Pension Financing Shortfall Is a Threat on the Horizon for State

Friday, April 23, 2010

In this Tea Party age, when thousands of people demonstrate nationwide against high taxes, the 15,000 people who rallied in Springfield last week tried a change-of-pace chant. “Raise My Taxes!” they shouted at the television cameras and any lawmakers who happened by.
The clamor over the state’s estimated $13 billion budget deficit —and concerns over jobs and spending that prompted the protests — tends to drown out discussion of an issue that economists identify as perhaps the biggest long-term threat to Illinois’s financial health: The state’s shortfall of at least $61 billion in pension funding and the lack of any realistic plan to catch up.
In fact, the state’s pension troubles are even more dire than the official figures would indicate, according to a review of pension data and other economic studies by the Chicago News Cooperative. Illinois, which sold $3.47 billion in securities so it could make its required contribution to pension funds this year, is laying plans to sell at least $4.6 billion more to meet its obligations for fiscal 2011 — a move that is likely to jolt financial markets and many investors who thought years would pass before the state tried another sale of notes to cover its pension costs. Taxpayers ultimately will bear the burden as the need to pay for the bonds strains the state budget and threatens spending in other areas.
To date, the state has provided only about 54 percent of the money necessary to meet its projected long-term obligations, according to a study by the Pew Center on the States. But economists who have studied the state’s figures say Illinois’s true obligation to retirees most likely is far larger than official estimates.
The state legislature’s Commission on Government Forecasting and Accountability has put the shortfall at $61 billion. But a group of business leaders led by the Civic Committee of the Commercial Club of Chicago estimates the actual figure at $79 billion, and Joshua D. Rauh, a Northwestern University economist and an expert on how states finance their pension systems, offers a much higher estimate: $166 billion in the largest three funds alone.
The fight over such a long-term problem has immediate consequences for the state. Illinois is borrowing billions of dollars to catch up on its pension shortfall, and the extra borrowing adds to the state’s debt burden.
Pensions are not the only area in which the state is failing to meet its long-term commitments to current and former employees. Illinois is $40 billion behind in covering retiree health care costs. In order to eliminate the shortfall — which had gone unnoticed because the legislature did not require reporting by state health plans until recently — taxpayers would have to lay out at least $550 million a year, according to Moody’s Investors Service.
In the past, the pension and health-care shortfalls were largely overlooked by Illinois taxpayers and politicians. But not any longer: the state’s pension problems, in particular, have become a major concern among investors, and a potentially potent issue as Springfield legislators try to agree on a state budget.
“Illinois is clearly at the top of the list in terms of states that have a funding problem for their pensions,” said Susan K. Uhran, managing director of the Pew Center on the States. In a nationwide study, Pew found that Illinois’s 54 percent funding of pension obligations is lower than any state in the nation.
Ted Hampton, a Moody’s analyst, said, “Not only do they have an under-funded pension relative to other states and a very weak financial situation, but they are struggling to make their statutorily required contributions to the pension plans, and they don’t have the revenues to do it.”
Moody’s downgraded Illinois’s credit rating in December and assigned a “negative outlook” in late March to a proposed state bond offering, in large part because of the pension problems. An upgrade announced earlier this year was the result of a change in Moody’s rating system, not an improvement in the state’s fiscal condition.
Laurence Msall, president of the Civic Federation, a tax policy and government research organization, said he was startled when he heard recently from David Vaught, the state budget director, that Gov. Patrick J. Quinn plans to issue up to $7 billion in new debt instruments, at least in part to pay for next year’s $4.1 billion pension contribution..
“This is both fiscally irresponsible and very expensive,” Mr. Msall said.
Illinois first issued pension bonds in 2003, when former Gov. Rod R. Blagojevich pushed through a $10 billion bond issue, the largest such deal ever, purportedly to help the state catch up on pension contributions. But nearly a quarter of the proceeds went to fill gaps in the state’s budget.
By 2007, the state’s unfunded pension liability had grown back to the level it had hit prior to the $10 billion bond sale. Now, the state’s taxpayers must pay interest of more than $540 million a year on those bonds and outlays will escalate sharply in coming years as the state must repay the borrowed funds.
Contributing to Illinois’s pension troubles is a tendency to be overly optimistic when budgeting how the pension-fund managers will perform.
Today, Illinois is one of only five states that budgets for an investment return as high as 8.5 percent. Over the last 10 years, four of the state pension funds — those representing teachers, state employees, judges and state lawmakers — have averaged only a 3.89 percent return. Data for the state’s university employees, representing about one-fifth of the state pension funds, could not be obtained.
For the four pension funds, the returns on investment over the last decade have come in at less than half the forecasted amount — a shortcoming that could have huge ramifications over time as state taxpayers are forced to make up the difference.
Even a small change in investment returns can have a huge impact on the long-term financial health of the state pension plans. But a recent change in the way Illinois reports investment results has shaken confidence in the state’s estimates.
A law passed last year allows the Commission on Government Forecasting and Accountability to report average investment results over a five-year period when estimating the state’s pension shortfall. The technique, called “asset smoothing,” can have a large impact after a year like 2009, when the five state pension funds as a group lost 20 percent.
Some pension watchers are crying foul over the practice. The issue caused a rift last year on the state’s Pension Modernization Task Force, prompting a group led by the Civic Committee to issue a dissenting report, in part because of concerns that asset smoothing was enabling the state to provide misleading estimates of Illinois’s unfunded pension liabilities.
Business leaders wrote in their report that asset smoothing “cannot possibly justify false reporting” of the state’s pension shortfall. Instead of the $61 billion official figure, the dissenting group put the unfunded liabilities at $79 billion.
In 1995, the state began a 50-year plan to catch up on its legal obligation to make good on pension commitments to state employees. The target: 90 percent financing of the state’s pension plans by 2045.
Since then, the state has taken some form of “holiday” on meeting its obligations under the plan in at least four separate years. And required payments are expected to rise sharply next year because fiscal 2010 marked the end of a 15-year ramp-up phase toward much steeper annual contributions.
Last month, the legislature adopted a program to permanently slow the growth of the state’s pension liabilities. The program raises the retirement age to 67, and caps the top pension-eligible salary at $106,800. Instead of the guaranteed benefits offered to current employees, new hires will be offered only a defined-contribution pension plan.
Mr. Rauh, from Northwestern, quickly dubbed the new law Illinois’s “irrelevant pension reform.” Despite the change, Mr. Rauh estimated, Illinois’s three largest pension funds will run out of money by 2018 if no further reform measures are enacted.
Such an event, Mr. Rauh said, “threatens to bankrupt the state on a 10-year horizon.”
The reforms do not go far enough, Mr. Rauh added. For example, current employees have earned the pension benefits they have accrued up to this point, but it would be legal, he said, to reduce pension benefits for any future work.
Without major reform in the near future, Mr. Rauh said, the state could face serious financial trouble. “How many years,” he said, “before the capital markets say, ‘Geez, these guys are close to running out of money.’ ”