The 100% Funding Goal

Printer Friendly Version

Background
Some employers have asked why IMRF established employer contribution rates so as to achieve 100% funding (assets equal liabilities). Proposals have been made to set a 90% (or lower) funding target as an alternative. This paper discusses the reasoning behind IMRF’s 100% funding goal.

History
IMRF was created in 1939 and began operations in 1941. As units of government joined, unfunded liabilities were created. But those liabilities were manageable, because employer contribution rates were set to cover both past liabilities (the cost of existing service employees had when their unit of government joined IMRF) and developing liabilities (the cost of each new month of service credit an employee earns).

The past liabilities are amortized over a period of years so that they are eventually paid off. Liabilities created with each new month of service are covered 100% by incoming employer and employee contributions. This funding approach is set forth in Article 7 of the Illinois Pension Code and can be called a 100% funding goal.

Morever, there are good reasons for a 100% funding goal:

1. It is the pension industry standard
2. Current taxpayers pay for current services
3. Future taxpayers are not burdened with higher taxes
4. Liabilities grow, unfunded liabilities grow faster
5. Investment earnings are the largest contributor to the plan
6. Local units of government go out of existence and may go bankrupt
7. Setting lower funding goals is a slippery slope
8. With lower funding, any reasonable benefit adjustment becomes more difficult
9. Employees will continue to make their 100% contribution
10. If employers withhold contributions, investments will need to be sold
11. Local governments have avoided the State’s pension funding crisis
12. IMRF is approximately 100% funded; to destroy that is shortsighted
13. If it’s not broken, don’t fix it

1. It is the pension industry standard
   
   The Governmental Accounting Standards Board requires funding for 100%. Monies are set aside and invested. Investment returns reduce future employer contributions. For 2003, investment returns will represent the vast majority of IMRF’s revenue.
   
   Prefunding retirement obligations (IMRF) can be contrasted with pay-as-you-go retirement plans (Social Security). The problems facing Social Security boil down to who will pay the cost of an ever larger growing group of retirees as the labor force slows in growth. At a national level in 2000, there were 4.8 workers for every person age 65 or older. By 2030, that number is expected to decline to around 2.9.
   
   IMRF faces the same demographic issues. In 1999, IMRF had 2.2 workers contributing for every 1.0 worker in retirement. By 2015, we expect this ratio to decline to approximately 1.0 worker for every retiree and perhaps to go even lower by the time the last baby boomer retires. IMRF needs to build reserves to meet that challenge.
   
   
2. Current taxpayers pay for current services
   
   With a 100% funding goal, a unit of government is fully paying for the services rendered by its employees in the year those services are performed. The employer is also making payments over a reasonable schedule for any past liabilities.
   
   As you know, the direct and indirect costs for an employee are more than his or her salary. It’s not unusual for fringe benefits to add 30% to 50% to an employee’s salary. Health insurance, worker’s compensation, vacation, sick leave, holidays, life insurance, Social Security and IMRF make up that cost. Fringe benefits cannot be funded at only 90% without seeing the local unit of government’s liability for those benefits grow or causing major morale problems with its employees.
   
   You might ask employees to take only 90% of their vacation days. But, you cannot ask an insurance carrier to accept only 90% of the premiums, or ask Social Security to accept only 90% of what’s due. Even if employees used only 90% of their vacation days, eventually employers have to pay for them (at perhaps higher salary levels).
   
   
3. Future taxpayers are not burdened with higher taxes
   
   Delaying payment of the full expenses incurred by taxpayers in one year to future years places a greater burden on future generations of taxpayers.
   
   It may make sense for future generations to pay for a municipal building with a 50-year life expectancy. But, does it make sense for a taxpayer who moves into a community in 2004 to pay for services rendered by its employees in 1994, 1984, 1974, 1964, or 1954?
   
   By paying less than 100% of current employee’s pension costs, future generations will be forced to pick up the tab.
   
   
4. Liabilities grow, unfunded liabilities grow faster
   
   IMRF’s liabilities are not stagnant. With each day, month and year of service credit members earn, the total liabilities for all participating employees grow.
   
   Today, IMRF’s liabilities stand at approximately $16.5 billion. In 10 years, we expect the liability will be $31.5 billion, and in one generation (in 20 years) it will grow to $53.5 billion.
   
   Today, IMRF is also nearly 100% funded. Using a 100% funding goal, in 20 years that $53.5 billion in liabilities will be nearly paid off. However, if we were to begin using a 90% funding goal, in 20 years a $0 unfunded liability today would grow to $5.35 billion.
   
   Employers bear the cost of those additional billions of liability. Those liabilities will have a negative financial impact when they are disclosed in the footnotes to the employer’s comprehensive annual financial report.
   
   In the long term, total employer contributions will be higher in a plan with a 90% funding goal than in one with a 100% funding goal. This happens because the employer, in addition to paying the normal cost of the retirement plan, must also pay interest on its unfunded liability. Further, funding to 90% creates a situation where in the contribution rate would be an increasing percent of payroll. This inserts yet another layer of instability and unpredictability into the operation of government finance.
   
   return to top
   
   
5. Investment earnings are the largest contributor to the plan
   
   IMRF needs the ability to participate in market upswings. No one knows when the financial markets will provide a big boost to IMRF’s assets.
   
   In 2003, IMRF earned approximately $3.0 billion. By setting appropriate and reasonable funding goals, positive markets will result in reduced employer and taxpayer costs.
   
   For example, at the beginning of 2003, IMRF was 101.5% funded on an actuarial basis. If we had been 90% funded, we would have earned $2.7 billion ($3.0 billion times 90%). The difference would have been $300 million. That difference would only be paid by future taxpayers.
   
   
6. Local units of government go out of existence and may go bankrupt
   
   IMRF covers a diverse group of employers, including school districts, counties and cities. It also encompasses units such as county hospitals, intergovernmental cooperatives, health districts, housing authorities, joint education projects and several others.
   
   The longevity of many IMRF employers is not guaranteed. If an employer dissolves, its pension liability is assumed by any successor entity. If a successor does not exist, the pension liability is assumed by all IMRF employers.
   
   In the last 10 years, some of the most challenging pension liability cases have arisen when city, county or township hospitals have ceased to exist. The surviving entity (usually a city) becomes wholly responsible for the hospital’s pension obligations. It’s easier for the city budget and the city taxpayers when the obligation is 100% funded instead of 80% or 90%.
   
   
7. Setting lower funding goals is a slippery slope
   and
   Local governments have avoided the State’s pension funding crisis
   
   Once you ignore industry practice and sacrifice sound actuarial principles for temporary budget relief; you start down a slippery slope.
   
   If you ignore the long term lowest cost approach (i.e., 100% funding), then any funding level goal is appropriate based on current needs. Funding goals of 90%, 80% or 75% will be justified as appropriate. Instead of having a sound funding plan for an ever-growing liability, short cuts and budget tricks will become reality.
   
   Take the pension systems funded by the state of Illinois as a case in point. The state systems cover teachers, university staff, state workers, judges and General Assembly members. As of June 30, 2003, the funded ratio of the five systems together was 48.6%. The unfunded liability was $43.1 billion.
   
   At that time, nationwide, Illinois placed 49th out of 50 in funding. Only West Virginia had a lower funding ratio. Illinois had the largest unfunded liability in terms of dollars of any state. This poor funding approach resulted in legislation in 1995 which required the state to make additional contributions to fund its retirement systems. The goal was to reach 90% funding by 2045. That funding goal and that length of time to achieve it were selected because they were thought achievable, not because they were actuarially sound.
   
   However, even that slow approach was too much for the State budget in the 2001-2003 recession. The much discussed $10 billion pension obligation bond legislation of 2003 resulted in only $7.3 billion being paid into the retirement systems, with future state contributions being reduced.
   
   The hole the State has dug itself into is huge. If a 100% funding goal had been maintained in the 1960’s and 1970’s, there’s a strong likelihood the state retirement systems would have been 100% funded (as was IMRF) in the late 1990’s and 2000’s. And, they would have been in better shape to survive the down investment markets in 2000, 2001, and 2002.
   
   With the infusion of the pension obligation bond monies, state retirement systems’ liabilities were reduced to $35.7 billion with a 57.3% funding ratio. That’s remarkable. After the State assumed $10 billion in new debt, the retirement systems remain a problem for the State’s fiscal budget.
   
   return to top
   
   
8. With lower funding, any reasonable benefit adjustment becomes more difficult
   
   In 2001, discussions began to enhance the IMRF regular and SLEP retirement benefit formulas. The negotiations arose, in part, due to IMRF’s funding surplus, which stood at $1.0 billion on December 31, 2000. The surplus was seen as a source of funds to absorb the cost for any formula enhancement.
   
   As the financial markets dropped, as funding levels fell, and as employer contribution rates rose, the possibility of a benefit increase faded. In 2004, the formula enhancements have not occurred, and there is no prospect for a benefit increase in the near future.
   
   
9. Employees will continue to make their 100% contribution
   
   Is it fair for an employer to fund a retirement benefit at 90% while requiring employees to continue their 100% contribution?
   
   Granted, the pension is fully funded at retirement, but why shouldn’t new employees contribute only a fraction of the required contribution until they become vested (eight years of service credit) or until they retire? Just as units of government, employees would probably like to have more take home pay until they need to retire.
   
   
10. If employers withhold contributions, investments will need to be sold
    
    IMRF is a mature pension program with a negative cash flow (more is paid out in benefits than is received as employee and employer contributions).
    
    This is a normal situation for older, well-funded programs with high funding levels. It is not a concern when there is a disciplined funding approach. The gap between contributions and payouts is satisfied from investment income such as interest, dividends, and rents.
    
    However, if employer contributions are lowered through a lower funding goal, investment income will not be sufficient to cover the gap and investments will need to be sold. A downward funding spiral will develop which will eventually push up employer contribution rates (unless even lower funding goals are established). This type of negative cash flow is not normal and it will be a concern.
    
    
11. Local governments have avoided the State’s pension funding crisis
    
    Once you ignore industry practice and sacrifice sound actuarial principles for temporary budget relief; you start down a slippery slope.
    
    If you ignore the long term lowest cost approach (i.e., 100% funding), then any funding level goal is appropriate based on current needs. Funding goals of 90%, 80% or 75% will be justified as appropriate. Instead of having a sound funding plan for an ever-growing liability, short cuts and budget tricks will become reality.
    
    Take the pension systems funded by the state of Illinois as a case in point. The state systems cover teachers, university staff, state workers, judges and General Assembly members. As of June 30, 2003, the funded ratio of the five systems together was 48.6%. The unfunded liability was $43.1 billion.
    
    At that time, nationwide, Illinois placed 49th out of 50 in funding. Only West Virginia had a lower funding ratio. Illinois had the largest unfunded liability in terms of dollars of any state. This poor funding approach resulted in legislation in 1995 which required the state to make additional contributions to fund its retirement systems. The goal was to reach 90% funding by 2045. That funding goal and that length of time to achieve it were selected because they were thought achievable, not because they were actuarially sound.
    
    However, even that slow approach was too much for the State budget in the 2001-2003 recession. The much discussed $10 billion pension obligation bond legislation of 2003 resulted in only $7.3 billion being paid into the retirement systems, with future state contributions being reduced.
    
    The hole the State has dug itself into is huge. If a 100% funding goal had been maintained in the 1960’s and 1970’s, there’s a strong likelihood the state retirement systems would have been 100% funded (as was IMRF) in the late 1990’s and 2000’s. And, they would have been in better shape to survive the down investment markets in 2000, 2001, and 2002.
    
    With the infusion of the pension obligation bond monies, state retirement systems’ liabilities were reduced to $35.7 billion with a 57.3% funding ratio. That’s remarkable. After the State assumed $10 billion in new debt, the retirement systems remain a problem for the State’s fiscal budget.
    
    
12. IMRF is approximately 100% funded; to destroy that is shortsighted
    and
13. If it’s not broken, don’t fix it
    There are sound reasons to work towards 100% funding. It has served employers, employees and taxpayers well since 1941. The natural principles underlying sound pension fund management have not changed during that time frame.