Chicago teeters closer to junk bond status under weight of pension costs

Chicago continued its tumultuous trek toward junk bond status today when Moody’s announced it was downgrading the city’s credit rating and delivered a scathing report that didn’t mince words: the city is on the road to financial insolvency, and pensions are driving them there.

Chicago’s credit rating, which previously stood at A3, was downgraded one notch to Baa1. Even with the downgrade, the city’s rating still sits slightly above Detroit’s.

But forgive the city’s residents for not celebrating—Chicago now has the second worst rating of any city in the country.

In it’s report, Moody’s laid out the logic behind the downgrade, and it all came back to one thing: the funding of the city’s pensions, or rather, the lack thereof. From the report:

Challenges:

– Substantially underfunded pension plans carried a Moody’s ANPL of $32 billion (net of enterprise support), equivalent to 8.0 times operating revenue (revenue in the General Fund, Debt Service Funds, and Pension Funds) in fiscal 2012

– Cumulative underfunding of pension payments relative to actuarially annual required contributions (ARCs) exceeded $7 billion in the period of fiscal 2003 through fiscal 2014; continued underfunding provides the city with near term operating flexibility but hastens the plans’ trajectory toward insolvency, which in turn could present extreme budgetary crises for the city

– Despite the prospect for pension cost reductions brought about through state legislation, unfunded liabilities will likely remain large; furthermore, the Illinois Constitution explicitly protects pension benefits, raising the possibility that an attempt to reduce accrued benefits of existing members would face litigation

– City management’s legal ability to increase revenue to fund pensions at actuarially sound levels is offset by practical and political limitations to immediately raising taxes so as to support actuarially sound contributions to pension plans

– Operating budget is constrained by fixed costs, namely debt service and pension contributions, which comprise a growing percentage of the city’s operating budget; annual pension costs are set to increase by $600 million in budget year 2015

– Direct and overall debt and pension burdens are well above average and growing; the substantial funding needs of overlapping governments exacerbate the practical limitations of generating new revenue from a shared tax base

In other words: Chicago maintains a dangerously unhealthy pension system, and state laws handcuff the city’s ability to do anything to fix it.

The city’s previous rating was A3, which indicates a strong capacity to meet financial commitments but a susceptibility to adverse economic conditions.

The new rating, Baa1, indicates an adequate capacity to meet financial commitments, but comes with the anticipation that adverse economic circumstances will likely lead to an inability to pay its commitments.

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