Chicago’s Future Is Brighter Than Headlines Suggest by Ty Schoback, Columbia Threadneedle Investment
- Chicago has formidable pension challenges, but we believe Moody’s and the municipal market have overreacted.
- Chicago’s large, diverse and vibrant tax base, with a growing population in recent years, provides the necessary tools to manage its pension challenges over the long term.
- Chicago is not Detroit. Any comparisons are misguided.
Recent public downgrades and negative market reaction due to Chicago’s large and growing underfunded pension liabilities have left many questioning whether Chicago will continue to function as a viable city. It is our view that Chicago remains an investment-grade credit, as it has many tools at its disposal to stabilize its fiscal profile. There is no denying that Chicago’s pension woes are formidable. However, we feel that Moody’s and the municipal market have overreacted.
Chicago’s fast and furious public ratings changes
Despite numerous public rating actions, Chicago’s credit profile has not materially changed over the past two years. Even though Chicago secured pension reform for two of its four pension funds in June 2014, Moody’s proceeded to lower its rating to Baa2 in February 2015. More recently, the Illinois State Supreme Court ruled the state’s 2013 pension reforms unconstitutional. While this ruling certainly does not bode well for Chicago’s 2014 pension reforms, the ruling had no direct impact on Chicago’s pension reform, which is based on an entirely separate legal argument. Regardless, on May 12th Moody’s lowered its Chicago’s rating further by two notches (Baa2 to Ba1) and into below-investment-grade territory. Meanwhile, Moody’s has not touched its State of Illinois rating, where the state supreme court’s ruling explicitly applies and will make closing the state’s fiscal year 2016 budget deficit much more difficult.
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Exhibit 1: Chicago G.O. bonds — fast and furious public rating changes
Sources: Moody’s, S&P, Fitch, 05/15
A below-investment-grade rating of Chicago implies there is a material risk that investors may not see a return of their capital — a view with which we strongly disagree. While it is undeniable that Chicago has serious pension challenges, it is quite a leap to think there is an imminent risk of default, or that the city would be considered as a candidate for Chapter 9 bankruptcy.
Fundamental view on Chicago
Chicago’s fundamental credit profile really has not changed much over the past two years. In fact, a case could be made that its fundamentals have actually improved slightly. What has changed is the market’s perception of Chicago’s creditworthiness. Columbia Threadneedle Investments has long considered Chicago’s credit profile to be insufficient to warrant AA category ratings. Chicago’s pension woes are not a recent development, as the city has been underfunding its pension plans since before 2000. Further, Chicago was operating with a structural budget deficit as recent as 2010, relying on one-time asset sales to plug operating budget gaps. However, since 2011, the city has largely balanced its operating budget through minor revenue enhancements and expenditure reductions.
Addressing the recurring underfunding of pensions has proved a more formidable challenge. In June 2014, Chicago secured pension reform for two of its four pension funds. This reform measure laid out an achievable funding ramp for the city to gradually meet the full annual required contribution (ARC) to the pensions in order to achieve 90% funded status over 40 years. The ability and willingness of a government to meet its full ARC within a closed amortization schedule is more important than the size of the unfunded pension liability that typically grabs more attention. Once Chicago is meeting its full ARC, the pension funded ratio will begin to stabilize in the short-to-medium term and improve over the long term. While it is possible that the reform will be ruled unconstitutional, it is important to recognize that city management has demonstrated an ability and willingness to address its pension challenges with a solution that involves new or increased revenues. Although city management has not detailed how the increased pension payments will be funded, it has sufficient budget tools to find the answer — likely to be some combination of tax increases, new taxes and/or cost reductions.
While some of the solutions outlined may not be perfect, they appear to strike a realistic balance between providing retirement security for city employees, not overburdening city taxpayers and not inhibiting the city’s economic performance.
Chicago is fully capable of addressing its pension challenge
Chicago has 2.7 million residents, making it the nation’s third most populous city, and is still growing. By numerous measures, it remains world class. Chicago also boasts a highly educated workforce that attracts employers. The city’s economy is not reliant on any single sector and continues to diversify its tax base. One notable example is its booming tech sector, which last year added more jobs than Silicon Valley. Chicago’s pension woes have been years in the making and will take years to fully address. However, with its robust economy, adequate budget flexibility and demonstrated willingness to tackle pensions, the city’s pension challenge is a fixable problem. Chicago has the necessary tools to lay out an achievable path to not only stabilizing, but improving, its pension funding levels.