California Turns Corner With Upgrade as Pensions Choke Illinois

Photographer: Ken James/Bloomberg

California Governor Jerry Brown gives the State of the State address in Sacramento, California. Close

California Governor Jerry Brown gives the State of the State address in Sacramento, California.

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Photographer: Ken James/Bloomberg

California Governor Jerry Brown gives the State of the State address in Sacramento, California.

California’s first credit upgrade in six years shows how curbs on pension costs, a voter-backed tax boost and an improving economy have allowed it to exit Wall Street’s basement, leaving Illinois as the lowest-rated state.

The higher rating by Standard & Poor’s marks a turnaround for California, which has the world’s ninth-largest economy and was once seen as ungovernable as it faced unrelenting budget gaps and issued IOUs to pay bills. Yesterday’s change came less than a week after Illinois had its score lowered, prompting officials to postpone a $500 million bond issue.

Both states have raised taxes. Both are controlled by Democrats, and both have seen unemployment decline. California Governor Jerry Brown, returning to the office he first held three decades ago, cut long-term retiree obligations, saving as much as $55 billion over 30 years. Illinois has skipped pension fund payments and failed to bolster America’s weakest retirement system, with a deficit that grows $17 million a day.

“California has made some difficult decisions, and is seeing generally improving finances, while Illinois has delayed the decisions,” said Robert Miller, a senior portfolio manager in Menomonee Falls, Wisconsin, at Wells Capital Management. The company oversees $1.4 billion in its two California funds.

California, whose 38 million residents make it the most populous state, is on track to collect $5 billion more in tax revenue in January than estimated in Brown’s budget, the state’s nonpartisan Legislative Analyst’s Office said this week, citing year-end stock sales and the improving economy as possible reasons.

Income Taxes

Illinois, with a population of about 12.9 million, will see revenue from personal-income taxes fall 1.5 percent this year, compared with a 13.8 percent increase in California, according to the National Association of State Budget Officers.

Brown persuaded voters in November to pass the highest statewide sales tax in the U.S. and raised levies on income starting at $250,000, for a temporary $6 billion annual revenue boost for seven years. He won reductions in pensions for new state employees and is benefiting from a legal change allowing his budget to be approved with a simple majority vote, rather than two-thirds of the legislature.

In Illinois, Governor Pat Quinn, a Democrat like Brown, has likened $97 billion of unfunded retirement obligations to a python strangling the state. Lawmakers have failed three times in the past eight months to agree on pension restructuring to increase employee contribution rates, freeze annual cost-of- living payments and eliminate free health care for retirees.

Increased Collections

While both California and Illinois have reported increases in tax collections as they recover from the longest recession since World War II, the Prairie State has had to pay Medicaid providers and other vendors to which it owes money, said Arturo Perez, fiscal affairs director for the National Conference of State Legislatures. Illinois’ backlog of unpaid bills has grown about $2 billion to $8.5 billion, Judy Baar Topinka, the Illinois comptroller, reported in January.

California, by contrast, “is in a whole different world than it was three or four years ago,” Perez said.

When Brown, 74, took office two years ago, he faced a $25 billion deficit with projected shortfalls of more than $18 billion annually through 2015. Last month, he surprised many in the statehouse when he unveiled a budget he said would leave an $851 million surplus, the first in almost a decade.

Just four years ago, California was forced to issue $2.6 billion of IOUs to pay daily bills amid a legislative impasse over how to erase a projected $42 billion deficit.

‘Very Different’

“California has some positive things, like the tax increase passed by the voters in November -- it would have been very different if they hadn’t passed that,” said Scott Pattison, executive director of the Washington-based budget officers’ group. “Illinois, frankly, has some financial management issues, particularly on the pension side, that have been unattended for a long time.”

The unexpected $5 billion increase in California’s projected tax revenue for January may be the result of high- income earners cashing out investments early in anticipation that federal income taxes would rise as part of a congressional deal over avoiding automatic tax increases, the Legislative Analyst’s Office said. U.S. levies on capital gains rose to 20 percent from 15 percent under this month’s agreement in Washington.

Another reason, the analyst’s office said, may be that wealthy residents chose to pay a portion of their obligations now instead of in April. Or it simply could be that the higher tax rates are generating more revenue than forecast as the economy improves.

Unemployment Decline

In California, the unemployment rate declined to 9.8 percent in December from 11.2 percent in the same month a year before, according to data from the state’s Employment Development Department.

The growth in jobs is being led by the technology industry in the San Francisco Bay Area, said Stephen Levy, director of the Center for Continuing Study of the California Economy in Palo Alto.

“For about the past 18 months the state has been adding jobs at a slightly faster pace than the nation,” Levy said yesterday in an interview. “That’s primarily due to very strong tech-related job growth in the Bay Area but also to a beginning upturn in housing and construction and a near-record tourism and convention year.”

Strengths ‘Re-emerging’

“The usual strengths of the California economy are re- emerging after the very long recession,” he said.

The Bay Area, home to Internet giants including Google Inc. (GOOG) and Facebook Inc. (FB), gained 91,400 jobs in 2012, up 2.9 percent from a year earlier, or more than twice the nationwide increase of 1.4 percent, according to Levy.

Tech jobs “pay a lot and so the folks there, when the industry is growing, there are not only added employees, there are added wages and bonuses, the stock prices are going up so there is a lot more wealth to spread around,” Levy said.

The California Public Employees’ Retirement System, the largest public pension in the U.S. with a market value of $254 billion, was fully funded with the global recession hit. That meant it had all the money it needed to pay for promised benefits to retirees for 30 years.

Cutting Liability

By 2009, at the depth of the financial crisis, the pension plan’s funding toward its obligations fell as low as 61 percent. It has since climbed to 74 percent, as of June 30, 2011, cutting $28 billion from its liability. Calpers, as the fund is known, has the authority to increase how much the state and cities must pay to cover retiree costs, depending on investment returns.

California still has tough financial challenges. Its pension funds faced a combined $112 billion of unfunded liabilities as of 2010, the Pew Center for the States said in a report last July. The state and local governments are short another $77 billion to cover the costs of retiree health care.

“The problems are still here, and they’re huge,” San Jose Mayor Chuck Reed said in an interview, referring to pension and retiree health costs.

S&P’s upgrade, the first since 2006, affects $73 billion of debt and lifts California one step to A, the sixth-highest level, the company said. California’s outlook was moved to stable from positive, and the grade on $9.3 billion of lease- revenue bonds increased to A- from BBB+. Moody’s Investors Service and Fitch Ratings raised California’s scores in April 2010 as part of a recalibration that didn’t reflect a change in credit quality, according to the California Treasurer’s website.

Political Gridlock

Illinois is paying for years of financial mismanagement and political gridlock, resulting in the worst-funded public pension system in U.S., with 39 percent of assets needed to cover projected obligations for five major groups of public employees, according to the Civic Federation, a Chicago-based nonprofit research group.

While unemployment in Illinois hovered near 9 percent last year -- it was 8.7 percent in December, above 7.8 percent for the U.S. -- pensions and unpaid bills represent the heart of the state’s financial crisis.

S&P cut the state’s general-obligation rating to A- from A on Jan. 28, citing inaction on pensions by lawmakers.

“We believe that legislative consensus on reform will be difficult to achieve given the poor track record in the past two years,” the S&P analysis said.

The financial hole was dug decades ago and made deeper by a series of reduced, delayed or ignored payments into the system. In 2005, for instance, lawmakers approved a so-called pension holiday that enabled the state to avoid cutting education and other programs. That cost the pensions $2.3 billion.

Financial ‘Python’

The state is legally required to make payments into the system annually, and with the backlog, the obligation is rising at a rate of more than $1 billion a year beyond the required amount. Quinn, in a failed campaign to prompt a legislative solution, called the financial pressure “Squeezy the Pension Python.”

Illinois postponed a $500 million offer of general- obligation bonds planned for Jan. 30, citing unfavorable market conditions after S&P lowered the state’s rating and threatened to cut it again.

While lawmakers returned to session last month in Springfield with vows to address pensions, the political challenge remains formidable. House Speaker Michael Madigan, a Chicago Democrat, is feuding with labor leaders who he says “strongly opposed” efforts to restructure the retirement plans.

Quinn, who is up for re-election next year, had a voter approval rating of 25 percent in a November poll. He faces a potential primary challenge from Madigan’s daughter, Attorney General Lisa Madigan, and William Daley, the brother of former Chicago Mayor Richard M. Daley.

To contact the reporters on this story: Michael B. Marois in Sacramento at mmarois@bloomberg.net; Tim Jones in Chicago at tjones58@bloomberg.net; James Nash in Los Angeles at jnash24@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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