Illinois lawmakers shouldn’t burden taxpayers with Tier 2 pension “fixes” until they know what they’re doing – Wirepoints

By: Ted Dabrowski and John Klingner

For decades Illinois lawmakers have made a mess of the state’s public pension plans. Now they’re about to do so again.

Several proposals to increase the pension benefits of Tier 2 workers – government workers hired after 2010 – are being floated in Illinois, some already in bill form. The purported reason for the increases is that some worker benefits may not be compliant with a federal requirement that requires a worker’s pension benefits be “at least equal” to what he or she would have received under Social Security.

The total cost to taxpayers for those potential changes – ranging from a few billion dollars to as much as $80 billion through 2045 – would make Illinois’ already untenable pension debts even more untenable. A recent Fitch report shows Illinoisans are already burdened with $172 billion in state-level pension debts – the largest in the country (see Appendix).

Unsurprisingly, these “solutions” are being promoted and pushed despite no formal evidence presented that anyone is out of compliance with the IRS’ “safe harbor” test – a test (Revenue Procedure 91-40) that determines if benefits meet the Social Security minimums. There’s been nothing from the IRS nor the state’s actuaries nor any of the various government employers that quantifies which workers – if any – are not in compliance, and what the costs of that noncompliance might be. Until lawmakers know the facts, they should do nothing to enhance the benefits of Tier 2.

The General Assembly should know whether the IRS safe harbor rules will be enforced or whether they are even enforceable. There’s an open question if the IRS has ever actually used safe harbor to force the payment of Social Security taxes for workers whose benefits are noncompliant. And even if imposed, there’s a question of how costly those taxes would be.

Also, given the Supreme Court’s recent rejection of the Chevron doctrine, there’s also the possibility that Illinois could challenge the legitimacy of the IRS safe harbor rules.

Another material concern is that lawmakers may try to make blanket changes to Tier 2 across all of Illinois’ state and local pension funds. That would be a costly mistake given that many pensioners in Illinois, like those in SERS and IMRF, are also covered by Social Security. By definition, those members can’t be out of compliance with safe harbor. Several of the other Tier 2 plans, like downstate police and fire, are not at risk of noncompliance due to previously-legislated pension sweeteners.

Considering so much is still unknown about the safe harbor issue, it would be political malpractice for Illinois lawmakers to pass any purported “fixes.” They should defend the Tier 2 laws as passed and not rush to change them out of fear of ambiguous federal rules and procedures.

Tier 2 deserves a defense much like the pension reform bill SB1 received when then-Attorney General Lisa Madigan argued for it in front of the state supreme court. She said, on behalf a Democratic majority, that “…the General Assembly has determined that the fiscal problems facing the state and its retirement systems cannot be solved without making some changes to the structure of the retirement systems.” That fact hasn’t changed in the 11 years since then.

The problem of Tier 2

Tier 2 pensions were originally created in 2011 to slow down the growth of Illinois’ pension debts, then already among the nation’s largest. Tier 2 reduced cost-of-living adjustments, capped pensionable salaries, and raised retirement ages, among other changes, for new government hires beginning in 2011.

However, Tier 2’s cost-saving measures may cause the benefits of some government workers – namely, Illinois’ highest-paid employees – to run afoul of the safe harbor rules. 

The controversy centers on the highest-paid government workers because of the salary cap used to calculate Tier 2 pensions. Prior to 2011, pensions in Illinois weren’t capped, but Tier 2 changed that by implementing a pensionable salary cap equal to that of Social Security’s own cap, which in 2011 was $106,800. 

The issue is that Illinois’ Tier 2 law limits the yearly increase of the pensionable salary cap to the lower of one-half the rate of inflation or 3%, while Social Security’s yearly salary cap grows at the full rate of inflation. That difference in growth rates over the years has opened up a large gap between the two caps. By 2024, Illinois’ Tier 2 pensionable salary cap was at $125,774, while the Social Security cap had grown to $168,600.

As that gap between the salary caps grows, the pensions of Illinois’ highest-paid government workers may eventually be worth less than the benefits they would get under Social Security. It’s the benefits of the big six-figure salary workers that could potentially be out of compliance.

The question is, how big does the gap in salary caps have to be before it becomes problematic? Even with 2024’s gap, the maximum $94,000 pension payout of a hypothetical Tier 2 retiree today far exceeds today’s maximum $45,864 Social Security benefit at full retirement age. It will take an analysis at the individual pensioner level to determine when and how such a worker falls out of compliance. At the moment it appears there is no entity – not the state, not the pension funds, not the IRS – that’s making that calculation today.

Enforcement?

Illinois lawmakers knew at the time of Tier 2’s passage in 2010 to be concerned about the federal standard for minimum benefits. In fact, in 2011 the state asked for and received a private letter ruling from the IRS on compliance. The IRS letter said that Tier 2 “satisfies the minimum benefit requirements… using the safe harbor formulas set forth in Revenue Procedure 91-40. Thus, Plan X qualifies as a retirement system…”

Those “safe harbor formulas” are provided by the IRS as a means to assure compliance with the minimum benefit standard. Most of the debate has centered on whether workers in Tier 2, as it stands, are within that safe harbor and, if not, what must be changed to bring it in.

But it’s an open question as to whether the IRS even enforces its minimum benefit rules for plans outside of the safe harbor. We were not able to identify any such instances nationally where the IRS has done so, though some examples may exist. Nevertheless, should the IRS eventually enforce minimum benefit standards, the question remains: what entity is responsible for testing for non-compliance, who and what will non-compliance apply to, and how much will it cost? 

Theoretically, the IRS would compel the non-compliant government employer and employee to be added to the Social Security rolls and to pay the Social Security tax. That is likely all that would happen. Tier 2 itself would not be affected, nor would it be in violation of any law or regulation given that government-offered pension plans are explicitly excluded from ERISA, the 1974 law that strictly governs private-sector pension plans. 

With regard to the Social Security tax, it may be far less costly than many are estimating. It’s unclear if the IRS would impose the tax on all compensation or only on the amount that a pension benefit falls short of Social Security.

If the latter is true, paying the Social Security tax may cost much less than any of the proposed Tier 2 “fixes.” If the former is true, the government should challenge the IRS’ decision-making. 

There is also the possibility of Illinois challenging the IRS’ entire safe harbor scheme altogether. In recent years, states have challenged regulations that appear on their face to be an overreach, are inconsistent, or that frustrate public policy. Those challenges have been given more power with the Supreme Court’s recent ruling in Loper Bright Enterprises v Raimondo, which ended the Chevron doctrine. In short, the court ruled that administrative agencies do not have unilateral authority to decide on an interpretation of laws or develop regulations that aren’t clearly authorized by legislation. 

As the safe harbor rules are written by the IRS and not part of the tax code passed by Congress, they may qualify as an overreach challengeable in court. This is particularly true because the rules may end up forcing Illinois to pay the state’s biggest Tier 2 pensioners even bigger pensions, creating an even larger burden on Illinois residents and the state’s pension systems. 

Proposed “fixes” 

Despite no evidence yet of the need for a Tier 2 fix, a few proposals are in play in Illinois. 

First, several of the state’s civic organizations have proposed to hike the Tier 2 salary cap to the same level as the Social Security cap and have them grow at the same pace going forward. The state’s actuary, Segal Consulting, projected a $5.6 billion increase in total state pension costs through 2045 if the Tier 2 cap is raised for the five state pension funds.

Even more expensive is the legislation recently proposed by Rep. Stephanie Kifowit and Sen. Bob Martwick. 

Their bill also makes equal the Tier 2 and Social Security salary caps going forward, but it also includes many other benefit increases that are straight-up giveaways to the unions. Martwick and Kifowit want Tier 2 workers to have a final average salary formula and retirement ages in line with Tier 1, as well as to receive automatic simple 3% cost-of-living adjustments going forward. 

Finally, there are public employee unions, notably the Chicago Teachers Union, who are calling for the complete elimination of Tier 2 by restoring Tier 1 benefits. Several civic groups have warned that restoring Tier 1 for state-level employees alone would cost Illinois taxpayers an extra $82 billion in pension contributions through 2045. 

One other issue regarding cost: which funds legislators make changes to matters greatly. A blanket change to Tier 2 across all state and local pension funds would cost Illinois taxpayers billions more than necessary, no matter which proposal lawmakers consider.

That’s because some workers in various funds, and nearly all members in IMRF and SERS, are already enrolled in Social Security and thus cannot be noncompliant with safe harbor. Other funds, such as the downstate police and fire funds, have recently had their benefits increased in various ways that leaves them at little risk of noncompliance. Increasing benefits for those workers would be an unnecessary cost.

The prudent course of action

The safe harbor issue is complicated and non-transparent, and from our own discussions with lawmakers, lawyers and tax officials, it appears no one has the facts. No one knows the depth of the problem, who’s impacted or how the issue will play out.

As we said above, it would be political malpractice for Illinois lawmakers to pass any purported “fixes” when so much is unknown.

Instead of rushing into legislation that may unnecessarily cost taxpayers billions, lawmakers should clearly understand the risk, if any, that the IRS will compel compliance with the underlying Social Security tax legislation and, if they do, what the mechanisms and costs of such compliance are. Lawmakers should be able to answer questions like these:

• Has the IRS ever enforced regulations and revenue procedures that elaborate on Section 3121, the relevant section on FICA taxes, of the Internal Revenue Code?
• If the IRS were to enforce those regulations, is there a reasonable case that could challenge Revenue Procedure 91-40, the safe harbor provision, from being enforced?

These questions should be answered before the legislature looks into how the IRS might enforce Revenue Procedure 91-40. The following questions then should be answered:

• What events might or will trigger an enforcement by the IRS?
• Which pension plans currently cause employees to be out of compliance with Revenue Procedure 91-40?
•  If employees are found to be out of compliance, how will they be brought into compliance? 
•  If compliance involves enrolling the employees in Social Security, will it be done on an individual or class basis? 
•  Would Social Security taxes be imposed on all compensation or only that portion between the existing Tier 2 pensionable salary cap and the Social Security salary cap?
• Could employees out of compliance be cured by promising them a retirement benefit equal to or greater than they would receive from Social Security?
• What would be the cost of any enforcement?
• Would costs be imposed retroactively? 

Once questions like the above are answered and all relevant options are subjected to a full actuarial analysis, Illinois lawmakers will be in a far better position to decide on their next course of action. For now, the most prudent choice is to do nothing.

However, if lawmakers remain compelled to act, there’s one piece of legislation they can consider. A bill by Rep. Blaine Wilhour, HB 5798, “provides that if an eligible Tier 2 member would receive a pension benefit that is less than the eligible Tier 2 member’s hypothetical Social Security benefit, then the eligible Tier 2 member’s pension benefit shall be increased to the amount of the hypothetical Social Security benefit plus $1.”

That language should give the state cover while lawmakers get their facts straight.

For further analysis of Illinois pensions and safe harbor, please see the following:  

• Segal: June 2023 — Actuarial Study on Tier 2 Pension Safe Harbor Exemption
• Civic Committee & Civic Federation: Tier 2 Pensions and Safe Harbor Explained
• Segal: June 2024 – Actuarial Analysis of Downstate Police and Fire Tier 2 Pension Safe Harbor Exemption
• Illinois Municipal League: Downstate Plan Tier 2 Benefits under the Definition of Retirement System for FICA Exemption Purposes

Appendix.