Illinois, which has the worst-funded state pension system in the United States, has agreed to settle federal civil securities fraud charges alleging it repeatedly misled municipal bond investors about the underfunding of its pensions, the Securities and Exchange Commission said.
Illinois neither admitted nor denied the charges and was not ordered to pay a penalty. It agreed to change its practices to more fully disclose risks to bond investors, the SEC said Monday.
The settlement of charges that Illinois failed from 2005 to early 2009 to fully tell investors the risks of buying $2.2 billion worth of its municipal bonds is the latest blow to the state's reputation as fiscally troubled and crippled by a pension shortfall of $98.6 billion.
In official statements accompanying bond offerings Illinois explained that factors such as market performance had contributed to the increase in its unfunded pension liability, but it "misleadingly omitted to disclose the primary driver of the increase - the insufficient contributions," the SEC said.
In order to keep its contributions low, Illinois had developed a complicated system that included "ramp-ups" and "pension holidays," the SEC said.
Instead of paying to pension funds what actuaries had determined to be the annual contributions, Illinois followed a funding plan approved by the legislature that deferred the payment of pension obligations, compounding its pension burden.
The legislature phased in the state's contribution over a fifteen-year "ramp" period, where the amount Illinois put in gradually grew until in 2011 it made the full amount. It then had to put in a level amount so the pension system was funded by 2045.
The state went further, amortizing pension costs over 50 years, instead of the typical 30, which gave it a longer window to pay off the liability. Then, it lowered the contributions in 2006 by 56 percent and in 2007 by 45 percent in "pension holidays."
Illinois "failed to disclose the effect of its unfunded pension systems on the state's ability to manage other obligations, the SEC said. "The state also did not inform investors that rising pension costs could continue to affect its ability to satisfy its commitments in the future."
It also did not explain to investors that its "inability to make its contributions increased the investment risk to bondholders," the SEC said, adding it "did not identify or discuss how this underfunding compromised the state's creditworthiness or increased its financing costs."
The state of Illinois has $19.67 billion pension obligation bonds outstanding, out of a total of about $50.2 billion in outstanding municipal bonds, according to Thomson Reuters data.
Institutional Failures
There were also institutional failures, according to the regulator. The Illinois government relied on bond underwriters, consultants and lawyers to advise them what to disclose but those same groups were relying on the state for the advice, SEC said.
"The result was a process in which no one person fully accepted responsibility for identifying and analyzing potential pension disclosures," the settlement document said.
Beginning in 2009, the state took steps to address the commission's concerns, the SEC said. Over the last four years, Illinois has improved disclosures in the pension section of its bond offering documents, retained disclosure counsel, and instituted written policies on disclosure.
In 2010, the state also enacted a law that employees hired after Jan. 1, 2011 would have a higher retirement age and lower pension.
Governor Pat Quinn said the commission had acknowledged the "proactive steps" Illinois took improve its pension disclosures, and that "the state began these enhancements prior to being contacted by the SEC."
Quinn and the state legislature are currently locked in a political battle as to how best to fix the funding gap, which is so large that it has led Illinois to have the worst credit rating among U.S. states. All three rating agencies have raised alarms that the swelling pension obligations and problems could eat away at the state's credit quality.
Investors' concerns over credit quality has driven up the amounts the state must pay to borrow - on Friday the spread of yields on Illinois debt to Municipal Market Data's benchmark scale was 140 basis points for a 10-year bond.
For the last year, the spread has averaged 149.8 basis points, the second highest after financially troubled Puerto Rico.
Many states had long short-changed their pension funds, and when their revenues collapsed during the 2007-09 recession, they pulled even further back on contributions. At the same time the leading source of revenues for pensions, investments, plummeted in the financial crisis. According to Pew Center on the States, the pension gap for all states is currently $757 billion.
Illinois Comptroller Judy Baar Topinka, a Republican who was not in office when the alleged abuses took place, said the state has done "the right thing."
"Unfortunately we will all be paying for the mishandling of the pension funds for many years to come. At the time I warned that raiding our pension funds and borrowing to make our payments was a 'ticking financial time bomb' and sadly, that has come to pass," Topinka said.
The case marks the second time the SEC has charged a state in connection with public pension disclosure failures. The SEC had previously charged New Jersey in 2010, for not adequately informing investors of the costs of its pensions, saying at the time the charges were a warning to all other issuers in the $3.7 trillion municipal bond market.
Elaine Greenberg, chief of the SEC's Municipal Securities and Public Pensions Unit said in a statement on the settlement, pension disclosure "continues to be a top priority."