The Worst Funded Pensions in America are in Chicago

worst funded pension
Public workers in Chicago are about to get left out in the cold. Source

The Windy City of Chicago has the worst funded pension system in the United States. A combination of corruption, skipping required pension payments, generous benefits, and ridiculous investment assumptions have put the financial future of the nation’s third largest city in jeopardy. Because of this pension problem, Chicago just raised property taxes by 72% over the next few years. Sadly, it will not be enough to avert disaster.

Chicago Politicians Promised the Moon, Didn’t Pay For It, and Put the Burden on Future Generations

Chicago politicians have a reputation for being some of the most dishonest and corrupt in the country. After all, two former governors of Illinois are in jail. Additionally, countless ward bosses and city politicians committed unethical activity at best, criminal at worst. Even though Chicago politicians broke no law in underfunding the pension, the ones who made steep pension promises and didn’t fund them are disgraces.

Politicians negotiate pension benefits with city workers, who have their interests represented by a union. These unions always ask for a lot more in salary and fringe benefits. The problem with increasing city workers’ salaries is that you have to pay for the expense immediately. That means a city council would have to raise taxes or seek additional revenue. Since this action is politically hazardous to reelection hopes, politicians usually do not want to hand out large salary increases to unions unless they have to.

Local Politicians Love to Give Away Benefits That They Don’t Pay For

The story of Chicago’s pension collapse is a similar one all around the country. Because Chicago politicians did not want to budge on aggressive salary requests from the city’s unions decades ago, they needed another way to keep them happy. If you think about the kind of person who serves in the public sector, he or she is likely to be more risk averse than the average person. These workers appreciate low co-pays and deductibles for healthcare, low pension contribution requirements, and generous retirement benefits. If they could not get salary increases, union leadership could make their members happy with future promises for a rosy retirement. Unlike salary, future pension benefits do not need to be paid for immediately. Therefore, politicians could promise huge future benefit packages way off into the future without needing to raise taxes on their constituents.

Chicago paid less than 20% of the required pension contributions for years, then the financial crisis happened

In theory, a city is supposed to contribute a sum of money every year to a pension fund to pay for future retirement promises. This is the ARC payment (actuarially required contribution). It means that if a pension fund sponsor pays X dollars each year, then the fund will be able to pay benefits well into the future. Chicago’s leaders made pension promises, but they never made the payments the pension professionals told them they needed to make. The massive bull market of the 80s and 90s temporarily slowed the deterioration of the Chicago pension. However, Chicago politicians used the great returns as an excuse to pay even LESS to the pension funds, not as an opportunity to fix their past misdeeds.

Chicago’s pensions entered 2008 in a precarious position already, and the financial crisis delivered the fatal blow. Pensions invest in a mix of stocks and bonds. Chicago’s allocation was extremely aggressive for a pension fund, so the fund’s assets plummeted. Unfortunately for the city, when the markets drop they still must pay benefits to their retirees. To do this, Chicago needed to sell holdings of their pension fund at large discounts to pay benefits. Fast forward to the present, and the Chicago pensions’ funded status was at 22.8% as of the last publication data in 2014. The figure is likely below 20% today. That means for every dollar that the city owes current and future retirees, they have less than twenty cents set aside for the bill.

Now Chicago’s Property Taxes are Skyrocketing

The larger Chicago pension funds depend on property tax revenue to pay for the city’s employer contribution. Because Chicago leaders kicked the can down the road for so long, the ARC payment is huge today. In the 10 years prior to 2015, Chicago contributed between 0.5% and 20% of what they were supposed to contribute in order to pay pensions. Their 2015 ARC payment is a big improvement, but it is still only at 50% what’s required.

To make up the massive gap, Chicago decided it needed to impose huge new property taxes. Average families will immediately be paying 13% more than what they paid last year. As I mentioned before, the final tax bill will be 72% more than what they pay now. The entire property tax increase is literally going straight to public worker pensions, particularly the police and fire pensions.

Pension Benefits in Chicago Make Every Police Officer or Firefighter a Six Figure Employee

The reason many taxpayers are upset in Chicago is that nothing like a police/fire pension exists in the private sector. If you are lucky, your employer might match your 401k contribution at a 4% maximum level. Hopefully, you have access to low cost index funds and do not make big mistakes with your money. Contrast this benefit to the pension for police and firefighters in Chicago. You can get up to 75% of your salary after 30 years of service, 50% for 20 years of service. A young man who joined the force at 22 and retired at 42 could expect a check of $3500 a month for life.

Given that most 40 or 50 something retirees will live long lives, for most retirees the city would pay them for more years than they served. A retired police officer who lives to 90 could collect 40 years-worth of pension checks even though he served for 30 years. Pension benefits are guaranteed as well. To determine the true cost, you should use a lower interest rate to discount the pension benefit. When you do this, you find that the true pension cost in Chicago is a couple million dollars per retiree. Amortize this multi-million dollar benefit over 30 years, and this pension benefits adds tens of thousands of dollars a year to total compensation for public workers.

So a lowly paid police officer making $60,000 a year is actually making much more. He might earn $60,000 in salary, $30,000 in future pension benefits, and $10,000 in future healthcare benefits with each paycheck. Chicago politicians drastically underestimated the true cost of retiree pensions and healthcare, or they didn’t care.

Expect Chicago to Lose Bigtime from this Pension Crisis

When you raise property taxes drastically, the net rent you take home as a landlord goes down. The cost of your total housing payments as a homeowner also increase. The effect of these higher costs is lower real estate prices. As real estate experiences downward pressure in Chicago, some taxpayers might decide to walk away from their properties because of tax payments as they have done en masse in Detroit. Additionally, the state of Illinois has its own pension crisis. They promised to raise taxes temporarily to fix some budget issues, and now the tax is permanent.

the city will become far less attractive to businesses

Chicago will become a less attractive place to do business as a result. City leaders are proposing all kinds of new revenue generation ideas. One of the strangest I heard in the news is a stormwater tax to offset the effect of businesses “disproportionately adding to the sewage treatment.” Leaders argue that since Wal-Mart is much bigger than a small house, they should pay an additional tax to support the stormwater system. The truth is that these businesses already pay fair rates to run the utilities. The city just needs more revenue desperately and will make up any reason necessary to justify taking more money for pensions. Clearly, Chicago’s leaders plan on shaking down the business community in Chicago for every dime they can.

The city will try to get as much money out of city residents as possible through the property tax increases. They will probably not impose an income tax.  Chicago decided against a local income tax. They decided that in part because of the damaging economic impact seen in Philadelphia from its 4% city income tax. The city believes it can get away with major property taxes increases. After all, their rates are lower than other large American cities. Therefore, it might have some wiggle room before hurting the local economy.

What’s the Difference Between america’s worst funded pension in Chicago and the pension Problems in New Jersey?

Chicago is the largest city in the financially troubled state of Illinois. Because the state has no money either, the city must handle the problem mostly by itself. I’ve written extensively about the coming disaster in New Jersey. I expect hundreds of thousands of pensioners to receive reduced payments within eight years. In Chicago, the funded status for the pensions is even worse than it is in New Jersey. However, at least Chicago might have a way out through increasing tax revenues. Chicago is THE major city in the Midwest.  Compared to New Jersey, the city’s property taxes are indeed very low. Income tax rates are also below those in New Jersey. Chicago’s pension situation is horrible, but there is wealth there that you can tax without driving it all to another geographic location.

both are trying last ditch efforts to save the pension systems

Unfortunately, The politicians in New Jersey can’t take away anymore money. Cost of living is so high and taxes are so high that there is little to no room to raise revenue in the state. The richest resident of New Jersey moved to Florida because of high taxes. When I traded bonds, the state started using the New Jersey Turnpike Authority as an ATM. That was the last source of money the state could take from to pay its soaring bills. Furthermore, the track record of the last few years with the state paying what it promised to on the pension funds is pitiful. Unexpected revenue shortfalls and budget pressures led Gov. Christie to make far less than the required payments to keep the fund solvent.

If anything, I would rather be Chicago than New Jersey right now from a financial standpoint. Even so, both governments will expose that the emperor has no clothes in the world of public pensions. We need to see who the courts put first in a bankruptcy scenario. Then, we will know what happens with the other states that are hurdling towards a pension crisis. If the stock market surges further, Chicago may yet survive. If it stagnates or falls, many public servants in Chicago will receive a pittance of what Chicago owes them as participants in America’s worst funded pension.

5 thoughts on “The Worst Funded Pensions in America are in Chicago”

  1. Dang, this is just sad. It’s tough to be counting on something your entire career then have the rug ripped out from under you. Hopefully the the city will be able to meet their obligations and people won’t suffer blows to what they imagined their retirement to look like.

  2. I think you’re right that Chicago will come out of this OK. It’s a huge city with a diverse economy, and people really really want to be there. So it has a lot more latitude to raise taxes and shake down businesses than other cities might. I’ll be curious to see how exactly they go about filling the gap though.

    In other news, Philly just reached a contract with its major blue-collar union, DC 33. The early articles about it are vague but it seems like a step backward. The previous mayor took a fairly tough stance against the unions, even pushing for a (gasp) 401k type of plan for new hires. The new deal apparently gets rid of that. The new mayor is much more beholden to the unions. Hope this is not a sign of things to come.

    1. Coincidentally, Philly has the worst funded pension plan in the United States after Chicago. Their demographics in some cases are even worse. There are more retirees receiving benefits than active workers, which suggests if the city can survive the next few decades it should come out ok.

      1. Another Problem with Philly is that they have a Deferred Retirement Option program. It allows workers to declare their retirement early and have an amount equal to their annual salary deposited into an IRA like account. When they retire, they get the pension and the IRA style lump sum. That’s a very expensive program.

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