Chicago Public Schools (CPS) have started the new school year without having the money to last the full academic year. Even though the school system has taken care of more than half of the budget shortfall, through cuts and more borrowing, they still face a $480 million gaping hole for the current school year. Yes, that’s right, the hole was previously $1.1 billion. Instead of getting their finances in order, CPS is running to the State of Illinois and expecting to be bailed out.
There is just one problem with this plan – the State is also broke and facing their own budget gap of $5 billion. While the Illinois Senate has passed legislation in an effort to patch the hole, by using state dollars and lowering the required payments to pensions, the House hasn’t yet passed the Bill, and it is unclear how it will be funded, according to the WSJ.
If the money doesn’t come through, the school system will be forced to make additional cuts, mid-year. Adding to the turmoil is the fact that the Chicago Teachers Union is operating under an expired contract. While a strike is not on the table yet, a mediator has been enlisted for help which means that negotiations cannot be going well.
Not surprisingly, one of the biggest drivers of the CPS budget shortfall is their pension obligations. While the teacher’s pension fund is the highest-funded in Chicago at 49%, (the other city pension funds are around 40% funded or less!), it is also the largest pension fund and therefore carries the largest pension unfunded liability at $9.6 billion.
Chicago politicians and pundits would have you believe the shortfall is because city finance managers had to choose between funding the pensions or paying for teachers and school expenses, but a recent study by Illinois Policy has found that was not the case. Rather, it is because pensions have been treated as a political slush fund.
Back in 1999, the system was fully funded. But after a number of ‘pension holidays’ which allowed money to be diverted from the pensions into school operations (mostly teachers’ salaries), the fund stands at only 49% funded. Why wouldn’t the Teachers Union stop this madness? Illinois Policy suggests it may be because their teachers were receiving consistent pay increases of 4.2% per year, which outpaced inflation and made Chicago teachers among the highest-paid in the nation.
By now, you may have realized this is a double whammy for pension obligations; the money is not only diverted from the pension fund, but the higher salaries increase the pension liabilities because they are based on ending salary amounts.
Another contributing factor to the shortfall is the fact Chicago teachers don’t have to pay very much out of their own paycheck into the pension system. As part of a deal made with the Teachers Union in 1981, CPS pays or ‘picks up’ a majority of the cost. Teachers are required to pay 9% of their salary to the pension fund, but under the 1981 deal they only end up paying 2% of their paycheck, while CPS ‘picks up’ the remaining 7%.
Contrast this to most private employees’ retirement accounts where employers typically only match 50% of employee contributions, and usually up to a maximum of around 6% of salary. This means that private sector employees pay on average 6% of salary into their own retirement account (which is not guaranteed, like CPS pensions), while their employer pays only 3%. Many Chicago teachers retire fairly young and actually end up drawing out much more than they ever put in; something that is simply not mathematically sustainable.
So what is going to happen? Typical of Chicago and other government fiscal crises, everything possible will be done to keep the status quo and avoid the pain for as long as possible. But this has already been going on for decades, and it looks like time is finally running out. CPS bonds have been downgraded to junk, so additional borrowing will be very expensive, if not impossible. As previously mentioned, the State will also be hard pressed to come up with the money.
Making cuts to the pension system would be a good start, but unfortunately it may already be too late for that. Furthermore, when the City of Chicago tried to trim their own pension benefits last year the move was struck down by the courts because the Illinois State Constitution prohibits the impairment or diminishment of public worker retirement benefits. The only option left is a significant tax increase or some form of bankruptcy.
Nobody likes to see schools being closed and services cut, but this problem didn’t emerge overnight, and it certainly shouldn’t have surprised anyone. This is the culmination of years of mismanagement, over-promises, unsustainable raises and picking up the tab on pension contributions. This is the end to a fool’s game of vainly gorging on short-term benefits and blindly ignoring the long-term grievous consequences.
Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.