Updated: September 1, 2018
Issue: Automatic annual increases in a retired TRS member’s pension benefit have been required by state law since 1969.
It is undeniable that the cost of the automatic annual increase, or AAI, is one of the major reasons that the cost of Illinois public pensions increases every year.
The AAI for retired Tier 1 members currently is set at 3 percent, compounded. In 2010, with the creation of Tier 2, the AAI for retired Tier 2 members was established at one-half of the rate of inflation in the previous year not compounded, with a cap of 3 percent. In 2017, with the creation of Tier 3, the AAI for the defined benefit portion of Tier 3 was set at one-half of the rate of inflation in the previous year, with no cap.
Under legislation enacted in July of 2018, some Tier 1 members in the future will be able to elect an AAI of 1.5 percent not-compounded when they retire. In return, a member accepting a 1.5 percent AAI will receive a cash payout equal to 70 percent of the monetary difference between what they would receive in retirement with a 3 percent compounded AAI and what they would receive with a 1.5 percent not-compounded AAI.
Critics of public pensions in Illinois say that the standard 3 percent AAI for Tier 1 is too expensive and is out of step with the annual benefit increases received by people who have retired from the private sector. In order to control costs, they argue that AAI for all Tier 1 members should be reduced.
However, an attempt to change state law and scale back the Tier 1 AAI in 2014 was overturned by the Illinois Supreme Court as a violation of the Illinois Constitution’s Pension Protection Clause.
Discussion: The history of the AAI for TRS and Illinois’ public pension plans reveals that the automatic annual increase was initiated at a time when the size of a retired teacher’s pension regularly did not keep pace with inflation. This was also true in subsequent years when the AAI was increased, or the calculation was modified from not-compounded to compounded.
Between 1915 and 1969, annual pension amounts for a retired teacher were set by statute. When state-funded teacher pensions were enacted in 1915, all retired teachers received $400 per year. That amount was raised to $600 in 1935.
In 1939, with the creation of TRS as an actuarially-based retirement fund, for the first time a teacher’s pension was individually determined by a formula that took into account each retiree’s age, service credit and contributions to the system. The maximum amount allowed was capped by statute. The initial maximum annual pension was $1,500. The maximum was raised to $3,500 in 1947; $4,800 in 1949; $6,000 in 1953; $8,000 in 1957; $12,000 in 1961. In 1969, a “progressive scale” formula tied to service at retirement was introduced to set the maximum pension of a retired teacher.
But also in 1969, state government recognized that while increases in consumer prices were driven by market forces and could occur at any time, any increase in a teacher’s pension to keep pace with the cost of living was tied to the political process and needed approval from the General Assembly and the governor. Inflation was growing faster than the buying power of teacher pensions.
The first automatic annual increase for TRS was enacted in 1969 and set at 1.5 percent, with each increase always calculated from the member’s original pension. Inflation in the United States at the end of 1969 was 6.18 percent.
The AAI was increased in 1972 to 2 percent, when inflation was 3.65 percent. During the next seven years, inflation averaged 7.56 percent, with a high of 11.8 percent at the end of 1974.
Inflation increased from 6.84 percent to 9.28 percent during 1978, and in that year the TRS AAI was increased to 3 percent – but still calculated each year from the member’s initial pension amount.
The TRS AAI remained unchanged until 1990, when the formula was altered in state law to require subsequent increases to be compounded – calculated from the member’s current pension amount instead of the original amount. Inflation at the beginning of 1990 was 5.4 percent.
The 3 percent compounded AAI is a product of a time when inflation was higher than it is now and had been increasing at a steady pace for many years. Inflation averaged 6.37 percent during the 20 year period prior to 1990, with a high of 13.9 at the beginning of 1990 and a low of 1.46 percent at the beginning of 1987.
Since 1990, the growth in the cost of living from year to year has been slower. In the 29 years since the current TRS AAI was set, inflation has averaged 2.47 percent, with a high of 5.4 percent in 1990 and a low of -0.09 percent in 2015.