A $107 billion pension bond proposal greets Illinois skeptics

BY SourceMedia | MUNICIPAL | 01/31/18 07:09 PM EST By Yvette Shields

CHICAGO – Borrowing $107 billion to pay down most of Illinois’ $129 billion unfunded tab offers an affordable solution to tackle the state’s pension albratross, the architect of the plan told skeptical lawmakers.

If managed properly, it should be a cost-effective part of a package of solutions to address the pension crisis, Runhuan Feng, an associate professor of mathematics at University of Illinois-Champaign, told lawmakers Tuesday at a legislative hearing on the plan he developed for the State Universities Annuitants Association.

Feng projects that his proposal would trim $103 billion off the estimated $341 billion in payments the state will make to bring the system to a 90% funded ratio in 2045 under the current 50-year funding schedule enacted in 1995. The system currently is 39.9% funded.

After outlining the plan, Feng was greeted with questions from skeptical lawmakers concerned over whether the market would purchase so much debt from the weakest rated state in the country, which has two ratings on the lowest rung of investment grade. They also questioned both bond interest and investment earning assumptions. They represent the same worries that have led market participants to pan the proposal.

“What’s the appetite” for so much debt, asked Rep. Mark Batnick, R-Plainfield.

“I’m not a bond expert,” Feng answered, adding that if there is an appetite the borrowing could help stem the steady rise in annual contributions that are now at about $8.5 billion but projected to keep growing to $17 billion in 2045. The state operates on a $36 billion general fund budget.

Rep. Robert Martwick, D-Chicago, chairman of House Personnel and Pension Committee, interjected that he plans followup subject matter hearings on the proposal during which he would include credit experts, bond experts, and economists among the witnesses.

Martwick said he hasn’t taken a position on the plan but if the state can save “billions” the idea is “worth exploring.”

While the Tuesday discussion was a subject matter hearing, Martwick filed on the same day House Bill 4371 that authorizes the borrowing. It was referred to the House Rules Committee.

Feng, who is a participant in the state’s pension system, and Martwick stressed that the math behind the proposal can be adjusted based on market input.

Market participants have thrown cold water on the plan since its surfaced early last week. Since statistical details of the plan were not released until this week, market commentary has mostly focused on how POBs are recognized as a poor governing choice. They have suggested that Illinois would lose its investment grade by taking on so much additional debt and questioned whether the market could digest the size.

Under the proposal, the state would sell 27-year fixed-rate taxable bonds this year to bring the system to a 90% funded ratio with just $21.4 billion of unfunded liabilities remaining.

Nearly 36% of the bond proceed allocated to each pension fund would be put into a special investment fund that would go to cover debt service until 2045.

The state’s annual contributions would be fixed at $8.5 billion to cover normal costs for the retirement funds and annual payments to special investment funds. Under the current funding schedule, the legislature’s Commission on Government Forecasting and Accountability estimates payments will rise to $14 billion in 2036 and keep rising to $17 billion in 2045.

The 27-year timeframe is tied to the current funding schedule established in 1995 that requires the state reach a 90% funded ratio in 2045.

Under the existing schedule, annual contributions rose from 4.8% of general fund revenues in 2011 to more than 25% this year and will remain between 20% and 25% until 2045.

The plan assumes bonds being offered with a 5.5% coupon and yields that range from 2.74% in 2019 to 4.30% in 2028 and 5.5% in 2045 with principal repaid in equal portions in 2036, 2038, 2039, 2041 and 2042.

The 10-year Treasury was at 2.72% Tuesday and the 30 year at 2.98%. That puts the projected spreads at 158 basis points on the 10-year and more than 200 bp on the longest bond that goes out 27 years.

Some current Illinois taxable spreads already exceed those levels, and that’s at current rating levels. IHS Markit’s Edward Lee said Illinois taxables are trading at 284 bp to the Treasury scale. Municipal Market Data’s Casey Logan said the state’s 10-year has been trading at about 265 bp to 269 bp spread and the 215 to 220 bp further out.

For the plan to work as proposed, the state would have to earn about 7% in most years. That compares to a traditional annualized rate of return of 7.62%.

Anticipating that comparisons would be raised to the state’s 2003 $10 billion GO pension bond sale, Feng offered both a positive and negative assessment. He labeled it a “good deal” based on investment returns which have averaged 7.62% while the bonds carry a 5.05% interest rate.

That’s a realized rate of return and in some years the rate has fallen short but it was made up by strong returns in other years.

The 2003 deal brought the unfunded tab down to $35.1 billion from $42.1 billion and raised the funded ratio to 60.9% from 48.6%. But more than $2 billion of the 2003 deal went to cover upcoming contributions. The state carried double-A ratings at the time.

Feng offered a critical assessment of using bonds to cover near term payments to “evade its liabilities.” Another downside was the state’s decision in future years to short contributions. The state also issued billions in 2010 and 2011 to cover contributions for budget relief.

State Rep. Grant Wehrli, R-Naperville, questioned the viability of interest rate projections. Others questioned whether a pension borrowing would then cap the state’s ability to borrow for infrastructure needs.

Feng stressed that targets could be altered to accommodate market insights. If the projected yields are moved higher, then the state’s annual contributions would rise, but if the 90% funded target is lowered then the size of the borrowing could be cut. Martwick had asked Feng to present a scenario under which annual contributions were kept to $8.5 billion.

Market participants still had little confidence in the proposal to solve the state’s woes.

“Turning a soft liability into a hard liability increases default risk in the long run if the state should encounter a difficult economic and fiscal patch down the road,” said Richard Ciccarone, president at Merritt Research Services LLC.

S&P Global Ratings’ lead Illinois analyst, Gabriel Petek, declined to comment directly on whether it could drive a downgrade.

“We would have to review it but it raises some pretty significant concerns from our standpoint, and if the plan in particular is devised to provide budgetary relief there’s a “considerable amount of market risk with that kind of strategy,” he said.

S&P put Alaska on CreditWatch in 2016 as it considered pension bonds.

The liability swap of a soft debt for a hard debt service one is not at the forefront of S&P concerns, Petek said. “We view the system at a distressed funding level” so any effort to push off payments would be viewed as a “negative credit implication for us.”

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

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