Originally posted at www.calpensions.com

Illinois state pension systems are the worst-funded in the nation — called a “crisis” by the governor, “unfixable” by a Chicago business group — and they share a problem with CalSTRS: years of deliberate underfunding.

A website unveiled by Illinois Gov. Pat Quinn last month, featuring a cartoon “Squeezy the pension python” crushing the Capitol, says state pension costs tripled in five years and are projected to exceed state spending on K-12 schools by 2016.

A video on the website by Salman Khan, an online educator, explains that growing pension costs are squeezing the money available for schools, public safety and health care.

Like other pension funds, the five Illinois state pension funds were hit by big investment losses during the decade. But what sets Illinois apart, with a funding level that fell to 38 percent, is the failure to make actuarially required contributions.

“The funding crisis is the result of the deliberate underfunding of pensions year after year, a practice as old as the pension funds themselves, dating back to the creation of the first pension fund: the Teachers’ Retirement System in 1939,” says the governor’s website.

Most California public pensions get actuarially required contributions. Unlike Illinois, nearly all of the retirement systems here have the power to set annual rates calculated by actuaries that must be paid by state and local government employers.

(The bankrupt city of San Bernardino stopped making payments to the pension fund. The California Public Employees Retirement System is asking a federal court to find the city ineligible for bankruptcy and a state court to force payment.)

Moreover, a labor-backed initiative, Proposition 162 in 1992, requires pension boards to give top priority to protecting pensions, a change from previous law that gave equal standing to minimizing taxpayer costs.

A notable exception to pension board power is the California State Teachers Retirement System, whose rates are set by the Legislature. For more than five years, the CalSTRS board has been urging the Legislature to raise rates.

But the state has been deep in red ink for most of the last decade and has made major spending cuts. The Legislature has chosen to deliberately underfund CalSTRS, rather than squeeze funding for other programs.

Now actuaries calculate the annual contribution to CalSTRS would have to be increased by two-thirds, about $3 billion a year, to project full funding of pension obligations over the next 30 years.

An increase of that magnitude seems unlikely, even though a voter-approved tax increase last month and a slowly improving economy may be moving the state budget toward the black and a possible surplus if spending is controlled.

The best CalSTRS may hope for is a modest increase phased in over several years, a plan that falls far short of full funding in the standard 30 years but, at a minimum, delays the date the fund is projected to run out of money, now about 2046.

Critics argue that even if the actuarially required contribution is being made, public pension funds are still being seriously underfunded because pension fund earnings forecasts are too optimistic.

Pension funds make forecasts of future revenue and costs to set contribution rates needed to pay for pensions earned during a year. And crucially, two-thirds of the revenue usually is expected from investment earnings, which are difficult to predict.

CalSTRS and CalPERS have both lowered their earnings forecast to 7.5 percent a year, down from 7.75 percent. The largest of the Illinois pension funds, the teachers system, this year lowered its earnings forecast to 8 percent, down from 8.5 percent.

A small drop in the earnings forecast can cause a big increase in the contribution rate. Lowering the CalSTRS forecast from 7.5 to 7 percent would add about $750 million to the additional $3 billion a year needed to project full funding in 30 years.

Although the earnings forecast is the big one, some suspect pensions may be underfunded, even while making actuarially required contributions, by inflating asset values, lengthening periods for paying off debt, delaying rate increases and other means.

CalPERS adopted a policy that spreads gains and losses over 15 years, well beyond the three to five years used by most funds. The aim is to “smooth” contribution rates, avoiding big annual swings as the stock market rises and falls.

The radical smoothing policy is part of the reason that the CalPERS funding level, about 70 percent of assets projected to be needed for full funding in 30 years, is nearly the same as the CalSTRS funding level, 69 percent.

While the CalPERS funding level may have been held down by actuarial policy, the CalSTRS funding level may have been increased by two automatic contribution increases.

A 10-year diversion of a quarter of the teacher contribution (2 percent of pay went into an individual investment fund with a guaranteed return) ended last year. Old legislation is pushing the state contribution from 2 percent of pay to 3.5 percent by 2016.

Neither pension fund has recovered from huge investment losses during the recession. The CalPERS fund peaked at $260 billion in 2007 and was valued at $245 billion last week. CalSTRS peaked at $180 billion and was at $155 billion on Oct. 31.

The CalPERS policy that keeps employer rates low has political overtones. The 15-year smoothing was adopted in 2005 as former Gov. Arnold Schwarzenegger briefly advocated switching new state and local government workers to 401(k)-style plans.

Public pension systems worry about getting swept up in the trend that has private-sector employers switching from pensions to 401(k) individual investment plans to avoid long-term debt.

A structural problem for pensions is that the need for contributions can go up as the ability of employers to pay goes down. A sagging economy that drops investment earnings below the forecast also can reduce tax revenue, straining government budgets.

A CalPERS policy that restrains rate increases in hard times eases the squeeze on government budgets, reducing the need for painful budget cuts. Critics might argue that debt is being pushed into the future and the need for sweeping pension reform concealed.

But whether its prudent or risky policy, CalPERS has the safeguard of being able to raise rates to keep funding moving in the right direction. The red line is fuzzy. The traditional view has been that a funding level of 80 percent is adequate.

One of the three major credit rating agencies, Fitch, said last year that it “generally considers a funded ratio of 70 percent or above to be adequate and less than 60 percent to be weak.”

CalSTRS has the task of persuading the Legislature that a return to good economic times will not yield the investment earnings needed to get its funding level moving up rather than down.

Illinois is an example of what can happen when pensions are deliberately underfunded. An analyst for the nonpartisan Illinois Policy Institute criticized Gov. Quinn for suggesting a “federal bailout” of the state’s pension funds.

The governor’s fiscal year 2012 budget said “significant long-term improvements will come only from additional pension reforms, refinancing the liability and seeking a federal guarantee of the debt.”

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/ Posted 10 Dec 12