CHICAGO — Illinois Gov. Pat Quinn and legislative leaders failed to resolve their differences on stalled pension reforms following a meeting this week as Standard & Poor’s sent the message that a reckoning looms over the strain of massive pension obligations on the state’s balance sheet.

S&P rates Illinois’ general obligation debt A-plus and has assigned a negative outlook to the credit since January 2011. “We expect to resolve the outlook on Illinois this year based on our review of the fiscal 2013 enacted budget and the state’s progress, if any, on addressing its significant pension liabilities and associated cost pressures,” read a report authored by analysts Robin Prunty and John Sugden.

The state is struggling with $82.9 billion of unfunded pension liabilities — representing a funded ratio of just 43% — and will pay $5.2 billion towards pensions in fiscal 2013, up by $1.1 billion in the current fiscal year.

The Wednesday report comes nearly one week after political differences derailed pension reforms in the Illinois General Assembly despite pressure from Quinn and progress on other fiscal challenges. Before adjourning, lawmakers limited spending growth in the $33.7 billion fiscal 2013 budget, completed a $2.7 billion overhaul of Medicaid, and made a dent in up to $9 billion of unpaid obligations.

The report said S&P would evaluate the budget to assess progress in moving toward structural balance, the soundness of state revenue estimates, and implementation risks of the Medicaid changes.

“There was no action during the regular legislative session on pension reform and we consider this negative from a credit standpoint,” the analysts wrote. “Despite significant revenue enhancement and ongoing revenue recovery, structural budget balance has been elusive and liquidity remains strained due to the state’s growing accumulated deficit.”

Prunty said in an interview that while Illinois retains some breathing room to act, she is concerned over the difficulty of achieving the three-fifths majority needed to approve legislation in a special session: “We are watching to see if there is credible action, but it’s hard to know if they will come to an agreement,” she said.

Quinn sought to use the rating agency message’s to nudge lawmakers. “It is clear from this as well as past ratings agencies’ comments that pension reform must happen immediately,” the statement read.

Legislative leaders all agree on the need for reforms but after a two-hour meeting with Quinn Wednesday they remain divided over how to achieve them. They will meet again in two weeks.

A dispute between Republicans and Democrats over a provision that would have shifted from the state’s public teacher pension payments to districts and colleges derailed the plan, and no vote was taken on its centerpiece, which would have cut cost-of-living increases. The COLA changes alone were estimated to trim up to $88 billion off state payments under a schedule that puts the state at full funding in 30 years. The teacher cost-shift savings were estimated at up to $29 billion.

Quinn, a Democrat, had backed away from the teacher cost shift backed by Democratic leaders in an 11th hour attempt to get the COLA changes passed last week, but after the meeting Wednesday he said the cost shift needs to be part of the pension solution. The GOP remains opposed.

A number of investors and rating agency analysts did praise Illinois’ successes, but they showed little surprise at the state’s inaction on pensions and warned of the looming impact.

“It’s frustrating, but it’s certainly not surprising,” said Shawn O’Leary, senior research analyst at Nuveen Investment Management. He recalled that the state’s finance team visited the Nuveen offices in Chicago last March and spoke with confidence that pension reforms would sail through the General Assembly in the spring.

“Illinois is at a point where it needs to demonstrate it has the willingness to do something substantive on pensions before the market begins to question their ability to do so,” O’Leary said. “The headline risks related to Illinois is such that as a manager you have to question what products it [Illinois paper] is suitable for.”

Moody’s Investors Service rates Illinois A2, the lowest rated state, with a stable outlook, and Fitch Ratings assigns an equivalent A and stable outlook. Investors have demanded a steep interest rate penalty from the state due to its liquidity and budget struggles. It topped more than 200 basis points in 2010, but narrowed to 160 to 170 basis points after adoption of an income tax increase early last year.

“I think they have a mountain to climb, a long way before they regain the trust of the market,” said Richard Ciccarone, chief research officer at McDonnell Investment Management LLC.

On Friday, the spread on a credit default swap for Illinois paper widened to 249.6 basis points from 236 at the end of May, although other states also showed a widening. Spreads on Illinois paper already are trading at a level that reflects a credit rated one to two notches lower.

Illinois faces a long and rough road, and that’s after reforms are adopted, according to Ciccarone.

“In order for the market to trust the state it will have to achieve true reform and they will have to show consistent evidence that they have funded the plan,” he said.

Neither a much-hailed 1994 reform plan nor a $10 billion pension bond sale in 2003 solved the state’s pension woes.

While the COLA changes would make a significant dent in future payments, Ciccarone said an infusion of cash is still needed. Quinn’s original proposal called for additional employee contributions.

Quinn’s focus on the issue won praise from Michael Pietronico, head of Miller Tabak Asset Management LLC. “There’s still a lot of work to be done but from an investor standpoint it’s a good thing when the governor is attentive to the problem,” he said. He added that he wouldn’t expect to see much movement in either direction on trading spreads until “more concrete news” comes out of Illinois.

Moody’s analyst Ted Hampton praised the session’s achievements and said his agency at the moment remains comfortable with the state’s current rating level, though pensions remain a central concern.

“Obviously this session yielded some progress on some fronts and not on others,” he said.

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