CHICAGO - Last week's Illinois Supreme Court ruling voiding legislation that overhauled the state's pension system ratchets up pressure on the state's leaders to fix the state's out-of- balance budget.
That's the message market participants and rating agencies sent after the court Friday voided 2013 pension reform legislation as a violation of state constitutional language that protects pension benefits from impairment or diminishment.
Standard & Poor's put the state's A-minus rating on negative watch late Friday and said it intends to act within the next three months with a focus on the current legislative session and deliberations on a fiscal 2016 budget.
Illinois is the lowest rated state at the low-single-A level and all three rating agencies assign a negative outlook.
To avoid the stigma of sliding to the triple-B rating category, Republican Gov. Bruce Rauner and the Democratic Party led General Assembly have vast differences to bridge to resolve a $6 billion deficit in a structurally sound way.
"Absent a credible budget for fiscal 2016 that has structural alignment of revenues and expenditures, we would lower our rating on Illinois to the 'BBB' category," the S&P report said. "The magnitude of any downgrade will be based on the 2016 budget condition and our assessment of liquidity and payables."
A rating in the triple-B category has precedent. California was rated BBB for a period in 2003 and 2004 before climbing back into single-A territory. Louisiana was rated BBB-plus in 1998 and Massachusetts was rated BBB from 1989 to 1992, according to Standard & Poor's.
Moody's said it has previously rated California and Massachusetts in the Baa category but no state has been in that category since the agency's 2010 ratings recalibration.
Illinois' temporary 2011 income tax hike helped ease a budget crunch, forcing the state's massive $111 billion unfunded pension obligation into the forefront as its primary fiscal challenge. Lawmakers hoped the 2013 reforms that cut benefits would stabilize the system.
Most of the temporary income tax hike rolled off as of Jan. 1, and the court's voiding of the pension legislation sent lawmakers back to the drawing board.
The clock is ticking on the current legislative session that runs through May, making passage of a new pension fix unlikely given political divisions between the governor and Democratic legislative majority and uncertainty over what could even withstand a legal challenge. That puts passage of a budget fix in the spotlight.
"The outcome of budget negotiations for the coming fiscal year will be significant to Fitch's evaluation of the Illinois credit," Fitch Ratings said in a special commentary. Rauner has proposed only cuts and potential savings from reforms, including $2.2 billion from a new round of pension cuts to erase the red ink. Lawmakers want new revenue but have not offered up specifics on where to raise it.
In a report out late Friday, Moody's called the court ruling a "negative."
"Although our rating on the state had assumed these measures would not be implemented, rejection of the pension benefit legislation puts the state under increased pressure to devise a way to pay for liabilities created through decades of insufficient contributions," analysts said.
With lawyers, market participants, and lawmakers still digesting the opinion's language Monday, the state's path forward on pensions remains unclear.
The state's fiscal 2016 pension contribution payment is scheduled to rise to $7.6 billion from $6.9 billion under an amortization schedule established in 1995.
The overturned law would have trimmed the payment by about $1.1 billion and cut more than $20 billion from the unfunded tab, which was expected to reduce required state contributions by up to $145 billion over the 30-year plan to fully fund the system by raising employee contributions, cutting cost-of-living adjustments, capping pensionable salaries, and raising the retirement age for some.
The court soundly rejected changes that cut promised benefits and its ruling appears to protect benefits that are in place for employees at the time of their hire.
The ruling did appear to leave the door open for what's known as consideration, offering employees and retirees some benefit in exchange for a change in the current pension structure, but otherwise offered no clear roadmap on what could work, several legal experts suggested.
Municipal Market Advisors said in its weekly outlook published Monday that language in the court's ruling underscores its position that a short- and long-term fix are both within the state's grasp, albeit with a likely tax increase, and that Illinois and Chicago bonds still offer income and incremental yield. "The fiscal year 2016 budget does not need to fix the entirety of the state's problems, but it does need to begin that process to win support from investors and rating agencies," MMA wrote.
The court's ruling questions the state's refusal to raise taxes.
"No possible claim can be made that no less drastic measures were available when balancing pension obligations with other state expenditures became problematic," the opinion said. "The General Assembly could also have sought additional tax revenue."
Most believe a new fix will take time. Rauner's proposed reforms would freeze accrued benefits and offer reduced benefits going forward.
Moody's and others have raised concerns over whether they now could pass muster given the court's position. "The court's latest ruling raises doubt that they can be implemented at all," Moody's said.
Rauner must first "attempt to get an amendment passed to the state constitution that would allow changes in pensions, but that might take a very long time, and its passage is questionable," John Mousseau, director of fixed income at Cumberland Advisors, said in a commentary.
"Then, he must try to get other reforms approved by the Illinois legislature, which has been derelict in cutting spending or investing the needed amounts in the pension system in the past. Their past inertia gives little comfort that they will move swiftly," he added.
Cumberland resumed purchasing Illinois bonds in 2013 after the state showed progress on pension reforms and budget issues but shed the paper in mid-2014 over headline risks.
The issue of so-called "consideration" could again come into play.
State Senate President John Cullerton, D-Chicago, had floated an alternative to the overturned law as reform efforts heated up in 2013. The Cullerton plan, which had been negotiated with unions, would have asked employees to accept reduced benefits in exchange for the benefit of maintaining retiree healthcare subsidies. The plan offered more modest savings, but Cullerton argued it was the only legal option.
Lawmakers, with the backing of business groups, chose the more profound savings in the plan House Speaker Michael Madigan, D-Chicago backed.
"If there are to be any lasting savings in pension reform, we must face this reality within the confines of the Pension Clause. I stand ready to work with all parties to advance a real solution that adheres to the Illinois Constitution," Cullerton said.
The Senate leader is working to revamp his proposal to accommodate another ruling from the state’s high court, which found retiree healthcare subsidies are protected benefits. The new plan under construction would offer a trade off to employees going forward relating to pensionable salaries and the incorporation of their cost-of-living adjustments or pay raises.
"The real key is this is the time for everybody to come together and the opportunity to do the right thing," said municipal restructuring expert James Spiotto, co-publisher of MuniNetGuide.com. "What history has shown us is that the best solutions have been where the government employer and the workers have realized the limitation of tax revenues and the need to invest in the community to stimulate the economy and come together on a solution."
Another option that could be resurrected is a shift in state support for the fund that covers university employees and the state's largest fund, which covers public school teachers outside Chicago. While such a move would ease the state's funding burden it would have ripple effect.
"A shift in funding burden could be negative for the credit standing of state universities and for many local governments, which would have to bear a much greater share of the employer contributions for their workers," Moody's warned.
The state immediately began to feel the impact of the ruling in secondary market trading with its spread on 10-year paper compared to the Municipal Market Data benchmark rising to about 150 basis points. That's up from a 12-month average of 144 basis points, according to MMD's Dan Berger.
"We expect to see cheaper trading levels in Illinois general obligation bonds," Mousseau said. The state's 20-year paper was already trading in the 4.40% yield range, 100 basis points higher than most other states' GOs. ""We would expect Illinois debt to quickly be trading near the 5% level."
