Dissecting Illinois’ Pension Problem Part III: Understanding Tiers

The following is a continuation of Dissecting Illinois’ Public Pension Problem Part II: Modeling Pensions.

Overview

Public employees are separated into two tiers, depending on when they began employment, and each tier contains a different vesting structure for their pension. The two tiers are simply referred to as Tier I and Tier II.

Tier I Employees

Tier I is made up of employees who started working and contributing to their pension prior to January 1, 2011. Before 2011, there was only one tier and most employees would receive a defined benefit with their pension. This means that the retirement benefit for employees would increase at a fixed rate over the years, subject to the pension formula and different criteria, to help cope with inflation. Employees in Tier I can start collecting the full benefit at age 62 as long as they have served at least five years. Members generally can start collecting the full benefit at a younger age with longer terms of service. For example, employees can collect the full benefit as low as age 55 if they have at least 35 years of service.

As underfunded pension liabilities continued to grow over the years, it became apparent that action was needed to mitigate and reduce liabilities. In 2010, the General Assembly passed Senate Bill 1946 which created a two tier pension structure for employees who began working after 2010.

Tier II Employees

Public Employees hired after 2010 are Tier II employees. These employees are subject to more strict criteria on when they can start collecting their full pension benefit and how the pension will grow overtime. While benefits for Tier I employees mostly contain a defined benefit, benefits for Tier II employees are subject to a defined contribution. This means growth is tied to the Consumer Price Index (CPI). The retirement benefit for Tier II employees will either increase at 3 percent or half-of-the-rise of CPI, whichever is lower.

Tier II also sets new regulations on when employees can start collecting the full benefit at retirement. Unlike Tier I employees, Tier II employees cannot fully collect the full pension benefit until at least age 67 with at least 10 years of service. If the employee decides to retire before age 67 or if they have less than 10 years of service, the payout of the benefit will only be a certain percentage of the full benefit moving forward throughout retirement.

Why the Need for Two Tiers?

By Summer 2009, underfunded pension liabilities had reached about $62.4 billion with a funding ratio of only 50.6 percent. Some later assumptions put liabilities at $77 billion and a funding ratio of 38.5 percent. It was apparent that if no action was pursued, the growing underfunded liabilities would continue to eat up more and more of the State’s budget. Moreover, the more in benefits that State is obligated to pay to retirees, the more in revenue the state needs to meet those obligations. If there are not enough members currently in the system making contributions or if taxpayer revenue is scare, that is a recipe for major solvency concerns (see Part II). In effect, the General Assembly passed Senate Bill 1946 Spring 2010 curtail rising liabilities and reform the pension system.

So how did we get here? Historical evidence suggests the perpetuation of underfunded liabilities was the folly of many and not subjected to a single action. In fact, it was the compounded effect of many various decisions made by different individuals over decades. The next piece in our series will provide a historical look at how Illinois’ underfunded pension liabilities grew overtime.

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