Fitch Ratings comments on Illinois’ Tier 2 debate

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Illinois needs to address questions surrounding its Tier 2 pension benefits, and while directly fixing Tier 2’s alleged failure to meet the IRS’s minimum safe harbor standard would be credit neutral, enhancing Tier 2 benefits more broadly or erasing the distinction between Tier 1 and Tier 2 could result in a downgrade, Fitch Ratings said Thursday.

“If Tier 2 does not meet safe harbor requirements, the state risks paying (and requiring employees to pay) FICA taxes, likely at significant expense,” Fitch said in its rating report. “Proposals that simply raise the pensionable earnings cap will likely result in modest increases in the pension liability and budgetary demands.”

Tier 2, enacted in 2011, was designed to lighten Illinois’ public pension burden. Applied to workers hired from January 2011 on, it reduced automatic annual benefit hikes and raised the full retirement age to 67 from 60.

Illinois Gov. J.B, Pritzker speaks in May 2024 in Chicago. The governor does not support scrapping Tier 2 entirely but has called for a review of, and if necessary an adjustment to, the pensionable earnings cap.

Bloomberg News

Unions have argued that Tier 2 falls short of the Internal Revenue Service’s safe harbor rules. Those rules require that pension plans provide benefits at least equal to those workers would get under Social Security, which most public employees in Illinois otherwise do not have to pay into.

But as the Civic Federation of Chicago pointed out, unions weren’t the only ones to criticize Tier 2; pension experts also voiced concerns. And earlier this year, two judges filed a lawsuit claiming that the 2010 pension reform law was unconstitutional and cheated them out of the pensions they felt they deserved.

“Being in violation of IRS rules is generally never a good place to be, so addressing this potential safe harbor [issue] is something that the state recognizes [it needs to do] — the governor has put a proposal in his legislative budget; the legislature has been talking about this,” Eric Kim, head of U.S. state ratings at Fitch, told The Bond Buyer. “The state and the local governments do need to address the Tier 2 issue. It’s just a question of how they do that.”

Kim noted that Cook County confronted the issue last year with House Bill 2352, which brought the county into alignment with IRS safe harbor provisions. 

For the state, “there are a number of different options,” Kim said. “Our view is that the most basic option, simply raising the pensionable earnings cap to match the Social Security wage base, seems like it would be the most credit-neutral. Getting rid of Tier 2 entirely does pose some risks from a credit perspective.”

The 2011 reform had some “clear benefits,” he noted, chief among them the savings to the state on an annual basis and an easing of Illinois’ heavy public pension burden. 

“Scrapping it entirely, as some of the proposals out there would suggest doing, could be negative from a credit perspective,” Kim cautioned. “But ultimately, this is a policy decision on the part of the state and local governments. We’re watching pretty closely to see what choice they make.”

Illinois Gov. J.B. Pritzker does not support scrapping the distinction between Tier 1 and Tier 2 entirely, his press secretary Alex Gough told The Bond Buyer. The governor has proposed a review of and, if necessary, an adjustment to the pensionable earnings cap. 

Workers in the Teachers’ Retirement System and State Universities Retirement System largely do not pay into Social Security, and some State Employees’ Retirement System workers are likewise not covered by Social Security, Gough noted. He added, “SURS and TRS would need to weigh in on what specifically needs to be fixed.”   

“The governor encourages the boards of the affected retirement systems and the legislature to review and adjust, if necessary, the structure of the Tier 2 pensionable earnings cap for employees not coordinated with Social Security to ensure that the systems are and remain compliant with federal law,” Gough said. “However, the review should focus on addressing that issue as part of an overall review of the state’s pension funding plan.”

Fitch’s Kim had some laudatory words for one of the governor’s other policy proposals regarding pensions: a plan to add three years to the amortization cycle and target 100% funding of the pension liability.

“We think [that] would be potentially a significantly positive move,” he said. “We’re waiting to evaluate and see, one, is the legislature open to that … and what does an actuarial analysis look like? But we have consistently said that one of the challenges for Illinois is its significantly large long-term liability burden.”

The state was statutorily required to target only 90% funding — “so it was continually underfunding its pensions; therefore, from our view, [there was] a structurally unbalanced budget built into law,” Kim said. “Changing that approach … could be meaningful, because it could indicate that the state would be making material progress in actually reducing that liability and being able to address that rather than have it continue to build up over time, as it is under the current statutory structure.”

Fitch is waiting to see what the final version of the 2025 budget offers. “Our expectation is that [they’ll continue] the pattern that we’ve seen in the past few years for the state of having a budget that makes progress toward structural balance, doesn’t do things that would be concerning to us — doesn’t build in significant one-time items or anything along those lines, and does invest and match recurring needs with recurring spending,” Kim said.  

Regarding the governor’s proposal to aim for 100% funding while adding three years to the amortization cycle, Gough said, “This proposal is a key part of an ongoing effort to fix the state’s pension system and we will continue to be engaged in conversation with the General Assembly on the issue.”

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