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Analysis: Illinois pension fix faces political, legal hurdles

By Karen Pierog

CHICAGO (Reuters) - Illinois lawmakers begin a two-month push on Monday to enact major pension reform, under pressure from taxpayers, workers, business groups and bond investors to fix the worst-funded state pension system in the United States.

The key objective: To put together a package of reform measures that are capable of addressing a nearly $100 billion unfunded pension liability, while still standing up to anticipated court challenges.

The state's constitution prohibits reduction in pension benefits to active and retired workers, and reform efforts have been inhibited by warnings made by union groups and others that they intend to file lawsuits to block implementation of many reforms.

The president of the Illinois Senate, John Cullerton, a Democrat, said he is preparing a two-pronged attack. He first will seek to pass a bill similar to the measure the House approved late last month that would impose restrictions on cost-of-living increases to pension payments to retirees.

As a back up, in case those reforms hit a constitutional roadblock, Cullerton said he will seek to offer workers a choice. They will either receive the benefits already promised, but have to forego state-funded healthcare care in retirement, or they will accept limits on cost-of-living increases in their pensions and still have access to state-funded healthcare.

"I'm trying to come up with a winning combination to pass a bill," Cullerton said.

Pensions are devouring an ever-increasing share of state revenue. That is a worry for the state's bondholders, as well as vendors, school districts and others doing business with a state that is running as much as a year behind on $9 billion in unpaid bills.

Illinois' credit ratings have been downgraded to the lowest levels among U.S. states as solutions to the pension problem remain elusive, and studies have shown Illinois has the lowest funding ratio of any state in the nation.

The legislative push that begins Monday comes two weeks after the state's lower chamber passed a reform plan that, if adopted by the Senate and signed into law by Governor Pat Quinn, could save as much as $100 billion in pension costs over 30 years, according to backers.

The House measure, which was sponsored by the powerful speaker of the House, Michael Madigan, a Democrat, limits cost-of-living allowances (COLAs) on pension payments, a significant factor in Illinois' rising pension costs. Cuts to COLAs also were part of another, more comprehensive bill that went down to defeat in the Senate on March 20. None of the reform bills passed so far by the House or Senate has been taken up in the other's chamber.

The Madigan-backed measure, which lists Cullerton as the Senate sponsor, would take the biggest step in reform so far by addressing cost-of-living allowances for pensioners.

Under it, retired workers would get the current 3 percent compounded annual automatic increase only on the first $25,000 of their pension. No pension increase would kick in until a worker turns 67 or has been retired for five years, whichever comes first.

The House also passed two measures earlier in March -increasing retirement ages for certain workers and limiting salaries on which pensions are based. Taken together the two changes would save only $1 billion over 30 years.

OFFERING A CHOICE

Cullerton's effort to put together a bill that can pass constitutional review already has begun, with a relatively modest measure dealing solely with the Teachers' Retirement System, which covers local school districts with the exception of the Chicago Public Schools.

The key to its constitutional viability, Cullerton believes, is the effort to offer pension beneficiaries a choice in how their benefits may change. The Cullerton plan offers something of value in exchange for reduction in pension benefits - in this case, health coverage in retirement - and this consideration could be key to any constitutional challenge.

The Cullerton bill would offer school employees the choice of retaining the current annual 3 percent compounded cost-of-living adjustment to their pensions, but no health benefits upon retirement. As an alternative, teachers could agree to a reduced COLA in order to have continued access to state-sponsored healthcare in retirement.

Cullerton would like to expand the approach taken with the Teachers Retirement System, the state's largest pension fund, to three of Illinois' other state-sponsored funds.

However, potential savings to the sagging pension system under this approach are expected to be much less than if COLA limits and other changes are imposed on workers and retirees, as prescribed in the House measure backed by Madigan.

HURDLES AHEAD

Public worker unions are taking a dim view of the bills. Both chambers are controlled by Democrats but state labor unions that traditionally back the Democratic Party have expressed skepticism that changes to member benefits can be made without violating constitutional protections.

In December, Henry Bayer, executive director of the American Federation of State, County and Municipal Employees Council 31 said that any proposal that includes a COLA limit would result in lengthy and costly litigation.

However, a recent state court ruling has begun to reframe the legal debate. On March 19, a state judge found that state-sponsored healthcare for retired state workers is not protected by the constitution. This has given rise to a belief that court challenges may face more difficult going than union rhetoric has suggested.

State Representative Elain Nekritz, a Democrat, said she believed the House's approach to pensions is constitutional because the courts would interpret the clause restricting pensions adjustments in light of the state's efforts to improve its sagging finances.

Beyond the struggle to redefine cost-of-living allowances and make other changes, some proposals are seeking to shift the cost of pension payments from the state to local authorities.

One controversial measure is to make school districts, community colleges and state universities pick up the cost of pension payments for their teachers. Currently, the state bears those costs.

Nekritz, the House's point person for pensions, said she expects the lower chamber to put together a comprehensive bill that could include shifting the cost of teachers' pensions to local taxing districts.

Many suburban Chicago Republican lawmakers oppose the move, concerned it would lead to property tax increases by local school districts. But Nekritz said the impact would be reduced by restricting the change to pensions for workers hired after any law is passed.

Other reforms under discussion include one that would require employees to pay more toward their pensions and another that would give the pension funds power to sue if the state fails to keep current on new payments into the state pension funds, according to Nekritz.

The state also could be required to use money currently allocated to pay off pension bonds to make pension payments once those bonds are retired. All told, the state has sold more than $17 billion in pension bonds since 2003.

LOW CREDIT RATING

Illinois' struggles with pension reform have drawn the attention of bond investors, and any reform measures likely will face skepticism from investors who have seen Illinois adopt reforms in the past, only to fail to deliver.

In 1994, the state legislature passed a plan giving itself 50 years to fix Illinois pension problems. But after a 15-year "ramp up" period expired, the legislature never came through with the large balloon payments mandated by the law.

In 1993, Illinois began issuing pension bonds, the proceeds of which were supposed to be used to put the state's pension system on solid footing. In all, $17 billion of pension bonds have been issued, but portions of the proceeds have gone toward making the state's annual pension payments, and the bonds have contributed substantially to the state's indebtedness.

The state's track record was reflected in the pricing of $800 million in bonds sold by the state of Illinois last week. The so-called credit spread for the 10-year, tax-exempt bonds over Municipal Market Data's triple-A scale, stood at 141 basis points last week. As recently as April 2010, Illinois' credit spread was just above 100 basis points, at the same level as California.

John Sinsheimer, Illinois' capital markets director, said the U.S. municipal bond market continues to demand "a significant penalty" for the state's failure to address the pension shortfall.

Richard Ciccarone, a managing director and the chief research officer at McDonnell Investment Management, said any reform plan should include a guarantee the state will not return to its old habit of not fully making annual pension payments. For decades Illinois skimped on making payments to the pension system as required by actuarial calculations. In fact, the state met its obligations in only one year of the past decade.

Despite its strong pledge to repay bondholders, Illinois "still needs cash in the bank" in order to make the actual payments, Ciccarone said.

Lawmakers and business and labor groups involved in the push for reform are uncertain whether a comprehensive fix can be achieved in both chambers of the Illinois legislature before the legislature's spring session is scheduled to end by May 31.

"We're a ways away from a proposal the governor can sign," said Steve Brown, a spokesman for Madigan.

Christopher Mooney, a political scientist at the University of Illinois, said that in the end, several pension reform bills likely will be combined into a single measure. A successful court challenge to any enacted reforms could actually help state lawmakers, he said.

"They'd have to start over but they would be in a much better position because they would have some guidance from the court on what is acceptable and not acceptable," Mooney said.

(Reporting By Karen Pierog; Editing by David Greising, Frances Kerry and Bill Trott)

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