Federal cash infusion won't erase Illinois' chronic fiscal strains

BY SourceMedia | MUNICIPAL | 04/13/21 02:50 PM EDT By Yvette Shields

Illinois? chronic structural budget and pension strains will persist long after it spends down $7.5 billion of new federal relief so lawmakers should avoid digging the hole any deeper.

Two recent reports underscore the state?s pre-COVID 19 fiscal ills that should weigh on lawmakers they work on a fiscal 2022 budget.

S&P Global Ratings warns of the pressures posed by the Illinois? burdensome pension tab even as it maintains scheduled contributions despite glaring structural woes cited in the recently published three-year budget forecast from the legislature?s non-partisan Commission on Government Forecasting and Accountability.

When applying fiscal 2022 proposed spending levels, the state?s roughly $5 billion bill backlog could jump to $9.9 billion, and $10.6 billion by the end of fiscal 2024, and a $1.2 billion fiscal 2022 deficit rises to $1.9 billion or $2.3 billion if spending grows by five- and 10-year historical rates of 2.7% or 3.2%, respectively.

The numbers look bleaker with the backlog skyrocketing to record levels of between $19.1 billion and $20.5 billion based on a fiscal 2021 spending base.

Gov. J.B. Pritzker has proposed a $95.5 billion fiscal 2022 budget with a $41.7 billion general fund, holding spending mostly flat to fiscal 2021 levels.

?The COVID-19 pandemic has affected current budget levels but has not changed the overall picture in the state of Illinois,? reads the COGFA report. ?The state continues to struggle with balancing its revenues and expenditures.?

A 2017 income tax hike helped, but more work is needed ?to truly be able to operate under a sustainable model moving forward,? the commission warned.

The report comes as state lawmakers are immersed in sorting through Pritzker?s budget proposal with the goal of passing a plan by the end of May. Pritzker laid out a spending blueprint before President Biden signed the $1.9 trillion American Rescue Plan into law, so it doesn?t incorporate the $7.5 billion of direct aid expected to flow to the state in two tranches in fiscal 2021 and 2022.

?This additional one-time money represents an opportunity for Illinois to pay back the [Municipal Liquidity Facility] borrowing, pay down portions of the backlog of bills, generate additional revenue through federal match, or fill any potential budget holes caused by the pandemic,? COGFA writes.

The state took out two loans totaling $3.2 billion last year through the Federal Reserve?s MLF and now owes about $2.4 billion on that tab, according to Comptroller Susana Mendoza. Another $1.4 billion is for short-term, interfund borrowing and through a treasurer's program. "The projected repayment of this $3.868 billion, not including total applicable interest owed, is $846 million in fiscal year 2021, $1.074 billion in fiscal year 2022, $908 million in fiscal year 2023, and $1.040 billion in fiscal year 2024," according to the comptroller.

State Comptroller Susana Mendoza, who manages state bill payments, has taken a similar position and the Pritzker administration has said those two areas ? paying off the MLF and chipping away at the backlog ? are priorities. But the administration faces pressure from various factions to raise spending in some areas and leave intact some of the $900 million in corporate tax breaks he has proposed eliminating.

?Our first priority is working to pay down our bills and making sure we are in a sound fiscal position going into the next? fiscal year, Anne Caprara, the governor?s chief of staff told a Senate Appropriations Committee reviewing the spending request for the governor?s office last week.

?We want to be mindful of the fact that these will be one-time dollars so whatever we do those dollars will disappear in a couple years and if we build up spending in an artificial way it is going to make our problem worse and our challenges more difficult in out years,? Dan Hynes, deputy governor for budget and economic issues said during the hearing.

The commission analyzed eight budget scenarios based on its revenues forecast for the next three years. That forecast, released early last month, doesn?t account for the federal aid or revenues Pritzker would raise in fiscal 2022 budget.

Under flat spending based on the governor?s proposed FY 2022 levels, deficits persist through fiscal 2023 with a surplus of $413 million reached in fiscal 2024, but the backlog of bills grows to $6.5 billion.

Based on a scenario using the budget office?s spending estimates for both FY 2021 and FY 2022, a $1.2 billion 2022 deficit would be erased and a $4.7 billion surplus generated in fiscal 2024 with the backlog of bills wiped out if spending was cut by 5.3%.

?This scenario shows the magnitude of spending cuts that would be needed to get the backlog of bills to $0," COGFA said.

The commission then applied various spending levels ? from flat growth to historical growth averages of 2.7% for five years and 3.2% for 10 years ? that fluctuate depending on the state?s priorities. Each accounts for the $5.4 billion bill backlog at the close of fiscal 2020 and does not assume any debt restructuring.

S&P and pensions
Pritzker has received praise for proposing to meet the state?s scheduled pension payment based on a statutory formula laid out in a 50-year funding ramp, and reach a 90% funded ratio in 2045, but the flawed schedule is at the root of mounting pressures and the budget doesn?t offer any fixes.

The state?s unfunded liability stands at $141 billion and the system is just 40.4% funded.

Over the next 20 years, the statutory funding requirements will double from 2022 levels. ?Even with contributions scheduled to escalate, it's probable funding progress will erode due to aggressive assumptions and methods that do not align with weak demographic trends,? S&P warned in its April 9th ?Pension Spotlight: Illinois.?

The funding ramp amortizes unfunded liabilities as a level percentage of assumed payroll rather than on a level-dollar basis, which we view as a form of deferring pension costs, wrote analyst Joseph Vodziak. ?The statutory funding requirements include various forms of cost deferrals that trade near-term budgetary relief for steeper cost escalation in the future,? he added.

S&P also believes there is a high likelihood pension contributions will continue to compete with other priorities in the state's budget as pension payments crowd out spending on services and could lead to officials to consider shifting more pension costs to schools, colleges, and universities.

Contributions of about $9 billion from the state and other employers in fiscal 2020 fell $4 billion short of an actuarial level. The state alone will contribute $9.36 billion in fiscal 2022.

Retiree healthcare benefits also loom large. The state does not pre-fund this obligation. ?This burden is likely to become substantially larger and more cumbersome if the current health care regulatory environment and inflationary trends persist,? S&P warns.

The Illinois Supreme Court has ruled that both pension benefits and other-post employment benefits are protected from cuts based on the constitution?s pension clause language that bars impairment or diminishment of benefits once awarded.

In the near term, Illinois is faring well in the market and its ratings have stabilized. Moody?s Investors Service and S&P restored the state?s outlook to stable in recent weeks. Both, along with Fitch Ratings, had cut the outlook to negative last spring due to expected pandemic fiscal wounds. Fitch had also lowered the state by one notch at the time.

Fitch and S&P rate the state at BBB-minus and Moody?s has it at Baa3. All represent the lowest investment-grade level and is the weakest among states.

The outlook revision to stable reflects ?the state's financial performance through the pandemic, in combination with increased levels of federal support that will moderate near-term fiscal and economic pressure,? Moody?s said.

Illinois saw its lowest spreads in the primary market since 2014 when it priced $1.26 billion of general obligation bonds last month. The state benefited from both strong market-wide demand for higher yielding paper and its improved near-term fiscal prospects.

The 10-year in that deal landed at a 120-basis-point spread to the Municipal Market Data?s AAA benchmark, but in secondary trading has since narrowed to 100 basis points.

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.