Will Illinois' Unfunded Pension Liability End Up Repricing Its Debt?

source: Raisdorf-inside.de
Credit rating agencies are giving Illinois a hard time about its unfunded pension liability. First, Moody's downgraded Illinois to A2 from A1 in January 2012, "making it the company's lowest-graded U.S. state." Then on January 11, 2013, Fitch placed Illinois' general obligation bonds (GO bonds) on Rating Watch Negative because of its "large and growing unfunded pension liability."

Fitch Ratings (1/11/2013) via Business Wire:

"The Rating Watch Negative reflects the ongoing inability of the state to address its large and growing unfunded pension liability, most recently through the failure to pass pension reform in the 'lame duck' portion of the 97th general assembly legislature that ended on Jan. 8. Fitch believes that the burden of large unfunded pension liabilities and growing annual pension expenses is unsustainable. The Rating Watch Negative will be resolved after an assessment of the extent to which the state takes action within the next six months that limits the impact of pension payments on the budget while bolstering pension funded levels. Failure to achieve meaningful results would lead to a downgrade of the rating.

Illinois's long-term liabilities, particularly pension liabilities, are very high for a U.S. state. As of June 30, 2012, the unfunded actuarial accrued liability was reported at $94.6 billion, resulting in a 40.4% reported funded ratio. This large unfunded pension liability is despite the issuance of pension obligation bonds and passage of bipartisan comprehensive pension reform affecting new employees in March 2010.

Annual pension funding requirements have been increasing significantly and growing pension payments are crowding out other expenditure growth and absorbing revenue growth. Pension payments from the general fund increased $965 million to $5.1 billion in 2013, an increase of 23%, reflecting in part the use of more conservative investment return assumptions. Fitch notes that even these large payments, which consume a well-above-average percentage of the state's general fund budget, are based on statutory formula and are below the actuarially required contribution (ARC)."

And finally, on January 25, 2013, Standard and Poor's downgraded Illinois to A- with a negative outlook from A, which made Illinois delay its $500 million bond offering.

S&P (1/25/2013):

"The downgrade reflects what we view as the state's weakened pension funded ratios and lack of action on reform measures intended to improve funding levels and diminish cost pressures associated with annual contributions," said Standard & Poor's credit analyst Robin Prunty.

The aggregate pension funded ratios on an actuarial basis declined to 40.4% at fiscal year-end 2012, compared with 43.4% in fiscal 2011. Based on the state's current projections, the funded ratio will decline further to 39% in fiscal 2013. The continued decline in pension funded ratios is due in part to contributions below the annual required contribution, investment returns below assumptions, and lower investment return assumptions. While legislative action on pension reform could occur during the current legislative session and various bills have been filed, we believe that legislative consensus on reform will be difficult to achieve given the poor track record in the past two years. If there is meaningful legislative action on reform, we believe that there could be implementation risk based on the potential for legal challenges, and it could be several years before reform translates into improved funded ratios and budget relief. In addition, Illinois has to manage other challenges, which include pending statutory reduction of rates on the personal and corporate income taxes beginning in fiscal 2015 and a high level of accumulated payables, combined with the more typical pressures facing the state sector in terms of a slow economic recovery, potential federal fiscal consolidation, and health care reform implementation."

Illinois delayed its $500 million bond offering because of the downgrade. According to Bloomberg News,

"The delay may hinder the school construction and transportation improvements that the sale proceeds would fund. Those projects would join the doctors, hospitals, pharmacists and other vendors who have waited more than six months in some cases for payments from the state. Illinois has $9 billion in unpaid bills."

So will any of these downgrades ever have an effect on Illinois' bond yields? When Illinois offered $525 million of GO bonds to competitive bidders in January 2012 after the Moody's downgrade, its spread to "top-rated debt" rose from 2009 but its "absolute" yield was still relatively low. Via Bloomberg News (1/11/2012):

"The $525 million tax-exempt part of today’s sale included 10-year general-obligation bonds priced to yield 3.1 percent, according to data compiled by Bloomberg. That’s 110 basis points more than the 2 percent yield of top-rated 10-year debt.

A 10-year bond sold on Sept. 16, 2009, the last time Illinois took competitive bids for tax-exempt general obligations, was priced at 37 basis points above top-rated debt. A basis point is 0.01 percentage point."

"Absolute rates on the tax-exempt sale for capital projects were the lowest for Illinois since at least 1976, according to Kelly Kraft, a spokeswoman for Governor Pat Quinn’s budget office."

Also read 'Market predicts state’s bond costs better than S&P ratings, experts say' at Medill Reports. If interested, I found a video of Salman Khan, founder of the Khan Academy, explaining the unfunded liabilities crisis across the country.

Illinois pension obligations: Using Illinois as an example of what happens when pension obligations are underfunded.

Source: Khan Academy

Did you know that unfunded pension liabilities aren't even reported on government balance sheets? In 2012, however, GASB, the Government Accounting Standards Board, voted to require states and municipalities to report this information to the public starting in 2013.

"“The new standards will improve the way state and local governments report their pension liabilities and expenses, resulting in a more faithful representation of the full impact of these obligations,” said GASB Chairman Robert H. Attmore. “Among other improvements, net pension liabilities will be reported on the balance sheet, providing citizens and other users of these financial reports with a clearer picture of the size and nature of the financial obligations to current and former employees for past services rendered.”"

Illinois has unfunded retiree health care benefits and pension obligation bonds outstanding as well. According to the Illinois Policy Institute (8/16/2012):

"State and local taxpayers are on the hook for far more than the pension debt owed by the state’s five pension funds. The state also owes $54 billion in unfunded retiree health benefits and another $15 billion the state borrowed to make its annual pension payments and shore up investment losses."


So, in conclusion, all of this explains why Illinois is #8 on CMA's top ten list of sovereigns most likely to default via their credit default swap spreads. ("CPD is calculated using an industry standard™ model and proprietary credit data from CMA Datavision and is based only on the price of the CDS and recovery assumption.")

Source: CMA - Market Data

Here is Illinois' 2011 CAFR (Comprehensive Annual Financial Report) if interested. Old data though.

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