Illinois Pension Plan Blames Low State Contributions for Serious Underfunding

The Teachers’ Retirement System of the State of Illinois recorded a drop in funded ratio to 40.6% and an increase in unfunded liability to $55 billion this year.

(October 31, 2013) — The Teachers’ Retirement System (TRS) of the State of Illinois recorded further underfunding despite a higher rate of return on investments during the 2013 fiscal year.

According to its latest report, TRS’s unfunded liability rose to $55.73 billion from $52.08 billion at the end of fiscal year 2012. The increase also dragged down its funded ratio—to 40.6% as calculated under state law and 42.5% using market value of its assets.

A silver lining was found in its investment returns, as the plan gained a 12.8% rate of return this year. It also recorded an 8.7% rise in total assets to $39.5 billion from $36.3 billion last year.

TRS Executive Director Dick Ingram stressed the importance of long-term investment performance in their financials, as the plan maintains relationships with current teachers and retirees for decades.

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“It’s important to note that the TRS 30-year rate-of-return at the end of fiscal year 2013 was 9% per year on average,” Ingram said in the report. “Our assumed return rate of 8% also is a 30-year expectation. TRS investments over time are more than right on target.”

However, Ingram said positive returns did little to mask the pension plan’s serious underfunding issues. “Despite these strong returns, TRS cannot invest its way out of the funding hole we are in,” he said.

The problem—and the solution—lies in the Illinois government, Ingram said: “This increase in the system’s unfunded liability, even with good investment results, is another wake-up call to state officials and our members that TRS long-term finances continue to head in the wrong direction.”

The report said the formula with which state contributions are calculated does not meet the requirements of standard actuarial practices commonly used in other states. Contributions, according to actuarial standards, should be $4 billion, rather than the $3.4 billion currently being paid.

“The contribution from the state that is required by the law continues to be far short of the amount required to ensure our long-term sustainability,” Ingram said. “Without changes to the pension code to ensure sustained and adequate funding, TRS faces the very real possibility that in a few decades the system will not have enough money to pay benefits to retirees. We cannot guarantee that TRS will have enough money to pay the pensions promised to every member.”

Ingram went on to say that not only has TRS never received a full actuarial contribution from the state of Illinois since its inception in 1939, but it is owed a total of $16.9 billion since 1970. “This consistent underfunding is the primary reason that TRS carries an underfunded liability,” he said.

TRS’s underfunding issues are only the tip of the iceberg. Illinois’ public pensions are currently facing a $145 billion pension problem as well as a credit ratings downgrade from Fitch.

Moody’s Investors Service also identified Illinois as the state with the highest pension burden according to its new liability measurement. Using a market-based discount rate Illinois’ liabilities totaled 241% of the state government’s annual revenue.

The State Employees’ Retirement System of Illinois also recorded a decline in funded ratio—as of June 30, 2012, it was 34.7% funded, compared to 35.6% in 2011.

(October 31, 2013) – High-yield bonds are at the most attractive valuations for several years, with B and BB-rated securities being singled out for value-seeking investors.

Fraser Lundie, senior portfolio manager at Hermes Credit, has issued a note telling investors that more than half of BB-rated bonds issued in the past 12 months are trading below face value, presenting an opportunity for investors.

“High-yield bonds have fallen by about four points since the US Federal Reserve’s talk of tapering its stimulus program spooked investors. The shake-out, which saw valuations decline from an all-time peak in May, impacted recently issued BB-rated bonds the most,” he wrote.

“Investing blow par reduces risk of capital loss, positions investors for future prices gains, and provides put options to benefit from buyouts as more companies—particularly those in the US—consider merger and acquisition activity as they gain confidence.”

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Using this derivatives strategy, Hermes has been able to exploit returns from sub-investment grade securities while maintaining the ability to redeem the bonds at more than face value, should the need arise.

Crown Holdings, a metal-packaging company, had been the subject of takeover rumours at the time of Hermes Credit’s purchase, so it acquired a change-of-control put that, if exercised, would value the bonds at nine points above the purchase price of 92 cents.

“Exploiting optionality is one of the relative-value techniques that we’ve applied for more than three years,” Lundie wrote. “As high-yield bond valuations remain generally high and liquidity at its lowest level in a decade, we seek to manage these risks and outperform by investing globally among bonds and derivatives through the capital structures of issuers.”

Hermes Credit isn’t the only fund manager enamoured with sub-investment grade bonds. Fixed income boutique 24 Asset Management is keen too.

Gary Kirk, partner and portfolio manager at the firm, told aiCIO he agreed there was selective value in sub-investment grade credit, particularly in those credits with a high single-B or BB-ratings that endured price declines in the aftermath of the Fed’s initial mention of asset purchase tapering.

“For those bonds trading at a discount to par, the upside optionality of future M&A is particularly interesting; as are those bonds which carry imbedded call prices, as these are invariably set at a premium to par,” he continued.

“There has been reasonable price correction since the Fed ‘stalled’ the tapering talk back in September and generally the initial price decline in European high yield was less pronounced than for their US dollar peers; but for selective credits in this sector we agree that there does still remain attractive upside.”

The attraction is being felt in the US too: Payden & Rygel’s head of high yield Sabur Moini said his firm had long been a believer in the value of higher-quality high-yield bonds.

“BB-rated companies are by definition less levered than single B- and CCC-rated companies and thus default risk is far more remote for such issuers as they have superior risk profiles in terms of margins and cash flows,” he told aiCIO.

“On a volatility risk-adjusted basis, the returns for the higher-quality end of the high-yield bond market are superior to that of the higher beta, lower-rated end of the asset over a five- and 10-year period.

The rush for yield in 2013 has created opportunities in the BB-rate market, and BB-rated bonds have materially out=performed in October 2013, Moini noted.

However, investors shouldn’t be fooled by 2013’s recent run of high returns of junk bonds further along the high-yield curve, he warned.

While in 2013 to date, the lower-quality end of the market had outperformed the higher-quality end, Moini believed this market had become “too toppy, or frothy” to consider now.