CHICAGO – A warning from Illinois’ largest public pension fund offers a stark reminder of the state’s most daunting fiscal threat – its $126.5 billion unfunded pension tab.

The Teachers Retirement System said changes that reduce the state's contribution in the current fiscal year will only make things worse later.

Significant pension changes that some believe could pass state constitutional muster were proposed during the regular session and enjoyed bipartisan support but they took a backseat as efforts built -- successfully -- to break a two-year-old budget impasse and stave off a cut to junk bond status.

“The 2018 budget may have stopped the bleeding, but Illinois faces significant structural headwinds that are not going away,” said Thomas Schuette, co-head of investment research & strategy, at Gurtin Municipal Bond Management. “Pensions remain the elephant in the room.”

The budget package included several “reform” measures first pitched by Gov. Bruce Rauner with projected budgetary savings of about $1.5 billion.

They limit end-of-career pension spiking, shift the cost of higher paid employers to local districts, and phase-in the impact of actuarial changes. The package also creates a Tier 3 defined benefit and defined contribution pension plan for some current employees.

The Teachers Retirement System late last month revised the state’s fiscal 2018 contribution that had been certified last fall, lowering it by $531 million to $4.034 billion from $4.564 billion to reflect the changes in law.

That includes the retroactive application of the law smoothing over five years the impact of actuarial changes since 2012. The fund has reduced its assumed investment return rates several times. The smoothing measure is expected to generate overall state budget relief of $800 million.

“The changes enacted this year in the pension funding formula move TRS further away from financial stability and continue to kick the can down the road. Period,” the fund’s executive director Dick Ingram said in a statement. “Cutting the state’s contribution only increases our concern that TRS will eventually become insolvent.”

The fund accounts for $71 billion of the state’s $126.5 billion in unfunded pension liabilities, which TRS called one of the largest in the country and said is a direct result of decades of underfunding by the state. In fiscal 2018, the state’s contribution will fall $2.839 billion short of what the system’s actuaries say is a sound actuarial funding level.

“For every dollar that the state cuts from the TRS contribution now, they will have to spend $3 down the road to replace that revenue because of the interest costs,” Ingram said. “A $530 million funding cut today just puts off the inevitable and will create a payment of $1.6 billion in the future.”

The newly set contribution does not include any potential cost savings from the creation of new Tier III “hybrid” retirement plan because it’s still under development.

The TRS board, which oversees the nation’s 37th largest pension fund, last year lowered its assumed rate of return to 7% from 7.5%, despite political pressure to hold the rate steady because of the budget impact. In 2012, TRS lowered the rate to 8% from 8.5 % and then in 2014 lowered it to 7.5%.

The TRS change was one of many around the country in which public pension systems lowered assumed rates as their actual investment returns lagged.

The pension burden strains weigh heavily on Illinois' ratings, which are lowest of any state. It was one of several factors that prompted Moody’s Investors Service to put the state on review for a downgrade in July even as lawmakers zeroed in on a successful override of Rauner’s budget vetoes.

“So far, the plan appears to lack concrete measures that will materially improve Illinois' long-term capacity to address its unfunded pension liabilities,” that report read. Moody’s later affirmed the state’s Baa3 rating and negative outlook.

In affirming the state’s BBB rating, Fitch Ratings said its negative outlook reflected the uncertainties related to successful implementation of the budget, risks in reducing a $15 billion bill backlog, and “achieving near-term pension contribution savings, partly at the expense of worsening the state's long-term liability picture.”

Standard & Poor's rates Illinois BBB-minus with a stable outlook.

Democrats and Republicans agree that action is needed to rein in both the growing annual pension contribution costs and the unfunded liabilities. There’s support for the so-called “consideration” model first developed by Senate President John Cullerton, D-Chicago.

“The budget is unbalanced by more than $1 billion. The governor remains committed to seeking bipartisan solutions to help balance the budget and to pass reforms to put Illinois on a path to sound fiscal footing,” Rauner spokesman Jason Schaumburg said in a statement. “Those reforms should include pension reform. He has asked the General Assembly to help achieve that this fall.”

House Minority Leader Jim Durkin, R-Western Springs, hopes the recent bipartisan compromise legislation that overhauled school funding formulas can be parlayed into agreements on pensions and infrastructure. Some believe a capital package could have an easier time ahead of an election year as members can return to their base with projects in hand.

“We need to be able to pick and choose” areas where there “is bipartisan agreement” and there’s a need to “go back in and address our pension problems” as well as infrastructure, Durkin said during an appearance on WBBM’s radio political program At Issue. “I know those are areas that we can find bipartisan support.”

Despite the talk, deep acrimony remains between the two sides over the budget impasse. The looming 2018 election and a potential fiscal 2019 budget fight could get in the way.

“Without political stability, we believe there is little oxygen for major pension reforms which will demand compromises,” Schuette said. “Both sides may wait things out to see if they have a better dance partner for pension reform after November 2018.”

The state faces a tough road on reforms. Lawmakers previously enacted reforms that cut benefits and raised employee contributions but the Illinois Supreme Court voided the changes in May 2015 as a violation of state constitutional provisions that protect benefits from being impaired or diminished.

Under Cullerton’s consideration model, employees would be asked to forgo compounded cost of living increases and other COLA changes. In exchange, salary increases would continue to count toward their pensionable salary upon retirement. The changes could trim $1 billion off what this year was supposed to be an $8.8 billion contribution to all the funds before the fiscal 2018 budget changes.

Supporters argue the plan can pass a legal test because they believe future counting of salary increases toward the pension calculation is not protected by law and employees. Unions say that argument is flawed because either choice represents a reduction in benefits so there is a not choice offering a new benefit and it’s a coerced choice not a voluntary one.

Left unchecked the unfunded liabilities keep rising. They rose to $126.5 billion in fiscal 2016 from $112.9 billion a year earlier and the funded ratio deteriorated to 39.2% from 40.9%. They have ballooned by $86 billion since fiscal 2001.

Under the funding schedule established by lawmakers in 1995, the state is required to make contributions as a level percent of payroll in fiscal years 2011 through 2045. The contributions are required to be sufficient, when added to employee contributions, investment income, and other income, to bring the total assets of the systems to 90% of the actuarial liabilities by fiscal year 2045.

The schedule has faced stinging criticism for its backloaded structure. The state settled fraud charges brought by the Securities and Exchange Commission for misleading investors over the health of the pension funds because of flawed schedule. Each system certifies an annual payment amount in mid-November for inclusion in the next state budget.

The Chicago Civic Federation, which tracks Illinois finances, has also suggested other measures to help the ailing system. It has recommended supplemental payments be made tapping revenue that will become available after existing pension bonds and proposed cash flow borrowing is repaid. The organization also has recommended a constitutional amendment limiting the pension protection clause to accrued benefits.

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