Imperiled Illinois Public Pensions Get Sweeping Reforms

The Illinois legislature passed landmark pension reform. Next on the legislative agenda: tackling the Chicago teachers’ pension plan.

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Pat Quinn, governor of Illinois, speaks prior to the grand opening of the Fashion Outlets of Chicago mall in Rosemont, Illinois, U.S., on Thursday, Aug. 1, 2013. Consumer spending, which accounts for 70 percent of the U.S. economy, increased 1.8 percent after advancing 2.3 percent in the period ended July 28, according to the Bloomberg Consumer Comfort Index. Photographer: Tim Boyle/Bloomberg *** Local Caption *** Pat Quinn

Tim Boyle/Bloomberg

Last week Illinois lawmakers were called into a special legislative session to fix the state pension system. The $98 billion Illinois pension fund, the problems of which have been a bugbear of Governor Pat Quinn since he first took office in 2009, has a 40 percent funding ratio and is running a deficit of $100 billion. In January and June ratings agencies, citing the state’s pension problems, downgraded Illinois’s municipal bonds. On December 10 S&P upgraded the state’s general obligation bonds from “negative” to “developing,” keeping its A– rating, citing the state’s pension reform as a reason.

On December 3 lawmakers passed the much-needed pension overhaul bill, which Quinn signed into law two days later. The reforms look to save Illinois $160 billion over the next three decades, with benefit cuts accounting for about $90 billion to $100 billion and the remaining $60 billion to $70 billion derived from debt reduction. Hovering in the background was Rahm Emanuel, who as mayor of Chicago was equally keen for the state lawmakers to finally pass a bill on this extremely politically charged issue.

The Illinois pension reform law has been criticized by many within the ranks of the state’s Democratic Party and national labor groups, including the AFL-CIO and the American Federation of Teachers. They see it as needlessly taking away workers’ benefits. While some on the right allege the changes are not deep enough, key local business groups, including the civic committee of the Commercial Club of Chicago, backed the bill.

Illinois’s pension problems are far from over. Organized labor groups have said they will challenge the new law in court, and the dispute could rise as high as the U.S. Supreme Court. Moreover, lawmakers still have to face the challenge of modifying Chicago’s pension funds, which have their own funding challenges and subsequent need for overhaul, to put it lightly. For one, the city faces a pension cliff in 2015. Illinois lawmakers are not done with pension reform yet.

“This has been a four-year-plus process,” says Steve Brown, press secretary for Michael Madigan, the speaker of the house and representative for a section of Chicago’s southwest side, an area known in part for its historically predominant population of public employees such as police officers and firefighters. The law “answers many of the questions that the ratings agencies and credit markets had about what was happening in Illinois,” he says. “It sets a clear path, probably a much better path than we had before in terms of stabilizing the pension funds.”

Madigan, who has long served as house speaker, was a co-sponsor of the pension bill, and his support was vital to its success. “The bill would not have passed without me,” he said in a statement released by Governor Quinn’s office. Earlier this year Madigan had not given his support to a proposed package of pension reforms, which subsequently failed to pass. That effort was championed by Senate President John Cullerton with the support of organized labor. In a statement released by his office after the pension bill passed, Cullerton applauded the end of the pension stalemate while acknowledging that “the legislative process involves compromise.” He did leave the door open, however, for a return to the negotiating table, saying, “Now it is time to move forward and allow the courts to rule on the constitutionality of our approach.”

The new law has five main components: a change to the cost-of-living adjustment for retirees, a percentage point decrease for employee contributions, an increase in the retirement age for certain employees, the creation of a defined contribution option and a strict schedule for the state to pay down the pension deficit. By sticking with these reforms, lawmakers estimate that Illinois’s pension plans will be fully funded by 2044. The law also includes a provision that would prohibit most collective bargaining on pension matters.

Within hours of the law’s passage, labor groups voiced their objections. “This is no victory for Illinois, but a dark day for its citizens and public servants,” said the We Are One Illinois, a coalition of more than 20 local labor groups headed by the Illinois AFL-CIO, in a statement. “Teachers, caregivers, police and others stand to lose huge portions of their life savings because politicians chose to threaten their retirement security.”

Labor groups were especially displeased with the changes to the cost-of-living adjustment, or COLA. Presently, most employees on the plan receive an annual 3 percent increase in their pension benefit. The new rule compounds the COLA at that rate on only a portion of a retiree’s pension — in most cases just $1,000. The retirement age for public employees who are 45 or younger has been raised as much as five years, for most workers to 60, in an effort to have the younger part of today’s unionized public workforce working longer.

The pension law also introduces defined contribution funds to the state system — an option that labor typically rejects, arguing that they do not offer adequate retirement security. In the case of Illinois, defined contribution plans will be available to only 5 percent of employees on a first-come, first-served basis. According to the pension reform law, the plan will offer a variety of options, including state-managed and private-sector-managed portfolios.

Republican Representative Tom Morrison, a member of the house personnel and pensions committee, voted against the bill, saying that the limited nature of the defined contribution option makes it inconsequential. He feels that the reforms did not go far enough in offering substantial change. “We don’t have the luxury of doing small reforms,” he says. “And I see this bill as too little, too late.” Capping the size of the defined contribution fund was a compromise made to ensure the bill’s passage, as was the decrease in employee contributions. House Minority Leader Jim Durkin, who voted in favor of the law, says the contribution decrease was a major point of contention on the floor and almost a deal breaker.

Under the new law, the Illinois state treasury is required to establish a pension stabilization fund, with money from that fund used to pay down the pension debt. The law includes a timetable for that paydown and requirements for the state to pay its pension obligations going forward.

Chicago Mayor Emanuel was quick to praise lawmakers in Springfield for passing the reforms. “Today the Illinois General Assembly cleared a major hurdle by passing pension reform for the state’s four retirement systems,” he said in a statement. “Now state workers will have the certainty that pensions they paid into and are counting on will be there for them when they retire, and taxpayers can feel confident that they won’t have to shoulder the burden alone.” Emanuel went on to urge lawmakers to now start on the second leg of pension reform — fixing Chicago’s funds.

The City of Chicago has $19.5 billion in unfunded pension obligations for firefighters, police and municipal workers and owes $13.9 billion in general obligation bonds. The $9.5 billion Chicago Teachers’ Pension Fund is also underfunded — to the tune of $17.1 billion. State Senate President Cullerton, whose district is on the North Side of Chicago, has made clear he is ready for the next round, saying, “It is critical that we turn our focus to the financial crisis facing the Chicago Public Schools’ pension system.” Cullerton has a powerful ally in the form of the American Federation of Teachers, which earlier this year endorsed his pension reform proposal, as did We Are One Illinois. During his time as mayor (since May 2011), Emanuel has already gone up against the teachers’ union in a particularly bruising fight over collective bargaining — and lost.

How Emanuel proceeds on pension reform will have ramifications for his 2015 reelection bid. Governor Quinn, however, is up for reelection next year. The common consensus in Illinois political circles is that Quinn needed pension reform before 2014. What looked to be a difficult Democratic primary became much easier this September when potential challenger Bill Daley, Obama’s chief of staff after Emanuel, stepped out of the race.

Quinn’s most likely Republican challengers, however, have wasted no time in criticizing his hard-won pension reform. Only State Senator Bill Brady, a Republican who ran against Quinn in the 2010 gubernatorial race, has endorsed the reforms. Brady, who served as part of the nine-member bipartisan panel of lawmakers that drafted the final bill, has endorsed the reforms. Private equity investor Bruce Rauner, who presently has the lead in the four-way GOP race, has said that the reforms do not go far enough. Illinois Treasurer Dan Rutherford, also in the race, has expressed doubts that the law will stand up to judicial review. A November 26 poll by Public Policy Polling, taken before the December 3 vote, has Quinn ahead of Rauner by 3 percentage points, tied with Brady at 41 percent, tied at 39 percent with Illinois State Senator Kirk Dillard and trailing Rutherford by 2 points.

The bond markets have so far responded positively to Illinois pension reforms. Spreads on Illinois bonds narrowed in anticipation of the deal. “The fact that the legislature was able to take action — and what appears to be significant action — is a positive indicator, both for credit but for governance as well,” says Karen Krop, senior director of U.S. public finance at Fitch Ratings in New York. Plenty of work remains, however, before Illinois can hope to improve its rating. “For one thing, on pension reform itself, we still need to see an actuarial analysis to determine the real expected impact,” Krop explains.

Like that of other states and territories that have made pension reforms, such as Rhode Island, Oregon and Puerto Rico, the Illinois package is likely to be challenged in court. The reduction of the employee contribution was made in part, according to Minority Leader Durkin, in anticipation that doing so would help prevent the law from contravention of the commerce clause of the state constitution. The commerce clause exists in most state constitutions to prevent lawmakers and others from reneging on previously agreed-upon contracts. By lowering the contribution rate instead of the promised benefit, the hope is that the law does not infringe on the commerce clause. We Are One Illinois and similar labor rights groups argue, however, that the reforms impair pension benefits, thus violating the constitution. Speaking at a conference on December 6 in New York, William Brandt Jr., a turnaround expert and CEO of Chicago-based consulting firm Development Specialists, says he? thinks the Illinois fight could be the first in the present round of legal challenges to pension reforms to reach the U.S. Supreme Court. “You will have an issue in the Supreme Court based around the Illinois situation: Can you alter and amend the COLA?” Brandt says.

Get more on pensions. Plus: The 2013 Pension 40.