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Leadership needed for Illinois pension reform, expert says

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The state of Illinois needs to get serious and create a fiscally sustainable pension-reform plan, warns University of Illinois finance professor Jeffrey R. Brown.

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3/17/2011 | Phil Ciciora, Business & Law Editor | 217-333-2177; pciciora@illinois.edu

CHAMPAIGN, Ill. – The state of Illinois needs to get serious and create a fiscally sustainable pension-reform plan, a former government economic adviser warns.

University of Illinois finance professor Jeffrey R. Brown says it's time for Illinois lawmakers to have an adult conversation with citizens about the state's bleak financial future, and the role that pension obligations play in the Land of Lincoln's yawning budget deficit.

"The conversation that we've had in Illinois about pensions so far has been very frustrating," said Brown, the director of the Center on Business and Public Policy in the U. of I. College of Business.

"It has unfortunately devolved into a combative debate about the relative value of public versus private sector workers, rather than a reasoned discussion about the optimal level and mix of pensions and other employee benefits as part of the overall compensation package for public workers. We need someone to step up to the plate and lead a thoughtful, nuanced conversation about this. But I don't know where that leadership is going to come from in the current environment."

The most vocal critics of pension reform in the current debate are current or near-retirees – "people who have been scared into thinking their retirement is at risk, which I don't think is a good place for this discussion to start," Brown said.

"Current and near-retirees need to be reassured by our state leaders that their pensions are safe. But we also need our legislators to start looking for a solution that recognizes the need to do something about reforming pensions for younger workers."

According to Brown, a history of underfunding the state's defined benefit plan has created an unsustainable financial burden for the state.

"Politically, we have the same problem with state pensions as we do with the underfunded Social Security system," said Brown, a former member of the bipartisan Social Security Advisory Board and a senior economist with the President's Council of Economic Advisers in 2001-2002.

"If you accept the notion that we're going to protect current and near-retirees, then the people who have the most at stake in this debate are those in the younger generation," he said. "They are the ones who will have to spend the rest of their lives paying the taxes to support this system, so we're really also talking about their taxes and their benefits. But it's difficult to get the younger generation fired up about these issues. It's unfortunate, but it's reality."

Although the state needs to protect those who are at or near retirement, Brown said current workers who are at least a decade away from retirement have plenty of time to adjust their behavior if changes are made to the defined benefit program.

"Public sector workers aren't so different from private sector workers that we can't discuss these things," he said. "What I find especially puzzling is the idea that taxpayers should be obligated to protect the current pension rules into the indefinite future for younger workers. If you're in your 20s, 30s or even your 40s, there is a good contractual case to be made that any and all benefits you've earned so far ought to be protected. But you might have another 20 or 30 years left to work in the system, and is it really reasonable to think that we can't have a conversation about what your retirement package should look like going forward from today? That's not a sensible way to run the state's fiscal policy, and that's what needs to change."

Brown cautions that he's not in favor of shifting workers from defined-benefit plans to state-sponsored 401(k) plans.

"To be clear, I'm not talking about throwing public workers into the deep end of the pool and seeing if they can swim, which is what has been done in the private sector with many traditional 401(k) plans," he said. "The private sector initially went a bit too far in that direction, and there's a lot of empirical evidence to suggest that the average person doesn't have the financial sophistication needed to make optimal decisions in a do-it-yourself environment. So the traditional 401(k) model isn't the answer."

Brown believes a smartly designed hybrid system – with a smaller defined benefit supplemented with an income-oriented defined contribution plan that is more akin to a 403(b) plan than a 401(k) – could be a better solution for both workers and state coffers.

"If we were designing a retirement system from scratch today, we wouldn't give someone only a state-funded defined benefit program, nor would we give them only a 401(k)," he said. "The idea of a hybrid plan is to acknowledge that there is some value to having a baseline level of guaranteed income for people who aren't in Social Security, but that there is also value to providing individuals with more control over part of their retirement plan."

Brown says a lot of workers, especially younger workers, would find having more control over their retirement savings attractive, especially since many younger workers "don't have any confidence in the state's ability to make good on their financial commitments in the long run," he said.

"To the extent that younger workers would be willing to accept a reduction in their expected future benefits in exchange for the increased security of having a fully-funded personal account, such an approach could save the state money in the long run," Brown said. "Because states cannot escape their funding obligations for defined contribution plans in the same way that they can for defined benefit (DB) plans, this approach would also enforce some much-needed fiscal discipline on the state."

But what's particularly problematic in Illinois is the Illinois Constitution's non-impairment clause, which will likely handcuff any attempt to enact pension reform or modernization plans, Brown said.

"The problem is, depending on whether the courts interpret the constitutional non-impairment clause as applying only to accrued benefits or to all future benefits for existing employees, we may be stuck in a world in which we cannot implement such a reform for everyone," he said.

"If that's the case, then we ought to consider a system that allows younger workers to voluntarily opt-out of the existing DB system and into the hybrid system. Research in other contexts suggests that many people would be interested in that type of retirement package."

Brown, the William G. Karnes Professor of Finance at Illinois, has been a member of the TIAA Board of Trustees since 2009.

Editor's note: To contact Jeffrey R. Brown, call 217-333-3322; e-mail brownjr@illinois.edu.

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