July 5, 2013
Amidst a flurry of reports on the State of Illinois’ inability to solve its ongoing pension crisis and worst bond rating of all 50 states, a new study claims that the State’s $96.8 billion unfunded pension liability poses no risk of default to bondholders.
The report, published by the Mercatus Center at George Mason University, compares Illinois’ current financial woes to the last state to default on its bonds, which was Arkansas in 1933. As an example of a highly-rated state, the report cites neighboring Indiana, which is ‘AAA’ rated and experienced a surplus in its most recent two-year budget cycle.
At the time that Arkansas stopped making payments to its creditors, the state’s debt costs took up roughly 30% of its total annual revenues. According to the paper, “Modeling State Credit Risks in Illinois and Indiana,” by Marc Joffe, the 30% debt-costs-to-revenues ratio is an appropriate threshold to judge the current possibility of Illinois and other states defaulting on their debts.
In order to represent the total financial obligations straining current state resources, the report compares annual pension costs and total bonded indebtedness to total revenues; calculating an updated total debt-to-revenue ratio.
Based on revenue projections from the Institute of Government and Public Affairs (IGPA) and actuarial cost projections from the State’s five retirement systems, Mr. Joffe concluded that in 2012 Illinois’ debt and pension costs combined made up only 9.8% of total revenues received by the State. Thus, “default probability would be zero under any plausible budget scenario.”
Looking forward, the study showed that in over one million budget scenarios simulated between the current year and 2030, using a variety of growth rates for revenues and pension costs, Illinois’ debt to revenue ratio only exceeded the 30% threshold four times. The study showed that Indiana never approached the 30% ratio under any plausible scenario.
However, as pointed out in the study, default by a government is often a political decision and defies data-based measurability. “The choice is between the embarrassment and loss of bond-market access triggered by default and the crowding out of programmatic spending arising from continued debt service,” writes Mr. Joffe.
Mr. Joffe is a principal consultant at Public Sector Credit Solutions and former director for Moody’s Analytics. He has published commentary critical of the rating agencies analysis of Illinois’ credit risk and his firm aims to provide additional quantitative analytics for participants in the bond market.
Joffe’s study also reviews the history of the 1840s financial crisis that led to a series of state defaults including Illinois and Indiana. Illinois failed to make its debt payments in January 1842 after years of selling bonds to build the Illinois and Michigan Canal. Debt costs related to the project actually exceeded the State’s annual revenues, leading to additional borrowing to pay for annual operations, according to the study. Illinois did not emerge from default until 1857 and fully repaid the debt by 1880.
Indiana’s default was caused by a similar imbalance of debt funded investments in railroads and other infrastructure exceeding state resources.
Although the study indicates an optimistic outlook for Illinois’ ability to avoid defaulting on its debts due to its growing pension liabilities, the paper concludes that these findings do not imply support for the State’s current fiscal policies or pension funding plan. “Fiscal policies that shift costs onto future generations are morally dubious in any case, but especially so in current context,” concludes Mr. Joffe.
With different parameters the study might also show a more likely possibility of Illinois reaching the 30% debt-to-revenue ratio. The revenue data used to calculate the ratio in Joffe’s paper includes all state revenues, which according to the paper totaled $64.0 billion in FY2012. However, as shown in the Institute for Illinois’ Fiscal Sustainability’s (IIFS) most recent budget analysis, State-source General Funds revenues, the operating funds available to make the State’s annual pension contribution, totaled only $30.0 billion. The Road Fund and Motor Fuel Tax Fund, which also are used to pay some of the state’s outstanding debts received $2.9 billion and $1.2 billion respectively in FY2012. The additional funds included in Mr. Joffe’s report represent trust funds, federal funding and other dedicated resources not typically available to fund general operating expenses. For purposes of the study, Mr. Joffe assumes that the State may borrow from one fund to another in a time of crisis to pay bondholders.
However, excluding these restricted funds and based on the current pension funding schedule, IIFS analysis shows pension cost alone are expected to consume 24.5% of State-source General Funds revenues in FY2014 and are projected to take up 35.5% by FY2033.