* Fitch Ratings…

Recent pension proposals from Illinois’ new governor are an important first step in addressing the state’s significant fiscal challenges, according to Fitch Ratings. But whether or not they are implemented, Fitch anticipates Illinois’ long-term liability burden will remain elevated and amongst the highest for U.S. states for the foreseeable future. Fitch also anticipates annual employee retirement costs will continue to pressure the state’s expenditure flexibility. Fitch’s focus in the near term, reflecting the key rating sensitivity in resolving our Negative Outlook, remains Illinois’ ability to achieve progress in addressing its immediate structural budgetary challenges. The pension proposals offer a mix of potential revenue increases, cash and asset infusions, indirect benefit changes and an actuarial adjustment, to address the liability and budgetary demands of the states’ pension systems. Several elements will take months or even years before full implementation. […]

The pension plan outlined by Illinois’ Deputy Governor for Budget and Economy includes five closely related proposals. The first is to dedicate $200 million of new revenue from a proposed graduated income tax as an annual supplemental pension contribution. While this would be in addition to the statutory pension requirement, Fitch notes this statutory requirement only targets 90% funding of pension liabilities. In fiscal 2018, the gap between the state’s 90% statutory funding requirement and the actuarially determined contribution was over $1 billion dollars, more than five times the amount of the proposed supplementary funding. The graduated income tax requires a state constitutional amendment that must be approved by legislative super-majorities (which Democrats have in both chambers) and then by voters, also by a super-majority. Fitch estimates the earliest it could be approved would be in the November 2020 general election.

A second proposal to repurpose or sell state-owned assets to support the pension systems is also uncertain. The administration recently created a taskforce to evaluate state assets for this purpose but has not yet indicated a specific target amount or a timeline. Fitch cautions that financial engineering transactions that use a government-owned asset to strengthen a pension plan’s funded condition and slow the burden of rising contributions are not a substitute for more fundamental reforms that correct an underlying sustainability problem.

The third proposal is for issuance of $2 billion in pension obligation bonds (POBs) to reduce the pension liability rather than as budgetary relief for annual contributions - this reflects about 1% of the most recent estimate of the Illinois’ Fitch-adjusted net pension liabilities of more than $162 billion. Fitch generally considers POBs a neutral to negative credit factor. If POB proceeds are deposited with a pension trust, while full actuarial contributions continue to flow uninterrupted from annual budgetary resources, the issuance of POBs offsets the unfunded liability and has little immediate effect on the issuer’s overall long-term liability burden. In announcing the plan, the Deputy Governor said the state would only pursue the bonds if interest rates are lower than the discount rate on pension obligations at the time of issuance. Fitch notes that the POBs could be multi-decade obligations and present inherent investment and timing risks.

Fourth, the administration proposes extending the buyout programs enacted with the state’s current year budget, perhaps permanently. Several of the buyout programs have accepted applications but no payouts have been made to date. Fitch previously indicated uncertainty in the savings budgeted in fiscal 2019 from these buyouts. Extending them indefinitely could add to current year budget pressure by eliminating the incentive for eligible pension system members to sign up for a buyout this year, thereby reducing the immediate savings to the state. Over the long-term, Fitch considers the proposed open-ended buyouts as indirect pension benefit changes that could gradually reduce the long-term pension liability, but would require an ongoing funding source. Illinois’ fiscal 2019 budget anticipated issuance of up to $1 billion in GO bonds to fund pension buyouts. Absent a constitutional amendment, Illinois’ ability to more directly reduce already-accrued retiree benefits appears sharply limited.

The fifth proposal is arguably the clearest and most achievable change, but one that comes with considerable risk. To reduce the annual budgetary burden, the governor proposes extending the current closed 26-year amortization by seven years to 2052, while maintaining the comparatively weak 90% funding target. Re-amortization has been used by other state and local governments when addressing pension challenges, but is typically in the context of a commitment to achieving full prefunding, making actuarially determined contributions, and sometimes, benefit changes for current or future employees and retirees. Illinois’ re-amortization would maintain an inadequate funding target and be combined with uncertain revenue commitments, and limited indirect benefit changes.

The pension proposals in aggregate attempt to reduce immediate budgetary demands and longterm net pension liabilities, but on their own are unlikely to affect Fitch’s rating trajectory for Illinois’ IDR in the near term. Resolution of our Negative Outlook hinges on the state’s ability to address structural budgetary issues in the current year and fiscal 2020, and demonstrate progress toward more sustainable fiscal management. Fitch has previously identified more than $2 billion in risks and one-time items in Illinois’ nearly $40 billion fiscal 2019 general funds budget. The administration recently estimated the structural deficit for fiscal 2020 at $3.2 billion. The governor’s pension plan and his upcoming executive budget proposal will begin the process of determining how Illinois will meet these pressing fiscal challenges. [Emphasis added.]

Discuss.