We Are One Illinois Analysis on the Impact of a Diet COLA

Why a COLA Cut to Half-CPI Puts Retirement Security at Risk

Updated: October 10, 2013
This updated brief illustrates: why the current 3 percent compounded COLA tracks inflation better than a Half-CPI COLA why cutting COLAs to Half-CPI is essentially as harmful as the COLA cut proposed in SB 1 and why adding a COLA holiday on top of the Half-CPI COLA can slash COLAs even deeper than SB 1 why the move to a Half-CPI COLA is legally dubious Illinois public university presidents and chancellors originally backed a proposal by five authors at the University of Illinois Institute of Government and Public Affairs (IGPA). The IGPA proposal would change the cost-of-living adjustment (COLA) for Tier 1 public employees and retirees from the current annually compounded 3 percent to one-half the annual change in the consumer price index (Half-CPI).1 The draft proposal by the conference committee on pensions adopts the Half-CPI COLA and adds on COLA holidays of one to five years. In doing so, the committees draft proposal cuts COLAs as deeply as or more deeply than the House version of Senate Bill 1 (SB 1). This brief explains why. The Current 3 Percent Compounded COLA Tracks Inflation Better than Half-CPI The current 3 percent compounded COLA is based on appropriate actuarial projections and has, in fact, proven to be a remarkably accurate adjustment for changes in the cost-of-living. Several points prove this, particularly in contrast to the proposed Half-CPI COLA. First, actuaries for two major state retirement systems, the Teachers Retirement System (TRS) and the State Employees Retirement System (SERS), have projected annual inflation at 3.25 percent and 3 percent, respectively.2 This is consistent with inflation projections from other major pension systems in the public and private sectors and is, essentially, a consensus inflation projection from experts in the actuarial sciences. Second, the IGPA report goes back more than three decades to use a high inflation era to justify the proposal, but recent economic history tells a more relevant story. A review of the COLA applied to Social Security benefits (which is also based on a measure of CPI) finds that only twice in the last thirty years has the COLA exceeded 5 percent. In fact, none of the last thirty annual adjustments exceeded 6 percent. A simple arithmetic average of the last thirty annual adjustments to Social Security benefits (1984 to 2013) shows an average annual increase of 2.9 percent right in line with the Illinois retirement systems 3 percent compounded COLA.3 In other words, the conference committees draft proposal would cause retirees to lose a COLA that has historically kept pace with inflation for the illusion of inflation protection. The premise that employees should lose their current COLA for valuable insurance protection from events that have not occurred in thirty years is not pertinent to modern economic times. Lastly, the current COLA does not enrich retirees, but serves its purpose by protecting pensions from the ravages of inflation over time. The Half-CPI COLA results in the loss of pensions purchasing power every year because it does not keep pace with inflation by its very design as a half-measure. Yet, seniors face
1

Brown, Jeffrey, et al. Six Simple Steps: Reforming the State Universities Retirement System. Institute of Government and Public Affairs. University of Illinois. March 12, 2013. http://igpa.uillinois.edu/system/files/Six-Simple-Steps-for-ReformingSURS.pdf 2 The State Universities Retirement System (SURS) uses a price inflation estimate of 2.75%. It is not immediately clear whether this is an identical proxy to what TRS and SERS use, but it is used for purposes of this analysis. 3 United States. Social Security Administration. History of Automatic Cost-Of-Living Adjustments.October 26, 2012. http://www.ssa.gov/cola/automatic-cola.htm

greater inflation risk than other demographic groups because they purchase goods and services, such as health care, that have higher inflation rates. The Half-CPI COLA with COLA Holidays Cuts Modest Pensions as Deeply as or More Than SB 1 The conference committees draft proposal would significantly erode retirees purchasing power and standards of living. The harmful effects of the Half-CPI COLA increase over time. Using the actuarial assumptions of each plan, the percentage loss in purchasing power caused by a change to a Half-CPI COLA to members of TRS, SERS, and SURS is demonstrated in the chart below: Table 1: Half-CPI COLA Cuts Pension Value Between 23.6% 27.2% Years in Retirement TRS SERS Purchasing Power Loss Purchasing Power Loss 5 6.5% 7.1% 10 12.6% 13.6 % 15 18.3% 19.8% 20 23.6% 25.4%

SURS Purchasing Power Loss 7.6% 14.7% 21.2% 27.2%

In a December 2012 report, We Are One Illinois studied the effects of a SB 1-style COLA cut and found the following results: Table 2: SB 1-Style COLA Cuts Pension Value Between 28.1% - 30.7%4 Years in Retirement TRS SERS Purchasing Power Loss Purchasing Power Loss 5 13.7% 13.7% 10 19.3% 18.2% 15 25.0% 23.0% 20 30.7% 28.1%

SURS Purchasing Power Loss 13.7% 19.3% 25.0% 30.7%

Thus, the Half-CPI COLA all on its own cuts COLAs essentially as deeply as SB 1. When including a 5-year staggered COLA holiday, the conference committees proposed COLA cut actually slashes pensions purchasing power more deeply than SB 1 for SERS and SURS members and essentially as deeply for TRS members, as illustrated in Table 3 below. Table 3: Half-CPI COLA with 5-Year Staggered Holiday Cuts Pension Value Between 29.5% 32.0% Years in Retirement TRS SERS SURS Purchasing Power Loss Purchasing Power Loss Purchasing Power Loss 5 10.9% 11.1% 11.4% 10 19.3% 19.8% 20.3% 15 24.6% 25.5% 26.4% 20 29.5% 30.8% 32.0%

We Are One Illinois. Analysis of Worker and Retiree Pension Benefit Cuts under the Quinn Plan and HB 6258. December 17, 2012. http://www.weareoneillinois.org/documents/studies.pdf. Note that SURS estimates in this brief are new and essentially identical to TRS calculations.

The COLA cut remains deeper than SB 1 for SERS and SURS under a 4-year holiday and for SERS under a 3-year holiday. In all other holiday circumstances, the cut is essentially as deep as SB 1 for all systems. In sum, teachers, nurses, caregivers, public safety officers, first responders, and other public employees and retirees would substantially face the same COLA diminishment as SB 1 under the conference committees draft proposal. For some, the cut would be even deeper than SB 1 when paired with various forms of COLA holidays. The Constitutionality of a Half-CPI COLA Is Questionable at Best The IGPA report acknowledges that the change in COLA could be considered a diminishment of benefits. To counter such arguments, the authors assert,[i]n our view, it would be constitutionally permissible to reduce the expected average future increase in exchange for the valuable insurance protection that individuals would receive during periods of high inflation. However, the authors cite no legal opinion and testified before the pension conference committee that no legal opinion had been sought to support this view. Moreover, this argument fails to recognize that the Half-CPI COLA does not truly or fully protect public employees and retirees from inflation but, instead, locks in the loss of purchasing power every year because annuities are adjusted at Half-CPI. Furthermore, the conference committees proposed ceiling to set a maximum COLA adds more legal doubt; it moves the Half-CPI COLA further away from its guise as a track of inflation and simply makes it another way to diminish COLAs. Conclusion The draft proposal developed by the conference committee has the same harmful effects on retirement security as the old, rejected version of SB 1 promoted by the House speaker. Cutting COLAs from the current 3 percent compounded rate to a formula based on Half-CPI is a substantial reduction in benefits like other extreme measures. Counter to proponents claims, it is not balanced by enhanced benefits to participants, and it is of dubious legality. Experience over the last three decades shows that partial protection from hyper-inflation is of little value compared to the way the current COLA preserves pensions purchasing power by accurately adjusting annuities according to increases in the cost-of-living in modern economic times. The Half-CPI diet COLA offers no more than the illusion of inflation protection or retirement security to those who have faithfully contributed toward their pensions and served the public.