Updated: December 13, 2019
Issue: Since the inception of Tier 2 in 2011, several issues have surfaced that are problematic for the members of this tier.
- A financial inequity for Tier 2 members.
- A potential violation of the Illinois Constitution’s limits on taxing individual income for Tier 2 members.
- Some Tier 2 members may be forced to enroll in Social Security, incurring added costs for both TRS members and school districts.
Discussion: Tier 2 members pay more than their benefit is worth and subsidize Tier 1 benefits.
Tier 2 creates both a financial inequity for Tier 2 members and a potential violation of the Illinois Constitution’s limits on taxing individual income.
Tier 1 benefits cost more than Tier 2 benefits because Tier 1 is encumbered with an unfunded liability built up by 81 years of insufficient contributions by state government.
Nonetheless, both active Tier 1 and Tier 2 members pay the same 9 percent salary contribution to TRS to help fund their future retirement benefits. Although each member’s contribution is dedicated to paying for their individual benefit, in reality all contributions are pooled together by TRS to help pay for all benefits.
In fiscal year 2020, a TRS Tier 1 benefit costs a total of 19.66 percent of a member’s salary. Subtracting the member’s 9 percent contribution from this “total normal cost” reveals that the employer’s cost for benefits will equal 10.66 percent of salary. That 10.66 percent will be paid primarily by state government, with a small portion contributed by school districts.
At the same time, a TRS Tier 2 benefit will cost a total of 7.25 percent of a member’s salary. This means that the Tier 2 member contribution of 9 percent not only will supply enough money to pay the entire “total normal cost” of the Tier 2 benefit, but will generate an extra 1.75 percent that is unaccounted for. Because the Tier 2 contributions are mixed with the Tier 1 contributions, the unaccounted-for 1.75 percent contribution will become a subsidy for Tier 1 benefits.
This Tier 2 subsidy has existed since the law was enacted in 2011. Over time, it is estimated that the Tier 2 subsidy will total $13 billion to $15 billion.
The financial inequity is that Tier 2 members will never see a benefit created by the 1.75 percent excess contribution. Tier 1 members, on the other hand, not only will realize the benefit created by their entire 9 percent contribution but also a benefit from the 1.75 percent Tier 2 subsidy.
The potential constitutional question involves Article IX, Section 3 – “Limitations on Income Taxation.” The Tier 2 contribution is measured as a percentage of salary, and the 1.75 percent excess payment is not used to help pay for that member’s retirement benefit. The member’s benefit is fully funded. Therefore, is the 1.75 percent, in effect, a tax on income levied separately from the state’s statutory income tax?
The Illinois Constitution requires that at any one time “… there may be no more than one such tax imposed by the State for State purposes on individuals…” In addition, income tax rates are set by state law and rates on individuals may not exceed the rate set on corporations by “a ratio of 8 to 5.” Any additional tax on income would violate that ratio.
Social Security for Selected Tier 2 Members
TRS actuaries have warned since 2010 that the law might force future teachers into Social Security, incurring added costs for both affected TRS members and school districts.
Currently, Illinois public school teachers do not participate in Social Security. As a result, under federal law their expected TRS pension must equal or exceed the benefit they would receive from Social Security. If a TRS benefit fails to meet this so-called “safe harbor” standard, then the member must be enrolled in Social Security while they still are actively teaching. This is determined on a member-by-member basis.
Provisions in the Tier 2 law over time artificially impede the growth of some members’ expected TRS pensions to the point where their expected Tier 2 benefits would be lower than the projected “safe harbor” standard.
The problem arises from the fact that a “pensionable salary cap” in the Tier 2 law increases at a slower rate than the Social Security wage base, which is used to calculate the “safe harbor” standard. At some point in the future the Tier 2 cap will start eroding the amount of money some teachers contribute toward their pensions. This, in turn, would artificially reduce the teachers’ expected retirement benefits.
TRS expects that the federal government will be able to predict which teachers may fall short of the “safe harbor” minimum early in their career. The Social Security Administration will want to be proactive by enrolling those teachers into Social Security so that the combination of their eventual pension and Social Security will fall within the “safe harbor.”
If a teacher is in the Social Security system, they will have to pay 6.2 percent of their salary in addition to what they contribute to TRS, which right now is 9 percent of their salary. School districts will have to pay 6.2 percent of every effected Tier 2 teacher’s salary to Social Security in addition to the 0.58 percent of every teacher’s salary the district pays to TRS.
TRS has suggested that an easy “fix” to this potential problem is to change state law to require that the Tier 2 wage cap track the Social Security wage base, which would eliminate the gap that causes TRS benefits to fail the “safe harbor” test.