Bill Frazer's

Core Municipal Report

Chicago’s pension experience has lessons for Houston

Chicago, Chicago that toddling town1

Mayor Turner started to publically discuss some of his plans to fix Houston’s pension system at the Texas House Pension Committee meeting a few days ago. He made it very clear that moving to a DC plan (defined contribution) is off the table, and that any resolution will require “shared sacrifices”. It’s difficult to see how the city gets out from this financial mess without some benefit reductions and higher property taxes. Until we know what benefit reductions the employee representatives will agree to it will be impossible to predict how big a tax increase the City will need.

In the meantime, it’s instructive to take a look at what Chicago has been doing. Chicago’s pension problems, among other things, have resulted in a junk rating for its general obligation bonds from one rating agency, Moody’s. Chicago, like Houston, has to look to its state legislature to impose changes in benefits or contribution requirements.

A summary of Chicago’s pension story goes like this:

● In 2010, the Illinois legislature approved large reductions in contributions for a four year period to “ramp-up” higher contributions to achieve a 90% funding level by 2040.

● The required “post ramp-up” contributions would increase by almost 300%.

● In 2015, the Illinois legislature approved negotiated benefit reductions.

● But the Illinois Supreme Court rejected the benefit reductions as being unconstitutional.

● To pay for a portion of the post ramp-up contributions, Chicago increased city property taxes by 59% in 2015.

● In 2015, the legislature extended the contribution “ramp-up” periods by another four years and extended the time available to reach the 90% funding level by 15 years to 2055.

● The Governor vetoed this legislation, but in 2016, the Illinois legislature overrode the Governor’s veto.

The end result is a much bigger problem and a 59% increase in city property taxes.

Chicago, like Houston, has consistently contributed amounts far less than required by its actuarial computations. These “short payments” are the biggest contributing factor to excessive pension liabilities and lead to higher contribution requirements in the future. Chicago’s short payments set the platinum standard of “kicking the can down the road.”

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The top of each bar in the chart above represents pension contributions due. The blue portion is the actual contribution made. The orange portion is the amount of the short payment.

In December 2010, the Illinois Governor signed a law designed to make Chicago’s pensions healthy again. But at the time Chicago officials claimed the new law would require a 60 percent increase in property taxes and the state Senate agreed to address the issue in 2011.

The 2010 law provided for a four year “ramp-up” in pension contributions for Chicago’s largest pension funds followed by much larger contributions starting in 2015. The contributions during the ramp-up period were about 30 percent of the post ramp-up contribution levels. For example, the Police Pension’s contribution in 2014 was scheduled to be $187.8 million, then it was to go to $592.8 million in 2015. The intention was to have the major pension funds 90 percent funded by the end of year 2040.

Several attempts were made by Chicago to reduce the city’s pension expenses, including agreements with some unions and employee representatives that would reduce benefits. These measures were passed by the legislature in 2014 but were ruled unconstitutional by the Illinois Supreme Court in March of this year.

Because the courts rejected benefit reductions, Chicago had no choice but to raise property taxes in 2015 by 35 percent and by another 24 percent in 2016 to 2018. The total tax increase is 59 percent over 2014 levels.

Furthermore, the legislature enacted a new law in 2015 that extended the contribution ramp-up and the 90 percent full funding target by 15 years, from 2040 to 2055. The Governor vetoed this legislation claiming that costs would grow by billions under the new plan. But the legislature overrode the veto and gave the mayor what he wanted.

All of the property tax increases are dedicated to additional pension contributions. This will enable Chicago to essentially double its annual pension contributions over the next few years. The chart above shows that pension contributions rose from $447 million in 2014 to $886 million in 2015, and are projected to go to $978 million this year.

But the chart also shows that $886 million is only 52 percent of the actuarial determined contribution in 2015 and the 2016 budgeted contribution will only be about 44 percent of the requirement. Not only that, but these contribution requirements are based on pre-GASB 67/68 actuarial assumptions, which means the targeted investment returns of 7.75 percent to 8 percent were used to discount liabilities.

New accounting rules allow pensions to discount liabilities by targeted investment rates only as far out into the future as the related fund assets and contributions will last. Then they must start using much smaller discount rates equal to long-term tax free municipal bond rates. This produces a much higher net pension liability and a higher annual pension cost.

The City’s municipal workers pension fund recently reported its net pension liability rose from $7.1 billion in 2015 to $18.6 billion in 2016 after converting to the new accounting methods. The independent Illinois Policy Institute projects the total net pension liability for all four of Chicago’s pension funds could be as high as $44 billion after adopting the newer rules. The annual interest expense on $44 billion would be over $3 billion.

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So as you can see, the new $978 million pension contribution, more than twice the level in 2014, and funded by a 59 percent increase in property taxes, will probably be less than 30 percent of the amount necessary to return Chicago’s pensions to financial health.

I suppose Chicago can dig its way out. Its total annual budget, including the larger pension contribution, is about $7.9 billion and property taxes are just $1.5 billion. On paper you could triple Chicago’s property taxes and everything would be fine. Or they could raise their utility taxes by 600 percent, or sales taxes by 10 times, or all sorts of combinations of tax increases, new fees, etc.

I haven’t seen Chicago’s revised funding projection schedules so I can’t decide whether they are viable or not. But I can tell you that Moody’s doesn’t like it and says the delayed funding is a credit negative on an already junk bond rating. Moody’s reaction was not well received at Chicago’s City Hall. The Chicago Tribune (Click here for full story) quoted city spokeswoman Shannon Breymaier as saying “"We refuse to apologize for not asking Chicagoans (to pay hundreds of millions more) in property taxes…” and “At the end of the day, not overburdening our residents takes priority over appeasing Moody's…”

Apparently Chicagoans didn’t like the 59 percent city property tax increase and probably won’t like other “revenue increases” either. But I doubt it’s Moody’s that needs appeasing. The city employees might want to start thinking about where their retirement money will come from if Chicago can’t find more revenues. And residents won’t be any happier if the city finds more money by reducing police staff to cut expenses in a city with an exploding crime rate.

Chicago, Chicago that toddling town1

References

1 - Listen to Frank Sinatra sing “Chicago” on You Tube Chicago, a song written by Fred Fisher, performed by Frank Sinatra and many others

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