California Beating Illinois Shows Pension-Gap Cost

Illinois Democratic Governor Pat Quinn
Though Democratic Governor Pat Quinn helped push for increases in personal and corporate income taxes in 2011, the state carried a backlog of about $8 billion in unpaid bills, not including pension obligations. Photographer: Daniel Acker/Bloomberg

California debt is beating Illinois bonds by the most in three months as investors choosing between the two lowest-rated U.S. states reward efforts to bolster the finances of the nation’s biggest pension.

Illinois lawmakers failed to advance any measures in a special session Aug. 17 aimed at addressing the nation’s worst-funded pensions. Standard & Poor’s last week cut the state’s credit one level to A, sixth highest. That’s one step above California, where the Legislature passed a plan last week that is projected to curb pension liabilities by as much as $55 billion.

The two states are “a study in contrasts in what they’ve done recently, especially as it relates to pensions,” said James Dearborn, managing director in Boston at Columbia Management Investment Advisers, which oversees $16 billion in munis. “Illinois continues to be the poster child for pension issues.”

U.S. states and localities face $2 trillion in unfunded public-employee retirement costs after the 18-month recession that ended in June 2009, according to Moody’s Investors Service. Some states that have confronted the gap, such as New York and California, have seen improved outlooks and lower yield penalties. New Jersey had its debt downgraded in February 2011 by S&P in part because of its pension liability.

Further Widening

The extra yield investors demand to own general-obligation bonds from Illinois issuers rather than those in the most-populous state reached 0.79 percentage point last month, the most since May, data compiled by Bloomberg show.

Past trading suggests the spread is poised to widen further after S&P’s Illinois downgrade. Two weeks after Moody’s cut the fifth-most-populous state’s rating in January to A2, sixth-highest, the gap rose to a record 0.89 percentage point.

Lawmakers in Illinois have proposed increasing employee contributions and passing some state costs onto school districts.

Illinois faces fiscal strains beyond its retirement obligations. Though Democratic Governor Pat Quinn helped push for increases in personal and corporate income taxes in 2011, the state carried a backlog of about $8 billion in unpaid bills, not including pension obligations.

‘Wretched’ Situation

“Pensions have become such an important factor for people looking at the muni market,” said Matt Fabian, managing director at Concord, Massachusetts-based Municipal Market Advisors. “Because Illinois has such a wretched pension-funding situation, it’ll continue to attract negative articles and bad news.”

Illinois has an unfunded pension liability of at least $83 billion, according to state figures. It had 45 percent of what it needed to pay future retiree obligations as of 2010, the lowest among U.S. states, Bloomberg data show.

The California Public Employees’ Retirement System, with assets of $237.3 billion, had 72 percent of the funds needed to cover obligations as of June 30, 2011.

S&P maintains a negative outlook on Illinois, citing “the potential for further erosion of the state’s pension funds.” The ratings company elevated California’s outlook to positive in February and said it was “poised for credit improvement.” Democratic Governor Jerry Brown is asking voters in November to raise income and sales taxes to close the state’s deficit.

Weekly Rally

In the $3.7 trillion muni market, yields on top-rated bonds maturing in 10 years fell a second straight week, according to a Bloomberg Valuation index. The benchmark 10-year yield dropped 0.08 percentage point to 1.76 percent. The index’s record low was 1.63 percent in July.

California is still S&P’s lowest-rated U.S. state because of recurring budget gaps. Brown in June signed a $92 billion spending plan that counts on higher taxes and cuts in health care and welfare.

The overhaul the state’s Legislature passed Aug. 31 would require public employees to pay half the cost of their benefits and work longer before they can retire. It also changes formulas to provide less retirement money and caps pension payments.

Calpers estimated the changes could save the state and its local governments from $42 billion to $55 billion over the next 30 years. It wouldn’t immediately improve the system’s unfunded liability, its actuary said.

“We wish it went further, but it’s a step in the right direction.” said Robert Miller, senior portfolio manager in Menomonee Falls, Wisconsin, for Wells Capital Management, which oversees $30 billion in munis.

Following are pending sales:

CHICAGO plans to sell $300 million of bonds backed by revenue from its sewer system as soon as Sept. 6, data compiled by Bloomberg show. Proceeds will go toward improvements to the system, according to bond documents. (Added Aug. 31)

DORMITORY AUTHORITY OF THE STATE OF NEW YORK is set to issue $238 million of lease-revenue bonds on behalf of the State University of New York as soon as this week. Proceeds will help finance student residences and refund debt, according to bond documents. (Updated Sept. 4)

SAN ANTONIO plans to sell $175 million on behalf of its water system as soon as this week, according to offering documents. The proceeds will be used for construction and refunding. (Added Sept. 4)

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