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Illinois’ huge pension obligation bond proposal – 3 good things and 3 bad things

January 31, 2018

The Illinois State Universities Annuitants Association (SUAA) recently developed a proposal for a $107 billion (with a b) bond offering designed to secure the funding of state government employee pension funds.

SUAA asserted the proposal could lead to a 90% funding ratio for the plans in 2018, up from what Truth in Accounting calculates at roughly 36% as of fiscal 2016.

Poof, problem solved?  No. There’s no such thing as a free lunch.

Here are three good things and three bad things about the SUAA proposal:

GOOD THINGS

1) This is ONLY A PROPOSAL. This proposal has friends in the Illinois General Assembly, but it is far from certain at this point.

2) If the proposal becomes reality, it could improve the financial position of the hundreds of thousands of members in these plans.

3) If the proposal is enacted, it would be a big payday for financial, law and credit rating firms.

BAD THINGS

1) Good things for government pension plan members and financiers aren’t necessarily good for taxpayers.

2) Experience indicates any short-term improvement in reported funding ratios would reduce discipline in Illinois government to reform and adequately fund the plans in the future.

3) The proposal would effectively double down on the forced participation of Illinois taxpayers and citizens in risky financial markets.

In Illinois, whether they like it or not, taxpayers and citizens are effectively investors in the stock market.

That exposure arises because massive (yet massively underfunded) state and local government pension plans are dominantly invested in equity and related risky investments.

The stock market may have boomed since the 2007-2009 financial crisis, but these government pension plans remain dramatically underfunded.

Under a state Supreme Court decision issued several years ago, benefits in these pension plans are effectively guaranteed to the pensioners.

That means, under current law, taxpayers and citizens are exposed to the risk of significant future downturns in the stock market. If the stock market goes down, taxpayers are obligated by law to pick up the resulting (higher) shortfall in the pension plan.

In turn, this ‘safety net’ for pension plan funding can motivate pension plans to concentrate in risky investments, given that plan members get the upside and taxpayers get the downside. The incentives are underlined by current (and questionable) accounting standards, which call for pension liabilities to use discount rates based on expected rates of investment returns.  Higher-risk investments offer higher expected returns, leading to higher discount rates and, in turn, lower reported pension liabilities.

Last week’s news about the pension bond proposal would double down on this downside risk facing taxpayers.

In ‘pension obligation bonds,’ bonds are sold to investors, who pay money. That money is used to fund assets in the pension plans, lifting their reported ‘funded status.’ But that money didn’t come out of nowhere.

The proposal would improve the funded status of the plans, initially. Proceeds from the offering would flow to the plans, where cash and investments would rise, relative to the net pension liability. But the reason cash and investments rose was that a new (huge) debt was created.  Which doesn’t necessarily improve the funded status of the State of Illinois.

And it could, and probably would, undermine the funded status – more certainly, for the slice of the pie for the rest of us supporting the pension systems and related financial firms.

By raising new huge debts, it would raise the state’s financial leverage -- and risk for taxpayers.

In financial failures, creditors and other interested parties don’t just stand idly by as a crisis becomes evident. If they can’t sell their position at prices they deem favorable, some of the more sophisticated, well-connected parties will put out a lot of effort to secure their position relative to other interested parties.

In liquidations, for example, a liquidator will sell assets on the market, and use the proceeds to pay off liabilities. In liquidation, those liabilities aren’t paid off equally. Some of them are more “senior” than others.

But the lines aren’t always clearly drawn, legally, and there are often creative ways to effectively secure one’s position in light of existing “seniority” status.

Last week’s proposal could be a symptom of incentives like this. Particularly in light of some of the good outcomes asserted by the SUAA for the proposal. 

In fact, their first one reads “ensure workers and retirees receive their constitutionally protected pensions.” 

The question arises – if those pensions are constitutionally protected, why is this proposal even necessary, if the goal is to ensure that members receive their benefits?

One answer may lie in movements afoot to draft an amendment to the Illinois Constitution to allow for changes (and reductions) in pension benefits.

Were the SUAA proposal to reach reality, it would help secure the financial positions of the members of the plan, given that the plan assets were more directly in the plan. Securing the plan participants, but at higher public risk.

Financial markets normally demand a premium rate of return for risky investments. Investors are likely to demand relatively high interest rates for these bonds, leading in turn to markedly higher interest expense for the State of Illinois.

The risks in these proposed bonds include questions relating to whether such a huge deal elevates market concern about the overall borrowing capacity of the state.  Pension catch-up costs are already crowding out other services, but the new deal could fuel that fire through higher interest expense for State borrowing more generally.

Some influential groups in Illinois would undoubtedly benefit from this proposal, at least in the short turn. They would include the Wall Street underwriters for the offering. Given the size of the offering, and looking at the fees paid in past Illinois pension obligation bond deals, fees for the proposed deal could run more than $400 million.

Those possible rewards provide useful perspective when listening to future hearings coming from the Illinois House Personnel and Pensions Committee, where a legislative leader in getting the proposal to the committee promised more hearings with other witnesses, including ‘bond houses.’

But think of the possibilities for putting $107 billion in bond proceeds to work. Why not go to Vegas, if taxpayers get the downside? Another ‘creative’ solution could take $107 billion in cash and buy Illinois lottery tickets.

On the other hand …

 
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