Illinois taxpayers on hook for $5.6 billion pension fix

Pension systems for teachers, state employees and university faculty need about $250 million more a year from Illinois taxpayers to avoid violating federal tax laws.

That's the conclusion of a study recently commissioned by the Illinois General Assembly's Commission on Government Forecasting and Accountability that analyzed whether Tier 2 pension benefits in those systems meet federal "safe harbor" requirements necessary to forgo Social Security tax payments.

The study, done by Chicago-based human resources and benefits consulting firm Segal, showed an earnings cap placed on some future state pensioners was lower than the federal cap for Social Security recipients. That makes pensions less valuable than Social Security for some future retirees, which violates federal tax law.

"Employees of state and local governments are provided an exemption (of paying Social Security taxes) if the employee participates in a retirement system that provides benefits that are comparable or better than the benefits provided through the old-age portion of Social Security," the report states.

The suggested fix is an infusion of $5.6 billion into the Illinois Teachers' Retirement System, State Employees' Retirement System of Illinois and State Universities Retirement System of Illinois over the next 22 years, according to the report.

"Failure to meet safe harbor is you get sued by the employees, and the remedy is that we as the employer have to pay retroactive Social Security benefits," said state Sen. Robert Martwick, a Chicago Democrat and chairman of the Senate's Special Committee on Pensions. "The cost and legal fees would be exponentially more expensive than just fixing Tier 2 now."

The teachers' pension system needs the most money, estimated at nearly $3.4 billion by 2045. The state employees' system would require almost $1.5 billion more during that time. The university faculty and staff pension program needs roughly $804 million, according to the study.

Tier 2 pensions were introduced in 2011 and were immediately controversial because they were far less lucrative than the Tier 1 pensions. Anyone hired before its introduction was in a Tier 1 pension plan. The biggest change in Tier 2 was a cap on earnings.

A Tier 2 pension is based on the average salary of the highest eight consecutive earning years during the employee's last 10 years of work, but subject to a $119,982 cap this year. Tier 1 pensioners have no cap and their final rate of earnings is generally the average of the four highest earning years of the past decade. Meanwhile, Social Security bases retirement benefits on salaries as high as $160,200.

Both the Tier 2 and Social Security salary caps change annually, but they use different formulas. The study suggests the state use the Social Security formula going forward to avoid violating the "safe harbor" requirement.

"Everybody knew Tier 2 was in violation of safe harbor. It was kind of like Captain Obvious. But now we have a number," said state Rep. Stephanie Kifowit, an Oswego Democrat and chair of the House Personnel & Pensions Committee. "And it's a small part of the unfunded liability that already exists in those pension systems because of fiscal mismanagement of the past."

Kifowit said she introduced legislation last session that would have fixed the Tier 2 issue, but the bill never made it out committee.

The $5.6 billion needed represents 4% of the $137.9 billion already earmarked for those pension systems through 2045, according to the study.

However, Illinois Federation of Teachers President Dan Montgomery said the "safe harbor" problem is just one of many issues with Tier 2 pensions.

"We have a teacher shortage now and it's clear the problem is pensions," he said. "I certainly hope this report helps start the public conversation we are going to need to have."

Other pension systems are affected as well. Earlier this year, legislation was passed that allowed Cook County to change its Tier 2 salary cap to mirror Social Security's earnings rate going forward. Most of Chicago's pension plans will have to do the same. The Illinois Municipal Retirement Fund will not, though, because employees and employers pay into Social Security and ultimately receive the benefit along with their pensions.