As most observers of Illinois municipal finance are aware, chronic underfunding of public sector pensions is not limited to major entities such as the city of Chicago or the Chicago Board of Education. The approximately 650 public safety (single-employer police and firefighters) pension plans in Illinois are 55% funded, in aggregate. In general, these plans have suffered from years of underfunding by the municipalities that make annual contributions to them.

Beginning in 2011, however, Illinois began requiring municipalities to fund these pensions more substantially, tying the future receipt of state revenue to the full payment of actuarially required contributions, with the goal of achieving eventual 90% funding by 2040. Overall, this revision in state law to address its pension funding woes has led to higher mandatory contributions, which, in turn, has caused a greater share of suburban and downstate (outside Chicago) budgets to be allocated for pension payments. This situation has created fiscal stress for certain municipalities, with negative credit implications, in part due to the limited revenue-raising flexibility of certain Illinois municipalities as well as the inability of others to reduce expenditures to accommodate the increased pension payments within their budgets.

In response, state legislators have proposed the consolidation of suburban and downstate single-employer police and fire pension plans as a solution to reduce costs and ultimately relieve budget pressure. Driving this legislation is the belief that larger pension funds would benefit from economies of scale arising from a larger entity composed of numerous funds. As envisioned by proponents of consolidation, the greater bargaining power of the combined entity would lead to lower costs in the long run as a result of reduced fees and costs. In addition, as backers of these proposals argue, consolidation would create greater investment opportunities, as state law currently limits the types of investments that can be made by smaller pension funds. On the other hand, opponents counter that the potential loss of pension boards' local control through consolidation would eliminate the ability of local governments to control the direction of their pension plans and lead to significant upfront costs. Despite these potential risks, S&P Global Ratings considers consolidation a better alternative to the current system that will likely reduce costs for local governments in the long run. Nevertheless, without additional revenue sources to address escalating pension costs and greater funding discipline, the gains likely to be achieved through consolidation will be inadequate to address Illinois' substantially underfunded public safety pension system.

Proposed Legislation: Seven Different Bills

There are seven separate bills that have been introduced in the Illinois General Assembly during the 2019-2020 legislative session that attempt to address single employer public safety pension underfunding through consolidation:

SB1106/HB1566:  This bill would consolidate all downstate public safety pension funds into the Illinois Municipal Retirement Fund (IMRF), which is the best-funded pension system in the state. Moreover, it would require all newly hired public safety employees to use the IMRF pension formula beginning in 2021. Local pension boards would be abolished upon consolidation. Investment restrictions currently existing for smaller funds would be removed.

SB1107/HB1567:   As proposed, this bill would consolidate downstate public safety pension funds into IMRF. The management of the funds would be under the purview of IMRF, but the process for calculating contribution rates for the pre-existing single-employer police and fire plan would be unchanged. Local pension boards would be abolished. Investment restrictions currently existing for smaller funds would be removed.

SB1108/HB1568:  Senate Bill 1108 and House Bill 1568 would enable eligible pension plans to delegate investment authority to the IMRF, and the local pension boards would therefore lose their investment authority. The local boards would retain control over the administration of certain aspects of the fund, including reporting of quarterly amounts available for investment.

SB1109/HB1569/SB1110/HB1570:  This package of bills would consolidate all downstate police and firefighters' pension plans into a single police pension plan and a single firefighters plan. The local boards would be eliminated and replaced with a single board for the each of the respective plans.

SB1111/HB1571:  This proposed statute would enable eligible pension funds to transfer their investment authority to IMRF. However, the local pension boards would not be eliminated, and they would retain a greater degree of pension fund administration than contemplated by other proposals. Specifically, they would be permitted to determine pension awards and disability determinations.

SB1112/HB1572:  SB1112 would amend current law mandating 90% actuarial funding by 2040. Instead, pension funds would have until 2050 to achieve 80% funding and be required to fund their plans to this level on an actuarial basis. In addition, the state would commission a study to determine the economic feasibility and costs associated with consolidation.

Strength in Numbers? An Analysis of the Potential Gains from Consolidation

One of the principal arguments in favor of consolidation involves the elimination of redundancies and duplication caused by having over 650 different pension plans with investment advisors doing similar work for each of the plans. Through consolidation, costs would be expected to go down in the long run, benefiting Illinois taxpayers, as a significantly larger plan would lead to an overall reduction of fees for these types of services. Similarly, administrative costs and fees involved in the preparation of actuarial reports currently required of municipalities would most likely be lowered in the event police and fire pension plans are subsumed within IMRF or if a single downstate police and fire pension plan were created.

Another likely benefit of consolidation would be greater transparency, which would improve the level of understanding for the investing public and taxpayers of overall funding levels, investment performance, and other key aspects of public safety pensions. Under the current system, individual single-employer public safety plan performance is typically buried in the back of the municipality's annual audit and varies considerably from plan to plan, making it extremely complicated to keep track across plans. With consolidation, particularly if all the police and fire pension plans are merged into two plans, overall annual investment performance, the mix of investments, and specific benefit characteristics would be easier to review and evaluate. In addition, it stands to reason that greater accountability on the part of the decision-makers of a larger pension entity, particularly with respect to investment decisions, would likely ensue as a result of consolidation. Currently, smaller municipal public safety pension funds have limited statewide exposure, and their funding levels and investment choices frequently do not receive much notice outside the municipality itself.

More investment flexibility

In addition, another positive impact that would accrue to a consolidated entity would be greater flexibility with regard to investments. Illinois' pension law limits the types of investments smaller pension funds – those with less than $10 million in assets -- can make. This puts these plans at a disadvantage as to larger pension plans. The proposed new legislation would eliminate this restriction through consolidation. Moreover, the larger size of a consolidated pension entity would likely lead to enhanced capability to diversify investments and reduce risk than currently available to small single-employer plans.

Further, consolidation would introduce another positive feature compared to single employer plans. A consolidated pension entity's larger size would give it improved bargaining power when negotiating investment fees and advice.

Making An Already Bad Situation Worse?

One of the major potential drawbacks of consolidation as proposed by General Assembly involves the significant upfront costs and fees needed to transfer large amounts of assets to IMRF, or to possibly create two entirely new pension funds. While it is unclear how much in commissions and fees would need to be allocated to support consolidation, it is clear these costs would be substantial. As a result, one argument against consolidation is that with pension funds in Illinois already cash-strapped, requiring additional capital to support new pension entities or to transfer sizeable assets in the aim of improving funding, is not fiscally responsible. Further, the liquidation of the assets of the pension funds and their eventual reinvestment into a larger fund as part of a consolidation process could lead to forced suboptimal market transactions and missed gains that would have been available to the currently existing funds in the absence of consolidation.

Potential loss of local control

Another significant potential objection to consolidation is the loss of local control of pension funds, which currently rest with local pension boards. The elimination of local pension boards entirely is one option being discussed legislatively. In such a scenario, investment decisions, disability determinations, and pension awards would likely be rendered by IMRF or a newly created pension fund, which current pension board officials fear may not be attuned to local concerns. Alternatively, another proposal provides for the retention of local pension boards, but would shift investment authority to IMRF. In either proposed scenario, the loss of a source of municipal authority would be significant, and, not surprisingly, has generated resistance from local pension boards.

Consolidation could lead to litigation

There are other potential disadvantages to consolidation. One is the possibility of a protracted legal fight should some form of consolidation be approved by state legislators. The Illinois constitution's pension protection clause, which prohibits the impairment of workers' pension benefits, could provide a source of legal authority for unions to claim that the wholesale shifting of assets and the potential short-term investment losses associated with such a maneuver are legally impermissible. Another weakness of consolidation involves the legislative proposals that authorize the consolidation of the public safety pension funds into IMRF. IMRF is currently the best-funded pension plan in the state, and the reallocation of a collection of weakly funded, smaller pension funds into the state's only well-funded statewide plan may diminish the strength of IMRF's current fiscal stability and funding levels, in addition to raising questions regarding the allocation of the unfunded liability. Furthermore, certain proposals currently pending authorize the use of IMRF funds for "reasonable expenses" to assist with consolidation of the pension funds into IMRF, which could raise the prospect of unforeseen costs that adversely impact IMRF.

Funding levels could deteriorate further

Wwe view SB1112/HB1572 as the weakest of the seven legislative proposals regarding consolidation. As discussed above, this legislation would amend state law mandating 90% funding of the plans by 2040 to permit 80% funding by 2050, and establish a commission to study consolidation. As a general matter, we consider pension plans with funding targets of less than 100% as a credit weakness, because these plans carry higher interest costs associated with the unfunded liabilities. In our view, the substantial deferral of costs envisioned under SB1112/HB1572 would lead to a significant ballooning of liabilities for plans already burdened by years of weak funding discipline. Moreover, the plan would exacerbate negative amortization, where the annual contribution is not large enough to cover the interest on the unfunded liabilities, leading to a weakening of the plan's funded ratio. This situation would create further stress for local governments attempting to manage higher levels of unfunded liabilities with each passing year.

Consolidation Would Offer Only Incremental Help

Creating the momentum for the legislative proposals described above is the belief that the current trajectory for public safety pension plans in Illinois, with weakly funded plans eating up a greater portion of municipal budgets annually, is not sustainable in the long term. From a credit perspective, the pooling of resources among these individual plans and the removal of investment restrictions that currently exist for smaller plans through consolidation represent a positive first step in arriving at a comprehensive solution in addressing state's public safety pension woes. However, as discussed, there will likely be significant short-term costs that will need to be absorbed, which could harm existing assets and current funding levels. The effective execution of a consolidation plan will be difficult and complex, given the number of plans impacted, and raise potential legal risks.

Despite these challenges, the potential long-term benefits of consolidation may outweigh its possible drawbacks. However, we view the consolidation of the state's numerous smaller public safety pension plans as an incremental structural improvement that will likely create some efficiencies and cost savings in the long run, but leave major pension funding questions unaddressed. Absent a comprehensive, long-term funding strategy that deals with continued pension shortfalls in an actuarially sound manner, Illinois' substantially underfunded public safety pension system will likely continue to hamper the finances of local governments.