CHICAGO — Whether Illinois can achieve the budget relief promised by pension buyout plans in its new state budget casts a shadow over its credit prospects, according to rating agencies.
“The state’s buyout offer is credit positive because it will generate significant pension liability savings to the extent that employees accept the offer…but reliance on savings poses modest budget risk,” Moody’s Investors Service wrote in a review of the proposals published this week.
Gov. Bruce Rauner on June 4 signed into the law the $38.5 billion fiscal 2019 budget heralding it as a balanced, bipartisan compromise plan that doesn’t rely on tax increases. It marked the first full-year budget he signed since taking office in 2015.
Budget watchdogs and buyside analysts have warned -- and lawmakers have acknowledged -- that the budget does little to tackle the state’s $129 billion unfunded pension tab or its roughly $7 billion backlog of unpaid bills and that it relies on one-shot revenue sources and some uncertain assumptions. Analysts also disagree with the “balanced” label.
Market participants generally believe the budget will see the state’s ratings through at least the November election but they are watching rating agency reactions closely.
Rating agencies have offered mixed reviews and some are still sorting through the details but all three are holding the state’s rating steady so far with little room available for a misstep.
“Timely enactment of a fiscal 2019 budget in Illinois is consistent with the stable outlook S&P Global Ratings currently maintains on the state's credit rating” of BBB-minus, the rating agency wrote in its recent review. “While the emergence of a more collaborative budget process has potentially constructive credit implications, the substance of the package largely represents an extension of the status quo.”
Moody’s rates the state’s general obligation bonds Baa3 with a negative outlook while Fitch has Illinois at BBB with a negative outlook.
“Getting a budget done and avoiding a political stalemate is a positive and something we were specifically watching for,” said Fitch Ratings analyst Eric Kim. “That said the enacted budget has some risks and it doesn’t make material progress” in dealing with the state’s long-term strains and “there are implementation risks.”
Potential downgrade triggers included maneuvers that drive up the bill backlog and a resumption of the political gridlock that left the state without fiscal 2016 and 2017 budgets, so the new budget passed those tests, but Fitch is still evaluating the plan and expects quick state action should any holes develop.
“It’s certainly possible whoever is governor that he and the legislature will be revisiting the budget early in the session next year,” Kim said, citing the uncertain revenue streams.
The state will offer some employees about to retire lump-sum payouts for forgoing guaranteed 3% compounding cost-of-living adjustments on their pensions and will offer vested pension participants who have left their pension-eligible jobs, but have yet to retire, a lump-sum buyout equal to 60% of their lifetime pension benefits on a present-value basis. The state’s forecasted savings is based on assumed acceptance rates of 25% for retiring members and 22% for the vested but inactive participants offered buyouts.
“Actual budgetary impacts will not be known, and pension funding requirements will not be adjusted, until late in the fiscal year,” Moody’s wrote. “As a result, the state faces a risk that the plan will either increase its underfunding of pension contributions or add to a backlog of unpaid bills.”
The buyouts would be financed with up to $1 billion of borrowing. A third measure further shifts the pension costs of end-of-career salary spiking over to local school districts and universities that participate in the statewide teachers’ fund.
Moody’s puts the state’s pension liabilities at $201 billion based on the application of its assumptions. The changes represent one of the few tactics the state can use absent raising new revenue due to stringent state constitutional pension benefit guarantees that have been upheld by the Illinois Supreme Court.
“In addition to their uncertainty, booking these savings upfront implies they will not dent the steep upward sloping pension contribution schedule facing the state,” S&P noted. “This follows a familiar pattern in which lawmakers favor the immediate recognition of any potential savings related to pension policy changes while deferring those that result in higher costs.”
Moody’s and S&P have warned of the state’s need for action sooner rather than later as retirement costs and debt service are consuming about 30% of revenues, twice the median for states, S&P said.
Based on projections from the Commission on Government Forecasting and Accountability, S&P said it estimates that by fiscal 2025 pension contributions from the state's general funds will increase by $1.7 billion, or 24%. They are projected at just over $7 billion in fiscal 2019 based on the savings tied to the three measures.
The state's current debt service schedule diminishes by nearly $1 billion in fiscal 2020 after short-term pension borrowing is retired, but the state has largely already incorporated those savings through its planned interfund borrowing.
“Finally, any additional unanticipated budget stress arising from, for example, weaker than expected economic performance, would only exacerbate the state's structural imbalance,” S&P added.
S&P and Fitch Ratings’ most positive comments recognized the on-time passage of the budget on bipartisan votes but they were tempered by a long list of potential problems.
The state’s leading credit risks “are its fiscal structure, which in our view, remains out of balance, a still-elevated unpaid bill backlog, absence of a budget reserve, and distressed pension funding levels,” S&P said.
The budget’s structural balance is not just flawed by its reliance on one-shots but also on revenue projections that could falter especially if the economy sours. Improved projections so far this year are largely due to non-recurring windfalls linked to federal tax reform.
“A huge chunk of over performance revenue projections could tail off,” Kim said.
“The economy itself is also a risk,” S&P added, given that the state lacks reserves and projects a narrow balance.