This article first appeared at The McAlvany Intelligence Advisor on Wednesday, March 4, 2015:
Downtown Chicago, Illinois at night.
Chicago is a microcosm of Illinois: it has a determined unwillingness to face reality. Even Moody’s, in its latest downgrade of Chicago debt, has failed to grasp the enormity of the shortfalls facing the city and the state.
Moody’s tried to be realistic, using unrealistic numbers:
[Our rating] incorporates expected growth in Chicago’s already highly-elevated unfunded pension liabilities and continued growth in costs to service those liabilities, even if recent pension reforms proceed and are not overturned….
The “expected growth” will likely surprise to the downside even the realists at Moody’s, as the real shortfall in the five pension plans the state is funding is vastly greater than even the $100+ billion the state faces. A “special pension briefing” performed back in November by the state’s Commission on Forecasting and Accountability showed the accrued liabilities on those plans to be $183 billion, with just $72 billion in assets, leaving a shortfall of $111 billion. On the surface, that means those plans are more than 60 percent underfunded.
But there are at least two problems with that calculation. First, it assumes that those assets will earn seven percent a year, or more, for as far as the eye can see. Secondly, it assumes that the investments will be safe and sound.
But in a two percent world, where are those investment managers likely to get seven percent? A quick peek into the assets backing the largest of the plans – the Teachers’ Retirement System – reveals investments in junk bonds, real estate, derivatives and private equity firms. In fact, TRS, according to Mish Shedlock, has invested more than $1 billion in bonds that Moody’s or Standard and Poor’s have rated as junk.
Further, according to the latest forecast from GMO LLC, a firm calling itself “a global investment management firm committed to providing sophisticated clients with superior asset management solutions,” predicts returns over the next seven years for equities and bonds to fall far short of the returns necessary even to meet the actuarial assumptions built into those plans.
With investment managers reaching for yield and taking consequent risks, in the “seven bad years” ahead, those pension plans are in desperate trouble.
But none of this is entering the political conversation as Chicago Mayor Rahm Emanuel is running for his political life against Chuy Garcia, both of whom have big plans to spend even more, for schools, for infrastructure, and other “investments” to get the economy moving again. In fact, Emanuel’s 2015 budget says nothing about the pending shortfall of revenues needed not only to service the increasing costs of those plans and nothing whatever about the state-mandated payments in 2016 to keep the police and firemen’s pension plans afloat. Instead, Emanuel issued this, following Moody’s report last week:
We strongly disagree with Moody’s decision to reduce the city’s credit rating and would note that Moody’s has been consistently and substantially out of step with the other rating agencies [Standard and Poor’s and Fitch Ratings], ignoring progress that has been achieved.
At the moment those other two agencies rate Chicago’s debt at A-plus or A-minus, each with a negative outlook. But in light of the imminent court ruling that could invalidate efforts to cut pension benefits along with the crushing and increasing burden of those benefits, observers are just waiting for the next two shoes to drop.
Illinois legislators, to their credit, passed a law cutting pension benefits and requiring present state workers to contribute more to their retirement and health benefit plans, but labor unions predictably sued to block it, claiming that the state’s constitution put such cuts off-limits. A judge agreed, and his decision is being appealed, with a decision expected in the next couple of weeks.
The unions have claimed that, under the Illinois state constitution, a pension promise made is one that must be kept, even if there isn’t the money to fund it. They hold that membership in a public pension plan is “an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.” Observers claim that the court is likely to throw out the state’s attempt, modest though it may be, to bring sanity back into the conversation. In an earlier case the Illinois Supreme Court ruled that promised benefits are “absolute” because the clause in the state’s constitution is “aimed at protecting the right to receive the promised retirement benefits [and] not the adequacy of the funding to pay for them.”
This disconnect from reality, therefore, extends from politicians at the local level to the judges, but mathematics will overrule them all.
It’s already happening in Detroit where pensioners receiving their March checks are noting a 4.5 percent haircut, with more to come.
At the moment, reality is a rare and precious commodity in the Windy City.
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Sources:
Chicago Tribune: State’s lawyers argue pension protection not ‘absolute’
Chicago Sun Times: City lawyers predict ‘catastrophic outcome’ if pension reform overturned
Chicago Business: Illinois’ pension mess likely to get worse when high court rules
Mish Shedlock: Bill Gross: Too Much Debt, Too Many Zombie Corporations, Low Interest Rates Destroy Pension System
Mish Shedlock: Illinois Pension Plans 39% Funded; Taxpayers On the Hook for $105 Billion in Liabilities; It Will Get Worse!
BondBuyer.com: Rating Squeeze Tightens on Chicago
Background on GMO LLC investment advisory firm
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