Note: Rep. Dwight Kay submitted legislation (HR31) requiring an immediate discovery and forensic audit of the Illinois pension plans. It’s a good idea…

By MARY WILLIAMS WALSH
Published: September 17, 2010
Click here to read the original article.

Earlier this year, Illinois said it had found a way to save billions of dollars. It would slash the pensions of workers it had not yet hired. The real-world savings would not materialize for decades, of course, but thanks to an actuarial trick, the state could start counting the savings this year and use it to help balance its budget.

Gov. Pat Quinn of Illinois approved a plan in April that seemed to help balance the budget, but it may imperil the pension fund.

Actuaries, including some who serve on the profession’s governing boards, got wind of what Illinois was doing and began to look more closely. Many thought Illinois was using an unorthodox maneuver to starve its pension fund of billions of dollars, while papering over a widening gap between what it owed and how much it had. Alarmed, they began looking for a way to discourage Illinois’s method before other states could adopt it.

They are too late. The maneuver, and techniques that have similar effects, are already in use in Rhode Island, Texas, Ohio, Arkansas and a number of other places, allowing those states to harvest savings today by imposing cuts on workers in the future.

Texas saved millions of dollars this year after raising its retirement age for future hires and barring them from counting unused sick leave in their pensions. More savings will appear in coming years. Rhode Island also raised its retirement age for future retirees last year, after being told it could save $90 million in the first year alone.

Actuaries have been using the method for years, it turns out, but nobody noticed, in part because official documents usually describe it in language few can understand.

The technique is fairly innocuous in normal times, allowing governments to smooth out their labor costs over many years. But it becomes much riskier when pension funds have big shortfalls, when they need several decades to pay down their losses and when they are cutting benefits for future workers — precisely the conditions that exist today.

“In a plan that is not well funded, I wouldn’t recommend it,” said Norm Jones, chief actuary for Gabriel Roeder Smith & Company, an actuarial firm that helps Illinois and a number of other states that have adopted the method. He said the firm’s actuaries informed officials of the risks and it was the officials’ decision to use the technique.

Struggling states and cities need to save money, but they run into legal problems if they tamper with the pensions their current workers are building up year by year. So most places have opted to let current workers and retirees go unscathed. Colorado, Minnesota and South Dakota are the exceptions, dialing back cost-of-living increases for people who have already retired. All three states have reaped meaningful savings right away, and all three are being sued.

Cuts for workers not yet hired do not save much money in the present — but that’s where actuaries can work their magic. They capture the future savings for use today by assuming, in essence, that 100 percent of today’s work force is already earning tomorrow’s skimpier benefits. When used in actuarial calculations, that assumption has a powerful effect. It reduces the amount a government must put into its workers’ pension fund every year.

That saves the government money. But it undermines the pension fund, which must still pay the richer benefits of today’s retirees. And because the calculations are esoteric, it is hard for anyone except a seasoned actuary to see what is going on.

“Responsible funding methods do not work this way,” said Jeremy Gold, an independent actuary in New York who has been outspoken about the distortions built into pension numbers. He said the technique was much like the mortgages with very low teaser rates that proliferated during the housing bubble.

“You aren’t paying down your principal,” Mr. Gold said. “You’re not even keeping up with the interest. You are actually increasing your debt every year.”

Dubious pension numbers in Illinois are not easily shrugged off after a warning shot fired by the Securities and Exchange Commission in August. The S.E.C. accused New Jersey of securities fraud, saying the state had manipulated its pension numbers to look like a better credit risk, while selling some $26 billion worth of bonds. The S.E.C. had never before taken action against a state. Now the commission is flexing its muscles, unleashing a team of specialized enforcement officials to look for more misleading public pension numbers.

An official with the S.E.C. declined to comment on Illinois’s maneuver. Commission rules bar officials from discussing investigations or revealing whether one might be in progress. Kelly Kraft, a spokeswoman for the Illinois Governor’s Office of Management and Budget, said the S.E.C. had not contacted the state and officials were confident that their disclosures were complete and accurate.

Officials in Rhode Island did not respond to phone calls seeking information about how the state achieved its pension savings. In other states, including Texas and Arkansas, officials said they were confident they were in compliance with the relevant statutes.

Actuaries must disclose their methods and assumptions, but this one has been hidden in plain view because it often goes by the name of a method that is widely used and is accepted by the Governmental Accounting Standards Board.

The technique falls into a family of complex and subtle calculations called “cost methods,” which actuaries use to spread pension costs over many years. Few outside of the profession know how the cost methods work or what their names mean.

Illinois issued public documents this year naming its cost method as one that did not permit the cost of future employees’ benefits to be factored into the current year’s contributions. The apparent contradiction caught actuaries’ attention.

Sandor Goldstein, an actuary in Springfield, Ill., who helps the state operate some of the pension funds in its big system, acknowledges that Illinois’s disclosures are “somewhat misleading.”

Mr. Goldstein made his remarks in a letter requested by the state, after an article in The New York Times raised questions about Illinois’s numbers. He recommended that the state clarify its disclosures.

He also said he had warned the state that its funding method “may not be an appropriate one.”

Mr. Jones, of Gabriel Roeder Smith, said Illinois’s disclosures might be “an incomplete description of the process,” but added that state officials “were probably trying not to get into a lot of technical detail that would be poorly understood anyway.”

Illinois’s pension funds are more fragile than most, but their survival is essential to thousands of people. The state’s teachers and certain other workers do not participate in Social Security, so for them, the pension fund is their only source of retirement income.

Frank Todisco, senior pension fellow at the American Academy of Actuaries, declined to comment on the situation in Illinois, but said the Actuarial Standards Board was working on revised standards that, if adopted, would clarify actuarial assumptions and lead to more detailed descriptions of risk.

“It’s a deliberative process,” he said. “We have to follow due process, and that sometimes takes a long time from start to finish.”

It can easily take several years to revise an actuarial standard. That may not be fast enough to help Illinois’s pension system, which continues to sink.

“When you’re in a deep hole, it’s a long way out,” said Mr. Jones.