 Illinois isn’t covering the interest payments on its pension debt. Those
interest payments total $9.1 billion a year.
This is the reason Illinois’ pension debt continues to grow. As with personal
credit card debt, until the interest is paid off none of the actual debt gets
erased. Illinois’ pension debt is so large that it’s unlikely payments will
cover the interest on the pension debt until 2028, according to a November 2016
special pension briefing from the Commission on Government Forecasting and
Accountability.
Illinois politicians have known for years about the state’s pension crisis, even
if they have not taken serious steps to address the problem. Gov. Bruce Rauner
recently spoke out on the cost of interest on the pension debt. Former Gov.
George Ryan weighed in as well, saying:
“First off, the biggest problem we got with the budget right now is the interest
they are paying on the debt. If I were the governor, … I’d say we are never
going to be able to pay the full debt back, so let’s eliminate half the debt
right now and write it off.
“If that’s not constitutional, it might be worth changing the constitution. That
would dramatically reduce the amount of interest that they’re paying. The bond
ratings would go up and the interest would go down.”
Ryan seemed to be referring to the annual “interest cost” on Illinois’ pension
debt, which is about $9.1 billion per year, or $25 million per day. The portion
of interest cost that isn’t covered each year is simply added to the debt.
Why Illinois’ pension debt keeps growing
Illinois has about $78 billion in assets on hand to pay for pensions. But the
present value of the state’s accrued liability is $208 billion. That leaves a
difference of $130 billion, which is money the state owes – but doesn’t have.
Illinois pension math assumes an annual investment return rate of just over 7
percent on $208 billion in pension assets. If pension assets end up returning
less than 7 percent per year, then the actual pension liability will end up
being much larger than is currently assumed.
However, $130 billion of that accrued pension liability doesn’t exist, which is
considered the pension debt. This debt does not bear interest like a bond does –
but it functions the same way in reality. Because $130 billion is missing,
Illinois will automatically miss out on the 7 percent annual investment return
on that nonexistent $130 billion. This “missed” investment return is about $9.1
billion per year, and is essentially the interest cost on the $130 billion
pension debt.
Illinois’ type of payment plan, which fails to cover interest, is called
“negative amortization.” The debt principal continues to grow because the
pension payment does not cover the interest cost. The portion of the interest
payment that isn’t covered is added to the debt.
As actuary Tia Goss Sawhney explained, a full pension payment is made up of
three parts:
[to top of second column] |
 Full payment = Employer normal cost + interest cost + principal
reduction payment
However, Illinois’ scheduled pension payments are too small to cover
the normal cost and interest cost, causing the unfunded liability to
go up. For example, in fiscal year 2018, Illinois will make an $8.9
billion pension payment, which will cover the $2.1 billion employer
normal cost and $6.8 billion of annual interest cost. However, the
annual interest cost is actually $9.1 billion, meaning that after
the employer’s portion of the normal cost, Illinois will come up
$2.3 billion short on the interest payment. The unpaid portion of
the interest cost is added to the debt, just as if a person didn’t
cover the full interest payment on a home loan or credit card. In
Illinois’ case, that $2.3 billion shortfall will be added to the
pension debt.
The reason the principal reduction payment is negative is because
the debt grows.
Illinois needs a constitutional amendment to allow for real pension
reform
As Ryan pointed out, Illinois’ pension math might never add up
without reducing the $130 billion pension debt, which the Illinois
Constitution currently protects from being restructured. Even though
Illinois is already overtaxed, and pension costs are driving up
taxes more each year, the state still can’t cover the interest cost
on the pension debt until 2028. On top of that, many local
communities like Chicago have pension problems that are even more
severe than the state’s problems. And the math gets even worse if
Illinois doesn’t hit investment returns of 7 percent per year.
A golden rule of finance is this: Debt that can’t be paid won’t be
paid. The state should develop a contingency plan to repeal the
Illinois Constitution’s pension protection clause and restructure
pension obligations to pull Illinois out of a potential death spiral
should the need arise. Such a plan should preserve benefits for
government workers with modest pensions while means-testing the
richer pension benefits. This would almost certainly be challenged
as a violation of the contracts clause of the U.S. Constitution, and
the U.S. Supreme Court might ultimately decide the matter.
Illinois might be one serious recession away from a financial death
spiral. A deep recession would reduce the value of pension assets
while also causing tax revenues to decline. Illinois’ pension
obligations would increase just as tax revenues dried up. After such
a recession ended, out-migration would likely surge as Illinoisans
increasingly realized the impossibility of financing their
government’s spending promises. If financial assets fall and do not
recover, Illinois’ pension math might be doomed.
The battered ship of Illinois’ finances is lurching toward a rocky
shore. Lawmakers should develop a contingency plan for an emergency
situation, and be prepared to enact it in order to salvage the
state’s finances.
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