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First Published in the RoundTable on Oct. 29 ,2008.
In a 30-page report submitted to Mayor Lorraine Morton on Oct. 24, a Blue Ribbon Committee confirmed the City has an unfunded liability of $145.8 million in its police and firefighter pension funds. While the Committee has been studying the issue since April, it has no magic bullet to solve the problem.

The Committee accepts the estimate made by the City’s current actuary, Gabriel, Roeder, Smith & Company (GRS), that the City’s unfunded liability to the pension funds as of March 1, 2008 was $145.8 million, or $4,490 per household. Under State law the City is obligated to fully fund the shortfall by 2033. While there has been some speculation that the time period may be extended, the Committee does not recommend the City should assume that will happen.

At the same time the City is making up the shortfall, it must continue to make annual contributions to the pension funds to meet the ongoing (normal) cost of pension benefits as they arise. In 2007 GRS estimated the combined cost of making up the shortfall and making current contributions through 2033 at $530 million.

The report sticks with the actuary’s estimates of the unfunded liability as of March 1, 2008, and does not attempt to measure the impact of the recent stock market declines on the unfunded liability. The City bears the risk of market losses on the investments made by the pension funds; and any investment losses incurred will thus increase the City’s unfunded liabiltiy. According to the City’s financial statements, as of March 1, 2008, the pension funds had total assets of about $108 million, $40 million of which was invested in stocks and mutual funds.

“Finding the money to make the required contributions will be painful,” the report acknowledges, but it goes on to state, “Our community has legal and moral obligations to provide for the pensions earned by all the firemen and policemen.” The report states, “it would be irresponsible” to hope for “upside surprises” and not to take appropriate action, and it lists a number of things the City should consider in order to raise funds or cut expenses. It also recommends changes at the State level.

The Committee was appointed by City Council to review the shortfalls in the pension funds. Its members include: Mark Metz (chairman), Greg Beard, Gerald Gordon, Aleks Granchalek, Peter Morris, Sandra Shelton, Bill Testa, and Jim Young.

The Police and Firefighter Pensions

A police officer or firefighter who has served 20 years, reached the age of 50 years and is no longer in active service is entitled to a yearly pension equal to 50 percent of his or her last salary. If the officer or firefighter serves longer than 20 years, the pension amount increases 2.5 percent for each additional year of service, up to a maximum of 75 percent of their last salary.

Police officers and firefighters contribute about 9.5 or 10 percent of their salary to the pension fund. The City is required to contribute an additional amount each year, called the annual required contribution (ARC). An actuary determines the ARC each year, with the goal of having enough funds available in the pension funds to pay benefits when needed.

Determining the ARC requires judgment and is based on assumptions of future events, such as the future rate of return on money contributed to the pension funds; the salaries in effect when employees retire; the age when employees will actually retire; and the length of time pension payments will be made.

How Did the Shortfall Arise?

The pension funds “did not become underfunded by $145 million overnight,” states the report. The unfunded liability as estimated by Ted Windsor & Associates, the City’s former actuary, “was just over $48 million as of March 1,1997, and grew to just under $98 million as of March 1, 2006.”

In 2007 the City hired GRS as its new actuary. The report says GRS used “more conservative assumptions” than the old actuary. In addition GRS changed the actuarial method “to one that requires more contributions in the near term.” GRS pegged the unfunded liability at $140 million as of March 1, 2007 – a jump of more than $40 million from the old actuary’s estimate a year earlier – and at $145.8 million as of March 1, 2008.

The Committee said the unfunded liability increased over the years and GRS adopted more conservative assumptions than used by the former actuary, because “longer-term results showed that actual experiences for Evanston’s pension plans consistently differed with actuarial assumptions.” The report lists some of these assumptions: “For a number of years, the plans earned less investment return than assumed, salaries increased more than was assumed, retirees lived longer than assumed, employees retired earlier than assumed, more employees became disabled than assumed, and fewer employees terminated service than assumed.”

The report says, “It was a ‘perfect storm’ of negative experiences for the plans. Add in a few benefit increases granted by the state legislature, and it all adds up to our current situation.”

Was There Any Wrongdoing?

The report poses the question, “Was the old actuary wrong?” The report says actuaries use long-term economic cycles to make their assumptions, and often do not adjust them in response to year-to-year fluctuations in actual experience. The Committee concluded, “All of the assumptions used by the old actuary were within the broad range of ‘reasonable’ as defined by industry standards.”

The report also asks, “What about the City Manager, Finance Manager, City Council and Mayor? Were they ‘asleep at the switch’?” The report finds these persons “were being told that the plans were well funded, the assumptions were reasonable, that the adverse trends would reverse and even out over time, resulting in improved funding status.” However, the report goes on to state, “Hindsight tells us that had more questions been asked, and more information been sought, City officials might have chosen to increase funding at an earlier time to mitigate the depth of the current crisis.” The report emphasizes, “Yet, we want to make clear that we found no evidence of any wrongdoing or malfeasance.”

Going forward, the report recommends that “City of Evanston officials implement appropriate policies and procedures to monitor pension related budget items and intervene at an earlier time to take corrective action.” The policies include the City’s bringing in a consulting actuary every three years to review the work of the City’s actuary; the City staff’s participating in meetings and conferences with their counterparts; the City Council’s continuing its dialogue with citizens by intermittent reports on pension status.

Funding the Shortfall

The Committee recommends that the City make contributions to the pension funds to both make up the shortfall and pay the ARC “based upon reasonably conservative assumptions that are most likely to prevent the contributions from rising too sharply in the future.” The Committee adds, “We should contribute enough now, to make sure we do not continue to put the problem off until a later date.”

While GRS’s estimates are more conservative than those of the former actuary, Mr. Metz told the RoundTable he viewed GRS’s estimates to be in the middle range and perhaps slightly toward the aggressive side in light of its assumption that the rate of investment return would be 7.25%.

The Committee says, though, “By changing to more conservative assumptions, the new actuary [GRS] has increased the probability that the plan’s payout obligations will be met over time from existing fund assets, and that the City and taxpayers will not encounter sudden surprises for additional revenue injections.”

The Committee does not recommend the City impose any specific fees or taxes or make any specific budget cuts to fund the shortfall, but instead lists options City Council should “consider” to raise revenues or reduce expenses. They include the following: selling or leasing the right to manage City property, such as parking garages; reviewing the propriety of property tax exemptions for non-profit organizations; charging a fee for City services provided to non-profit organizations; changing the budgeting process from the current incremental approach to zero-based budgeting, which requires reevaluating each program every year to justify its expenditures; reducing municipal services provided to the community; privatizing or outsourcing municipal operations, such as sanitation, health and social services, and revenue collection; and attracting and retaining more business, office, industrial and retail services in the City.

The report states, “property tax increases should only be considered as a last resort.”

Actions at the State Level

The Committee also recommends the City work through elected State officials toward several reforms. These include changing the law that prohibits pension funds from investing more than 45 percent of their assets in equity investments and contains other restrictions.

The Committee also recommends the State, on a going forward basis, give “serious consideration” to changing the pension program from a “Defined Benefit Plan” (i.e. one in which a set retirement benefit is paid out) to a “Defined Contribution Plan” (i.e. one in which a set contribution is made to the employee’s 401(k) plan, etc.). The report says this has become standard practice among private sector employers. It says, “The major difference in the plan types is who bears the risk of underperformance of pension plan savings or assets.”