1. State & Local Pensions + IRAs October 3 & 5, 2006

2. 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 plans Discuss the State University Retirement System (SURS) of Illinois

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

4. Traditional IRAs Receive immediate tax deduction Money grows tax-free (inside buildup) Pay ordinary income tax rates upon withdrawal Contribution limits 10% penalty if withdrawn before 59½ Must begin withdraws by 70½

5. Roth IRAs Do NOT receive up front tax deduction Money grows tax free (inside buildup) No taxes at withdrawal Contribution limits But in actuality, this allows person to put in MORE of before tax earnings into a Roth

6. 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

7. Eligibility for Roth IRA Modified AGISingleMarried filing jointly < $95kFull contrib. $95k – 110kPartial contrib.Full contrib. $110k – 150kNot eligibleFull contrib. $150k – 160kNot eligiblePartial contrib. > $160kNot eligible Can contribute at any age (even >70)

8. Contribution Limits Age < 50Age 50+ 2006-07$4,000$5,000 2008$5,000$6,000

9. 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

10. 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

11. Rollovers When 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 IRA Most dollars now held in IRAs are from rollovers

12. How Big are IRAs? TypeMillions of HHs Median Holdings Any IRA42$20,000 Traditional35$37,300 Roth13$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

13. National Savings As a nation, we care about national saving rate because saving is what funds investment, and investment is what funds future economic growth Nat’l Sav’g = Private Sav’g + Gov’t Sav’g Do targeted savings vehicles increase national saving?

14. Does Tax Deferral Increase National Saving? Not necessarily. Some tax-deferred saving would have occurred even if there were not tax deferral Tax deferral reduces government revenue  decreases government saving A debate among economists over the extent to which targeted savings plans increase saving versus subsidizing saving that would have occurred anyway Relevant in debates over pensions, IRAs, tax policy, Social Security, etc.

15. State & Local Work Force 16 million state and local employees in the US About 12% of U.S. labor force 54% of employees in education field Highly unionized (37% vs. 8% in private sector) Another 4 million retirees

16. 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 state Lawmakers 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

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

18. Sources of the Funding Problem? Same “perfect storm” that hurt corporate plans Falling asset values Falling interest rates Chronic under-funding Pension “holidays” No regulatory body enforces contributions Political “give-aways” Generous increases in benefits without specifying how they would be paid for

19. How Fill the Shortfalls? Reduce pension spending Hard to do if benefits are guaranteed Raise taxes Politically difficult Cut other spending Schools? Medicaid? What gets cut? Naively believe in a free lunch “Pension Obligation Bonds” – imposes risk on the taxpayer (more on this shortly)

20. The State of Illinois 5 th highest income state in the nation Second worst pension funding status in the nation Illinois has 5 large state pension funds Combined, about $35 billion underfunded State budget is about $43 billion 2005: State owed its pensions $2.6 billion Within 5 years, over $4 billion annually For comparison, we spend about $6 billion on K- 12 public education in Illinois

21. 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 employees More give-aways: in past 10 years, the legislature has added nearly $6 billion in new benefits (largely early retirement incentives)

22. SURS State University Retirement System of Illinois as a “case study” As of 3/31/06, SURS had: Assets = $14.5 billion Liabilities = approx $21.5 billion Funding ratio = 68%

23. Three SURS Plan Traditional 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 early A “self-managed” DC plan This one is fully funded by definition

24. “Pension Obligation Bonds” Governor Blagojevich in 2004 Issued $10 billion in pension obligation bonds Used roughly $2.5 billion to make the annual contribution to the pension plan Invested 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?”

25. Illinois Public Act 94-0004 Signed 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 7/1/2005 Every new benefit enhancement must be fully funded and must expire after 5 years unless renewed by Legislature Requires a member’s employer to pay the actuarial value of increased benefits that arise because of earnings increases >6% over prior year

26. Other provisions … May help, but may not Removes SURS Board power to set the effective interest rate for money purchase plan and gives power to state Comptroller Creates an “Advisory Commission on Pension Benefits” to prepare a report on how to solve pension problem