Illinois Evading Pension Fix Leads State Gaps Wider: Muni Credit

Led by Illinois, U.S. states have lost ground for five straight years in socking away enough assets to pay retired workers.

Illinois was the most-populous of five states, including Kentucky, North Dakota, Oregon and Vermont, where pension-funding ratios fell at least 21 percentage points from 2007 to 2012, data compiled by Bloomberg show.

The nationwide median ratio of 69 percent is down from almost 83 percent in 2007, according to the data. The longest recession since the 1930s devastated portfolios and pushed some officials to forgo pension allocations as tax revenue sank. Even with investment returns rebounding, many states haven’t funded enough to fill the gap. In some cases, including Illinois, proposals to cut payouts by reducing benefits have stalled.

“A lot of states are not making their full contributions,” John Carlson, vice president in the Federal Reserve Bank of Cleveland’s research department, said in an interview. “When they’re underfunded, they’re supposed to make additional contributions to close the gap.”

For states and municipalities nationwide, the swelling obligations are leaving officials with the quandary of where to allocate tax dollars -- to services such as education or toward retiree benefits. In Illinois, which has $5.3 billion in unpaid bills, Democratic Governor Pat Quinn has likened the pension expense to a python strangling state finances.

Lawmakers’ Limits

States with weaker funding levels can pay a price in the $3.7 trillion municipal-debt market. Illinois, Pennsylvania and New Jersey have had their credit ratings cut since the start of 2011 in part because of pension burdens.

Illinois lawmakers have failed to enact a pension fix at least five times in the past 15 months. Legislators are meeting today as part of a session that is scheduled to last through tomorrow.

The state has seen the extra yield on its bonds swell to more than five times that of California, even though the latter is rated just one level higher by Standard & Poor’s. Increased relative borrowing costs mean more money going to repay debt and less left to pay for services for residents.

Investors’ Choice

“I’d rather invest in a state that is more underfunded and making its contributions than a state that is less underfunded but not trying to catch up,” said Eric Friedland, head of municipal credit research in New York at Schroder Investment Management North America, which oversees about $3 billion of munis.

States may have to reduce benefits, increase taxes or limit services to keep pension promises, said Eileen Norcross, senior research fellow at George Mason University’s Mercatus Center in Arlington, Virginia.

“There’s going to have to be a structural reform of a lot of these plans,” she said.

Forty-eight states have enacted pension changes since the 18-month recession that ended in June 2009, according to Luke Martel, senior policy specialist at the Denver-based National Conference of State Legislatures.

“In some states they need multiple rounds of reform, and Illinois would be one of those,” he said.

Illinois, whose 12.9 million residents make it the fifth-biggest state, has seen its funding level fall to 40.4 cents on the dollar, from almost 63 cents in 2007, Bloomberg data show.

Illinois Void

Chris Ryon, who helps oversee $10 billion of munis at Thornburg Investment Management in Santa Fe, New Mexico, said his firm owns no Illinois general-obligation bonds, in part because of the pension challenge.

Illinois has the lowest grade among U.S. states from the three biggest rating companies, at four steps above junk.

To catch up, some states have turned to alternative assets such as hedge funds or private equity to boost returns.

Such holdings, which are harder to value and sell, more than doubled to 24 percent of public-pension portfolios from 2006 to 2012, according to Cliffwater LLC, a Marina del Rey, California-based firm that advises institutional investors.

“In the past few years, they’ve embraced this idea that if they take on more risk on the asset side, somehow it’s going to make up for market losses,” Norcross said. “There’s been a troubling shift overall towards higher-risk investments.”

Diversification Drive

Illinois State Board of Investment, which oversees three of the state’s five plans, has 10 percent of assets in hedge funds, compared with about 9 percent to 9.5 percent in the past few years, William Atwood, its executive director, said in an interview. Hedge funds help diversify away from stocks, he said.

In the fiscal year through June, Illinois’s portfolio earned 14.4 percent, compared with 11.8 percent for its benchmark and an assumed return of 7.75 percent, according to Atwood.

Improved returns won’t help if contributions don’t increase, said Atwood. Illinois’ pensions have been underfunded for decades, he said.

“You’re not going to invest your way out of the Illinois funding problem,” Atwood said. “The best thing you can do is reliably hit your return assumption over a lengthy time period, and then fund the system.”

Overhaul Reward

States such as Rhode Island have improved funding ratios by reducing payouts, said Carlson, who warned that because of legal issues involved in cutting benefits, “some of this will be played out in the courts.”

Rhode Island has the 11th-lowest funding ratio. Yet the figure in 2012 was about 62 percent, up from about 54 percent in 2007.

The state overhauled its system in 2011, pushing back the age for full retirement for public workers and introducing 401(k)-type savings plans to supplement traditional pensions. It also suspended cost-of-living increases for retirees.

In the municipal market this week, issuers from Hawaii to Maine are offering about $5.8 billion in long-term debt, up from $4.9 billion last week. They’re borrowing with benchmark yields rising from the lowest level since June.

Top-rated 10-year munis yield 2.68 percent, the highest since Oct. 25, Bloomberg data show. That compares with 2.67 percent (USGG10YR) on similar-maturity Treasuries.

The ratio of the yields, a gauge of relative value, is about 100 percent, the lowest since June 21. It compares with an average of 94 percent since 2001. The smaller the number, the more expensive munis are compared with federal securities.

To contact the reporters on this story: Darrell Preston in Dallas at dpreston@bloomberg.net; Brian Chappatta in New York at bchappatta1@bloomberg.net

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

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