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There was little joy in this Holiday Season discussion of the fiscal outlook for the state of Illinois. The state’s expenses have exceeded revenues since 2001 and ratings on Illinois debt have been falling for thirty years, driven by a growing pension debt (Note: contributions to the pension system do not offset the present value of future obligations). On December 10, 2020, CFA Society Chicago welcomed a panel moderated by Dave Sekera, CFA, chief US market strategist for Morningstar Research Services LLC, to provide a diverse set of perspectives on this issue: public policy, rating agency and municipal bond buy-side.

Adam Schuster, senior budget and tax research director at the nonpartisan Illinois Policy Institute, was the first panelist to share an overview of the topic and led attendees down the scary path of Illinois’s financial position. He stated that Illinois has the worst fiscal health of any state, in his opinion, and this evaluation is confirmed by the score of the rating agencies, who all place Illinois debt one rating above junk. The state was proudly AAA in the 1970s and 1980s, but decades of budget deficits and the growth of unfunded pension debt have eroded the rating to its current BBB- / Baa3. Schuster added that many states tightened their fiscal belts coming out of the Great Financial Crisis, but Illinois did not make any meaningful reforms at that time. Budget deficits have grown materially higher from 2010 to 2019 than from 2000 to 2009. Fixing “Illinois’s pension problem is paramount,” said Schuster. Illinois has not imposed on itself such constraints as a “true” balanced budget amendment (as 39 other states have) or other spending limits. A “true” balanced budget means that revenues and expenses match at the end of the year, not just at the beginning of the year when generous assumptions for revenue or expenses can be used in a budget.

Schuster explained a proposal by his organization, Illinois Policy Institute, to begin addressing the state’s unfunded pension liability. An amendment to the state constitution would be necessary to implement the entire plan. The “Hold Harmless” pension reform plan would save $2.4 Billion in the first year of implementation, and $50 Billion by 2045. It calls for proper 100% funding of new obligations, tying cost of living adjustments (COLA) to inflation, applying a Tier 2 pensionable salary cap to active Tier 1 workers, and increasing the retirement age by five years for those under 45.

Next up was panelist Ted Hampton of Moody’s, who provided the rating agency’s view of Illinois as a credit. He opined on Moody’s Baa3 rating, with a negative outlook. A downgrade to below-investment-grade, would imply “substantial credit risk.” Almost all US states are very strong credits, with ratings of AAA (highest) or AA1. Illinois has experienced eight downgrades from Moody’s since 2003, primarily due to large unfunded pension liabilities, unbalanced operations and a lack of financial reserves. Moody’s has placed a negative outlook on Illinois’s debt in 2020 as a result of the potentially negative impact from the COVID-19 pandemic combined with Illinois’s lack of financial reserves. There were not many upbeat segments of the entire discussion, but Hampton cited Illinois’s large and industrially diverse economy as an important positive attribute underpinning the state’s credit rating. Also, Hampton was not as concerned as Schuster about Illinois’ consistent population drain.

Diving into the specifics, Hampton informed listeners that Moody’s evaluates states’ pension situation in two ways. From a balance sheet perspective, Moody’s adds pension liabilities to debt, and then divides that sum by GDP. Illinois’ ratio is 30%, which is an outlier at four times the median ratio for all fifty states. Second, Moody’s considers an Income Statement perspective, using the Fixed Cost measure, which incorporates pension contributions, retiree health contributions and debt service, all in relation to the total budget of the state. A figure above 30% signals a problem. Illinois’s ratio is again an outlier on the risky side, with a reading above 30%. Hampton explained that passage of the progressive income tax amendment would have been positive for credit, in Moody’s eyes. However, the recent rejection of this measure means the state must find other ways, that don’t require a constitutional amendment, to address is fiscal predicament. One final note, Moody’s would view negatively the state’s assumption of obligations from smaller government entities within the state.

Hampton handed off to Andrea McKeague of Northern Trust For a buy-side perspective of Illinois’ outstanding debt. She saw a negative credit picture, composed of unfunded pension liabilities, a growing backlog of bills, and a lack of reserves. Illinois has ignominiously distinguished itself from most other US states in two ways. First, in 2020 alone, Illinois has twice tapped the Federal Reserve’s Municipal Liquidity Facility (MLF), which was established in this year to support municipalities through the COVID-19 pandemic. Second, the backlog of bills continues to grow, and is larger than those of other states.

McKeague then gave an investing overview of Illinois bonds. Coming into the pandemic, credit spreads on IL bonds were tight, at 100 -150 bps over the AAA scale. At this level, McKeague argued that investors may not have been properly compensated for the fundamental risk of holding Illinois obligations. However, spreads rose to 450 bps (over AAA yields) in the wake of the pandemic and after IL first drew on the MLF in May 2020. Spreads subsequently narrowed only to rise to 300 – 325 bps after the election, at which point the progressive tax amendment was also defeated. As of the date of this panel discussion, spreads have tightened to 215 bps over the AAA reference yield. Finally, she observed that Illinois is trading worse than Chicago, which in her opinion is in much worse financial shape than the state of Illinois.

Addressing the technicals of the municipal bond market, McKeague pointed out that demand is chasing the supply. Supply is shrinking faster for investors who cannot hold taxable municipal bonds, as some tax-exempt bonds have recently been refinanced as taxable bonds. Spreads are tighter than McKeague would have expected given fundamentals, but she believes the technicals of the market account for such spreads. McKeague then addressed the question, “will there be forced sellers of Illinois debt if the rating is downgraded to junk?” McKeague believes that investors who would have been forced sellers due to a below-investment-grade rating have already sold their Illinois bonds. She believes the salient impact of a downgrade could be a lack of access to the market, alluding to Puerto Rico’s experience.

After each of the panelists had shared their opening perspectives, Sekera opened the panel up to Q&A. The first question posed to the panel was to confirm or refute the idea that Illinois does not have a problem with debt outstanding, but rather that the problem is the under-funded pension system. Schuster agreed with this notion, noting that 77% of Illinois’s net debt is from retirement benefits. 55 points of the 77% is from pension obligations, with 22 points of the 77% from health insurance obligations.

Sekera then asked why the pension system is so underfunded? Schuster opined that poor system design accounts for the pension problem. Illinois’ system is too rigid, without mechanisms to adjust for lower than expected investment returns or other drivers of pension deficits. In contrast, Wisconsin has a fully funded defined benefit plan and a provision to tie employee contributions and cost of living increases to investment returns. In the Netherlands, if the funding ratio falls below 103%, the state is forced to either cut benefits or increase contributions.

Next, Sekara asked the panel for more comparisons of Illinois’ situation to that of other states. Hampton said that Illinois is the most stressed among the fiscally troubled group of Connecticut, New Jersey, Hawaii and Kentucky. Illinois is unique in its constitutional retirement benefit protections. This prevents lawmakers from lowering previously granted benefits and this law has been upheld by the Illinois Supreme Court. This constitutional protection has led Moody’s to place a lower rating on Illinois debt than debt of similarly leveraged states. Schuster also explained that the $230 Billion pension debt is only for the five retirement systems administered by the state of Illinois. There are 650 additional funds, the city of Chicago’s pension fund among them, that are underfunded by another $116 Billion.

Sekera returned the discussion to the investment implications of Illinois’ pension deficit, asking about pension under-funding, bill backlogs, drawing on the MLF, and consistent budget deficits. McKeauge focused on solutions that may improve the attractiveness of Illinois debt. The most practical solution, raising taxes, would exacerbate population loss. She seemed to describe a negative feedback loop of higher taxes, leading to a lower tax base, resulting in a need to raise taxes further, and consequently decreasing the tax base even more. One tactic used by other states, including California, has been to push expenses onto local governments.

Sekara asked the panelists to muse about where and how reform for this worsening situation would occur. Hampton was sure that a tax hike was out of the question while the stresses of the pandemic persist. Schuster cited Governor Pritzker’s intentions to focus on spending cuts but doubts that the governor will find material success. The governor has also vowed to eliminate certain business tax deductions, but Schuster does not believe this will make much of a dent in the deficit. Similarly, small tax or fee increases could be enacted, but none that are material compared to the deficit. The practical tactical response to the crisis will be “budget gimmicks” and drawing down already depleted reserves. McKeague agreed with Schuster’s assessment, observing that Illinois has never done a good job of cutting expenses, which has brought Illinois to its current precarious position. McKeague pointed to the possibility of higher income tax rates, which are currently only average in Illinois versus those in other states. She sees many types of taxes going higher, including casino taxes and real estate transfer taxes. However, she reiterated her fear that higher taxes could accelerate population drain and could make Illinois a less attractive home for businesses. Finally, she noted that Illinois’ higher education system is showing lower enrollment, and this could worsen with higher taxes.

The next question was for Hampton, asking about Moody’s rate of return assumptions that are used to calculate the present value of pension obligations. Hampton explained that Moody’s uses its own discount rate, not the one Illinois uses, in making this calculation. To facilitate comparisons across states, Moody’s uses the same discount rate assumptions, based on an average derived from a basket of rates, for all pension plans. Schuster considers the current assumptions used by Illinois unrealistic—the state owes more than the unfunded liability suggests. A shift to a more realistic lower discount rate would inflate the present value of the pension liabilities.

Sekera asked Schuster specifically, whether there will be support for pension and budget reform by a Democrat controlled General Assembly. Schuster reminded the group that in 2011 and 2013, reforms legislation passed through a General Assembly that was controlled by a Democratic super-majority and was signed by a Democratic governor. The 2013 reforms, which modified Tier 1 employee benefits, were ultimately thrown out by the Illinois Supreme Court, however. So, based on recent history, the make-up of the state government does not preclude pension legislation reform. Schuster seemed to reveal some optimism that state legislators are becoming more willing to consider reform. Schuster suggested that pressure will be kept on state government, pointing to elector support for reform and media focus on the issue.

Sekara asked Schuster whether the Tier 2 employee reforms have started to improve the pension outlook. Schuster explained that the current pension debt is almost entirely attributable to Tier 1 employees. A pernicious aspect of the tier 2 reforms, in Schuster’s view, is that newer (Tier 2) employees are paying to support the pension obligations of Tier 1 employees. Schuster wondered for how long the Have-nots (Tier 2, with worse benefits) would be willing to subsidize the Haves (Tier 1 employees). Schuster saw no work being done to shift employees to a 401 (k) program from the defined benefit structure.

The last question posed by Sekara asked “what can Illinois do if it outright falls into distress, restructuring, or bankruptcy?” McKeague explained that there is not a precedent for a state to declare bankruptcy. Cities have done so, and Puerto Rico defaulted, but no state has done this. She continued to say that there is no condition or process for a state bankruptcy to occur or be administered. Hampton shared that Moody’s current rating does not anticipate a restructuring.

In conclusion, some cause for hope was heard during the discussion. Since Illinois’ fiscal position cannot worsen without the state potentially losing access to the bond market, perhaps state government has no choice but to act now on pension and budget reform. However, Schuster senses an increasing willingness to reform in the state legislature and Hampton believes that Illinois’ strong and diverse economy would continue to serve as a strong foundation as reforms are enacted and Illinois’ credit profile is rebuilt.