Illinois considers $107 billion bond issue to bail out beleaguered pension plans; it matters across state lines.

Public employee pension plans are in varying degrees of health across the country. We’ve written of the near-record underfunding, unrealistic assumptions for investment returns, problems in California and Oregon (problems may be understating things), and acknowledged that Washington is in relatively good shape, allowing that may be setting a low standard.  

But little prepared us for the extraordinary measure being contemplated in Illinois, a poster child for basket-case pension problems. Bloomberg reported in late January,

Lawmakers in Illinois are so desperate to shore up the state’s massively underfunded retirement system that they’re willing to entertain an eye-popping wager: Borrowing $107 billion and letting it ride in the financial markets…

Illinois owes $129 billion to its five retirement systems after years of failing to make adequate annual contributions. Because the state’s constitution bans any reduction in worker retirement benefits, the government’s pension costs will continue to rise as it faces pressure to pay down that debt, a squeeze that has pushed Illinois’s bond rating to the precipice of junk.

The magnitude of the proposal is unprecedented, though it has been done before on a much smaller scale, with mixed results.

Many American governments have sold bonds for their pensions, albeit on a much smaller scale. Illinois did so in 2003, when it issued a record $10 billion of them. New Jersey also tried it, only to see its pension shortfall soar again after the state failed to make adequate payments into the system for years. Detroit’s pension-fund borrowing in 2005 and 2006 helped push it into bankruptcy.

A business columnist for the St. Louis Post-Dispatch writes,

A $107 billion borrowing would be the largest municipal bond issue ever, by far. The state would probably pay a higher interest rate to move all those bonds, and rating agencies might downgrade the state’s credit. Illinois is already the lowest-rated state, just one step above junk-bond status, so a downgrade could have dire consequences.

He cites an acknowledged pension authority who chooses not to mince words.

“It’s very possible you would end up losing money on this,” says Andrew Biggs, a pension expert at the conservative American Enterprise Institute. “Stocks aren’t guaranteed. This is a Hail Mary plan written by people who are financially illiterate.”

This week, the Wall Street Journal reviewed the “magic pension trick” under consideration.

At the request of state retirees, a University of Illinois math professor performed a crack analysis showing how the state could use interest-rate arbitrage to shave its pension costs. Under the professor’s math, the state could sell 27-year, fixed-rate taxable bonds and invest the proceeds into its pension funds. This would supposedly stabilize the state’s pension payments at $8.5 billion annually, save taxpayers $103 billion over three decades and increase the state retirement system’s funding level to 90% from 40%…

Improbable? The WSJ editorial board thinks so.

The professor based his analysis on pension obligation bonds issued under former Gov. Rod Blagojevich in 2003 with a 5.05% coupon that have earned on average 7.62% in the pension system. But that period included two bull equity markets, and even the state pension funds project only a 7% long-term return.

Illinois’s borrowing costs have also increased as its credit rating has slipped to a notch above junk from double-A. Last year the state’s taxable bonds due in 2035 traded at yields up to 7.2%. Investors may demand even higher rates because of the substantial interest-rate and credit risk given rising rates and the length of the 27-year bonds.


These magic bonds wouldn’t carry the state’s “full faith and credit” protection, for whatever that’s worth nowadays in Springfield. In effect, public workers’ pensions would be the bond security.

Two relevant precedents are the cities of Detroit and Stockton, California. Both borrowed to finance pensions and then later defaulted.

A pair of scholars, Joshua Rauh Associate Professor of Finance at the Kellogg School of Management at Northwestern University and NBER, and Robert Novy-Marx, Assistant Professor of Finance at the University of Chicago Booth School of Business and NBER, explain why what happens in pension-strapped states like Illinois matters to the rest of us.

The federal government should be worried about state pension liabili- ties. In the absence of fundamental reform, some large state pension funds may not last through this de- cade. When the funds run through their assets, the size of promised bene t payments will be so large that raising state taxes enough to make these pension payments will be infeasible. Just as the European Union is not standing back to watch Greece fail, the federal government will face massive and likely irresistible pressure to bail out the affected state governments.

Take Illinois, for example. Even if its main three pension funds earn 8 percent returns and the state makes enough contributions to secure new bene ts in the coming years, those funds will run out of money in 2018. At that time, bene t payments owed to the workers who are already in today’s state workforce will be an estimated $14 billion per year. That is half of the $28 billion in total general fund revenues that Illinois is expected to have re- ceived in 2010.

While this problem is particularly severe in states such as Illinois, Connecticut, and New Jersey, many more states have public pension systems that appear unsustainable even on a 15-year horizon.

They make a series of recommendations, including closing defined benefit plans to new workers (a “soft freeze”), who would be offered that defined contribution plans that are common in the private sector. They also suggest some federal policy changes, including how federal tax policy would treat pension bonds. 

We propose that the federal government cut a deal with the states. A state should be allowed to issue tax subsidized bonds for the purpose of pension funding for the next 15 years—if and only if the state government agrees to take three specific measures to stop the growth of unfunded liabilities:

1. The state must close its DB plans to new employees and agree not to start any new DB plans for at least 30 years;

2. The state must annually make its actuarially required contribution (ARC) left over from the existing DB plans;

3. The state must include its new workers in Social Security, and provide them with an adequate DC plan, again for at least 30 years. 

We aren’t endorsing the recommendations. Rather, we cite them here to demonstrate the severity of the public pension crisis nationally and how the fiscal problems may swiftly flow across state lines.