By: Ted Dabrowski and John Klingner
The world’s collapsing interest rates have just made survival that much harder for Illinois’ pension funds, most of which are built on the assumption that they can earn around 7 percent on their investments. Interest rates have fallen below zero percent in Europe, while US 30-year interest rates fell below 2 percent for the first time in history. Ten-year rates here are now at 1.5 percent, also near their lowest level ever.
Low rates are particularly hard on the most underfunded pensions because those funds are forced to keep more of their money in short-term, low-yield bonds so they can cover near-term pension payouts. Low rates also hammer the smaller police and firefighter pensions around the state because they, by law, are forced to keep large parts of their investments in bonds.
Expect funding levels to continue their descent across the state.
Illinois’ pensions are just 38 percent funded. That’s the third-worst rate in the nation, just behind fellow crisis-wracked New Jersey and Kentucky.
Chicago’s firefighter plan is just 17 percent funded while the city’s police and municipal plans are just over 20 percent funded.
And many of Illinois’ 650 local police and fire funds are just as bad. The overall funding ratio across the state is just 55 percent, but nearly 100 of those funds have funding ratios lower than 40 percent.
Low interest rates make it that much harder for the funds to grow what little money they have left to invest. And that means Illinois’ true fiscal crisis will come sooner than later, everything else equal.
The low funding ratios have already contributed to Illinois’ just-one-notch-above-junk credit rating – no state has been rated junk before. Chicago already has a junk rating from Moody’s, while Chicago Public Schools is already five notches into junk – two notches lower than the city of Detroit.
Lower interest rates are likely to put even more pressure on the rating agencies to drop credit ratings in Illinois even further. That’s particularly true if US interest rates follow the path of those in Europe, as some analysts expect. There, interest rates have gone below zero, meaning investors get back less money than they actually invest. Germany’s most recent 10-year bond rate was at a negative 0.71 percent.
Low interest rates will make things worse in Illinois for three reasons.
First, because the funds need to set some money aside for payouts to current retirees, they can’t afford to have it all locked up in risky investments. That forces them to keep money in investments that are liquid and easy to sell – meaning bonds. The problem is, those bonds pay little and don’t keep up with how fast the plan’s pension promises have been growing. That alone makes the funding hole in the pension plans bigger.
Second, lower bond rates will tempt the plans’s managers to make even bigger investments in stocks and other risky assets. And that could spur a liquidity crisis if there is a major stock market correction.
Finally, Illinois law requires most of the 650 police and firefighter pensions around the state to invest much or most of their money in bonds. Half of those funds must invest 55 to 90 percent of their holdings in fixed income investments. With interest rates now so low, they have little hope of earning meaningful returns.
A fundamental flaw of defined benefit pensions is now fully exposed. They guarantee high benefit payouts to pensioners but they are backed by investments that are far from guaranteed.
The gap between the two has reached absurd levels.
Read more about how interest rates and investments mean deep trouble for pensions: