CHICAGOS RETIREMENT SYSTEMS

Revenue Options to Address Chronic Underfunding

March 14, 2014

INTRODUCTION
It will take a serious commitment of new revenue to begin to address the City of Chicagos pension funding shortfall, to restore solvency to Chicagos retirement systems, and to produce a fair, constitutional way forward. To this end, this report, produced by We Are One Chicago and its partners, presents the following information: an overview of the Chicago retirement systems revenue options that address chronic pension underfunding several additional revenue-generating ideas worth exploring

The City of Chicagos public employees and retirees teachers, firefighters, nurses, health care workers, police officers, librarians, and others are the cornerstones of their communities. These working and retired middle-class families live in, serve, and anchor the diverse neighborhoods that comprise Chicago. Millions of people city residents, visitors from downstate, business commuters, and tourists from near and far rely on services performed by Chicagos public workforce. They teach our children, respond to emergencies, care for our most ill, protect our lives and property from harm, and carry out both the basic and complex tasks that keep Chicago running and contribute to its vibrancy, safety, and economy. The citys retirement systems hold the life savings of Chicagos public servants. Unlike the private sector workforce, the citys employees and retirees do not receive Social Security. City pensions are their only sure foundation for retirement security and dignity in their later years, and they consistently pay toward them out of every paycheck 8.5%, 9%, or more. In addition, city pensions are modest averaging just more than $40,000 in one of the nations more expensive cities. Some receive less. For instance, the average pension received by those in the fund for municipal employees is around $33,000. Although Chicago-area millionaires and billionaires have used pension outliers to stir up a frenzy to slash workers and retirees life savings, these are the same wealthy, big business titans who if they actually paid their fair share in taxes would help the city more adequately fund both its retirement systems. Further reinforcing this point, a commission organized under former Mayor Richard M. Daley found Chicagos retirement benefits to be middle-of-the-road or even less generous compared to other cities, particularly for police officers and firefighters.1 Lastly, as with the state-funded retirement systems, the Illinois Constitution protects City of Chicago pensions, stating in pertinent part from Article XIII, Section 5, that membership in a retirement system is an enforceable contractual relationship, the benefits of which shall not be diminished or impaired. Nevertheless, the City of Chicago faces a pension funding shortfall for several reasons. First and foremost, for decades, politicians manufactured the shortfall by skipping and shorting the employers portion of the payment to the retirement systems. This has resulted in a large debt owed to the systems that has been accumulating systematically and deliberately over time. As the citys commission found, current benefits are not, in themselves, unaffordable.[W]ere it not for the deficit we would not face a crisis.2 In line with this, for years, the employer payment portion of Chicagos retirement systems was funded via a multiplier that had no relation to what was actuarially required per normal pension funding practices. This artificial multiplier underfunded all systems, especially during recessions when funding is most vital to maintain fund health. The funds for municipal employees and laborers still use this method and continue to suffer as a result. Funds for teachers, police, and

Page

fire were recently subjected to funding holidays and a cliff payment. Again, this exacerbated and worsened the already-low funding levels and helped to manufacture todays crisis. The Great Recession, brought on by big banks, corporate CEOs, and Wall Street greed, also significantly harmed already low pension funding levels. Most telling of all, Standard and Poors reaffirmed a negative outlook on the citys general obligation bond rating, writing that: Hindering budget flexibility is a political unwillingness historically to raise property taxes to meet budgetary challenges, particularly with respect to looming pension payment increases. In our view, the city also has a limited capacity to cut spending, given that nearly two-thirds of 2012 general fund expenses were in the area of public safety.3 In short, chronic underfunding, not modest benefit levels, has been the primary problem, and even S&P and the former Daley commission recognize that new revenue is needed. Public servants retirement life savings cannot be disconnected from the public services they provide. Alternatives exist to attempting pension theft through illegal cuts to modest pensions. 1. OVERVIEW OF THE RETIREMENT SYSTEMS4 The five systems are the Chicago Teachers Pension Fund (CTPF), Firemens Annuity & Benefit Fund of Chicago (Fire Fund), Policemens Annuity & Benefit Fund of Chicago (Police Fund), Laborers Annuity & Benefit Fund of Chicago (LABF), and the Municipal Employees Annuity & Benefit Fund of Chicago (MEABF). Employer contributions for the city retirement systems come from City of Chicagos property tax. Chicago Public Schools (CPS) is subject to the Property Tax Extension Limitation Law, which limits the level of property tax increase allowable. The CTPF, Fire Fund, and Police Fund all face deliberately manufactured cliff contributions, having faced decades of underfunding in the form of inadequate employer contributions and pension holidays where politicians substantially reduced employer payments. This occurred particularly in the years leading up to the cliffs. The LABF and MEABF faced similarly inadequate employer contributions and continue to be subject to the artificially set multiplier that has no relation to what is actuarially required. Figure 1: Statutorily Mandated Employer Contribution ($ Millions)5 Retirement System FY2013 6 Chicago Teachers' Pension Fund $207.7 Contribution Change from Previous Year Firemen's Annuity & Benefit Fund $109.5 Contribution Change from Previous Year Policemen's Annuity & Benefit Fund $191.8 Contribution Change from Previous Year Laborer's Annuity & Benefit Fund $14.5 Contribution Change from Previous Year Municipal Employees' Annuity & Benefit Fund $156.0 Contribution Change from Previous Year TOTAL CONTRIBUTION Cumulative additional contributions $679.5 FY2014 $612.7 $405.0 $113.9 $4.4 $187.1 -$4.7 $15.3 $0.8 $163.0 $7.0 FY2015 $696.5 $83.8 $255.0 $141.1 $630.6 $443.5 $15.6 $0.3 $168.4 $5.4 FY2016 $716.2 $19.7 $262.5 $7.5 $651.6 $21.0 $16.0 $0.4 $174.1 $5.7 FY2017 $736.7 $20.5 $270.5 $8.0 $671.9 $20.30 $16.4 $0.4 $179.8 $5.7

$412.5

$1,086.6 $1,140.9 $1,195.8

Page

$1,092.0 $1,766.1 $1,820.4 $1,875.3

2.

REVENUE OPTIONS

As presented in Figure 1, statutorily mandated employer contributions increased significantly in FY2014 and will continue to grow by a considerable means in the coming years. By FY2017, the citys pension contribution is estimated at $1.2 billion more than its FY2013 contribution. While these increased contributions address the unfunded liabilities of the CTPF, Fire and Police pension funds, according to the Commission on Government Forecasting and Accountability, the LABF and MEABF are projected to run out of assets by 2027 and 2025, respectively. This section of the report presents revenue options that lawmakers at various levels of government could consider to address the citys accrued pension debt while restoring stability to its retirement systems. These ideas do not involve changing property taxes,7 but instead involve other revenue ideas, many of which have been previously put forth by Chicago Inspector General Joseph M. Ferguson, the Center for Tax and Budget Accountability (CTBA), the Comptrollers Office, the Governors Office of Management and Budget, and most recently, the Chicago Teachers Union. Figure 2 provides a capsule summary of each revenue idea, with further discussion following the figure. Taken together, ideas discussed below would generate between $1.3 billion to $2.3 billion to help restore stability to Chicagos retirement systems. Figure 2: Revenue Options
Revenue Option Create a City Income Tax, Focused on High Earners 1% aggregate city income tax implemented as graduated rate structure If graduated, this tax can be designed to largely exclude filers earning less than $100,000 and instead focus on those earning $1 million or more Revenue estimate based on Citys 2009 AGI Create a Commuter Tax 1% income tax on nonresidents who work in the City Revenue estimate based on 2010 BLS and Census data Replaces revenue lost from the repeal of the Head Tax Broaden Sales Tax to Include More Services. Service categories that could be taxed include: Agricultural services Industrial and Mining Services Construction Transportation of Services Storage Utility Services Finance, Insurance and Real Estate Personal Services Business Services Computer Services Automotive Services Admissions and Amusements Professional Services Leases and Rentals Fabrication, Installation and Repair Services Institute a Financial Transaction Tax on CME, Board of Trade and Board of Options Exchange Estimated Revenue ($ Millions) Source (Year Estimate Made)

$500

Chicago Inspector General (2011)

$300

Chicago Inspector General (2011)

$437-$1,425

Chicago Inspector General, and CTBA (2013)

$38.2 - $100

Chicago Inspector General (2011,

Page

$0.01 tax on each contract traded on these exchanges would produce: o CME ($15.5 million) o CBOT ($10.8 million) o CBOE ($11.9 million) More revenue would be generated if the tax were assessed on the total value of the contract $7

updated with 2013 exchange data)

Subject foreign dividends to the states income tax

Eliminate the retailers discount for the sales tax. Eliminate the Economic Development for a Growing Economy (EDGE) Tax Credit, a corporate tax loophole Repeal the special tax break to the Chicago Mercantile Exchange and Chicago Board Options Exchange COMBINED REVENUE ESTIMATE

$3.5

$0.7 $1.9 $1,288.3 - $2,338.1

Governors Office of Management and Budget (2013) Comptrollers Office, and CTBA analysis (2012) Comptrollers Office, and CTBA analysis (2012) CTBA analysis (2013)

Create a City Income Tax, Focused on High Earners Cities across the United States use income taxes to finance their operations. Examples include New York City, St. Louis, Denver, Portland, Columbus (OH), Pittsburgh, and many more including some counties in Indiana and school districts in Iowa. 17 states allow local governments to impose a Local Option Income Tax (LOIT),9 and out of the five largest cities in the United States, two (New York City and Philadelphia) have an LOIT.10 Income taxes raise significant amounts of revenue. For instance, New York City estimates it will raise $8.169 billion in FY2014 from its income tax, 11 and its rates range from 2.907% to 3.648%. The Chicago Inspector General estimates a flat city income tax at 1% a much lower rate than New York City would raise $500 million. Ideally, the tax could be designed more fairly to adjust to the taxpayers ability to pay through using a graduated structure. Revenue generated from a graduated structure depends on the rates and income thresholds used, but a simple design based around the 1% rate would raise the same amount of revenue, even after adjusting for deductions and credits.12 Critical to note, implemented in its ideal form, a graduated tax can be designed to raise the Inspector Generals estimate of $500 million while excluding filers earning less than $100,000. The rates can be adjusted so that those earning $1 million or more pay the bulk of the tax. Lastly, it is also important to consider that when the State of Illinois raised its flat income tax rate from 3% to 5%, it did not share revenues with local governments through the Local Government Distributive Fund (LGDF). In effect, all local governments forwent $670 million annually in revenue from the tax increase. Chicagos portion of this forgone revenue is $140 million. Create a Commuter Tax Similar to the city income tax, a commuter income tax would ensure equitable treatment of those who benefit from public services and Chicagos status as a global city. Nonresidents working in Chicago benefit from police and fire protection, public works, and other vital core services much like city residents.

Page

Again, the Chicago Inspector General estimates a flat commuter tax of 1% would raise $300 million, but the tax could be designed more fairly to adjust to the taxpayers ability to pay through using a graduated structure. Revenue generated from a graduated structure depends on the rates and income thresholds used, but a simple design based around the 1% rate would still likely yield $300 million, after adjusting for deductions and credits. Broaden Sales Tax to Include More Services Depending on which services are included or excluded, broadening and modernizing the sales tax to match more closely to todays economy would generate between $437 million and $1.425 billion for the City of Chicago. Revenue would come from both the states imposed sales tax (6.25% rate) and the citys home rule sales tax (2.25%). Mayor Rahm Emanuel has advocated for expanding the sales tax and lowering the rate. Institute a Financial Transactions Tax on Exchange-Traded Contracts The Chicago Inspector General estimated in 2011 that instituting a penny tax on each contract traded on Chicagos three major exchanges the Chicago Mercantile Exchange/the Chicago Board of Trade (CME Group) and the Chicago Board of Options Exchange (CBOE) would generate $37 million annually. Updated using 2013 volume data, such a tax would generate $38.2 million. If the tax is assessed on the total value of the contracts, it could generate as much as $100 million, conservatively. A financial transactions tax would be one way of making sure all businesses pay their fair share and may help to reduce the type of financial speculation that contributes to economic volatility, uncertainty, and market crashes. Subject Foreign Dividends to the States Income Tax The state exempts the dividend income of foreign affiliates from companies in-state income, even though this income is taxable at the federal level. Subjecting foreign dividends to the states income tax would generate $7 million for Chicago. Eliminate Retailers Discount on the Sales Tax The states retailers discount is the most generous in the nation, giving back 40 percent more than the next-largest state (Texas) as of 2008, because of the relatively high rate (i.e., 1.75 percent) and lack of a cap on compensation. Illinois is among just 26 states that provide a discount and is one of only 13 with no cap on the amount any individual store or chain can receive. Neighboring states Iowa and Minnesota provide no discount. This policy can be lucrative for large retailers. In 2008, a report by the taxpayer subsidy watchdog group Good Jobs First calculated that Wal-Mart alone received more than $8.3 million per year in vendor compensation.13 Eliminating the discount would generate approximately $3.5 million. (Note that this estimate is just for revenue from the states imposed sales tax, and additional revenue would be generated from the citys sales tax.) Eliminate the Economic Development for a Growing Economy (EDGE) Corporate Tax Loophole Elimination of the EDGE corporate tax loophole would generate $690,000 for the City of Chicago.

Page

Repeal the Special Tax Break for the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE)

After threatening to leave the state, the CME Group and CBOE won an expensive new tax break that is estimated to cost Illinois $85 million in FY2014. This type of special corporate welfare a handout for just two businesses does not provide a solid foundation for economic equity and prosperity. Repealing the CME/CBOE tax break would generate $1.9 million for the City of Chicago. 3. ADDITIONAL REVENUE-GENERATING IDEAS In addition to the revenue options discussed above, several other revenue-generating ideas merit consideration by elected officials and policymakers: Permanent Rules to Ensure Recently-Closed Sales Tax Loophole Remains Closed In November 2013, the Illinois Supreme Court ruled on Hartney Fuel Oil Company v. Hame. Prior to that ruling the local sales tax was imposed in the jurisdiction the sale took place in, even if the majority of a business activities were in a different municipality. The Illinois Supreme Court ruled that retailers are subject to the sales tax in the municipality where most of their selling activities occur. Basically, this closes a loophole in previous law. The Department of Revenue implemented emergency rules recently based on the court ruling14. The change in rules for the local sales tax will likely generate revenue for Chicago because many businesses completed their transactions in other municipalities to avoid the citys sales tax. As a means of increasing Chicagos tax revenue, permanent rules to keep this loophole closed should be considered. Pension Obligation Bonds When retirement systems are significantly underfunded, as all the Chicago systems are, cash flow becomes an issue and impacts investments. Underfunded systems often liquidate assets to pay for benefits, which means they have a smaller investment portfolio. This can impact investment returns, which in turn affects the financial status of the retirement system. Basically when a retirement system becomes underfunded, the problem snowballs when employers underfund the systems. Increasing contributions to a pension system upfront is important because the cash infusion helps mitigate the cash flow problem. Issuing a Pension Obligation Bond would do just that. More money up front means the financial condition of the funds will improve more quickly, which can save the city money in the long run. Level-Dollar Debt Re-amortization As a means of mitigating the severe increases to the citys pension contribution, lawmakers could re-amortize the debt currently owed using a flat level dollar, rather than level percent of payroll, amortization schedule (as it is the unfunded liability, not benefits, that are causing the problem). Under a re-amortization proposal, the citys contribution wouldnt necessarily be that much less (if at all) from current law. However, re-amortization would create a flat level dollar schedule, which would mean the required contributions would not increase significantly from year-to-year. Renegotiate City of Chicago & CPS Bond Swap Contracts Renegotiating or canceling bond swap contracts at no cost to taxpayers would stop the immense transfer of taxpayer money from the City of Chicago to the banks. The City of Chicago entered into bond swap contracts in attempts to borrow money at stable and low rates by betting against low interest rates. As the Federal Reserve drove interest rates downwards and kept them at the zero bound amid the Great Recession and subsequent recovery, these bond swap contracts turned against the City of Chicago in favor of the lending institutions, making the City of Chicago responsible for crushing annual payments for the life of the contract. Not only are the

Page

City of Chicagos bond swap contracts very long, but they are structured unfairly giving the banks protection instead of the taxpayers. Currently, the City of Chicago15 has eleven bond swap contracts with undisclosed financial institutions. They currently are responsible for paying off $549,929,000 with taxpayer money. If the City of Chicago wanted to terminate their bond swap contracts, they would be required to pay a termination payment of $71,650,000. Along with the City of Chicagos Bond Swap Contracts, CPS16 currently has ten bond swap contracts making them currently responsible for paying off $314,449,000 with taxpayer money. CPS termination payment is $36,066,000. Renegotiating or canceling bond swap contracts would make bond swap contracts fairer and keep taxpayer money with the taxpayers, and would have saved taxpayers $1.868 billion17 from 2010-2012.18 This is an option worth exploring as it could generate large sums of upfront savings for the City of Chicago and CPS particularly in light of the nearly $2 billion in forgone savings that could have accumulated from 2010-2012.

CONCLUSION
As this report demonstrates, clear alternatives exist that do not involve unconstitutional, unfair attempts to slash the modest life savings of the citys employees and retirees. Elected officials face a bevy of choices beyond destabilizing communities and raiding the life savings of hardworking public servants. Lawmakers must consider these revenue options, as it will take a serious commitment of new revenue to restore solvency to Chicagos retirement systems. The reports revenue options generate a substantial sum, ranging between $1.3 billion and $2.3 billion, and deserve consideration by elected officials in city and state government.

Commission to Strengthen Chicagos Pension Funds. Final Report, Vol. 1: Report & Recommendations (Chicago: April 30, 2010), 7.
2 3

Ibid, 8.

Spielman, Fran. Standard and Poors reaffirms negative outlook for city bonds. Chicago Sun-Times 25 Feb. 2014. http://www.suntimes.com/news/metro/25827936-418/standard-poors-reaffirms-negative-outlook-for-city-bonds.html COGFA, Illinois Public Retirement Systems: A Report on the Financial Condition of the Illinois Municipal, Chicago and Cook County Pension Funds of Illinois (Springfield, IL: January 2014). Sources: Segal Consulting, Public School Teachers Pension and Retirement Fund of Chicago: Statutorily Required Funding Valuation as of June 30, 2013 (Chicago: December 13, 2013); COGFA, Illinois Public Retirement Systems: A Report on the Financial Condition of the Illinois Municipal, Chicago and Cook County Pension Funds of Illinois (Springfield, IL: January 2014).
6 7 5 4

CPS contribution to CTPF includes required contribution and additional contribution.

The use of revenue sources beyond property tax dollars to meet the citys pension obligations may require a change in law. $101.7 to $331.7 million would be from the states income tax, and $335.1 to $1,093.8 million would be from the Citys sales tax. Those states are: Alabama, Arkansas, California, Delaware, Indiana, Iowa, Kentucky, Maryland, Michigan, Mississippi, Missouri, New York, New Jersey, Ohio, Oregon, Pennsylvania, Virginia, and Washington. Source: Dagney Faulk, Kevin Kuhlman, Hikoyat Salimova, and Sikant Devaraj, An Overview: Local Option Income Taxes in Indiana (Muncie, Indiana: Center for Business and Economic Research, March 2011), 2.
9 8

Page

New York Citys LOIT is a graduated rate structure, with rates ranging from 2.907% to 3.876%. New York states personal income tax rate is a graduated rate and ranges from 4% to 8.82% Philadelphias LOIT is 3.924% for residents and 3.495% for non-residents. The state personal income tax rate in Pennsylvania is 3.07%
11

10

The City of New York. Office of Management and Budget. Adopted BudgetFiscal Year 2014. Expense Revenue Contract (New York City, June 2013), ii. http://www.nyc.gov/html/omb/downloads/pdf/erc6_13.pdf

Chicago Teachers Union. The Great Chicago Pension Caper: Neighborhood Destabilization in An Age of Austerity. February 17, 2014. http://www.ctunet.com/blog/text/ChicagoPensionCaper021714.2.pdf
13

12

Philip Mattera with Leigh McIlvaine, Skimming the Sales Tax: How Wal-Mart and Other Big Retailers (Legally) Keep a Cut of the Taxes We Pay on Everyday Purchases, Good Jobs First, November, 2008, http://www.goodjobsfirst.org/sites/default/files/docs/pdf/skimming.pdf

14

The Department of Revenues emergency rules are available here: http://www.revenue.state.il.us/News/HartneyDecision.htm City of Chicago. Comprehensive Annual Financial Report 2012, 2011, & 2010. Chicago Public Schools. Comprehensive Annual Financial Report 2012, 2011, & 2010.

15 16 17

City of Chicago, Comprehensive Annual Financial Report 2012 (p.75), 2011 (p.75), & 2010 (p.74); and Chicago Public Schools, Comprehensive Annual Financial Report 2012 (p.71), 2011 (p.68), & 2010 (p.66). Also see: Service Employees International Union. Big Banks Squeeze Billions in Profits from Public Banks 2010. http://www.seiu.org/images/pdfs/Interest%20Rate%20Swap%20Report%2003%2022%202010.pdf

18

Page