Illinois recently became only the second state in U.S. history to be charged with securities fraud by federal regulators (New Jersey was the first, in 2010). On March 11, the Securities and Exchange Commission (SEC) accused Illinois of deceiving investors regarding the health of its state employee pension funds, in a series of bond offerings from 2005 to 2009. The SEC accused state officials of misleading bond investors “by omitting to disclose information about the adequacy of [the state’s] statutory plan to fund its pension obligations” and deviations from that plan, both of which significantly misrepresented the extent of the state’s unfunded pension liabilities.
Illinois settled immediately, without either admitting or denying the charges. In exchange, the SEC did not require the state to pay a penalty. Considering the extent of Illinois’ pension funding shenanigans, that kid-glove treatment is surprising, to put it mildly. So how did the Land of Lincoln get to this point?
In 1994, the Illinois legislature enacted a statutory funding plan that set a schedule for the state to fully fund at least 90 percent of its pension obligations by 2045. But the state failed to inform investors that its plan deferred most of the funding contributions well into the future, according to the SEC complaint. Payments were to be phased in over a 15-year “ramp” period, during which pension liabilities continued to grow. Illinois compounded the damage by ceasing even those minimal contributions during “pension holidays” in 2006 and 2007. Consequently, when the state issued a series of bonds from 2005 to 2009, to help cover its pension obligations, it misled investors by misrepresenting the magnitude of unfunded pension liabilities.
It seems unimaginable that the SEC would agree to a similar no-guilt, no-penalty settlement with a private firm. So, why did Illinois get special treatment? As Forbes’ Edward Siedle notes, “The SEC apparently needs reminding that it actually has the power, some might even say responsibility, to impose fines as a deterrent to multi-billion frauds.” Springfield’s pension shell games are serious. The state’s pension funds have a 57 percent, or $83 billion, unfunded liability — for which Illinois taxpayers will be on the hook one way or another.
But the state’s malfeasance doesn’t end there. The SEC’s complaint doesn’t even address the high discount rate Illinois uses to forecast pension fund investment earnings, which vastly understates the extent of the plans’ underfunding. The state projects annual investment returns of 8.2 percent — at the upper end of the unrealistically high annual return projections used by many public pension funds. Some funds are able to achieve an average of around 8 percent per year, but with a great deal of year-to-year variability. Because pension obligations grow so quickly, however, those funds are advised to use a far more conservative discount rate — such as a “risk-free” rate pegged to the returns on U.S. Treasury bonds. As a primer on Illinois pensions issued by the Commercial Club of Chicago explains, “one of the dangers of using such high discount rates is that public pension plans must achieve equally high rates of return on their assets each year — otherwise the value of the assets in their plans slips below the value of the liabilities, and the unfunded liabilities grow rapidly.”
It makes little sense, then, for Illinois to discount its contribution requirements so heavily. One might argue that the state is misleading taxpayers even more than bond buyers, as its unfunded liabilities mount.
But there is another set of victims in all this: state employees, whose retirement security is threatened by pension funds that simply may not have the money to pay out benefits. George S. Canellos, acting director of the SEC’s Enforcement Division, said regarding the charges, “Municipal investors are no less entitled to truthful risk disclosures than other investors.” But what about individual workers? The Manhattan Institute’s Diana Furchtgott-Roth asks, if bond buyers are entitled to disclosure, “does it follow that potential union members are also entitled to truthful risk disclosures about the state of pension plans when they are pressured to join?”
If there is a trace of optimism to be found in all of this, it is that public pensions’ crushing pressure upon state finances is forcing state lawmakers to move toward reform. Illinois was forced to enact pension reform legislation. And though that was fairly modest, as the underfunding crisis continues, it may embolden some Springfield lawmakers to look for more robust, long-term solutions. They would do well to consider the Illinois Policy Institute’s proposal to freeze the current defined benefit pension system and move future state workers toward defined contribution retirement plans.
Ivan Osorio is editorial director at the Competitive Enterprise Institute.