How effective was Illinois’ pension reform?
The state of Illinois had two milestone events recently. The legislature passed a long-awaited pension reform and the state treasurer issued $350 million of taxable general obligation (GO) bonds. The Bond Buyer reported on the GO offering:
The yields ranged from 0.75 percent on the short end to 5.65 percent on the long end. The two-year maturities priced at a yield of 1.28 percent, 95 basis points above a Treasury rate of .33 percent. The spread on the state’s final 2038 maturity was about 175 basis points more than the 30-year Treasury rate of 3.90 percent Thursday.
Thomson Reuters Municipal Market Monitor’s Dan Berger wrote in a December 10 commentary about Illinois GO bonds:
Hopefully, MMD clients have learned some lessons during the past few years. One of these lessons is that spreads are a leading indicator of credit.
(A3/A-/A-) State of Illinois General Obligation bonds are a perfect example of this phenomenon. Last week the Illinois legislature passed a bill designed to alleviate the ‘Prairie State’s’ pension liabilities which are estimated to be $100bln. Reuters reports this bill as a ‘landmark.’
What happened next? We saw improved trading in IL GO bond trading and lowered the spread of 10 year IL GO bonds from +173 bps to +160 bps. Last night this spread closed steady from Friday’s level at +158 bps.
Berger details the lower spreads (or yield to benchmark) that market participants were paying for Illinois GO bonds. This means greater market confidence in Illinois’ fiscal future following pension reform. Investors were demanding less yield for the risk of owning Illinois bonds.
Adam Buchanan, Vice President of Institutional Sales & Trading at Ziegler Capital Markets in Chicago said that pension reform was going in the right direction and that the market liked this.
As the yields for Illinois bonds came down (spreads narrowed), the state brought the new $350 million taxable bond offering into the market to take advantage of lower borrowing costs.
The credit rating agencies weighed in on reform in Illinois. Moody’s showed it as the largest reduction by any state of its accrued pension liabilities (COLA = cost of living adjustment):
Fitch Ratings wrote:
Illinois’ long-term liabilities, particularly pension liabilities, are very high for a U.S. state and will remain so even if there is improvement with pension reform. 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 percent reported funded ratio. The state notes that the recently enacted reforms could reduce unfunded liabilities as much as $21 billion, which would improve the funded ratio by approximately 6 percent.
The true impact of pension reform will not be known until an actuarial analysis is undertaken by the state. Illinois is the weakest of the states in terms of its ratio of debt and unfunded pension liabilities to personal income, at 24.8 percent, well above the median of 7 percent for states rated by Fitch.
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 percent, reflecting in part the use of more conservative investment return assumptions. Pension payments increase a further 17.3 percent to $6 billion in fiscal 2014.
Morningstar noted that the pension reform increased the retirement age:
Currently, the official retirement age differs based on an employee’s age and years of service, with some agreements allowing members to retire as early as 55 years old. Moving forward, that retirement age will be increased gradually but only for current employees who are 45 years old or younger. For each year that an employee is under the age of 46, the allowable retirement age will be increased by four months. This increase is capped at five years for all affected.
Moody’s says that additional payments into the pension system will come from two places, and will furthermore cause the pension system shortfall to shrink:
Supplemental contributions [to the pension system] under the latest reforms would come from two sources: 10 percent of the savings would be from the reforms, including cost of living adjustment (COLA) changes, and revenue the state is currently using to provide debt service on pension funding bonds issued in 2010 and 2011. The last of those bonds mature during the fiscal year ending June 30, 2019, when debt service requirements will total $900 million.
These supplemental funds, which will exceed $1 billion annually starting in fiscal 2020, would accumulate in the state treasury’s Pension Stabilization Fund and be transferred monthly to the pension systems. However, the state will not use these funds to reduce its base contributions, which under SB 1 must be enough to achieve full amortization of unfunded liabilities over 30 years.
Market and rating agency reaction to Illinois’ pension reform was positive. The state’s legislature and governor are to be commended for passing the legislation. The value and legality of the reform remains to be analyzed, however. Stay tuned.