Municipal

Perspective April 1, 2016

Chicago Public Pension Ruling

The Chicago pension ruling confirms that reform will be a challenge and may heighten political risk around public contracts in Illinois and elsewhere. 

In an unsurprising decision on March 24, the Illinois Supreme Court ruled that Chicago’s 2014 pension reform ran afoul of the state constitution.The June 2014 reform law, Public Act 98-0641, reduced annual increases in pension benefits in violation of Illinois’ pension protection clause. The March 24 decision reaffirmed a prior decision establishing that, in Illinois, pension benefits cannot be “diminished” for current or retired workers.[2]

Absent a solution, Chicago’s un-reformed funds are scheduled to deplete their assets by 2024 and 2028, respectively.

The ruling improves Chicago’s near-term cash-flow at the expense of long-term credit stability. Chicago’s pension reform required $130 million in additional FY 16 contributions which are now unlikely to be made.[3] However, the long term outlook for the City has become gloomier. Absent a solution, Chicago’s un-reformed funds are scheduled to deplete their assets by 2024 and 2028, respectively.[4] At that time, contributions will rise sharply (see graph below). These costs will be in addition to growing contributions to the City’s police and fire pension funds and expenses for other essential services.

Rating agencies may downgrade Chicago’s credit rating further. Shortly after the pension ruling, Fitch downgraded Chicago’s GO rating by two notches, from BBB+ to BBB-, and kept the rating on a negative outlook.[5] Moody’s has warned that “delayed implementation of a clear plan to fund municipal and laborer pension plan liabilities will likely weaken Chicago’s credit quality."[6]

In this white paper, we explore the remarkably inflexible legal standard the Illinois Supreme Court has established to protect public pension benefits in Illinois as well as Chicago’s now-limited options for pension reform.  Notably, Chicago’s pension challenge may eventually lead to a rethink of public pension law, perhaps in the form of federal intervention. It also raises questions for investors. First, what is the relative ranking of bonds compared to pensions in Chicago’s capital structure? Second, Chicago’s struggles also may prompt questions as to whether the inexorable requirement to fund pensions will weaken public confidence in Illinois government and sap support for long-term financial obligations, more broadly.

Pension Benefits in Illinois: The Guarantee that Keeps on Guaranteeing

As we outlined in a 2010 white paper, public pension benefits are protected by state laws as opposed to federal ERISA rules.[7] States have traditionally chosen to protect the right to receive a pension in one of three ways: as a contract right, a property interest, or a gratuity. Each approach offers varying degrees of protection, with contract-based states offering the surest safeguards. Contract principles permit impairment of pension benefits only when it is both reasonable (there is a fiscal emergency) and necessary (there is no alternative).[8]

However, in 2014, the Arizona Supreme Court introduced a fourth approach. This standard guarantees the payment of promised benefits regardless of a government’s fiscal distress.[9] The Arizona approach strongly informed the recent pension decisions in Illinois. Similar to Arizona’s, Illinois’ constitution reads “membership in any pension or retirement system of the State…shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired."[10]

The high courts in Arizona and Illinois have construed this language to provide two layers of legal protection. First, under an ordinary contract theory (impairment is allowed if reasonable and necessary) and second, by a guarantee (diminishment or impairment is prohibited under any circumstance).  In both states, the benefits protected encompass those offered at the moment an employee is hired plus any enhancements during the term of employment. There is no ability to close the existing pension plan for a current employee and enroll her in a less expensive one; that would diminish benefits promised at the date of employment. Rather, benefit reductions are permitted only for new hires.[11]

The standard established by the Arizona and Illinois supreme courts is highly unusual, if not unique, in the context of U.S. public finance. Courts often interpret constitutional and statutory language so as to strongly protect long-term obligations such as those for bonds, pensions, and collective bargaining agreements (albeit less so). These obligations need insulation from the whims of the budget cycle and the political pressure that inevitably rises during recessions. Otherwise, they would lose their force as binding obligations. But at bottom, no public commitment is immune from legislative interference when justified by an emergency. In this sense, establishing a legal standard that guarantees a claim against public coffers—regardless of real world conditions—represents the extreme boundary of public finance norms.

(Non)-Options for Chicago

The practical impact of Illinois’ inviolable standard for pension benefits is to severely limit Chicago’s ability to adjust its pension debt, and it increases the likelihood that the pension adjustment—when it comes—will be larger than it otherwise might have had to be. As we explained last year in Chicago: The Tax Man Cometh (March 2015), Chicago’s fiscal woes are fixable, but likely only with a mix of tax hikes, spending cuts, and pension reforms at multiple levels of Illinois government (state, city, county, school district, etc).[12]

Below we consider some possible methods by which Chicago could reduce its pension liabilities. In our view, the most legally sound solution, the “consideration model,” offers limited savings while other approaches seem politically remote, such as a constitutional amendment, or invite significant legal uncertainty (Chapter 9). However, the risk of an outright pension default (a runoff situation) increases significantly the longer it takes to implement a reform. In our estimation, the analyses here underscore the policy dysfunction introduced by the court’s “guarantee” standard. (Note: we have not considered below recent proposals for the state’s pension debts that could conceivably be applied to Chicago, including voluntary pension buyouts, borrowing to fund the liability, or re-amortizing the liability.)

The “Consideration” Model.  The simplest approach to managing Chicago’s pension stress would involve negotiating anew with labor unions. Notwithstanding the conclusion that pension benefits are guaranteed, the Illinois Supreme Court hinted that benefit reductions might be possible if “an employee knowingly and voluntarily” agreed to benefit modification “in exchange for valid consideration from the employer."[13] Some have read this language to mean that the City can reduce benefits in exchange (in “consideration”) for another benefit. The State of Illinois is currently working on such an approach to resolve its own pension problems.[14] Chicago plans to negotiate reduced pension benefits along similar lines.[15]

The crux of the “consideration” proposals is that employees are offered a choice. Illinois law permits the City to collectively bargain for lower wages or to change the conditions of employment.[16] It also permits increases in annual employee contributions into the pension funds.[17] In theory, the City might offer employees the following option: (a) lower wages and the same pension benefit, or (b) increased wages and a lower pension benefit.

In our view, the City is on reasonable legal footing in exploring a consideration-based approach. However, this strategy is unlikely to save much money, and it is not free from legal ambiguity. As a financial benchmark, the state’s consideration-based solution portends modest savings. That proposal is expected to save $500 million beginning in 2018 or about six percent of the state’s existing all-funds statutory payment.[18] From a legal viewpoint, it’s possible that guaranteed benefits can’t be bargained away, at all. A careful reading of the recent Chicago decision reveals that the court concluded only that pension benefits could be “modified,” not necessarily reduced.[19]

A Constitutional Amendment. Another strategy is to enact a constitutional amendment declaring that Illinois’ pension protection clause applies only to accrued benefits.[20] If passed, such an amendment would protect employees and retirees from a reduction in earned benefits. However, it would permit Illinois governments to close existing pension plans and open less expensive ones, reducing the liability for unearned benefits.

An amendment along these lines seems unlikely. In Illinois, legislatively referred amendments require a three-fifths vote of the legislature to make the ballot. Then, three-fifths of the voters must approve the proposal.[21] And, there is limited political support for such an amendment. Democrats control the Illinois House and Senate by wide margins and party leaders are unenthusiastic about the concept of limiting the clause to earned benefits.[22]

Even if an amendment passed, it might prove legally questionable. Employees whose benefits were reduced would likely argue the amendment violated the federal constitution’s contract clause. The federal constitution may, in fact, prohibit Illinoisans from voting their way out of an existing covenant with public employees.[23]

Chapter 9.  Illinois law currently prohibits municipalities from filing for Chapter 9,[24] but some lawmakers are now seeking Chapter 9 legislation as a way to threaten pension impairments and to bring employees and retirees to the negotiating table.[25] Certainly, the threat of Chapter 9 could serve to focus the minds of a municipality’s employees and pensioners. However, pension impairment via the federal bankruptcy code seems unlikely.

Most of the public support for new Chapter 9 legislation comes from Illinois’ minority Republican Party. Democrats are broadly uninterested in the legislation, and again, they control the legislature by significant majorities.

Also, it’s not clear that Chapter 9 would sanction the impairment of Illinois’ pensions, anyway. A “guaranteed” pension may very well survive a bankruptcy filing.[26]  In Detroit’s landmark bankruptcy, the court established that bankruptcy law owes “substantial deference” to creditor protections outlined in state constitutions.[27] Moreover, the Detroit bankruptcy court suggested that constitutionally “guaranteed” pension benefits should be exempt from impairment in Chapter 9. In assessing whether Michigan’s constitution protected Detroit’s pensions from impairment, the court wrote:

“[Michigan’s] constitution could have given pensions protection from impairment in bankruptcy in several ways. It could have simply prohibited Michigan municipalities from filing bankruptcy. It could have somehow created a property interest… Or, it could have established some sort of secured interest in the municipality’s property. It could even have explicitly required the State to guaranty pension benefits. But it did none of these.[28] (Emphasis added by Breckinridge.)

The Risk of Runoff. If Chicago is unable to craft a sustainable pension reform over the next several years, either through a consideration approach, a constitutional amendment, or by enacting a Chapter 9 statute, it may one day default on its pension obligations. In this case, current state laws may impede Chicago’s pensioners from forcing payment from the City or State of Illinois.

First, state law currently prohibits Chicago from making full annual pension contributions. So, even if City officials want to keep the funds solvent in a runoff situation, they lack the authority to do so. A change in state law is needed to empower the City to make timely and full payments.

Also, pensioners may have limited rights against the City if their pension checks are reduced. Illinois statutes specify that the City’s pension benefits are not a “debt of the… [City]… but shall be held to be solely an obligation” of the pension fund.[29] The Illinois Supreme Court concluded that the state constitution nullifies this language, but it is unclear what remedy pensioners might have against the City absent clarifying legislation. Under current law, a future court might have difficulty enforcing a ruling against the City.

Finally, it’s doubtful the state legislature could be compelled to contribute to the City’s pension funds. In the Chicago case, the court noted that the method by which Illinois choses to fund Chicago’s pension systems is beyond its control.[30] More broadly, state legislatures have a history of disregarding court rulings when they infringe on zones of authority reserved for the legislature—such as fiscal policy. An ongoing example is in Kansas, where the state senate recently passed a budget that ignores a state Supreme Court decision mandating changes to school district funding.[31] Employees and pensioners could also seek redress against the state in federal court, but this raises sovereign immunity concerns.

Flickers of Federal Intervention

Chicago’s pension plight may one day contribute to a rethinking of public pension protections. Alongside a handful of other significantly distressed pension plans, Chicago’s pension funds are at a material risk of entering a runoff situation. If a large plan, like Chicago’s Municipal Employees’ Annuity and Benefit Fund were to default on its pension obligations within several years of similar events in Central Falls (RI), Pritchard (AL), and importantly, Puerto Rico, it is reasonable to expect growing federal interest in the state and local public pension space. This seems especially true if today’s low interest rate environment remains the norm for several more years. A greater number of plans could weaken which would, in turn, spook a larger swath of public sector employees and retirees.

A smattering of federal proposals has already been floated. This includes a 2014 bill that would establish rights for municipal employees and retirees similar to those in corporate bankruptcy,[32] a bill to establish annual annuities for public employees,[33] and most recently, a bill to prioritize Puerto Rico’s pension payments as part of its restructuring.[34] As we have noted before, municipal insolvency laws generally crop up in one of two instances: a single issuer requires special legislation to address distinct distress or a widely applied law is needed to address a financial issue shared by a broad contingent of issuers.[35] National problems like the widespread debt-driven distress of the 1930s invite national solutions. It is no accident that Chapter 9 was enacted in 1937. Today’s pension stress remains localized, but it could very well grow into something more prevalent.

National problems like the widespread debt-driven distress of the 1930s invite national solutions.

Considerations for Investors

As the analysis here suggests, adjusting Chicago’s pension debt is a policy conundrum. This raises a couple of concerns for investors.

First, investors may wonder how bonds would fare if Chicago had to balance satisfying its pension guarantees with paying bondholders. We expect that bonds paid from the City’s general fund or from its property tax levies will perform worse than pension debt.

The best benchmark for Chicago’s situation is Detroit (although it is an admittedly weak benchmark, given its severe tax base decline and service insolvency relative to Chicago). In Detroit, unlimited tax general obligation (GO) bondholders and limited tax GO bondholders recovered less than pensioners. Recent analyses suggesting that certain Chicago-area GO bonds should be treated as special revenue bonds in the event of Chapter 9 have merit, in our view.[36] Also, Chicago’s alternate revenue bonds should theoretically be paid throughout a restructuring, as well. However, all of these arguments are untested, which raises the likelihood of negotiated settlements.

In addition, we remain wary of a growing unwillingness to honor debt obligations in the context of state-managed workouts. The reorganization of Harrisburg, Pennsylvania included a restructuring of GO debt service payments. Recent developments in Atlantic City suggest the state may allow a GO bond default there, as well.

A second consideration for investors is more subtle. As Chicago’s taxpayers discover that guaranteed pension obligations are nearly impossible to adjust, they may become more discerning about the City’s long-term debts, in general.  One can imagine a constituent asking what else the City guaranteed that he is unaware of. Transparency, voter-approval, and limitations on debt have been a hallmark of public finance for well over a century.[37] The stringent guarantee standard established by the Court for opaque, un-voted, unlimited pension debt runs counter to these principles and, for that reason, threatens to temper public willingness to honor long-term obligations.

Conclusion

Breckinridge does not anticipate a Chicago pension or bond default in the near-term. We expect pensioners, unions, employees, and public officials will eventually negotiate a solution. The risk of inaction is too great. Still, on current trajectory, two of the City’s major pension funds are once again on a path toward insolvency, and the Illinois Supreme Court’s March decision creates substantial hurdles to designing a workable solution for Chicago’s employees, retirees, and residents. We will be monitoring developments in Chicago’s pension-reform efforts insofar as they may clarify the contours of Illinois’ public pension protections and the path to reform. Chicago’s experience will inform how other Illinois governments manage their own pension stress. Without a solution, it might also inform future federal regulation in the area of public pensions.

 

[1] Jones v. Municipal Employees’ Annuity and Benefit Fund of Chicago, 2016 IL 119618, March 24, 2016.
[2] Heaton v. Quinn (In re Pension Reform Litig.), 2015 IL 118585, May 8, 2015.
[3] See: “Chicago Pension Reforms Struck Down by Illinois Supreme Court,” The Civic Federation, March 31, 2016.
[4] The Municipal Employees’ Annuity and Benefit Fund (MEABF) runs out of money in 2024 and the Laborers’ Annuity and Benefit Fund (LABF) in 2028. See the February 2016 letter to elected state and city officials posted on the MEABF website and accompanying documents. Available at: http://www.meabf.org/legislature.
[5] Fitch downgraded Chicago on March 28, 2016.
[6] See: Chicago, IL: “Illinois Court Nixes Chicago’s Bid to Restructure Retiree Benefits, a Credit Negative, Moody’s Investors Service, March 28, 3016.
[7] The white paper, Legal Protections for Pension Benefits and the Implications for Bond Investors is no longer available on the Breckinridge website but may be obtained by request.
[8] This is the legal standard for impairing state and local contracts as outlined by the U.S. Supreme Court in U.S. Trust v. N.J., 431 US 1 (1977).
[9] Fields v. Elected Officials Retirement Plan, 234 Ariz. 214, February 20, 2014.
[10] Ill. Const., art. XIII, § 5. Arizona’s pension clause is promulgated under Ariz. Const. art. 29 § 1(C). It reads: “membership in a public retirement system is a contractual relationship that is subject to [the contracts clause] and public retirement system benefits shall not be diminished or impaired.”
[11] See: Heaton v. Quinn (In re Pension Reform Litig.), 2015 IL 118585, at ¶46 and ¶49, May 8, 2015
[12] Chicago: The Tax Man Cometh, Breckinridge white paper, March 2015. Available at: http://www.breckinridge.com/insights/whitepapers.html?year=2015.
[13] Jones v. Municipal Employees’ Annuity and Benefit Fund of Chicago, 2016 IL 119618, at ¶53, March 24, 2016. “Consideration” is a legal term that essentially means “value-in-exchange”. In most contracts, each party to the contract must receive something of value for acting (or not acting) in accordance with the terms of an agreement.
[14] See Monique Garcia and Kim Geiger, “Senate President Cullerton offers new pension plan,” Chicago Tribune, May 2015 and the Senator’s 2013 pension proposal outlined in SB 2404.
[15] See: Yvette Shields, “Emanuel Sees Pension Roadmap in Supreme Court Ruling,” The Bond Buyer, March 30, 2016.
[16] See: 5 ILCS 315-1 also known as the Illinois Public Labor Relations Act”.
[17] See: Chicago, IL: “Illinois Court Nixes Chicago’s Bid to Restructure Retiree Benefits, a Credit Negative, Moody’s Investors Service, March 28, 3016.
[18] See: p. 47 of the Governor’s FY 17 Budget Summary. Note that the statutory payment is less than the full actuarially required payment. The FY 17 budget called for $7.8 billion in all-funds pension payments in FY 17. This compares to annual pension cost of 8.3 billion in FY 14.
[19] See: Heaton v. Quinn (In re Pension Reform Litig.), 2015 IL 118585, at ¶46, footnote 12 and Kraus v. Board of Trustees of the Police Pension Fund, 72, Ill. App. 3d (1979). In Kraus, the court approved modifications that enhanced benefits while also requiring increased annual contributions from employees.
[20] See: “State of Illinois FY 2017 Budget Roadmap,” The Civic Federation, p. 4 (February 2016).
[21] See: Article XIV of the Illinois Constitution.
[22] Karen Pierog, “In pension battle, Illinois governor faces constitutional fight,” Reuters, May 10, 2015.
[23] We expect that most federal courts would seek to honor the will of voters if they sought to amend the public pension clause. As a general rule, federal courts seek to defer to state fiscal prerogatives promulgated in state constitutions. Sovereign immunity doctrine could apply here, as well. However, state constitutional amendments that violate federal law aren’t always tolerated. A recent example is in Perry v. Schwarzenegger, 704 F. Supp. 2d 921 (2010). In that case, a federal court overturned a California constitutional amendment that prohibited same sex marriage.
[24] See: In re Slocum Lake Drainage District of Lake County, 336 B.R. 387, 390 (N.D. IL 2006).
[25] See: IL HB414 (2015).
[26] In the Chicago pension case, Jones v. Municipal Employees’ Annuity and Benefit Fund of Chicago, the court used the word “guarantee” at least three times in reference to the City’s obligation to make pension payments. See ¶44-¶45.
[27] See Summary of Oral Opinion on the Record, In re City of Detroit, p. 31, November 7, 2014.
[28] See: Opinion Regarding Eligibility, U.S. Bankruptcy Court for the Eastern District of Michigan, p. 80. December 5, 2013
[29] See: 40 ILCS 5/22-203 and Jones v. Municipal Employees’ Annuity and Benefit Fund of Chicago, 2016 IL 119618, at ¶42, March 24, 2016.
[30] See: Jones v. Municipal Employees’ Annuity and Benefit Fund of Chicago, 2016 IL 119618, at ¶37-¶40, March 24, 2016.
[31] See: Peter Hancock, “Kansas Senate passes budget, ignores Supreme Court ruling for now,” Lawrence Journal-World, February 11, 2016.
[32] See: Bankruptcy Fairness and Employee Benefits Protection Act, S. 2418. (Introduced June 3, 2014).
[33] See: Secure Annuities for Employee (SAFE) Retirement Act of 2013.
[34] See: “Democratic Puerto Rico Debt Bills Give Pensions Preference,” Bloomberg.com, March 14, 2016.
[35] See Breckinridge’s 2012 Credit Outlook. Available by request.
[36] See Kroll Bond Rating Agency’s January 19, 2016 rating of BBB/negative for Chicago Board of Education’s GO debt.
[37] For a nice discussion of the origins of debt limits and voter-approval requirements see: Richard Briffault, The Disfavored Constitution: State Fiscal Limits and State Constitutional Law, 34 Rutgers L. J. 907 (2003).

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