Should the state of Illinois, with its dubious distinction of running the nation’s most poorly funded public pension system, encourage the federal government to provide financial assistance or even a massive bailout?

That is a basic, yet controversial question that few power brokers want to confront. Yet it is not going away, especially as the state pension crisis deepens, a BGA Rescuing Illinois report has found.

Those who oppose federal intervention—and there are many—argue that Illinois alone must fix the pension disaster by using all the tools at its disposal, including raising revenue to fund pensions and reorganizing or cutting retiree benefits.

Other observers, however, contend that the funding shortfall for the state’s major pensions is so daunting, $111 billion and counting, that it surpasses Illinois’ ability to solve its own problems. As a result, some legal and financial experts suggest federal assistance may become a last-resort option just as it proved to be in 2008 for failing banks and domestic automaker giants.

Even the politically conservative Rauner administration isn’t slamming the door on the concept although it prefers a state-backed resolution.

Bruce Rauner

 Gov. Bruce Rauner walks down the hallway after speaking to the Chicago City Council. Photo courtesy of the Chicago Sun-Times.

“Pension reform is critical to the financial future of Illinois, and the administration is open to any constructive ideas to address the state’s pension crisis, including those that originate at the federal level,” a spokeswoman for Rauner said when asked by the BGA for its view of whether the federal government should play a role in addressing the Illinois pension crisis.  “We continue to look for common-sense pension reforms at the state level that will be a lasting solution for future generations.”

The state’s five pension systems that cover teachers, government workers, and elected officials average a combined funded ratio of 40 percent, about half the 80 percent funding level that is considered safe and a widely held standard based on corporate plans.

 Related Article: Next Up: Illinois Municipal Bankruptcy?

State law requires each pension system to be 90 percent funded by 2045.

This requires about a fifth of the state budget be earmarked for pension funding. Indeed, the Civic Federation, a Chicago-based research organization that focuses on improving the quality and cost-effectiveness of state and local government services, estimates the state’s contributions to its five pension funds will rise by $288.8 million to $7.8 billion in the 2017 fiscal year. This amount far exceeds the accepted range for pension contributions of 4.5 to 7.5 percent.

Illinois is not the only sovereign state stuck in the mire. In the U.S., total unfunded government pension liabilities run close to $1 trillion; 27 states have unfunded pension liabilities of $10 billion or more, and 26 states have funding ratios that put them “at risk” under federal regulatory standards, according to a recent Pew Charitable Trust survey.

“Public pension plans are at risk of insolvency within a decade,” wrote Terrance O’Reilly of the Willamette University College of Law in a 2014 paper published in the Michigan Journal of Law Reform. “These risks are significant, and the solutions currently contemplated are likely to fall short of what is necessary to contain the problem.”

The Illinois Supreme Court decision in May that tossed out a 2013 pension reform law put the state back at square one in terms of devising a plan to meet the backloaded obligation. Political gridlock has sidelined passage of a budget, much less a plan to address the funding liability.

Meanwhile, the possibility of federal intervention to address unsustainable debt is under discussion in some quarters of government.

Capitol Building Fed

Is Illinois Puerto Rico?  

A key test case is Puerto Rico, which is languishing under a $72 billion mountain of debt. The nature of the obligation is different—the island commonwealth borrowed heavily to spur economic development—but in both cases, the enormous size of the liability threatens to result in wrenching cuts in jobs and public services.

During the fall, the Obama administration began considering ways to help the commonwealth, including a plan that would enable the U.S. territory to restructure its debt under the supervision of a federal bankruptcy court. That was a more ambitious plan than one earlier proposed by the island’s nonvoting member of the House of Representatives, Pedro Pierluisi, to allow Puerto Rico’s municipalities  and public corporations to reorganize under Chapter 9 bankruptcy protection.

 The Treasury Department took it a step further, proposing a “Super Chapter 9” that would enable the Commonwealth itself to file for bankruptcy, although it would have to agree to accept independent federal fiscal oversight.

These and other proposals were considered by Congress as part of omnibus year-end appropriations bill. However bondholders lobbied hard against a court-ordered restructuring that would likely shrink their investment returns.

The bill ended up extending Medicare benefits to hospitals but didn’t include the opportunity for a supervised debt restructuring.

U.S. Treasury Secretary Jacob Lew visited the island recently and called on Congress to pass legislation that would enable Puerto Rico to restructure its debts and avoid default. House Speaker Paul Ryan has committed to producing a plan by the end of March.

Puerto Rico has withheld millions in tax refunds and payments to suppliers to make recent bond payments. The press has openly compared Puerto Rico’s plight to Illinois’ woes.

New Jersey Trial Balloon

Meanwhile in New Jersey this past summer, State Senate President Steve Sweeney proposed that the Federal Reserve sponsor a nationwide low-interest loan program to help his state pay unfunded pension costs.

Under Sweeney’s plan, the federal government would provide states with low-interest loans, about 1 percent, to pay down pension obligations and restructure their longterm payment schedules.

In a press release, Sweeney said a low-interest federal loan program would cost far less than current borrowing expenses, reducing overall costs for the states and their taxpayers. For New Jersey, future pension payments would drop by approximately 50 percent.

“This program would be more affordable for the states because pension payments would be reduced without cutting benefits,” Sweeney said in a press statement announcing his proposal.

Sweeney’s idea, however, failed to gain support and no bill has been introduced. New Jersey’s unfunded pension gap isn’t as wide as that of Illinois: The Garden State ranks in the bottom third of states, with a funded ratio of 63 percent.

Federal Reserve Bank

Why Not Tap Fed?

Just as the Federal Reserve Bank extended loans and other assistance to banks and financial institutions during the fiscal crisis, the central bank could lend money at low interest rates to states and municipalities, contends Saqib Bhatti, a Chicago-based fellow at the Roosevelt Institute and director of the ReFund America Project, which seeks ways to improve the financial health of U.S. cities that suffered during the 2008 recession.

During that financial crisis, the Fed extended a variety of credit programs, including short-term deposits, bridge loans, and other lending facilities to financial institutions. This is in addition to the Treasury Department Troubled Asset Relief Program (TARP) which spent about $475 billion to stabilize banks and automakers. (Congress initially authorized $700 billion but that amount was reduced.)

This type of lending would enable cities and states to avoid high fees from Wall Street money managers and free up funds for services, Bhatti argues.

The Fed has the power to lend to cities and states for up to six months, but Congress would have to authorize the central bank to make direct long-term loans. 

Another option is for Illinois to establish a state-chartered bank that could accept loans from the Fed, Bhatti said. North Dakota is the only state with such a bank. Established in 1919, the Bank of North Dakota issues loans to farms, business owners, students, and home buyers. It can borrow at the Federal Reserve’s discount window and lend directly to local governments at rates lower than those available in the municipal bond market.

“Financial institutions can go to the discount window but states cannot,” Bhatti said. “The cheapest money is not available to taxpayers.”

The Federal Reserve isn’t the only route to low-interest loans. Experts have floated other methods.

For example, professors Joshua Rauh of Stanford University and Robert Novy-Marx of the University of Rochester proposed that a state be allowed to issue tax-subsidized pension security bonds for the purpose of pension funding.

Reform required

The state must first agree to take specific steps to stop the growth of unfunded liabilities: Close its defined benefit plans to new employees, make its actuarially required contributions for existing defined benefit plans, and include new workers in Social Security but also provide them with an adequate defined contribution plan.

Federally backed bonds essentially transfer pension obligations from a soft “promise” to hard debt that must be paid on time, said Jim McNamee, president of the Illinois Public Pension Fund Association, which represents pension fund managers and trustees.

“Will public officials have the discipline to support that going forward?” he said. “I’m for anything that guarantees our getting on a good financial footing.”

Taking it a step further, O’Reilly of the Willamette University College of Law suggested that the federal government institute an optional regulatory regimen for public pensions.

Public plans could be eligible for financial support if they agree to oversight in the way that private plans are regulated by the Employee Retirement Income Security Act (ERISA).

Until recently, the idea of some type of federal intervention was unthinkable. Former Gov. Pat Quinn was forced to backpedal in 2011 when a sentence in his proposed budget said the state might consider seeking a federal guarantee of debt to maintain pension funding. The controversial line: “significant long-term improvements will come only from additional pension reforms, refinancing the liability and seeking a federal guarantee of the debt, or increasing the required state contributions.”

Quinn said in an interview at the time that he included the possibility “as a precaution,” but its inclusion in the document prompted round of criticism from Republican legislators in Washington, D.C. and Springfield.

Lots of opposition

Opponents of federal intervention point to ideological and practical considerations. They argue that federal intervention would violate state sovereignty. States have the power to raise taxes, cut spending, and issue debt, noted Karen Krop, senior director at Fitch Ratings Inc. “A bailout is not in the cards—Illinois has a political problem, one of its own making,” she said.

Indeed, federal intervention would take decision making out of the hands of local officials accountable to the citizens that elected them. “Should we cede decision-making to unelected outsiders with no skin in the game?” said McNamee of the Illinois Public Pension Fund Association.

Opponents often cite the moral hazard dilemma: a federal rescue would reward the laggard states that failed to meet their obligations.

“Bad behavior shouldn’t be bailed out,” said Ted Dabrowski, vice president of policy for the Illinois Policy Institute, a think tank that supports limited government. 

A bankruptcy option would be preferable to any form federal intervention, Dabrowski said.

There is no mechanism for states to file for bankruptcy protection—although some experts have suggested that Congress adopt such enabling legislation. Under federal law, states may allow municipalities to file for reorganization under the Chapter 9 provision, but Illinois is among the 50 percent of states that haven’t authorized such an option.

The bankruptcy option could provide the leverage needed for parties to negotiate and come to terms, even if a formal case is never filed in court, Dabrowski said.

Perhaps the biggest obstacle is political, as public pensions have become a polarizing issue. Bondholders fear they’ll be forced to make concessions in a restructuring. Others argue pension benefits aren’t affordable and need to be scaled back. 

Labor leaders and many Democrats—pointing to the State Supreme Court decision striking down pension reform—say the state should stand by its promises. They worry that corporate interests and Republicans would use a court-supervised reorganization to open contracts and bust unions.

Representatives of the major unions representing public employees, including American Federation of State, County, and Municipal Employees Council 31 (AFSCME) and Illinois Federation of Teachers (IFT) did not return phone calls seeking comment.

The Rauner administration did not comment beyond its email remarks to the BGA.

(The governor recently voiced support for a revised version of a pension reform bill that would save $1 billion annually.)

Political longshot

If relief measures for the pension crisis require congressional blessing, the conservative U.S. House isn’t likely to be sympathetic, said Ralph Martire, executive director of the nonprofit Center for Tax and Budget Accountability, a Chicago-based think tank that promotes policy reforms in education, social services, health care, and economic development.

And the U.S. Senate?

Sen. Dick Durbin has said in the past that Illinois can’t count on a bailout from the federal government, a spokeswoman noted. Given Republican opposition to bankruptcy authority for Puerto Rico and a Detroit bailout, support for state-by-state bailouts looks unlikely in this Congress, she added. Sen. Mark Kirk’s office didn’t respond to a request for comment.

“I don’t see enough clout to make it happen,” Martire said. “During the fiscal crisis the banks had lobbyists. Pension systems don’t make political contributions.”