Illinois' Answer to Saving too Little? Borrow More and Hope

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After years of under-funding its state pension programs, Illinois has come up with an idea that can be described as risky at best. Illinois plans to borrow money, and then invest that money, in the hopes of earning more than it must pay back in interest.

If you don’t see the danger in using money invested in volatile markets to pay fairly predictable pension payments, you’re probably an elected official in Illinois.

The Wall Street Journal‘s editorial board highlights something that I have been discussing for years here on YourSurvivalGuy.com (see here, here, here, and here). The expected rates of return on these pension funds are overly optimistic. They write:

At the request of state retirees, a University of Illinois math professor performed a crack analysis showing how the state could use interest-rate arbitrage to shave its pension costs. Under the professor’s math, the state could sell 27-year, fixed-rate taxable bonds and invest the proceeds into its pension funds. This would supposedly stabilize the state’s pension payments at $8.5 billion annually, save taxpayers $103 billion over three decades and increase the state retirement system’s funding level to 90% from 40%. Can the mathemagician make House Speaker Michael Madigan disappear too?

The professor based his analysis on pension obligation bonds issued under former Gov. Rod Blagojevich in 2003 with a 5.05% coupon that have earned on average 7.62% in the pension system. But that period included two bull equity markets, and even the state pension funds project only a 7% long-term return.

Illinois’s borrowing costs have also increased as its credit rating has slipped to a notch above junk from double-A. Last year the state’s taxable bonds due in 2035 traded at yields up to 7.2%. Investors may demand even higher rates because of the substantial interest-rate and credit risk given rising rates and the length of the 27-year bonds.

These magic bonds wouldn’t carry the state’s “full faith and credit” protection, for whatever that’s worth nowadays in Springfield. In effect, public workers’ pensions would be the bond security.

Two relevant precedents are the cities of Detroit and Stockton, California. Both borrowed to finance pensions and then later defaulted. Creditors had no recourse when the cities went bankrupt. States can’t file for bankruptcy under federal law, but Illinois lawmakers could seek to extend maturities or reduce interest payments on the bonds. Good luck to creditors in court.

The real goal with these bonds is to shift the pension-liability risk from public workers and retirees to investors and taxpayers. This would liberate politicians to spend more and remove any incentive unions have to reform pensions. After borrowing for pensions in 2003, state lawmakers skipped payments, increased spending and scrapped retirement reforms for new workers.

E.J. Smith - Your Survival Guy

Preparing your investments and family for when disaster strikes.

E.J. Smith is the Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH, where he completed course-work in Practical and Defensive Handgun, Conceal Carry Pistol, Shotguns, Precision Scope Rifle and Kidnapping Prevention. E.J. plays a Yamaha Recording Custom drum set with Zilldjian cymbals. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@youngresearch.com. Sign up here to receive all the best content from Richardcyoung.com each week.