State & Local Pensions + IRAs

October 3 & 5, 2006

By the end of today you should be able to:

Explain in a bit more detail how an IRA works, and the basic difference between a “traditional” IRA and a “Roth IRA”Explain the status of US state and local pension plansDiscuss the State University Retirement System (SURS) of Illinois

Overview of IRAsIndividual Retirement Accounts (IRAs) were first introduced in 1974 for those without pensionExpanded in 1981 to include everyone and raise contribution limitsTax Reform Act of 1986 scaled back tax deferral Taxpayer Relief Act of 1997 created new Roth IRAsEconomic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) raised contribution limits

Traditional IRAs

Receive immediate tax deductionMoney grows tax-free (inside buildup)Pay ordinary income tax rates upon withdrawalContribution limits10% penalty if withdrawn before 59½Must begin withdraws by 70½

Roth IRAs

Do NOT receive up front tax deductionMoney grows tax free (inside buildup)No taxes at withdrawalContribution limits

But in actuality, this allows person to put in MORE of before tax earnings into a Roth

Eligibility for Traditional IRA

Everyone under age 70½ with earned income is eligible. No income limit.However, the deductibility of contributions does depend on income as well as whether you are covered by a qualified plan at work

Eligibility for Roth IRA

Modified AGI Single Married filing jointly

< $95k Full contrib. Full contrib.

$95k – 110k Partial contrib.

Full contrib.

$110k – 150k Not eligible Full contrib.

$150k – 160k Not eligible Partial contrib.

> $160k Not eligible Not eligible

Can contribute at any age (even >70)

Contribution Limits

Age < 50 Age 50+

2006-07 $4,000 $5,000

2008 $5,000 $6,000

Which is Better?If tax rate while contributing is same as tax rate at withdrawal, then there is “no difference”

=$1 x (1+r)t x (1-withdraw) [traditional]

=(1-contribute) x $1 x (1+r)t [Roth]

However, you are, in a sense, contributing “more” to Roth because it is after-tax dollars

Which is better?

If tax rate while working > tax rate in retirement choose traditional IRA

Pay lower tax rate in retirement

If tax rate while working < tax rate in retirement choose Roth IRA

Pay lower tax rate now

RolloversWhen you leave employer with vested pension benefit, you must either leave the money in the plan, “roll it over” to a plan at a new employer, or “roll it over” into an IRAMost dollars now held in IRAs are from rollovers

How Big are IRAs?

Type Millions of HHs

Median Holdings

Any IRA 42 $20,000

Traditional 35 $37,300

Roth 13 $12,400

Employer Sponsored

8 $30,000

In 2001, there were $2.1 trillion held in IRAs$1.8 trillion in DB plans, and $2.4 trillion in DC plans

National Savings

As a nation, we care about national saving rate because saving is what funds investment, and investment is what funds future economic growthNat’l Sav’g = Private Sav’g + Gov’t Sav’gDo targeted savings vehicles increase national saving?

Does Tax Deferral Increase National Saving?

Not necessarily.Some tax-deferred saving would have occurred even if there were not tax deferralTax deferral reduces government revenue decreases government savingA debate among economists over the extent to which targeted savings plans increase saving versus subsidizing saving that would have occurred anywayRelevant in debates over pensions, IRAs, tax policy, Social Security, etc.

State & Local Work Force

16 million state and local employees in the US

About 12% of U.S. labor force54% of employees in education fieldHighly unionized (37% vs. 8% in private sector)

Another 4 million retirees

State & Local Pensions

Unlike in the corporate world, traditional DB plans are still the norm here

90% of state/local workers have DB plans

Benefits often “guaranteed” by the stateLawmakers often powerless to reduce benefits to existing employees

These plans are, in general, not governed by ERISA, and thus there is no requirement that they be kept fully funded

Funding Status

The unfunded liability of state & local pension plans is roughly $278 billion at end of 2003Barclay’s estimate: if these funds accounted for pensions the same way as corporate plans, shortfall would be about $700 billion

Sources of the Funding Problem?

Same “perfect storm” that hurt corporate plans

Falling asset valuesFalling interest rates

Chronic under-fundingPension “holidays”No regulatory body enforces contributions

Political “give-aways”Generous increases in benefits without specifying how they would be paid for

How Fill the Shortfalls?

Reduce pension spendingHard to do if benefits are guaranteed

Raise taxesPolitically difficult

Cut other spendingSchools? Medicaid? What gets cut?

Naively believe in a free lunch“Pension Obligation Bonds” – imposes risk on the taxpayer (more on this shortly)

The State of Illinois

5th highest income state in the nationSecond worst pension funding status in the nationIllinois has 5 large state pension funds

Combined, about $35 billion underfundedState budget is about $43 billion2005: State owed its pensions $2.6 billionWithin 5 years, over $4 billion annuallyFor comparison, we spend about $6 billion on K-12 public education in Illinois

Why is Illinois such a Basket Case?Lack of political will: since 1970, there has never been a year in which Illinois has fully met its pension obligations“Impairment clause” – state constitution prohibits Legislature from making any changes that would “impair” benefits to existing employeesMore give-aways: in past 10 years, the legislature has added nearly $6 billion in new benefits (largely early retirement incentives)

SURS

State University Retirement System of Illinois as a “case study” As of 3/31/06, SURS had:

Assets = $14.5 billionLiabilities = approx $21.5 billionFunding ratio = 68%

Three SURS PlanTraditional DB is very generous

Employees get the “best of” three different approaches to calculating benefits, including:

• A “final average salary” plan• A “money purchase” plan that provides guaranteed

rate of return well in excess of risk free government bond rates

There is also a “portable DB” that pays less than DB, but which gives you more if you terminate employment earlyA “self-managed” DC plan

This one is fully funded by definition

“Pension Obligation Bonds”Governor Blagojevich in 2004Issued $10 billion in pension obligation bondsUsed roughly $2.5 billion to make the annual contribution to the pension planInvested the remaining $7.5 billion with the hopes that he can use this $7.5 billion plus interest to repay the $10 billion plus interest

“If only it were so easy”“Why stop there?”

Illinois Public Act 94-0004Signed June 1, 2005

Makes things worse:Reduces states pension contributions for this year, thus making the problem larger

Makes things better:Removes money purchase option from DB plan for new employees hired after 7/1/2005Every new benefit enhancement must be fully funded and must expire after 5 years unless renewed by LegislatureRequires a member’s employer to pay the actuarial value of increased benefits that arise because of earnings increases >6% over prior year

Other provisions …

May help, but may notRemoves SURS Board power to set the effective interest rate for money purchase plan and gives power to state ComptrollerCreates an “Advisory Commission on Pension Benefits” to prepare a report on how to solve pension problem