I’ve talked extensively about the U.S. pension problem and warned of the dire consequences ahead.
And they aren’t pretty.
But I almost fell out of my chair when I read about the latest debacle.
You need look no further than the state of Illinois for an example of the havoc caused by underfunded pensions and political gridlock.
In fact, earlier this month, two of the major credit-rating agencies (Moody’s and S&P) lowered their grade for Illinois state debt to one notch above junk.
You read that right:
The state’s bonds are on the brink of becoming “junk” — meaning they’ve almost fallen below investment grade!
These major credit agencies serve a vital role by independently reviewing each bond issuer’s financial strength. They determine if the entity will be able to pay its bills and remain liquid. This is particularly important in bond markets around the world.
Plus, ratings are used to determine pricing and corresponding interest rates. And bond issuers with a lower rating need to provide a higher interest rate to attract capital.
The downgrade leaves Illinois with the lowest rating ever given to a U.S. state. And it’s not rocket science to see why Illinois debt was downgraded. Consider the following:
- Two years without a state budget helped the state amass $14.5 billion in unpaid bills, according to Moody’s, which represents 40% of the state’s operating budget.
- Moody’s estimates that liabilities for the state’s five major pension plans soared 25% in the year ended June 30, 2016, to $251 billion.
- Retirement and health benefits combined with debt payments absorb 29% of the state’s general-fund expenditures, according to S&P.
- And get ready for things to get a lot worse because the Legislature just failed to pass a budget for the third year in a row!
And with no budget yet again, Illinois can expect S&P and Moody’s to downgrade its debt rating to outright “junk”.
A junk rating will only exacerbate the problem.
One, the state will have to pay millions of dollars in penalties to bond holders.
Two, it will float fewer bonds because many mutual funds are unable to hold any debt rated below investment grade.
And with an estimated budget deficit of $5 billion, it’s clear why the state’s gutting many social services and school programs.
And this dynamic will lead to more state and local job cuts and to an even larger rollback in social services.
I know what you’re thinking: If they don’t have the money, just make larger cuts to retirement benefits. But that’s illegal. The Illinois constitution says that pension promises can’t be cut for services already rendered.
The state has done a masterful job of keeping out-of-control pension woes out of the public eye by using creative accounting tricks, including unrealistic discount rates in their liability calculations.
But Illinois’ day of reckoning is quickly approaching.
The pension disaster is getting worse by the day. This epidemic will continue to spread to other states and ultimately to the federal level.
Here’s what you can do to protect yourself:
Limit exposure to government debt as much as possible. Instead, purchase high-quality blue-chip stocks on market weakness and accumulate safe-haven assets like gold when the time is right.