Tough Choices For The Illinois Pension System Case Solution

1. Explain what conflict of interest is and how it affects Illinois’ pension system and pension reform?

Since the state of Illinois had opted to manage the pension systems itself rather than leaving the responsibility with the federal government, the state followed Government Accounting Standards Board (GASB) instead of SEC. The rules set by GASB were very lenient and had many loopholes that allowed the state governors to take advantage of flexibility and leaving the burden of state contribution to the pension fund for the future governments. Until 1986, governments were not required by the GASB to contribute to the pension fund to meet the future pension obligations. Although subsequent amendments by GASB required the state to report the unfunded balance, the government was still obligated to make payments that were immediately required for the current period. After further legislation in 1989 and 1994, the government began to make additional payments, but these payments were still insufficient to meet the gap despite huge budget surpluses of the government in these years. As a result, the gap widened with the passage of time and the situation became worse after the pension fund portfolio suffered huge losses due to recession in 2008.

2. List the attempts of the state legislature and the former governors to reform the pension and explain their consequences.

In 1995, the state of Illinois under Governor Rod used GASB’s accounting rules to exercise the option of discounting the future pension obligations at a discount rate other than the US Treasury bond rate. Thus, the future pension obligations were discounted at 8.5%, the expected return on the asset portfolio, rather than a much lower Treasury bond rate. As a result, the present value of the pension obligations was grossly understated, and a very difficult benchmark of 8.5% was set for the portfolio. Although the pension obligations bonds issued in 2003 at 5% were expected to earn a margin of 3.5% for the portfolio, the actual return remained very low, around 2%, from 2003 to 2008 owing to the economic recession. In 2005, Governor Blagojevich tried to improve the situation by shifting some of the burden on the employees and local school districts, but legal complications nullified most of his attempts and the problem persisted.

3. Discuss the pros and cons of the following proposals to solve Illinois’ pension problem. 

i. Asset Allocation

The discount rate that the Illinois pension system was using to discount the future pension obligations was around 8.5% whereas the, in last 10 years, the portfolio return had been roughly 3.1%. Therefore, it was obvious that the current asset allocation system was not even able to meet the benchmark requirement. In order to increase the portfolio return, Illinois pension system could invest more in riskier assets like real state and equity market. The timing for these changes in portfolio allocations was also quite suitable considering the expected recovery of the economy from the recent recession. However, limitation in considering this option was the fact that liabilities of a pension system are quite stable and the state could not afford a risk level beyond a certain limit.