Will Public Pensions Sink Illinois?

The Associated Press reports, Illinois debt is about to be rated 'junk.' What that means:

Illinois is on track to become the first U.S. state to have its credit rating downgraded to "junk" status, which would deepen its multibillion-dollar deficit and cost taxpayers more for years to come.

S&P Global Ratings has warned the agency will likely lower Illinois' creditworthiness to below investment grade if feuding lawmakers fail to agree on a state budget for a third straight year, increasing the amount the state will have to pay to borrow money for things such as building roads or refinancing existing debt.

The outlook for a deal wasn't good Saturday, as lawmakers meeting in Springfield for a special legislative session remained deadlocked with the July 1 start of the new fiscal year approaching.

That should alarm everyone, not just those at the Capitol, said Brian Battle, director at Performance Trust Capital Partners, a Chicago-based investment firm.

"It isn't a political show," he said. "Everyone in Illinois has a stake in what's happening here. One day everybody will wake up and say 'What happened? Why are my taxes going up so much?'"

Here's a look at what's happening and what a junk rating could mean:

Why now?

Ratings agencies have been downgrading Illinois' credit rating for years, though they've accelerated the process as the stalemate has dragged on between Republican Gov. Bruce Rauner and the Democrats who control the General Assembly.

The agencies are concerned about Illinois' massive pension debt, as well as a $15 billion backlog of unpaid bills and the drop in revenue that occurred when lawmakers in 2015 allowed a temporary income tax increase to expire.

"In our view, the unrelenting political brinkmanship now poses a threat to the timely payment of the state's core priority payments," S&P stated when it dropped Illinois' rating to one level above junk, which was just after lawmakers adjourned their regular session on May 31 without a deal.

Moody's did the same, stating: "As the regular legislative session elapsed, political barriers to progress appeared to harden, indicating both the severity of the state's challenges and the political difficulty of advocating their solutions."

What is a 'junk' rating?

Think of it as a credit score, but for a state (or city or county) instead of a person.

When Illinois wants to borrow money, it issues bonds. Investors base their decision on whether to buy Illinois bonds on what level of risk they're willing to take, informed greatly by the rating that agencies like Moody's assign.

A junk rating means the state is at a higher risk of repaying its debt. At that point, many mutual funds and individual investors — who make up more than half the buyers in the bond market — won't buy. Those willing to take a chance, such as distressed debt investors, will only do so if they are getting a higher interest rate.

While no other state has been placed at junk, counties, and cities such as Chicago, Atlantic City and Detroit have. Detroit saw its rating increased back to investment grade in 2015 as it emerged from bankruptcy — an option that by law, states don't have.

What will it cost?

Battle says the cost to taxpayers in additional interest the next time Illinois sells bonds, which it inevitably will need to do in the long-term, could be in the "tens of millions" of dollars or more.

The more money the state has to pay on interest, the less that's available for things such as schools, state parks, social services and fixing roads."

For the taxpayer, it will cost more to get a lower level of service," Battle said. Comptroller Susana Mendoza, who controls the state checkbook, agreed.

"It's going to cost people more every day," she said. "Our reputation really can't get much worse, but our state finances can."

Other impacts?

Because the state has historically been a significant funding source to other entities, such as local government and universities, many of them are feeling the impact of Illinois' worsening creditworthiness already.

S&P already moved bonds held by the Metropolitan Pier & Exposition Authority and the Illinois Sports Facilities Authority — the entities that run Navy Pier, McCormick Place, and U.S. Cellular Field — to junk. Five universities also have the rating: Eastern Illinois University, Governors State University, Northeastern Illinois University, Northern Illinois University and Southern Illinois University.

Cole Lauterbach of the Illinois News Agency also reports, Lawmakers spend Sunday talking pensions; still no budget:

Illinois House lawmakers used one of their final days of the special session discussing the merits of different pension reform proposals. No votes were taken on it or a budget.

After quickly going through the motions to enter and exit the special session mandated by Republican Gov. Bruce Rauner and passing a couple non-budgetary items, panel discussions continued.

The state's official estimate of unfunded pension liabilities is $130 billion, but Moody's places the state's shortfall at closer to $250 billion. Both numbers are higher than nearly any other state. Illinois' annual pension obligation is around 25 percent of its annual budget. That's set to increase based on the changes to reforms made by lawmakers and former Gov. Jim Edgar.

Lawmakers on both sides of the aisle have filed reform proposals for pensions. They make a number of changes ranging from limiting cost-of-living increases in exchange for other benefits, to creating a new classification for teachers with a different structure of benefits.

Virtually all of the panelists that testified Sunday had union connections, and they were cool to any proposal that made pensions more affordable to taxpayers. They said the proposed reforms would diminish pensions, deemed unconstitutional by the Illinois Supreme Court.

"Pensions are good public policy," said Daniel Montgomery, president of the Illinois Federation of Teachers, who opposed changes to the current systems beyond those that would lead to better funding. "We've had a long history of not funding them properly."

Others said the changes did nothing to solve the massive fiscal crisis.

"Taxpayers have put in $20 billion more than the 'Edgar ramp' originally called for and yet, despite those billions more, pensions are going bankrupt," said Ted Dabrowski, vice president of Policy for the Illinois Policy Institute. "We may soon have the first junk bond rating of any state. Pensions are a driver of that. Illinois needs the boldest reforms. The two bills in question would only perpetuate the crisis and make things worse."

Dabrowski advocated eliminating defined benefit pensions for new state hires, which he said are unaffordable to taxpayers and going bankrupt. Instead, new state employees should be enrolled in a defined contribution plan similar to 401(k)'s that most private businesses have converted to. This would give the employees control of their retirement funds and prevent politicians from under-funding them.

While the thought of having a lifetime guaranteed paycheck from a pension sounds appealing, there are setbacks. Should a teacher spend a decade in a classroom, decide to change course and pursue another career, their pension would not be portable. That decade of contributions would be lost. Members of some pensions are also ineligible for Social Security benefits, making their defined-income plans their only offered source of income in retirement beyond a separate plan. And some, such as Dabrowski, fear Illinois' pension systems are so underfunded that they face bankruptcy, which would lead to reduced benefits.

What a mess. I've been watching the slow motion train wreck of Illinois's public pensions for years, especially the Teachers' Retirement System (TRS).

The Illinois House and Senate recently passed legislation to reform teacher pension funding but the situation is so grave that Illinois Governor Bruce Rauner, a former private equity executive before his 2014 election to the governor's office, has made several new appointments to the board of the $46 billion pension plan and named Marc Levine chair of the Illinois State Investment Board (ISIB) and to the teachers' retirement board.

As far as reforms, I don't agree with Dabrowski who advocates eliminating defined-benefit pensions for new state hires. Illinois's teachers and public sector employees know all too well about the brutal truth on defined-contribution plans.

Importantly, shifting public or private sector workers out of DB into DC plans just doesn't make sense. It's dumb public policy because it will exacerbate pension poverty over the long run and detract from Illinois's economic activity over the long run.

But the unions can't have their cake and eat it too. Illinois teachers need to accept some form of risk-sharing in their plan just like Ontario's teachers did, which is why their plan is fully funded while Illinois's TRS is still on death watch, chronically underfunded and in need of major reforms.

The other thing that the Ontario Teachers' Pension Plan has is first-rate governance, separating government out of investment decisions and paying its pension managers properly to attract and retain talent to bring assets internally.

It looks like Marc Levine is trying to reform the way Illinois public pensions are doing business but the situation is so grave that they absolutely need concessions from unions to share the risk of their plan. I've discussed all these issues in my comment on the pension prescription where I also discussed the big squeeze fees have on these pensions.

As far as the issue of pension portability, I don't understand why teachers who leave their work after a certain number of years cannot leave their pension money in a DB fund and get reduced benefits in the future. If they want to receive a lump-sum payment to put it into their 401(k) plan, sure, but my advice would certainly be against this.

Honestly, what Illinois and other states that suffer from similar pension woes need is to amalgamate all these public pensions at the state level, introduce better governance, adopt a shared-risk model, and get real on investment  returns even if this means higher contributions from employees and the state government (these plans need be jointly sponsored).

But none of these reforms are being discussed. Instead, lawmakers want quick fixes which will make things worse for everyone, including Illinois taxpayers.

In the meantime, rating agencies are taking notice, targeting chronically underfunded US state plans,  much to the dismay of state governments and taxpayers. Not that the rating agencies have much of a choice but to take notice. The pension storm cometh and it will crush many chronically underfunded mature state pension plans.

In fact, ValueWalk recently did an analysis stating that US pensions funds have a $4 trillion hole and even a 5% decline could be catastrophic. But it's even worse than that because this analysis only focuses on assets, not liabilities. If rates plunge to record low levels and stay there, the catastrophe will be much worse than anything we can imagine (remember a decline in rates impacts pension deficits a lot more than a decline in assets because the duration of liabilities is a lot bigger than the duration of assets).

The situation really scares me because it will impact millions of workers and beneficiaries of these state plans as contributions rise and benefits decline. It's not just GE that botched it pension math, it's pretty much the majority of US public plans, and when it hits the fan, it will be devastating.

Maybe I'm too cynical, perhaps I'm not seeing a silver lining in this grim situation, but I doubt it. I've been looking at this from all angles and it's just ugly and getting worse. But if you see some hope in this US public pension catastrophe, feel free to email me your thoughts at LKolivakis@gmail.com.

Below, Marc Levine, chairman of Illinois State Board of Investment, talks about the hedge fund wrecks and which ones he actually trusts. The “Fast Money” traders weigh in.

Over the weekend, I listed Penta's top 100 hedge funds on LinkedIn but didn't notice any of the three hedge funds mentioned in the clip below, which isn't necessarily a bad thing. In fact, I quickly looked at the portfolio and AUM of HR Vora Capital Management which was among the three mentioned below and liked what I saw (take all these top hedge funds lists with a shaker of salt!!).

But like I said when I went over GE's botched pension math, more hedge funds and private equity funds aren't the solution to America's public pension crisis. So, no matter what Mr. Levine and his team do on that front, it won't make a big difference when it comes to public pensions sinking Illinois.