April 10 (Bloomberg) -- Rod Blagojevich is in prison. But the worst things the former governor did to Illinois weren’t even illegal.
This month, the Teachers’ Retirement System of the State of Illinois made a dire announcement to its members. TRS, which covers most public-school teachers in Illinois outside Chicago and has more than 360,000 members, said the following:
“If the General Assembly does not continue to provide all of the funding called for in state law, calculations done by TRS actuaries show that the System could become insolvent as soon as 2030. Preventing insolvency may include significant changes for TRS -- new revenues must be generated and if they are not benefits may have to be reduced.”
The teachers’ fund is one of the country’s worst-financed statewide pension systems, reporting that it is only 47 percent funded. And that’s if you buy the system’s rosy accounting assumptions, including that it will achieve 8.5 percent annual returns on its assets. This level is tied for the most aggressive investment assumption among state pension funds in the country, and the fund has had to get creative in an effort to meet it. Pensions & Investments magazine says it has the fourth-riskiest pension investment portfolio in the U.S., with less than 17 percent of its investments in fixed income and cash.
Teachers Left Hanging
Perhaps the teachers’ fund will be fabulously lucky, and rich investment returns will cover pension costs so taxpayers won’t have to. But the odds of that are vanishing. Indeed, the system’s funding status is so poor that it achieved a 23.6 percent return on investments in 2011 and still managed to shave only $2 billion off its $46 billion unfunded liability. And it’s not as though the fund can make such gangbuster returns consistently -- in 2009, it returned negative 22.7 percent.
Closing the TRS funding gap -- and the gap at the State Retirement Systems of Illinois, which is only 36 percent funded -- will depend on taxpayers’ willingness to start paying far more than they ever did for pensions. And as the TRS statement makes clear, that is far from a sure bet, meaning that pensioners may see their benefits cut.
Public pensions are a problem all over the country, but they are a special problem in Illinois, mostly because the state has failed, for decades, to make proper contributions into its pension funds. Illinois, more than most states, has used its pension funds as a vehicle for off-balance-sheet borrowing, financing high spending without high taxes by making unfinanced pension promises.
No individual is more personally responsible for allowing this to happen than Rod Blagojevich, who became governor in 2003 and who was impeached in 2009. Illinois is not unique because it has struggled to manage its budget in the recession; many states have similarly failed to act responsibly in the last four years. It is much more notable as a place that let its fiscal problems spiral out of control while the economy was strong, leaving an unusually daunting mess for lawmakers to clean up in the recession.
Of course, he didn’t act alone. Illinois made bad pension decisions before he was elected, and the Legislature approved his worst ideas. But the governor pushed other lawmakers to give in to their most irresponsible impulses.
One of his first initiatives was a pension-obligation bond plan. For years, Illinois had been struggling to come up with enough cash to make required payments into its pension system (even though its law stating what was “required” was more lax than what was recommended by the Governmental Accounting Standards Board). Blagojevich proposed that the state shore up its pension funds by issuing $10 billion in bonds and investing the proceeds in the pension fund.
No Bond Windfall
In principle, nothing is wrong with pension-obligation bonds. They simply swap one form of indebtedness (unfunded pension obligations) for another (bond debt). But in practice, when a jurisdiction issues these bonds, it is usually up to no good, and this was no exception.
The pension funds would invest the proceeds in stocks and bonds with a target investment return of 8.5 percent a year, but the interest on the bonds was only about 5 percent. This was marketed as a free lunch, but it wasn’t one: Interest payments were fixed but Illinois taxpayers were on the hook to pay if the assets underperformed, which they did.
A second problem was that the governor used the expected free lunch to justify putting only $7.3 billion of the $10 billion in bond proceeds into the pension fund. The remaining $2.7 billion went to pay bond interest and to cover part of the state’s required pension contributions in 2003 and 2004 -- freeing up money to spend on other initiatives, including an aggressive expansion of Medicaid and the Children’s Health Insurance Program. This meant that when you added together the unfunded liability and the outstanding balance on the bonds, the plan widened Illinois’s overall funding gap for pension benefits.
Even after the proceeds from the pension-obligation bonds had run out, Blagojevich and the Illinois Legislature continued to underpay the required pension contributions, by $300 million in 2005, $1.2 billion in 2006 and $1.1 billion in 2007.
As the recession hit, the Legislature started passing budgets it knew were unbalanced, causing the state to run out of cash mid-year and run up billions of dollars in unpaid bills. Periodically, the state would issue general-obligation bonds to pay off the bills backlog, again shifting pension liabilities into bond debt.
Even as the state budget fell apart and he spent profligately, Blagojevich, a Democrat, steadfastly opposed increases in the income or sales tax. He even alleged that his impeachment on the grounds of having tried to sell Barack Obama’s Senate seat was a plot to get him out of the way so that the Legislature could raise the income tax.
Income Tax Increase
Starting after the 2010 election, with Blagojevich gone, the Legislature did raise the income tax, from a flat 3 percent to a flat 5 percent. But Illinois’s budget situation was so dire that even a 66 percent increase, which raised general fund revenues by about 20 percent, still left an annual gap of more than $1 billion.
In 2010, Republicans gained seats in the Legislature and have blocked any further general-obligation bond issuances to close budget gaps. As a result, the unpaid bills backlog has reached more than $8 billion, and there is no plan to pay it off. Because of the tax increase, at least the backlog is no longer growing very much, and vendors can expect to be paid on a rolling basis after waiting about five months.
But the state hasn’t taken the steps it needs to reform its precarious pension system. Michael Madigan, the Democratic speaker of the state Assembly, has belatedly become an advocate for aggressive pension reform, but Governor Pat Quinn and public-employee unions stood in his way through 2010 and 2011. The state did sharply reduce benefits for workers hired after 2010, but material savings from those changes won’t materialize for decades, and the state used those estimated savings to shave a few hundred million dollars off its annual required pension contributions in the near term.
Much of the current trouble would have existed with or without Blagojevich. But when fiscal times get tough, it falls to the governor to tell the Legislature “no.” In the middle of this decade, while neighbors like Indiana were getting their fiscal houses in order, Blagojevich was the one telling the kids in the Legislature to eat all the candy they wanted and stay up as late as they felt like. And that has left lawmakers with a much bigger mess to clean up now.
(Josh Barro is a contributor to Forbes.com and a fiscal policy analyst based in New York City. The opinions expressed are his own.)
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