I wrote last week that there is no longer any low-hanging fruit with respect to the underfunding of Chicago pensions. There are no easy solutions to the pension debt faced by the city of Chicago pension funds. The payments the city is committed to making over the next 40 years will severely tax its budget, and the plans are so poorly funded that, absent these contributions, they face honest-to-goodness insolvency, no differently than the poster child for insolvency, Central States (Teamsters).
Here’s one solution: a nice bout of hyperinflation. A majority of the liability (depending on plan) is in the form of benefits in payment, or the frozen benefits due to terminated/vested participants. Since the cost-of-living adjustment is a fixed 3% for the Tier I folk who make up the majority of this group of plan participants, the plan will come out ahead if inflation gallops along at 10%, 20%, or more, for a couple years. To be sure, current workers will likely see their pay increase to match inflation, so the inflationary period would have to last long enough for them to retiree, in order to impact their benefits, but surely it’ll be worth it.
Then how about soon-to-be former mayor Rahm Emanuel’s preferred solution, pension obligation bonds?
There is no clever financing alchemy to these bonds, merely the intent to profit from the difference between the interest rate at which the city could issue these bonds and the expected investment returns that their supporters hope to achieve by investing the proceeds, and, while there is no reason for us all to start pulling our money out of mutual funds and hiding it under our mattresses, it remains a risky endeavor for the city to undertake, all the more so because these bonds would be taxable and issued at the market rate for such bonds, and because the only way for the city to lower the interest rate is to guarantee investors an asset, in this case, future sales tax revenues, as collateral. And none of this has any connection to pension financing but one indicator of the soundness – or, rather lack thereof – of this approach is apparent in that the city isn’t aiming at finding a new revenue source for schools or parks or road resurfacing in this manner. (For reference, see my prior articles “Public Pensions And Public Trust“, “Why Chicago’s Pension Obligation Bond Plan Is Even Worse Than It Seems“, and “Is This The Real Reason For Chicago’s Pension Obligation Bond Proposal?” as well as “Chicago doesn’t need to gamble on pension bonds” at Crain’s Chicago Business, and “Seven reasons why Mayor Emanuel’s proposed pension plan fails” at Wirepoints.)
So what’s left? Yes, benefit cuts.
And, yes, care should be taken to mitigate harms, rather than applying across-the-board cuts. Active Tier I workers might have Tier II or III retirement eligibility rules applied to them. Participants might have the 2.4% benefit increase rescinded. Retirees’ benefits could be capped, or fractionally reduced only to the extent they exceed a livable retirement income. COLAs might be set at actual inflation, with a “holiday” to freeze benefits until they match what they would have been if they had tracked these lower inflation rates, and provided only up to a benefit level that resembles what the rest of us receive in Social Security. A “grand bargain” could remedy existing harms, such as the Tier II pay caps and the the high vesting requirements. And all of the above should be balanced with a serious assessment of to what extent the city can increase taxes further without overburdening its residents and doing more harm than good through population loss — a subject I don’t claim to be expert in.
How might cuts be achieved? Yes, it’s an encouraging sign that Emanuel has himself spoken in favor of a constitutional amendment, a necessary first step before any solution by the legislature can be considered.
But which example of cuts would the city then follow?
One model for benefit reductions, though at the state rather than local level, was that of Rhode Island, which instituted a number of changes to remedy a 48% funded (FY 2010) pension system, with a reform that was signed into law in November 2011. (See “What are the Rhode Island Pension Reforms?” at the Civic Federation website and Pension Reform Case Study: Rhode Island by Reason Foundation for details.)
The law made a number of changes to Rhode Island pensions:
- The traditional plan was frozen and future accruals were dropped from between 1.6% to 3% down to 1% plus a new Defined Contribution plan.
- COLAs were frozen until the total funding levels for all state plans exceed 80%, with interim increases paid based only in cases of favorable asset return, every five years, and, after that 80% funding level has been met, COLA payments will still be contingent on funding level.
- COLAs will only be applied to the first $25,000 in income in any case.
- Retirement age is increased for all employees, though the increase is partial for vested employees.
Predictably, unions sued, and ultimately the parties came to a settlement agreement in 2015, which included
two one-time stipends payable to all current retirees; an increased cost-of-living adjustment cap for current retirees; and lowering the retirement age, which varies among participants depending on years of service
according to Pensions & Investments.
Could Illinois and Chicago follow Rhode Island’s example? We are handicapped in two ways: in the first place, that state had a more favorable legal structure and was not obliged to make any constitutional changes; secondly, the political environment was different – the State Treasurer, now governor, Gina Raimondo, was a Democrat, but here in Illinois, our incoming Democratic governor, J.B. Pritzker, still insists that Illinois need take no action except to borrow and reduce its funding target.
Is Chicago, then, doomed to bankruptcy? The Detroit experience would seem to be a worst-case scenario. Retirees’ pensions were cut by 4.5%, COLAs were eliminated (except for police and fire COLAs, which were reduced from 2.25% to 1%), and retiree healthcare benefits were reduced to 10% of their prior value. While it no doubt caused hardship for many retirees, as profiled in a summer Detroit News report, the city’s situation was unsustainable:
At the time of Detroit’s bankruptcy, pension and health care obligations made up about 40 percent of the city’s annual budget, and it was projected to climb to 60-70 percent within a few years, [retired U.S. Bankruptcy Judge Steven Rhodes, who presided over the city’s case] said.
However much Detroit and Chicago may share financial woes regarding pension fund underfunding, the impact was clearly far greater in the case of a city like Detroit, with its dramatic decline in population producing far greater burdens, in terms of the relative number of retirees compared to the city’s tax base and current spending.
But even the case of Detroit was not a “simple” case of negotiating with creditors as would be true of a corporate bankruptcy. As Forbes Contributor Pete Saunders wrote back in 2016, key local foundations such as the Ford Foundation actually brought cash to the table to boost pension funding in what was called the “Grand Bargain.” Were it not for their actions, the pension reductions might have been much harsher.
At the start of Detroit’s bankruptcy process, creditors honed in on the potential value of the city-owned art collection of the Detroit Institute of Arts. The philanthropic community was alarmed at the possibility of losing the city’s world-famous cultural heritage at bargain-basement prices, and was spurred into action. After negotiations with the Kevyn Orr, Detroit’s emergency manager leading the city through the bankruptcy process, and state, union and corporate leadership, a deal was struck that shifted the foundation focus from simply saving the artwork to a broader contribution to resolving the debt crisis. That led to the philanthropic pledge of $366 million over twenty years, along with a public union pledge to accept reduced benefits and significant corporate contributions, to help Detroit speed successfully toward approval of its plan of adjustment.
Saunders expresses the hope that local foundations in other rust-belt cities such as Chicago might likewise play a role in solving their pension crises. I’m less hopeful that foundations will step in outside of Detroit; perhaps it’s the (suburban) Detroiter that’s still in me even after living my adult life in suburban Chicago, but my sense is that Detroit foundations see themselves as much more connected to the city than is the case for foundations which happen to be headquartered in Chicago.
(Incidentally, my first intention was to cite Stockton, San Bernadino, and other Californian cities as bankruptcy examples, but, as it turned out, they did not cut pensions, even after rulings that enabled them to do so. because, due to the way in which their pensions function through the CALPERS system, it would have been an all-or-nothing deal which was not a feasible alternative.)
There’s a third alternative, at least in principle: a group of lawyers and actuaries, W. Gordon Hamlin, Jr., Mary Pat Campbell, Andrew M. Silton, and James E. Spiotto, have proposed that municipalities use a prepackaged Chapter 9 bankruptcy process to reduce their pension debts. (The short version of their proposal is an article at MuniNet Guide, “Embracing Shared Risk and Chapter 9 to Create Sustainable Public Pensions“; the longer version is “Transitioning American Public Pension Plans to a Shared Risk Model Through Prepackaged Chapter 9 Plans of Debt Adjustment,” by Hamlin and Campbell.)
They write (in the first link):
Real reform needs to begin with a task force of affected stakeholders (employees, teachers, retirees, school districts and local governments) who work with an independent actuary and an independent facilitator/mediator to design a new pension plan along the lines of the New Brunswick shared risk model. Second, the legislature has to adopt that model through enabling legislation and then require school districts and local governments to contribute on a one-time basis an amount sufficient to bring the relevant plan up to 120% funded status (calculated with a discount rate of less than 5%), an amount that none of those entities could afford.
Having created a framework for reform, the Chapter 9 bankruptcy process can provide the vehicle for transitioning to a shared risk model. Having satisfied the “insolvency” criteria of the Bankruptcy Act, the local entities would inform bondholders and other creditors that the upcoming Chapter 9 bankruptcy will not impair them and will only address pension liabilities. The local entities would begin the process of disclosure and voting with the three classes of unsecured creditors (current employees, inactive employees, and retirees) to try to reach agreement on a new shared risk model. Once these negotiations and voting by the impaired classes are complete, the Chapter 9 petition, the prepackaged Plan of Debt Adjustment, can be filed, indicating that a majority by number and two-thirds (2/3) by amount of the claims voted (of at least one of the classes of impaired creditors) have voted in favor of the plan. The Bankruptcy Court then approves the reform plan transitioning all the local employees and retirees into the shared risk plan. Direct state employees and retirees would transition voluntarily, perhaps with the incentive that COLAs would only be available within the shared risk plan. Assets would then be transferred to the new shared risk plan. . . .
The case law now permits municipalities to alter their pension obligations in Chapter 9 proceedings, even if statutes or constitutional provisions prohibit impairment of contracts. Some 24 states currently permit Chapter 9 filings, with some requiring approval by a state official. States which have not granted such approval, like Illinois, could do so with an enabling statute.
Is this too good to be true? Or is it worth a shot, or at least adding to the discussions we have? At any rate, we need to start having those discussions.
As always, I invite you to share your comments at JaneTheActuary.com, where you can also see links to past and future articles in this series.