The biggest threat to Illinois public employees and pensioners is clear: The state, due to its failure over decades to properly fund public pensions, now finds itself in a potentially un-solvable dilemma. It cannot afford to pay pensions as currently structured, and yet the state constitution prohibits most reforms that would reduce benefits.
The second biggest risk facing Illinois pensioners – lack of inflation protection – might also be the state’s biggest opportunity. In recent months, much has been made of the 3 percent “Cost of Living Adjustment” (COLA) that Illinois pensioners receive each year. Here’s the interesting thing about the COLA: it isn’t one.
Under the current law, pension payments go up by 3 percent per year regardless of inflation, and thus this adjustment has nothing to do with the cost of living. Indeed, state law doesn’t even call it a COLA, but rather an automatic annual increase (AAI).
True, in the past few years a 3 percent increase has been more than enough to keep up with inflation. But, inflation was around 5 percent as recently as 1990, and inflation was as high as 13.5 percent in 1980.
A fixed 3 percent adjustment does nothing to protect against the risk of inflation. By contrast, the Social Security COLA, which is based on the percentage increase in the Consumer Price Index (CPI-W), does offer protection. In periods of low inflation, Social Security payments do not increase much, but when inflation is high Social Security increases more, allowing seniors to maintain their standard of living.
From 1979-1981, prices increased by almost 40 percent, as did Social Security benefits. Illinois public pensioners’ compound AAI over this period would have been just over 9 percent, implying a 21 percent decline in purchasing power.
Even modest inflation can be a serious threat. Consider a pensioner receiving $10,000 per year. In three years, the AAI would increase that $10,000 to $10,927 With 5 percent annual inflation, goods and services that cost $10,000 initially would cost $11,576 after three years.
The pensioner’s real purchasing power would have declined by more than 5 percent. Over 20 years, the difference between a 3 percent AAI and 5 percent inflation would reduce purchasing power by almost a third.
The latest figures from the Cleveland Fed estimate expected inflation to be 1.53 percent over the next decade. But, just because inflation is expected to be low doesn’t mean that there is no risk of high inflation, especially given the Fed’s accommodative monetary policy and a growing national debt. These are risks that prudent individuals might like to reduce.
So, how might this represent an opportunity for reform? If the state provides current and future pensioners with the option to voluntarily exchange the 3 percent AAI for real inflation protection, it could give pensioners valuable insurance while simultaneously reducing the state’s expected pension costs.
Practically speaking, the most likely vehicle for such a trade would be for the state to offer to exchange some of the pensioner’s future payments for a lump sum, as recently suggested in a proposal issued by the Institute of Government and Public Affairs at the University of Illinois. The pensioner could then use this money to invest in assets that provide inflation protection, whether offered by the U.S. Treasury or financial services firms.
Because the money could be used to purchase valuable inflation insurance, and because it reduces pensioners’ exposure to the political risks of underfunded pensions, participants should be willing to accept it at a discount, thus reducing the state’s overall obligations.
Given the constitutional constraints facing the state, win-win proposals such as this may play a major role in addressing its pension problem.
Jeffrey R. Brown is William G. Karnes Professor of Finance and Director of the Center for Business & Public Policy and Nolan H. Miller is Professor of Finance and Julian Simon Faculty Fellow in the College of Business, both at the University of Illinois at Urbana-Champaign.