The Securities and Exchange Commission alleged this week that Illinois deliberately misled investors who bought the state's bonds by failing to disclose how much the state pensions were underfunded.
The SEC said Illinois had failed to disclose the extent to which the pensions were underfunded from 2005-2009 - a period during which the state issued $2.2 billion in bonds.
"Municipal investors are no less entitled to truthful risk disclosures than other investors," George Canellos, acting director of the SEC's Division of Enforcement, said in a statement Monday. "Time after time, Illinois failed to inform its bond investors about the risk to its financial condition posed by the structural underfunding of its pension system."
Illinois became the second state charged with securities fraud by the SEC - New Jersey was the first, in 2010 - and both states agreed to heed the commission's cease-and-desist orders without admitting or denying wrongdoing; neither state faced penalties.
And with severely underfunded pension plans in numerous states, Illinois will likely not be the last to face charges.
State Pension Woes Nationwide
A June 2012 report by the Pew Center for the States showed the gap between states' assets and their obligations for pension promises totaled $757 billion in fiscal year 2010.
The pension crisis worsened during the Great Recession, when states' revenues plummeted. That prompted states to reduce contributions to funds and revenues for pensions, and the biggest source of revenues for pensions - investments - decreased sharply.
The Pew report noted many experts believe a healthy pension system should be at least 80% funded. But by fiscal 2010, 34 states were below the 80% threshold.
The report said nearly every state has reduced pension benefits or increased employee contributions in the past three years.
But, the report stated, "Though states have enough cash to cover retiree benefits in the short term, many of them - even with strong market returns - will not be able to keep up in the long term without some combination of higher contributions from taxpayers and employees, deep benefit cuts, and, in some cases, changes in how retirement plans are structured and benefits are distributed."
The Illinois State Pension Mess
There are three major, state-level public employee pensions in Illinois: the Illinois State Employee Retirement System (SERS), the Illinois State Universities Retirement System and the state Teachers Retirement System. All three are in the top 10 underfunded state pension systems in the United States with Illinois SERS leading the pack.
SERS is only 39% funded and has an unfunded pension liability of $96.8 billion, which has caused rating agencies to give Illinois the worst rating of any state government in the United States. As of December 2011, the state teachers retirement system was 46.1% funded and the state university retirement system, 43.5% funded
A report by the Illinois State Budget Crisis Task Force estimated that by 2015, pension servicing will take up 25% of the state's annual budget. Already, spending for police and fire services and education are being trimmed because of increased pension service costs.
Illinois faces some problems peculiar to that state. First, state employees hired before 2010 receive a compound annual 3% increase in their pensions through a cost-of-living allowance that is not linked to any index.
People looking to reform the Illinois pension system say that this is a major reason for SERS's huge underfunding problem. Predictably, public employee unions are resisting any changes to the pension program.
Why Major Pension Reform is Needed
Which brings us to the second problem that's peculiar to Illinois: Under the state's 1970 constitution, pensions are considered an enforceable contractual arrangement between the state and its employees that "shall not be diminished or impaired."
Public employee unions interpret this phrase to mean any changes to existing pension agreements are unconstitutional. Pension reformers argue that, while unilateral changes to pensions are indeed unconstitutional, changes may be negotiated between the state and its employees.
The relative aggressiveness of pension reform depends upon your interpretation of the constitution. But, even though Illinois is controlled by Democrats in both houses of the legislature and in the governor's mansion, politicians recognize that significant reform is needed.
Illinois Gov. Pat Quinn pointed to the pension crisis in March 6 remarks on his fiscal year 2014 budget address.
"Inaction on comprehensive pension reform has left our state with less revenue for our most important priorities," Governor Quinn said. "Without pension reform, within two years, Illinois will be spending more on public pensions than on education. As I said to you a year ago, our state cannot continue on this path. Pension reform is hard. But we've done hard things before."
Will Taxpayers Pick Up Part of Pension Tab?
House Speaker Michael Madigan, a Democrat from Chicago, told an audience of electricians from the International Brotherhood of Electrical Workers, "One place you must go is the COLA adjustment. You cannot evade that."
Commenting on the pressure pension costs are placing on the state budget, Madigan continued, "These dollars are all tax dollars. In part, they come out of your pockets."
The Illinois legislature is currently considering two reform plans, both sponsored by Democrats. One more radical proposal calls for raising the retirement age from 65 to 67, asking state workers to pay 2% more of their paychecks into the pension program and to cut back on the 3% COLA mentioned above.
This proposal will be challenged in the courts and it will be up to the Illinois Supreme Court to determine if it is constitutional.
A less-aggressive proposal would offer current employees and retirees a choice of whether to receive a reduced pension and keep their healthcare benefits or to give up healthcare and keep their full pension benefit. Some legislators object to this proposal because it could enshrine an unlimited healthcare benefit as a constitutionally protected pension benefit.
How Feasible is it to Cut Public Employee Benefits?
I recently had an opportunity to speak with an acquaintance who is a senior investment manager of a major state pension fund. We discussed the possibility of cutting pension benefits to retired state workers.
While he was all for reducing pension benefits for new state employees, he asked, "How do you cut benefits to someone who made a career choice in the 1960s to accept a lower salary in return for a higher pension?"
His preferred solution was to get states to pay up to meet their pension obligations. In his state, just like in Illinois and many other states around the country, politicians have deliberately withheld pension contributions in order to fund other spending.
Muni Bond Buyers Beware
For investors, the lesson here is that state governments (as well as cash-strapped local governments) are likely to have significantly underfunded pensions.
The longer the underfunding problem is ignored, the bigger it will be, particularly in the current low interest rate environment.
Not every muni bond issuing authority will have constitutionally protected pension liabilities like Illinois.
But Illinois' problems should be a lesson to all investors to tread carefully and to do your homework before buying a muni bond that's dependent upon general tax revenue for repayment. Public employee pensions may prove to be stiff competition for an issuer's limited cash.
Related Articles and News:
Underfunded Pensions Undermine the Entire Economy
The Chicago Tribune:
Senate committee approves 2 pension proposals
The Chicago Sun-Times:
Illinois business leaders: Reject pension reform bill SB1
The State Journal-Register:
Madigan: 'Cannot evade' COLA changes in pension overhaul
Quinn: Pensions to blame for Illinois' worst budget
Pension reform is on its way