Detailed Analysis of SB 2591 Andrew Szakmary gave us permission to post his letter to various senators which contains his analysis of SB2591. Dr. Szakmary is a Finance Professor at the University of Richmond formerly at SIU. Thank you Dr. Szakmary for the analysis. Dear Senator: I urge you in the strongest possible terms to vote against SB 2591, the so-called “reform” of the State Universities Retirement System (SURS). As explained in detail below, the bill singles out Tier 1 university employees and retirees for massive, unfair pension cuts that violate their contractual rights under Article XIII, Section 5 of the Illinois Constitution and under Article 1, Section 10 of the U.S. Constitution. Unless the bill is amended to allow SURS participants the option to keep the pension terms they currently have, I promise you that lawsuits will be filed against the State of Illinois in both state and federal courts, and it is highly unlikely the bill will be upheld. Allow me to explain, as a Finance professor, how SB 2591 diminishes pensions for Tier 1 SURS members. First and most obviously, it drastically reduces the automatic annual increases (AAI) that retirees receive. Under current law, which has been in effect since the late 1980’s and under which I was recruited to work at Southern Illinois University in Carbondale in 1990, retirees receive a compounded 3% AAI each year. Under SB 2591, retirees will instead receive ½ of the percentage increase in the CPI-U each year. To estimate the likely diminishment effect of this provision, consider that as of June 14, 2013 the breakeven inflation rate between ordinary 30-year U.S. Treasury Bonds and 30-year Treasury Inflation Protection Securities (TIPS) that are indexed to the CPI-U is 2.12%. Thus, according to the best gage of long-run expected future inflation in the CPI-U that we can gleam from market data, SURS retirees’ expected AAI’s will be reduced from 3% annually to 1.06% annually. Due to compounding, this change would have a massive negative effect on SURS retirees over time. In my case, assuming a life expectancy of approximately 81 years as estimated by SURS actuaries and using SURS’ 7.75% assumed rate of return on investments as a discount rate, I have computed that this provision would result in an expected diminishment of the present value of my lifetime pension benefits of 16.7%. If you were to assume a longer life expectancy for me and/or use a lower discount rate in the NPV calculation, the degree of diminishment would be even greater. While this next provision is unlikely to seriously affect me personally due to the nearness of my retirement date, a second, more complex way SB 2591 diminishes benefits for many SURS participants is via unilateral, unjustified changes to the effective interest rate under the money purchase formula. Tier 1 SURS participants who joined the system prior to July 1, 2005 are eligible to have their retirement annuities determined using this formula, and for the majority of eligible members it results in a higher annuity than the general formula. The basic way in which the money purchase formula works is that normal member contributions of 6.5% of salary each year are combined with “deemed” contributions by the State of 9.1% of salary. These contributions are then compounded forward at the effective rate of interest each year, and when a member retires an annuity is determined based on the accumulated value of the contributions, some assumed life expectancy as determined by SURS actuaries and the prescribed rate of interest (currently 7.75%) that will not be changed by SB 2591. Thus, the money purchase formula under SURS is basically like a defined-contribution plan, and the effective rate of interest is intended to credit system members’ accounts with SURS’ investment earnings. The effective rate of interest was set by the SURS Board prior to July 1, 2005 and has been set by the Illinois State Comptroller since that date. The effective rate set by the Comptroller for FY 2014 is 6.75%. Between 1973 (when SURS first began meaningfully investing in equities) and FY 2012, using geometric means, the effective rate has averaged 8.01% while SURS’ investment earnings have averaged 8.54% annually. Thus, even under the current system for crediting member accounts under the money purchase formula, system participants have been slightly shortchanged historically. SB 2591 proposes that from July 1, 2013 forward, instead of being determined by the current statutory factors that are supposed to reflect SURS’ actual investment returns, the effective rate of interest will be arbitrarily set to equal the 30-year U.S. Treasury Bond yield plus 0.75%. As of June 14, 2013 the yield on 30-year T-bonds published by the Treasury was 3.28%. If this rate remains unchanged over the next two weeks then under SB 2591 the effective interest rate in FY 2014 will be set at 4.03% instead of the 6.75% that has already been certified by the Illinois State Comptroller. Moreover, given that SURS invests 70% of its portfolio in stocks and that, historically, stocks have earned annual investment returns that are 3-4% higher than long-term bonds, there is every reason to believe that SB 2591 would result in similar reductions to the effective rate of interest in the future. If the magnitude of the reduction in future fiscal years is similar, then the impact on SURS members is basically as follows: for every year beyond July 1, 2013 a member delays retirement, his/her annuity under the money purchase formula will be reduced by approximately 2.55%, compounded. Thus, for example, a member who retires on July 1, 2023 will receive (1 - 0.0255)10 = 77.24% of the amount due under current law, which would constitute a diminishment of nearly 23%. This would be on top of the diminishment such a member would see as a result of the reduction in his/her AAI. Because the 0.5% per year of salary that SURS-covered employees contribute to the cost of their AAI’s under the money purchase formula is arguably less than the true cost of providing the current 3% AAI’s during retirement, the normal cost to the state of providing university pensions is higher than the deemed 9.1% state contribution under the money purchase formula. However, it is not much higher: SURS currently estimates the normal cost at approximately 11% of salary. The only reason the State must now contribute much more to SURS is because of the pension ramp and past underfunding. Aside from the constitutional issues with SB 2591, I would like to appeal to your basic sense of morality and fairness by asking this question: what is wrong with the current system, i.e. why is it too much to ask that the State of Illinois contribute 11% of salary each year towards university employee retirements, when most private employers also contribute approximately this much if not more? As you are well aware, SURS members do not participate in Social Security and the state does not pay the employer portion of the 6.2% payroll tax on their behalf. So, for the vast majority of university employees, the State currently is paying the equivalent of a private employer that contributes 5% of salary into a defined contribution plan. Even Wal-Mart contributes 6%. Sincerely, Andrew Szakmary
Posted on: Thu, 20 Jun 2013 02:32:14 +0000
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