Focus on Finance: Funding Pensions in the Windy City

Lois Scott is the first female chief financial officer for the City of Chicago. Mayor Rahm Emanuel has entrusted Scott, who has obtained more than 30 years of financial experience that includes a portfolio of client projects valued at more than $60 billion, and her team to help him dig Chicago out of its financial challenges and fix its pension crisis. Before joining the City, she was cofounder and president of Scott Balice Strategies LLC. President Bill Clinton named her a White House fellow, tasking her with helping craft the American response to the capital funding crisis in Southeast Asia in 1997. She also chaired the Management Committee of the Export-Import Bank of the US. Scott earned her bachelor’s degree and MBA at Cornell University by the age of 22.

Mayor Emanuel was recently quoted that Chicago will have to double property taxes or eliminate vital services if state lawmakers don’t restructure pension laws so the city can avoid an almost doubling of its required contribution to $1.2 billion in 2015. Despite the recent passage of the long awaited Illinois pension bill, the State Legislature remains tightly gridlocked on addressing legacy issues. Given this reality, should Chicago be preparing for these future costs?

Our pensions are a function of state law. Both benefit and funding levels are set by the state so we have our hands tied by the statutory structure of Illinois. There are some who say that we should be increasing taxes now to provide for this future liability. However, others are quick to remind us that this action would certainly be subject to a lawsuit. The law is very clear that the city should be collecting and depositing for these pension costs, but for us to do so ex parte would be far beyond what the law permits us to do. The question is: If you are a Chicago taxpayer and the city is voluntarily taxing you beyond what the law permits, how do you respond?

The mayor has been pretty clear about addressing the unstructured liabilities of current employees. Right now Chicago pays $500 million per year for pensions. These costs are projected to rise to $1.2 billion by 2015, largely due to an upcoming police and fire pension obligation. In comparison, our property tax levy in the city is $800 million. To support this $1.2 billion annual obligation, we will have to essentially double the city’s share of the property tax.

However, these actions will only address the actuarially required contribution (ARC) funding issues of two of our four pensions – Police and Fire. Municipal employees and laborers, which are not included in this obligation and don’t have ARC funding, are currently being managed on a multiplier basis. The combined underfunded liabilities of Chicago’s four pensions have grown to nearly $20 billion . Without reforms, all four of these funds will be broke by 2030. We are in a very complex situation.

What makes the issues facing Illinois and Chicago pensions unique from other US states and cities? Are there municipal finance developments in other parts of the country that are of particular interest to you? 

From a state level, there are five states that have a very similar constitution as Illinois. New York, New Jersey, Michigan, Arizona, and Illinois all have constitutional protections on pension benefits, which makes pension reform a much more difficult issue for these states to address. However, the recent Puerto Rico Supreme Court Decision, which also has a similar constitutional protection, rejected the notion that these pension benefits can’t be touched. This is the first time we have seen a Supreme Court rule on that issue.

From a city level, what makes Chicago unique is the layering effect. Chicago is the worst funded city in pensions in the worst pension funded state in the country. The taxpayers that have to address Chicago’s pension problems are the same ones who have to address issues facing Cook County, the Metropolitan Water District, Chicago Park District, the Chicago Transit Authority, and the state. How deeply and quickly do we hit this economy to address these problems? In terms of benefit cuts, from a taxpayer’s perspective, we have not done enough. From labor’s perspective, we have done way too much. With 90 percent of Chicago’s workforce unionized, this makes our choices different.

We are closely monitoring bankruptcy developments happening in Detroit. While Chicago isn’t intending or planning to enter bankruptcy, developments in Detroit will inform labor and management nationwide what direction pension negotiations are going to go. Another aspect of the Detroit bankruptcy that we are watching is its proposed treatment of general obligation debt. Nationwide, cities have relied on general obligation debt as a primary funding and capital source. If Detroit changes the rules of the road on that, significantly impairing investors, the implied risk to general obligation debt will inherently increase, raising the cost of issuance in the capital markets. This will definitely force us to rethink how we raise capital as a city.

You mentioned that Chicago is not near the fiscal distress that Detroit has recently faced. However, national press and media have been quick to draw comparisons between the two cities. Could Chicago face a distress situation similar to Detroit in the future? 

No, I don’t think so. Do we have deep financial stresses? Yes. The fundamental problem with Detroit is its lack of economic strength to support a tax base. Chicago has that in spades. The reason that we have received the rating agency downgrades that we have is not because we can’t afford our pensions, but rather because we haven’t funded them. Chicago is a highly levered organization, and the issue that the rating agencies and investors have with Chicago is that we can resolve our issues, we just have chosen not to.

What we know, however, is that the minute we pull the lever of increasing revenue, our ability to drive reform in the system will be gone. The city needs to implement reforms that will promote long–term health, even if it means short-term stress and discomfort for people in the financial community about the fact that we haven’t increased revenues at this point. We are balancing revenues with reforms.  That’s what you saw with the recent Chicago Park District reform proposal. When we enact reforms, we increase revenues. When the employees increase what they pay into the system, the state increases its contribution multiplier.

I am glad you brought up the Chicago Park District reform proposal. This is a recent breakthrough in Chicago pension negotiations. Do you believe that this reform could set a precedent for some larger union reform deals down the road?

Absolutely. However, every single pension fund is unique. There is no cookie cutter approach, so finding a solution to Chicago’s pension issues will not be as simple as taking the Park District reform and applying it everywhere. This is the first pension reform package that was done under the new mayor.  While this benefits our sister agency, not the city directly, it does break through a barrier. The reform addresses the major drivers that Mayor Emanuel outlined in his pension reform initiative: 1) cost of living adjustments, 2) retirement age, 3) employee contribution, and 4) introducing a choice element to more sustainable pension plans, especially for newer and younger employees.

Chicago pension reforms have to be approved by the state legislature. Senate President John Cullerton believes that pension decisions should have equal weight. In other words, if the state takes something away, it should give something back in return. The law does not consider equal weight under consideration. Cullerton broke his stance with the Chicago Park District reform proposal. For him to actually not only vote in favor, but sponsor the Chicago Park District reform proposal, sets a major 180 degree turn in his position and sets a path for the city to propose future reforms.

So, a significant piece of this pension puzzle will be increasing revenues. Are you concerned that businesses will leave the city out of frustration of using taxes as a way to solve systematic or unaddressed problems?

Business is already frustrated with inaction at the state level. What they see is a city that is functioning pretty well, experiencing financial challenges, but rising to meet its needs. The mayor has stated that we will continue to phase out retiree healthcare, and we don’t have other postemployment benefits (OPEB) the same way that other governments do. What is in our control, we have acted on compassionately but concisely.

While taxes may be high, small businesses to large corporations receive significant benefits from being located in Chicago. The actions of the mayor within economic development are the best in class in the nation. The restructuring of community colleges, with corporate America shaping curriculum to meet the skills needed for high demand careers, is creating the best talent pipeline in America. Additionally, Chicago is cultural destination that is uniquely preferred by the millennial generation. This is a place where people want to be.

If you think about globalization, Chicago has the only airport in the nation with direct flights to any other city in the country. So if you are a foreign company and you need a US headquarters, where do you put it? Chicago is very well poised to become a leading international city. Needless to say, I am extremely bullish on our growth prospects.

You had a very successful private sector career before assuming the role as Chicago’s CFO. What drew you to this position, and what would you say is the most striking difference between your roles in the private and public sector? 

In the private sector, generally, there is always a metric that you can quantify as a win. If you are an investor and you present higher returns than your benchmark, that is a win. If you are a corporation and your profits increase, that is a win. In the public sector, issues are multidimensional. There are a million agendas. Getting the right financial outcome does not mean it is the right answer. It is really the difference between playing checkers and playing chess in terms of the complexity of issues and how you have to train your mind to think them through.

In terms of how I got here, I did not go looking for this position. It was not on my agenda. Contrary to what has been recently reported, I was not good friends with the mayor. Mayor Emanuel requested that I take this position. I said no. Over the course of several weeks, Mayor Emanuel continued to request to speak further about it. He stated it simply. “You have a chance to get in the game and try and help your fellow citizens, and you are telling me you aren’t interested? I don’t believe it.” He was right. I had the opportunity to do something good for this city. That was the fundamental driver of my decision to take on this role.