State & Local Pensions + IRAs

1. State & Local Pensions + IRAs October 3 & 5, 2006

2. By the end of today you should be able to: • Explain in a bit more detail how an IRA works, and the basic difference between a “traditional” IRA and a “Roth IRA” • Explain the status of US state and local pension plans • Discuss the State University Retirement System (SURS) of Illinois

3. Overview of IRAs • Individual Retirement Accounts (IRAs) were first introduced in 1974 for those without pension • Expanded in 1981 to include everyone and raise contribution limits • Tax Reform Act of 1986 scaled back tax deferral • Taxpayer Relief Act of 1997 created new Roth IRAs • Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) raised contribution limits

4. Traditional IRAs • Receive immediate tax deduction • Money grows tax-free (inside buildup) • Pay ordinary income tax rates upon withdrawal • Contribution limits • 10% penalty if withdrawn before 59½ • Must begin withdraws by 70½

5. Roth IRAs • Do NOT receive up front tax deduction • Money grows tax free (inside buildup) • No taxes at withdrawal • Contribution limits • But in actuality, this allows person to put in MORE of before tax earnings into a Roth

6. Eligibility for Traditional IRA • Everyone under age 70½ with earned income is eligible. No income limit. • However, the deductibility of contributions does depend on income as well as whether you are covered by a qualified plan at work

7. Eligibility for Roth IRA Can contribute at any age (even >70)

8. Contribution Limits

9. Which is Better? • If tax rate while contributing is same as tax rate at withdrawal, then there is “no difference” • =$1 x (1+r)t x (1-withdraw) [traditional] • =(1-contribute) x $1 x (1+r)t [Roth] • However, you are, in a sense, contributing “more” to Roth because it is after-tax dollars

10. Which is better? • If tax rate while working > tax rate in retirement  choose traditional IRA • Pay lower tax rate in retirement • If tax rate while working < tax rate in retirement  choose Roth IRA • Pay lower tax rate now

11. Rollovers • When you leave employer with vested pension benefit, you must either leave the money in the plan, “roll it over” to a plan at a new employer, or “roll it over” into an IRA • Most dollars now held in IRAs are from rollovers

12. How Big are IRAs? In 2001, there were $2.1 trillion held in IRAs $1.8 trillion in DB plans, and $2.4 trillion in DC plans

13. National Savings • As a nation, we care about national saving rate because saving is what funds investment, and investment is what funds future economic growth • Nat’l Sav’g = Private Sav’g + Gov’t Sav’g • Do targeted savings vehicles increase national saving?

14. Does Tax Deferral Increase National Saving? • Not necessarily. • Some tax-deferred saving would have occurred even if there were not tax deferral • Tax deferral reduces government revenue  decreases government saving • A debate among economists over the extent to which targeted savings plans increase saving versus subsidizing saving that would have occurred anyway • Relevant in debates over pensions, IRAs, tax policy, Social Security, etc.

15. State & Local Work Force • 16 million state and local employees in the US • About 12% of U.S. labor force • 54% of employees in education field • Highly unionized (37% vs. 8% in private sector) • Another 4 million retirees

16. State & Local Pensions • Unlike in the corporate world, traditional DB plans are still the norm here • 90% of state/local workers have DB plans • Benefits often “guaranteed” by the state • Lawmakers often powerless to reduce benefits to existing employees • These plans are, in general, not governed by ERISA, and thus there is no requirement that they be kept fully funded

17. Funding Status • The unfunded liability of state & local pension plans is roughly $278 billion at end of 2003 • Barclay’s estimate: if these funds accounted for pensions the same way as corporate plans, shortfall would be about $700 billion

18. Sources of the Funding Problem? • Same “perfect storm” that hurt corporate plans • Falling asset values • Falling interest rates • Chronic under-funding • Pension “holidays” • No regulatory body enforces contributions • Political “give-aways” • Generous increases in benefits without specifying how they would be paid for

19. How Fill the Shortfalls? • Reduce pension spending • Hard to do if benefits are guaranteed • Raise taxes • Politically difficult • Cut other spending • Schools? Medicaid? What gets cut? • Naively believe in a free lunch • “Pension Obligation Bonds” – imposes risk on the taxpayer (more on this shortly)

20. The State of Illinois • 5th highest income state in the nation • Second worst pension funding status in the nation • Illinois has 5 large state pension funds • Combined, about $35 billion underfunded • State budget is about $43 billion • 2005: State owed its pensions $2.6 billion • Within 5 years, over $4 billion annually • For comparison, we spend about $6 billion on K-12 public education in Illinois

21. Why is Illinois such a Basket Case? • Lack of political will: since 1970, there has never been a year in which Illinois has fully met its pension obligations • “Impairment clause” – state constitution prohibits Legislature from making any changes that would “impair” benefits to existing employees • More give-aways: in past 10 years, the legislature has added nearly $6 billion in new benefits (largely early retirement incentives)

22. SURS • State University Retirement System of Illinois as a “case study” • As of 3/31/06, SURS had: • Assets = $14.5 billion • Liabilities = approx $21.5 billion • Funding ratio = 68%

23. Three SURS Plan • Traditional DB is very generous • Employees get the “best of” three different approaches to calculating benefits, including: • A “final average salary” plan • A “money purchase” plan that provides guaranteed rate of return well in excess of risk free government bond rates • There is also a “portable DB” that pays less than DB, but which gives you more if you terminate employment early • A “self-managed” DC plan • This one is fully funded by definition

24. “Pension Obligation Bonds” • Governor Blagojevich in 2004 • Issued $10 billion in pension obligation bonds • Used roughly $2.5 billion to make the annual contribution to the pension plan • Invested the remaining $7.5 billion with the hopes that he can use this $7.5 billion plus interest to repay the $10 billion plus interest • “If only it were so easy” • “Why stop there?”

25. Illinois Public Act 94-0004Signed June 1, 2005 • Makes things worse: • Reduces states pension contributions for this year, thus making the problem larger • Makes things better: • Removes money purchase option from DB plan for new employees hired after 7/1/2005 • Every new benefit enhancement must be fully funded and must expire after 5 years unless renewed by Legislature • Requires a member’s employer to pay the actuarial value of increased benefits that arise because of earnings increases >6% over prior year

26. Other provisions … • May help, but may not • Removes SURS Board power to set the effective interest rate for money purchase plan and gives power to state Comptroller • Creates an “Advisory Commission on Pension Benefits” to prepare a report on how to solve pension problem