By Mike “Mish” Shedlock
Despite a massive rally in the stock market, Illinois public pension liabilities continue to grow.
GARS, the Illinois General Assembly Retirement System, is only 13.52% funded, down from 17% funded in 2013. How long can GARS last?
Meanwhile, Illinois has accrued a combined net pension liability of roughly $130 billion on which it assumes a 7% return.
Effectively, that is an interest liability of $9.1 billion a year even though that liability technically does not bear interest.
This is a guest post from Michael Lucci at the Illinois Policy Institute.
Interest on Illinois’ Pension Debt is $9.1 Billion Per Year
Illinois isn’t covering the interest payments on its pension debt. Those interest payments total $9.1 billion a year.
This is the reason Illinois’ pension debt continues to grow. As with personal credit card debt, until the interest is paid off none of the actual debt gets erased. Illinois’ pension debt is so large that it’s unlikely payments will cover the interest on the pension debt until 2028, according to a November 2016 special pension briefing from the Commission on Government Forecasting and Accountability.
Illinois politicians have known for years about the state’s pension crisis, even if they have not taken serious steps to address the problem. Gov. Bruce Rauner recently spoke out on the cost of interest on the pension debt. Former Gov. George Ryan weighed in as well, saying:
“First off, the biggest problem we got with the budget right now is the interest they are paying on the debt. If I were the governor, … I’d say we are never going to be able to pay the full debt back, so let’s eliminate half the debt right now and write it off.
“If that’s not constitutional, it might be worth changing the constitution. That would dramatically reduce the amount of interest that they’re paying. The bond ratings would go up and the interest would go down.”
Ryan seemed to be referring to the annual “interest cost” on Illinois’ pension debt, which is about $9.1 billion per year, or $25 million per day. The portion of interest cost that isn’t covered each year is simply added to the debt.
Why Illinois’ pension debt keeps growing
Illinois has about $78 billion in assets on hand to pay for pensions. But the present value of the state’s accrued liability is $208 billion. That leaves a difference of $130 billion, which is money the state owes – but doesn’t have.
Illinois pension math assumes an annual investment return rate of just over 7 percent on $208 billion in pension assets. If pension assets end up returning less than 7 percent per year, then the actual pension liability will end up being much larger than is currently assumed.
However, $130 billion of that accrued pension liability doesn’t exist, which is considered the pension debt. This debt does not bear interest like a bond does – but it functions the same way in reality. Because $130 billion is missing, Illinois will automatically miss out on the 7 percent annual investment return on that nonexistent $130 billion. This “missed” investment return is about $9.1 billion per year, and is essentially the interest cost on the $130 billion pension debt.
Illinois’ type of payment plan, which fails to cover interest, is called “negative amortization.” The debt principal continues to grow because the pension payment does not cover the interest cost. The portion of the interest payment that isn’t covered is added to the debt.
As actuary Tia Goss Sawhney explained, a full pension payment is made up of three parts:
Full payment = Employer normal cost + interest cost + principal reduction payment
However, Illinois’ scheduled pension payments are too small to cover the normal cost and interest cost, causing the unfunded liability to go up. For example, in fiscal year 2018, Illinois will make an $8.9 billion pension payment, which will cover the $2.1 billion employer normal cost and $6.8 billion of annual interest cost. However, the annual interest cost is actually $9.1 billion, meaning that after the employer’s portion of the normal cost, Illinois will come up $2.3 billion short on the interest payment. The unpaid portion of the interest cost is added to the debt, just as if a person didn’t cover the full interest payment on a home loan or credit card. In Illinois’ case, that $2.3 billion shortfall will be added to the pension debt.
The reason the principal reduction payment is negative is because the debt grows.
Illinois needs a constitutional amendment to allow for real pension reform
As Ryan pointed out, Illinois’ pension math might never add up without reducing the $130 billion pension debt, which the Illinois Constitution currently protects from being restructured. Even though Illinois is already overtaxed, and pension costs are driving up taxes more each year, the state still can’t cover the interest cost on the pension debt until 2028. On top of that, many local communities like Chicago have pension problems that are even more severe than the state’s problems. And the math gets even worse if Illinois doesn’t hit investment returns of 7 percent per year.
A golden rule of finance is this: Debt that can’t be paid won’t be paid. The state should develop a contingency plan to repeal the Illinois Constitution’s pension protection clause and restructure pension obligations to pull Illinois out of a potential death spiral should the need arise. Such a plan should preserve benefits for government workers with modest pensions while means-testing the richer pension benefits. This would almost certainly be challenged as a violation of the contracts clause of the U.S. Constitution, and the U.S. Supreme Court might ultimately decide the matter.
Illinois might be one serious recession away from a financial death spiral. A deep recession would reduce the value of pension assets while also causing tax revenues to decline. Illinois’ pension obligations would increase just as tax revenues dried up. After such a recession ended, out-migration would likely surge as Illinoisans increasingly realized the impossibility of financing their government’s spending promises. If financial assets fall and do not recover, Illinois’ pension math might be doomed.
The battered ship of Illinois’ finances is lurching toward a rocky shore. Lawmakers should develop a contingency plan for an emergency situation, and be prepared to enact it in order to salvage the state’s finance.
Start Mish Comments – Death Spiral
Lucci noted: “Illinois might be one serious recession away from a financial death spiral.”
He is too optimistic. Illinois’ pension is in a financial death spiral whether a recession hits or not.
Despite a massive rally, state of Illinois pension liabilities grew. It will not take a recession for a crisis to hit. Illinois is in a crisis now.
That crisis will be obvious to everyone when a big correction hits the stock market. Like it or not, a big correction is guaranteed at some point.
Thanks to the monetary policies of the Fed, ECB, Bank of China, Bank of Japan, and central banks in general, stock markets have now surpassed the 1929 high in bubbliness.
Only the dot-com bubble was bigger.
John Hussman has an excellent write-up of the bubble in When Speculators Prosper Through Ignorance.
Pater Tenebrarum at the Acting Man blog continues the discussion with Speculative Blow-Offs in Stock Markets – Part 2
Central banks’ seriously misguided attempts to fight routine consumer price deflation, fueled very destructive asset bubbles that eventually collapse.
Worse yet, many pension plans did not even benefit from the speculative boom, but they sure will participate in the next collapse.
GMO 7-Year Forecast
As of the end of 2016, GMO forecast real (inflation-adjusted) losses in both US stocks and bonds for the next seven years!
Things are so bubbly now, that GMO now foresees nominal losses in US equities. At this juncture, even gains of say 3.5% for the next seven years would sink the system.
Public unions are already screaming for tax hikes to bail them out. Giving in to such an approach would do nothing but further drive businesses and wealthy Illinoisans out of the state, compounding the problem.
It’s time to admit reality: The Illinois pension system is insolvent, and not just at the state level. Illinois cities are also impacted.
- At the municipal level, we need bankruptcy legislation so that cities and municipalities can shed liabilities in bankruptcy proceedings.
- At the state level, we need pension reform. I propose taxing pension benefits above a certain level at a high enough rate to make the system solvent.
How likely is that?
For the answer, please recall my opening remarks: GARS, the Illinois General Assembly Retirement System, is only 13.52% funded, down from 17% funded in 2013.
Illinois is in a pension crisis. Forced admission of that fact will soon be thrust on Illinois politicians who will undoubtedly have an eye on your pocketbook. In fact, they already do: Mary Pat at Stump reports Illinois wants to tax ALL THE THINGS!
Lest you think only Illinois is affected by this mess please consider:
- Dallas on Verge of Bankruptcy Due to Pensions; Just a Matter of Time (For Dallas, Houston, LA, Oakland, Chicago, etc)
- Criminal Witch Hunt in Dallas Pension Fiasco
- In Search of a Fix (When None is Possible): What Happens?
Every state in the union will be affected as soon as the stock rally subsides. Even flat returns for seven years would bankrupt most state pension systems.
Corrupt states like Illinois will never address the problem properly.
We need national bankruptcy legislation to allow municipal bankruptcies in every state, national right-to-work legislation, and the end of prevailing wage laws to lower cost burdens on cash-strapped cities and states.
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