Tuesday, June 4, 2013

Fitch Downgrades Illinois' GO Bond Rating to A-; IL's Unfunded Pension Liability is Approaching $100 Billion

Source: Ken Lund on Flickr 
Illinois' $94.6 billion unfunded pension liability (now probably at $100 billion), growing annual pension expenses, $5 billion in unpaid bills, and its inability to pass pension reform on May 31 forced Fitch to downgrade its GO rating to 'A-' on June 3.

"Illinois' long-term liabilities, particularly pension liabilities, are very high for a U.S. state. As of the most recent actuarial valuation, dated 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."

Read Fitch's full press release below or at Fitchratings.com.

"Fitch Downgrades Illinois' GO Rating to 'A-'; Outlook Negative
03 Jun 2013 4:26 PM (EDT)

Fitch Ratings-New York-03 June 2013: Fitch Ratings has downgraded the rating on $27.5 billion in outstanding Illinois general obligation (GO) bonds to 'A-' from 'A'.

In addition, the ratings related to the state based on its appropriation are downgraded to 'BBB+' from 'A-' as noted at the end of this release.

The Rating Outlook is Negative

SECURITY
Direct general obligation, full faith and credit of the state of Illinois.

KEY RATING DRIVERS

FAILURE TO TAKE ACTION ON PENSIONS: The downgrade 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 during the regular legislative session that ended May 31, 2013. Fitch believes that the burden of large unfunded pension liabilities and growing annual pension expenses is unsustainable, and that failure to achieve reform measures despite the substantial focus on this topic exacerbates concern about management's willingness and ability to address the state's numerous fiscal challenges.

NEED FOR LONG-TERM SOLUTION REMAINS: Temporary increases in both the personal and corporate income taxes, coupled with statutory spending limits, have closed a significant portion of the structural gap in the state's budget through fiscal 2014. The state will need to find a more permanent solution to the structural mismatch between spending and revenues, a prospect that appears more elusive following the inaction on pension reform, given the high profile support accorded that issue. The Negative Outlook reflects the continued rating pressure presented by the need for solutions to both the budget and pension issues.

LONG TERM LIABILITIES HIGH: Pension funding levels are exceptionally weak, and the unfunded liability as a percentage of personal income is at the high end of states rated by Fitch. The state's debt burden is above average and has risen over the past few years with issuance for operational purposes.

CONTINUED RELIANCE ON DEFERRING PAYMENTS: The state still carries a large accounts payable backlog, which totaled $5 billion at the end of fiscal year 2012. On a positive note, the state is using higher than forecast fiscal 2013 income tax collections to pay down a portion of the accounts payable balance. Nevertheless, the presence of this accumulated liability, and the reduced flexibility it causes, contributes to rating pressure.

ECONOMY A CREDIT STRENGTH BUT RECOVERY SLOW: The state benefits from a large, diverse economy centered on the Chicago metropolitan area, which is the nation's third largest and is a nationally important business and transportation center.

GO PLEDGE STRONG: There is an irrevocable and continuing appropriation for all GO debt service, and continuing authority and direction to the state treasurer and comptroller to make all necessary transfers from any and all revenues and funds of the state. The state funds debt service in advance by setting aside 1/12 of principal and 1/6 of interest every month for payments due in the ensuing 12 months.

RATING SENSITIVITIES
Maintenance of the 'A-' rating will require timely action in advance of the expiration of temporary tax increases in fiscal 2015. Deterioration in the state's financial position, as evidenced by excessive use of non-recurring revenues or additional payment deferrals would likely lead to a negative rating action. In addition, Fitch continues to believe that pension reform that enhances the funding levels of the pension systems and controls the growing impact of pension payments on the budget is necessary to stabilize the credit.

CREDIT PROFILE
The downgrade on the GO bonds of the State of Illinois to 'A-' from 'A' 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 general assembly legislature that ended on May 31. Fitch believes that the burden of large unfunded pension liabilities and growing annual pension expenses is unsustainable and the failure to take action to address the problem in the regular legislative session, despite the significant focus and support that reform efforts received, reflects a management profile that is inconsistent with maintenance of the 'A' rating.

Illinois' long-term liabilities, particularly pension liabilities, are very high for a U.S. state. As of the most recent actuarial valuation, dated 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. Pension payments will increase a further 18.2% to $6 billion in fiscal 2014. 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 ARC.

INABILITY TO REACH AGREEMENT ON PENSION REFORM
The legislature grappled with various pension reform proposals throughout the most recent legislative session and, despite competing legislation passing in both the house and senate, was not able to come to agreement on a final form of pension reform. Fitch believes that enactment of reform is critical to the long-term stability of the state's fiscal position, although legal protection of pension benefits is particularly strong in Illinois and Fitch expects any changes to be litigated.

Several reform proposals were presented by the governor and various legislators that would adjust benefits for existing employees, increase employee contributions, limit cost of living increases, and increase the retirement age. Other proposed structural changes to the pension program have included shifting some responsibility for employer contributions to school districts and state universities and establishing a 30-year funding schedule based on the actuarially required contribution (ARC) that aims to reach 100% funding by 2042. Under current statute, annual contributions are designed to reach 90% funding by 2045. In evaluating the credit impact of any reform, Fitch's focus would be whether the changes enhance the funding levels of the pension systems and control the impact of pension payments on the budget.

COMPREHENSIVE SOLUTIONS REMAIN ELUSIVE
The Negative Outlook reflects the challenges faced by the state in finding comprehensive solutions not only to reducing its unfunded pension liabilities, but also to maintaining budgetary balance in light of the temporary nature of the tax increases and the large accounts payable backlog.

The temporary increase in tax revenue, in conjunction with enacted hard spending limits moved the state closer to budgetary balance for fiscal years 2011 through 2014. Medicaid reforms implemented in the fiscal 2013 budget also made significant progress toward alleviating some pressure on the general fund. However, the tax increases will begin to phase out in 2015; thus, even if the state maintains budget balance to that point, it will once again be faced with a significant budget balancing decision to make permanent the tax increases, make severe expense reductions, or identify new revenues.

The legislature has passed a budget for fiscal 2014, which begins July 1, largely in line with the governor's proposal, which assumed modest revenue growth and controlled most discretionary spending to accommodate growing pension payments and increased healthcare expenses. The budget is expected to be balanced on an operating basis within the limitations of the current pension funding schedule, but does not address the accumulated accounts payable backlog.

For more information on the State of Illinois, please see Fitch's press release titled 'Fitch Rates $800MM Illinois GO Bonds 'A'; Ratings Remain on Watch Negative' dated March 22, 2013 and available at 'www.fitchratings.com'.

In conjunction with the action on the state's GO rating, Fitch has downgraded to 'BBB+' from 'A-' the rating of the following credit, which relies on state appropriation and is rated one notch below the state GO rating:

--$438 million Illinois Sports Facilities Authority, sports facilities bonds (state tax supported) series 2001.

The Rating Outlook is Negative."


Here's more info on Illinois' unpaid bills (payables) via the April/May Illinois Comptroller's Quarterly.

"At the end of March the third quarter totals showed the state’s financial position had not improved. In fact, payables at the IOC were $6.510 billion, or $940 million higher than the same time last year. Specifically, the IOC backlog was comprised of $4.893 billion in General Revenue Fund bills, $1.307 billion in Education Assistance Funds liabilities and $310 million in Common School Fund payables. When estimates of bills held at state agencies were included, the state’s total bill backlog was approximately $8.5 billion at the end of the quarter.

With a stronger-than-expected tax season, however, the IOC was able to cut into the size of the backlog in April and bring temporary relief to state vendors. At the end of April, total General Funds payables totaled $3.115 billion ($1.805 billion in General Revenue Fund bills and $1.311 in other General Funds) – approximately $1.5 billion lower than one year before. When estimates of agency bills were included, the state ended April with a total bill backlog of $5.5 billion. However, it is important to note that the strong tax season is viewed as a one-time occurrence prompted by a tax season in which residents and businesses accelerated transactions to take advantage of 2012 federal tax rates.

Moving forward,the IOC expects the amount of fiscal year 2013 obligations carried over into the next year to exceed $6 billion and, depending on the budget enacted by the General Assembly, the back log continue to remain high in the summer and fall months. Long-term fiscal questions also remain. More than two years after the state’s income tax increase went into effect, base revenue growth is still primarily dependent on income tax receipts; when those increases are reduced in 2015, revenues will experience a significant decline – causing payment delays to grow.

So, bring on the reform. And how about legalizing marijuana? Tax marijuana sales and dealer incomes like pharmaceuticals, cigarettes and alcohol (Ex-Microsoft exec seeks to create 'Starbucks of marijuana'; Illinois Senate Passes Medical Marijuana Legislation).

More articles on Fitch's downgrade and related blog posts from January 2013.

*Illinois Losing Rally as State Fails to Fix Pension: Muni Credit (Bloomberg)
*Illinois Bond Grade Cut as Lawmakers Can’t Fix Pensions (Bloomberg)
*Illinois Pension Reform: Credit Concerns Rise After State Legislature's Failure (Reuters at HuffingtonPost)
*Path to Illinois pension reform now even trickier (AP)
*Analysis: Tough going ahead on path to Illinois pension reform (Reuters)
*Illinois hits a sorry milestone (unfunded pension liability hits $100 billion, Crains Chicago, 3/2013)
*Fitch Places Illinois GO Bonds on Negative Watch, Says Large Unfunded Pension Liabilities Unsustainable - TEXT (1/11/2013)
*Will Illinois' Unfunded Pension Liability End Up Repricing Its Debt? (1/30/2013)

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