Update on Illinois Pension Reform

For updated information on this subject please read our latest blog post. This year has seen a flurry of lawsuits related to Illinois Pension Reform, including previous changes made to the State Retiree Health Insurance.  Many of the cases are still in process, but here is an update on what we know:

Pension Reform

In late 2013, Illinois General Assembly passed a bill aimed at reforming the pension systems for most Illinois public employees and Governor Pat Quinn signed the bill into law.  This bill reduced future benefit increases for current retirees and decreased expected benefits for those not yet retired.  Lawsuits quickly followed questioning the constitutionality of this law.  The law was slated to go into effect as of June 1, 2014, but was suspended pending resolution of these lawsuits.  This means that SURS and other State Retirement Systems are operating under the rules as they existed before pension reform was passed.

You can see my summary of the pension reform in two prior blog posts from December 6th and December 23rd.  You can also view a SURS press release regarding the halting of pension reform here.

Health Insurance

Before the pension reform discussed above, changes were made in 2012 requiring State Retirees to contribute towards the cost of their health insurance by a  2% deduction from their pension (1% for retirees enrolled in Medicare).  Like pension reform, lawsuits were filed challenging this law.  The opinion of many experts at the time of passage was that Retiree Health insurance was a separate benefit from pension benefits and therefore not constitutionally guaranteed.  This was further backed by an initial court ruling.  Since that time, there has been more action by the courts.

First, the Illinois Supreme Court overturned the lower court's decision by ruling that Retiree Health insurance is in fact protected by the same constitutional provisions that protect pensions.  Then, shortly after, another ruling halted the July 2014 planned increase in premium contributions to be made by pensioners.  Finally, a ruling this week determined that the state may no longer deduct health insurance premiums from retirees' pensions.

You can read more about this change here.

Implications

It is still too early to make substantial planning decisions.  Immediately, retirees can expect their pension benefit to increase in the next month or two as health care deductions are halted.  It is also possible that previously deducted premiums will be refunded.  For retirees who previously deducted premiums paid as an Medical Expenses under their Itemized Deductions on their tax returns, they may have to claim refunds as income.

Additionally, some retirees opted out of state insurance in favor of alternative Medicare Supplemental, Medicare Advantage or other policies.  This might sway those retirees to return to the state plan during open enrollment for 2015.

Longer term the State's position on pension reform looks more weak, but this is a complex legal matter.  I expect we are a long way from any final resolution.

Further Clarification on Illinois Pension Reform

Updated information on this subject can be found in our latest blog post. This post follows up my initial posting about Illinois Pension reform and specifically how it impacts State University Retirement System (SURS) members.  You can read my original post here.

Notwithstanding the likely legal challenges of pension reform, many items are subject to interpretation in the new law.  It is likely additional legislative guidance will be needed to fully understand the impact of these reforms.  This post is based on information from a knowledgeable representative of SURS, but may change in the future.

Pensionable Earnings Limits

See the original post for complete details on this change.  A question that arose is, if your income currently exceeds the limit, how would your future contributions be affected?

SURS interpretation is that your contributions will be based on pensionable earnings.  Similar those who contribute to social security, no SURS contributions will be required on salary exceeding the limit.  If your salary is grandfathered in, contributions are up to your grandfathered salary.  No future pay increases exceeding the limit will increase your grandfathered limit or contributions.

For example, your salary in 2013 is $150,000.  The pensionable earnings limit is $110,631.26.  You receive a pay increase to $160,000.  Your pensionable limit remains at $150,000 and contributions are based on salary up to that limit.

Future raises will not increase your grandfathered limit, which is equal to the participant’s annualized rate of earnings as of June 1, 2014.

Money Purchase Changes

This was not mentioned in my last posting, but changes are also being made to the Money Purchase Formula, which is one of three options for calculating your defined benefit pension.  The annuity under this method is calculated by a cash value (determined from contributions made by the employee, employer, plus an effective interest rate determined annually).  If used, this system determines the annuity from cash value using an actuarial table.  The larger the cash value, the larger the annuity (up to limits).  The effective interest rate of that cash value going forward will be the 30-year US Treasury bond rate plus 75 basis points (0.75%).  Estimating the current 30-year US Treasury bond rate at 3.85%, the current Effective Interest Rate would be equal to 4.6%.  Compare this to the effective interest rate 7/1/12 through 6/30/13 of 7.5%.  As the interest rate is decreased, the potential cash value will grow more slowly therefore slowing the potential growth of the annuity.

This will also affect purchasing of service credit and the refund for those in the Portable system.

You should also note, the actuarial assumptions used in determining the annuity tables may now be revised annually.  If experienced lifespans are increased or earnings are decreased, annuities calculated under this system would also decrease.

Pension Reform for SURS Participants

This past week, the Illinois General Assembly passed a bill aimed at reforming the pension systems for most Illinois public employees and Governor Pat Quinn has signed the bill into law.  It is likely too early to begin a full assessment of what these changes mean for participants, including those in the State University Retirement System (SURS).  Time will be needed to fully review, interpret and digest the implications of the entire 327 page bill.  Additionally, lawsuits to contest the constitutionality of this bill are expected and will take time to resolve. At this point, we know very little.  The following is an attempt to summarize key provisions and begin thinking about planning to be done in the future.  As so much is unknown, it is likely too early to begin making decisions regarding your employment or retirement prospects.  This includes trying to contact SURS for an assessment of your individual situation.  Below are some of the key provisions with some of my own planning commentary in red:

Note: 

• A Tier 1 participant is an employee or retiree who began SURS participation before January 1, 2011.  A Tier 2 participant is an employee who began SURS participation on or after January 1, 2011.
• This content mostly applies to all pensions, written specifically to those in the SURS system.  A colleague, Dave Grant of Finance for Teachers, has a more thorough blog post specific to the Illinois Teachers' Retirement System (TRS).  You can read his post here.

Automatic Annual Increases:

Beginning in 2015, annual increases for Tier 1 participants will be 3%, compounded annually, but will only apply to the lesser of the annuity or a multiplier equal to $1,000 times number of years of service.  The multiplier will be adjusted annually by inflation (CPI-u).  Since the cost of living adjustment (COLA) was added to the SURS pension in 1989 and has become a large portion of the pension liability, this was a likely target of reform.  In past conversations Karen and I have had with a knowledgeable SURS official, it was this official's opinion this COLA Adjustment was not constitutionally guaranteed.  Soon to be filed court cases will be the final judge.

Retirement Age:

For those under the age of 46 (as of June 1, 2014), retirement eligibility will be delayed.  The younger you are, the longer the delay.

Earnings Limits:

Tier 1 participants will be subject to the same pensionable earnings limits that Tier 2 participants are already subject to (currently about $110,000, adjusted annually).  Participants exceeding this limit at the time of enactment will be grandfathered in at their earnings rate on June 1, 2014.  It appears if your salary is currently over this $110,000 limit, future pay increases will not increase your pensionable earnings except to the extent the pensionable limit exceeds your income.  However, number of years in the SURS system will still affect your final pension.  This is a big loss for higher income earners or those who expect higher income in the future.

Employee Contribution Decrease:

Tier 1 participants will have their contribution decreased by 1%.  This appears to be a point of negotiation in exchange for other losses of benefits.  This will likely be a point of consideration for the courts to judge if this is adequate consideration for lost benefits.  At a minimum, anyone affected may consider contributing that 1% decreased contribution to an alternate retirement savings vehicle such as their 403b or Deferred Compensation Plan.  

Defined Contribution Plan:

Tier 1 participants will have the option of electing into a defined contribution type plan by July 1, 2015.  This will be limited to 5% of participants.  A lot more details are to be worked out here, though it will likely look similar to the SURS Self Managed Plan (401a).  This may be enticing to younger, higher income participants.    

Unused Sick/Vacation Time:

For new hires after June 1, 2014, unused sick and vacation time will no longer be applied towards service credit or enhancing pensionable earnings.

For more details on these changes, see the full bill (SB1 - Click Here) or a summary of changes by SURS (SURS Summary of Senate Bill 1).

Note: It appears many of these changes are not slated to affect participants in the self-managed plan or Tier 2 participants.

The Takeaway:

This is a very contentious issue with various interested parties and real impacts on many people.  It will take a lot of time before all these issues are sorted out.  As more is known, we will be addressing the individual impact with each of our affected clients.  For those who are not our clients, I acknowledge that planning in uncertainty is difficult and stressful.  My best advice is focus on what you can control and build some cushion into your savings plan to deal with the uncertainty.  Contact us if you want the peace of mind of having an experienced Advisor on your side helping to plan for events such as this.

A Simple Strategy to Maximize Open Enrollment

As the year draws to a close, days grow shorter, and the holiday bustle begins, there is one item many are dealing with – Open Enrollment.  This is often the time of year to review and elect changes to your employer benefits for the coming year.  Although this may not make your top 10 holiday task list, here is one helpful tip to maximize your election for the upcoming year: The days of employer pensions are past and today’s worker needs to take responsibility to secure a comfortable retirement.  According to the National Institute of Retirement Security, Americans are doing a poor job of it.  They report the median retirement account balance is only $3,000.  This is nowhere near the $1-2 million figure most professionals quote as needed to ensure financial independence.

Do yourself a favor and make one small change this year.  Increase your own retirement savings contribution by 1%.  You will hardly notice the change.  Assume you earn $40,000 per year and are paid bi-weekly.  An increase of 1% in savings means saving about $15 extra per pay period.  Plus, if you save to a pre-tax account such as an 401k or 403b, you will save tax.  Assuming an average federal and state income tax rate of 20%, your $15 contribution will only result in a paycheck decrease of $12.00 net of tax.  Would you even notice a change that small?

The chart below illustrates the power of increasing your retirement savings annually.  Barney and Eric are both 30 years old earning $40,000 per year.  They each have $3,000 in savings and are saving 5% of income per year.  Eric increases his savings rate by 1% per year until he hits 10% annual savings at age 36.  Assuming they each earn a 7% return on investments over their careers, Barney would end up with savings of $328,000 compared to Eric’s $580,000.

Even though Eric is saving more, he probably does not notice much difference in lifestyle as compared to Barney.  Barney does have more discretionary income throughout his career, but he is likely spending it on goods and services that have little lasting value.  Because he is used to spending more than Eric, Barney needs 5% more annual retirement income.  This means he needs even more savings than Eric to maintain his lifestyle through retirement!  And, if Eric continues increasing savings by 1% each year until he is 41 to achieve 15% savings, he will have $741,000 at retirement.

If you are lucky, your employer might even offer the option to automatically increase your savings each year.  Choosing this election increases your retirement savings on an annual basis or when you get a pay raise.  According to Nudge by Richard H. Thaler and Cass R. Sunstein, these types of automatic options in plans can help you avoid the procrastination that is so common for all of us.

Even if your employer does not automatically adjust for you, you can easily setup a reminder on your Google Calendar.  Otherwise, you can hire me to be your “paid nag” and make sure you are on track to reach financial independence at your desired age!

Moving Jobs, Moving Retirement Plans - New York Times

Changing jobs can be a stressful event.  At the same time you are learning new job responsibilities and acclimating to a new company culture, you have to juggle financial decisions such as choosing new employee benefits.  An often neglected detail of this process is what to do with your old retirement plans.  We often work with clients in “cleaning up” these old accounts that multiply and are lost track of over a career. With all the complexities of rolling over old plans, studies are showing many younger professionals are just cashing these plans out.  I recently discussed this with Ann Carrns of the New York Times.  I explain why I see this happening.  Here is an excerpt from that article:

[Jake] says when young adults are switching jobs, money is often tight — they may be moving, and need financing for rental deposits and other costs — and it is tempting to withdraw the cash.  In addition, he said, it is often difficult for them to envision retirement, when they are just starting their careers.

Besides the tax consequences of this action, which can be high, cashing out small retirement plans cheats the individual out of their most important asset — time.  The more time you have in investing, the less you need to “save” to end up with the same pot of money at the end.  By cashing out now, you are cheating your future self.  By putting off savings, you end up saving more and ending up with less value at retirement.

It is easy to see why someone in their 20′s or 30′s would be so willing to make this trade-off.  Retirement is an abstract concept many years into the future.  I try to counteract this thought by aiming for a different goal.  Replace the concept of “Retirement” with “Financial Independence”.  Financial independence is having the freedom from working to support your lifestyle.  Instead, you have the financial flexibility to work, volunteer or even not work and follow your passions.

The entire article was printed in the October 5th Edition of the New York Times, which you can read online by clicking this link.

Detroit and Public Pensions - Kiplingers

This past month, I spoke with Anne Kates Smith of Kiplinger Magazine on how those in public pensions should react to the the ongoing news regarding the Bankruptcy of the City of Detroit.  She posed the question, what should pension participants expect? Before addressing this concern, I would first start by cautioning everyone to put the Detroit crisis in perspective.  Municipal and Government bankruptcies are rare, and though they do happen from time to time, focusing on the outlier makes us believe this is more common than it really is.  This is a common mental bias we should be aware of.  This is why I always remind clients, focus most of your energy on what you can control because it will have the biggest impact on your future.

Given there is some risk, how should you respond?  I answered:

"Relying solely on your employer is never a good move," [...]

If you can contribute to a supplemental savings plan, such as a 403(b) or 457(b), do so. [...] If you're not offered a savings plan outside a traditional pension, set up your own individual retirement account—even if you don't qualify for tax-deductible contributions. Kuebler tells clients to aim for savings equal to 15% of income, which means that if the state requires you to contribute, say, 8% toward a pension, you should sock away another 7% elsewhere.

Your actual rate of savings may vary based on your own goals and resources, but each employee needs to take some responsibility towards their own retirement.  The State University Retirement System (SURS) for Illinois University Employees and the Teachers' Retirement System (TRS) for public school teachers are a great component of a retirement plan, but needs to be integrated with outside sources of retirement funding as well.

Be sure to check out the complete article in the October issue of Kiplinger or online.