Don’t look before you leap to expand pension benefits
“First, do no harm” applies to public finances, too.
As we’ve covered, Chicago’s pensions debts are significant. After two decades of underfunding, the Police and Fire funds are only 24% and 20% funded, with a combined unfunded liability of over $17 billion1. I don’t think it’s hyperbole to say that dealing with this unfunded liability2 is the single biggest public finance issue the City of Chicago faces.
So why are politicians considering making that liability $3 billion larger?
What’s going on here
Some context seems useful. Back in 2010 a change in state law created a new “Tier 2” pension benefit which applied to public employees hired after January 1st, 2011. These benefits are a lot less generous than those granted to employees hired before then (the Tier 1 beneficiaries), with changes including a higher retirement age for full benefits, a reduction in the annual cost of living adjustment (COLA)3, and a reduction in the salary used in calculating pension benefits.4 The changes resulted in immediate improvements to our pension liabilities and are widely understood to have helped slow liability growth in the last few years.
On the other hand, these were pretty significant changes, and as I’ve mentioned before, Chicago public employees don’t get Social Security. For any pension plan to be a legal replacement for Social Security, it needs to provide at least as good a benefit as an employee would have received if they instead participated in Social Security. The IRS has a series of ‘safe harbor’ rules that a pension plan can meet to ensure they are in compliance with this law. Historically this has not been a problem for Chicago employees, but the rollback in benefits for Tier 2 employees was meaningful enough that this might matter for some employees in coming years, as Social Security benefit increases in recent years have outpaced pension benefit increases (which are based on a lower inflation formula).
Enter State Senator Robert Martwick and his plan - if the Tier 2 benefits aren’t generous enough, we can make them larger! Martwick introduced two bills, SB1629 and SB1630, which pretty directly rollback the Tier 2 reforms5 to ensure safe harbor compliance. But while this addresses the potential safe harbor problems, it also creates an immediate other problem - it makes our unfunded liabilities worse. If you believe, as I do, that these liabilities are the city’s greatest public finance challenge, that’s a big deal. Normally, this might be okay - if our last reform went too far, let’s scale it back and see where we are; if that goes too far the other way, we can always pass another reform to balance it out.
Permanent Benefits are Permanent
Except, we can’t. The Illinois Supreme Court has already told us that any provision of pension benefits is an irrevocable promise which cannot be reduced, meaning that any reforms we pass here are a permanent expansion for any current public employees. Moreover, it’s not actually clear whether we’re violating the Safe Harbor rules, nor is it clear exactly how far we’d need to adjust things to stay in compliance. We’re also not sure exactly how much these reforms would cost us (the Lightfoot administration estimated the cost of the proposals to be around a $3 billion change in the liabilities).
The Civic Federation, Chicago Tribune, Lori Lightfoot, and others have emphasized the need to study this issue further, and they’re right. This is the fiscal equivalent of realizing that you’ve injured your foot - you’re not sure what; it might just be a sprained ankle but it could be something more serious - and determining that the first step you should take is to have it amputated. Surely we should look into the issue a bit more seriously before doing things we can’t later reverse!
The Latest Update
In what seems like a promising sign from the new mayoral administration, at the end of May Martwick tabled his proposals at the request of Brandon Johnson for a while as Johnson’s new pension working group dives in to study how best to approach the issue. I’m a bit skeptical of what they’ll produce - as many have noted, the group’s makeup is heavy on politicians and union leaders but lacks any representatives from the business community or groups like the Civic Foundation - but tabling the proposed bills for now is at least an acknowledgment that we need to make sure we know what we’re getting into before passing laws we can’t undo.
For context, the city’s entire budget was roughly $12 billion this year.
And the $16 billion unfunded liability of the Labor and Municipal funds, for about $33 billion in total.
Tier 1 beneficiaries receive a 3% compounded benefit annually, while Tier 2 beneficiaries receive either 3% non-compounded or 1/2 of the annual change in CPI, whichever is lower.
Tier 1 beneficiaries get a pension based on the average of the highest four of the last five years of service, while Tier 2 pensions are based on the average of the last eight of the last ten years. Since salaries typically go up over time, given union salary schedules, a longer window of years generally results in a lower average salary. Tier 2 pensions also have a cap on the earnings used to calculate that final average salary.
Specifically, they increase the annual COLA to either 3% or 100% of the annual change in CPI, whichever is lower, and change the pensionable salary to the highest consecutive 4 year period in the last 5 years of service.