. So they have been playing a shell game with its finances for many, many years, including pensions.

For many years, Illinois was a low-tax state. When I moved here from Virginia, I was shocked to find that the state income tax rate in Illinois was far below that of Virginia’s. I was absolutely shocked. It’s not because Illinois was providing less. It’s because it was borrowing more. And one of the places it was borrowing from was the pension fund, by not funding it. The legislature was even, in some cases, continuing to increase its pension benefits promises while failing to put enough money into the pension funds to fund even the lower level of promised benefits. It was just borrowing from the future, which eventually leads to crisis. Eventually, you run out of money. Things come due, and you’re mortgaged up to the hilt. That is essentially where the state of Illinois is now.

Illinois raised its income tax to 5 percent several years ago on a temporary basis because it had billions of dollars of outstanding current bills which it wasn’t paying. By statute, current bills that aren’t paid on time have to be paid with interest at something like 1 percent a month or 1.5 percent a month. We’re talking credit card interest rates here. So the Illinois legislature deigned to raise taxes in an effort to generate enough cash to pay those current bills. It was not enough. The state hasn’t completely gotten rid of its backlog of the current bills, on which it’s paying credit card interest rates; it has paid off about half of them. But the date of expiration for this income tax increase is coming. The Democratic candidate for governor, Gov. Pat Quinn, wants to make the higher tax rate permanent. The Republican candidate says, we’re not going to make it permanent, but he has no plan for how to increase revenue or cut spending. It continues to be this wishful thinking: if I say it doesn’t exist, the financial mess doesn’t exist. And it’s nuts.

Q. So what do you suggest the state does about it?

A. I have several suggestions. One is, we need more revenue. Where can we get revenue from? One obvious place to get revenue is to start including retirement income in the tax base for state income tax. Right now, it’s not included. Changing that isn’t going to produce enough money by a long shot, but you’ve got to start somewhere. Telling retired people that they have to pay state income tax, just as they have to pay federal income tax, on their retirement income is a place to start. And it’s a particularly good place to start because the people who are affected have essentially underpaid their taxes in previous years. They’ve received the services but they didn’t pay the full cost. So that’s suggestion number one.

Another set of suggestions revolve around changing work rules to close off some opportunities for employees to “spike” their pension benefits. Right now, employees can work lots of overtime in the years immediately prior to retirement to “juice up” their salary for purposes of calculating their pension benefits—or they can work with friendly administrators to get outsized pay raises for a couple of years immediately prior to retirement (not as outsized as they used to arrange, but still substantial), which has the same effect. The state could impose proportionality standards on pay raises and limit the amount of overtime which would cut back on these opportunities.  They can limit multi-year accruals of vacation and sick pay. Frankly, I think that eliminating these opportunities would be a win-win situation for both employees and the state. It’s a win for the state in that closing off these options will reduce the amount of pensions that become due in the future. For employees, though some employees will receive smaller retirement benefits than they hoped to receive, the constant drumbeat of stories about abusive pension payouts that you see in the Tribune now will come to an end. If I were an employee, I’d be really worried about the political backlash created by ongoing revelation of abusive situations. With enough public support, the state legislature can do some very nasty things to state employees.

My third suggestion is that, in the longer term, particularly given Illinois’ unbroken history of dysfunctionality, it actually makes sense for the state government to move its pension program in the direction that private enterprises have moved, which means going from a defined benefit plan to a defined contribution plan. That means the employer and employee decide together how much to set aside in the retirement account, including an employee contribution. But I wouldn’t stop there. The other thing many people do not understand is that most state and city employees in Illinois are not covered by social security. The only pension benefits that they get are those that come through the state system. This matters because social security is like a defined benefit plan in that it guarantees an annuity for life, indexed to inflation. It’s not generous, except for the people on the lowest end of the rate scale, but it does keep people from losing everything. And so my suggestion is, going forward Illinois ought to be moving towards what amounts to a hybrid situation, with social security as the defined benefit portion of the retirement package and a defined contribution plan on top of that. This is what most private pension arrangements now look like. This hybrid system will cost money, more than Illinois is currently paying towards retirement benefits (but possibly less than it will cost to fully fund its current pension promises). There is no way that the residents of this state will avoid paying more in taxes.

Ultimately, the total amount of money devoted to retirement benefits, like other forms of compensation, should be a subject of bargaining between employer and employee. But the amounts at issue ought to be transparent to the employer (the state), employees, and the voting public. The current lack of transparency breeds bad behavior by all the affected parties.

Q. How do you make anyone listen to these ideas?

A. You write articles and you hope somebody in the popular press notices them and writes articles about them. There is no magical way of getting people to pay attention to you. Because it is a topical area, people might pay attention to it. Everybody cares about this. And I’m trying to write a piece that is not particularly pro-employee or anti-employee. I’m saying, this is a total mess; what is a way forward that makes sense? These are not solutions that will please anyone. They involve taxpayers coughing up more money to pay for employee pension benefits, and they will cost some employees some of their anticipated pension benefits. But I think the overall package makes more sense than the pension bill passed December.

Q. Are you optimistic Illinois will figure this out?

A. The question is, will it be forced to in some way? It is becoming much harder for Illinois to borrow money because people finally understand how risky this debt is, and if potential investors add to this risk the endemic political dysfunction, why would anyone buy state of Illinois debt right now? I can see state legislators deciding to tell all those creditors to go hang—it is actually a “legal” option (in that there is no court capable of ordering a remedy if it does that). That’s a serious risk that ought to keep a lot of investors away. They can buy bonds from other states that are more responsible, or they can buy private enterprise bonds. So capital markets might force Illinois to deal with reality.

Do we have enough honest politicians who are willing to basically fess up to the facts? I don’t know. In part it depends on whether Illinois voters are willing to face up to the mess we are in. I think it will be interesting to see whether Quinn wins. Even he’s not going far enough. He’s not talking about raising enough money to solve this problem. He’s just stating, excuse me, there’s no way we can go back to 3.75 percent income tax rates. Which seems pretty obvious to me.

As the bills come in and the state has to cough up money to pay them, it can put off some trade creditors. But the state can’t tell its retired employees, sorry, you’re going to get your pension benefits a year and a half late. Nor can it skip paychecks for current employees. That’s not going to fly. So when that happens, when it can’t borrow the money in order to make payments to ordinary people, be they retirees, or taxpayers owed income tax refunds, or whatever, it might be forced to do something. At some point, there’s an end game. I think we’re approaching it. From where I sit, the finances look pretty dismal.