* From Fitch Ratings’ “Illinois: What Happens Next” report…
The governor-elect’s plans regarding pension liabilities focus more on possible adjustments to the state’s funding schedule, rather than on any steps to seek employee consent for or constitutional changes to allow for accrued benefit changes, or shifting costs to school districts or public universities as proposed by the incumbent. When asked about his pension proposals during the campaign, the governor-elect suggested stepping up the statutory payment to a level-dollar amortization that would potentially mean higher annual contributions in the near- compared to the systems’ level percentage-of-payroll amortization under current statute. He did not provide extensive details on where the necessary funding would come from. Fitch notes that the current statutory contribution remains inadequate relative to the level recommended by actuaries to ensure full funding over time.
So far so good.
One possibility, advocated by the also progressive-leaning Center on Tax and Budget Accountability (CTBA) in Illinois, is to use pension obligation bonds (POBs) to partially fund stepped-up pension contributions for several years. The proposal also calls for re-amortization of pension liability with a new funded ratio target of 70% by 2045, versus the already comparatively weak 90% statutory funding target (also by 2045) under the current statutory ramp-up. The CTBA’s executive director was recently appointed as one of 17 members of the governor-elect’s budget and innovations transition committee.
Fitch has previously noted that issuance of POBs is generally neutral to negative for an issuer’s credit quality. If POB proceeds are deposited with a pension trust, while actuarial contributions continue to flow uninterrupted from annual budgetary resources, the issuance of POBs offsets unfunded liability and has little immediate impact on the issuer’s overall long-term liability burden.
However, the CTBA proposal to use proceeds for budget relief by offsetting an annual pension contribution is viewed by Fitch as deficit financing. Such situations result in the issuer’s bonded debt increasing without necessarily a corresponding decrease in its net pension liabilities, a factor that may negatively weigh on the credit ratings.
* I asked the CTBA’s Daniel Kay Hertz for a response…
CTBA agrees that using POBs to “offset an annual pension contribution”—ie, to replace funding that would normally be coming from tax revenue—is irresponsible. That was one of the upshots of our Crain’s editorial in August.
But I think it’s not right to say the POBs in the reamortization plan are “offsetting an annual pension contribution.” Those POBs are *in addition to* the amounts paid with tax revenue as scheduled under current law. In other words, CTBA’s reamortization plan doesn’t create false savings by substituting tax-funded spending with debt-funded spending; it uses all of the POB proceeds to directly increase contributions to the pension systems as a bridge to the level-dollar amortization contributions.
As for the 70% funded ratio target, two things. First, and most importantly, by putting more money in the pension systems up front, CTBA’s reamortization plan actually increases the funded ratio *faster* than the current ramp through about the mid-2030s. That’s crucial in the short term because it gives the pension systems more breathing room in the increasingly likely case of a recession. In the longer term, it’s important because it means that, fifteen years from now, if the state decides it wants and is in a position to increase its funded ratio target for 2045, *it will be in no worse, and maybe a better, position to do that than under the current ramp*. Because, again, the funded ratio is actually higher under the CTBA reamortization than under the current ramp through the mid-2030s.
Second, while pushing the pension systems’ funded ratios higher is important, it needs to be weighed against the state’s capacity to raise revenue and fund crucial public services. Our view is that the current ramp—which achieves a 90% funded ratio in 2045 by calling for annual contributions approaching $20 billion at the end of the schedule—is just not sustainable without unrealistic, and intolerable, revenue increases and service cuts.
In large part because of the pressure created by pension debt in the ramp, Illinois’ real per capita General Fund spending on current services has already declined by more than 20% since FY2000, including a 50% cut to higher education. We understand that a 70% funded ratio target isn’t ideal in the abstract, but in the actual circumstances Illinois finds itself in, we believe it is part of a plan that responsibly stabilizes the pension systems while creating room for the state to meet other obligations that Illinoisans depend on.
* I had earlier asked Hertz to explain the group’s idea…
So basically the challenge with replacing the ramp with the level-dollar reamortization is that, while the level-dollar saves a lot of money over the whole 2019-2045 period, it requires higher payments for the first eight years.
Our suggestion, essentially, is that in each year where the level-dollar payment is higher than the ramp payment (as currently projected), we fill the gap with a POB, to avoid facing a cliff of either new revenue just for pension contributions or service cuts. So if in a given year the level-dollar payment is $1 billion over what the ramp would have called for, the state would issue $1 billion in POBs. Since the level-dollar payments are higher than the ramp payments for the first eight years, that means we’re talking eight years of POBs, which add up to a total of $11.2 billion.
The period over which we pay off those POBs is 30 years, at (in our model, using a very high 6.5% interest rate) between $900 million and $1 billion per year when all of them have been issued.
Then there’s the question of the freed up revenue from the old POBs that are coming off the books in the next year or so. In our model, we see that revenue—nearly $1 billion a year—as money that should be redirected from paying debt service on POBs to directly supporting the pension systems, and so we use that as well to boost the state’s annual contributions.
* Is there arbitrage involved?…
No. There may very well be some arbitrage benefit, but that isn’t really the point. The point is to be able to immediately get annual contributions to the pension funds up to the amount called for by the level dollar plan.
In a “pure” version of reamortization, you just make that full payment from tax revenue, and the state would be forced to either immediately raise a sizable amount of additional funds or cut spending. The POB idea is to ease that transition so there aren’t big shocks on either side.
And to be clear, making the full payments with tax revenue would save more money, looking just at the pension systems, than easing the transition with POBs. But a) the POB version still saves $67 billion between 2019 and 2045 in our estimates, and b) the POB version may be more realistic, given that the state has many other crucial services it needs to fund. In other words, we don’t think it’s a great idea for the state to find the money to make the level-dollar contributions by further slashing higher education funding or human services.