Board of Education of the City of Chicago, Illinois

Transcription

1 U.S. Public Finance Local Government General Obligation Rating Report Board of Education of the City of Chicago, Illinois Unlimited Tax General Obligation Bonds (Dedicated Revenues) Series 2016A Taxable Series 2016B Analytical Contacts: Kate Hackett, Managing Director (646) Jenny Maloney, Director (646) Gopal Narsimhamurthy, Senior Analyst (646) Karen Daly, Senior Managing Director (646) Page 1 January 21, 2016

2 Table of Contents Executive Summary... 4 Security... 4 Use of Proceeds... 5 Rating Summary... 6 Outlook: Negative... 8 Rating Determinant 1: Governance and Management Structure and Policies... 9 Organization of the School District... 9 Budget Process Balanced Budget Policy Fiscal Monitoring and Reporting Mid-Year Budget Adjustment Reserve Policy Use of One-Time Revenue Debt Management Policy Capital Improvement Plan Collective Bargaining Agreements State Fiscal Oversight of CPS State Budget Impasse Rating Determinant 2: Municipal Resource Base Population Business and Commercial Tax Base Employment Property Tax Base and Ad Valorem Limitations Rating Determinant 3: Debt and Additional Continuing Obligations Direct and Indirect Debt Alternate Revenue Bonds Variable Rate Debt Cash Flow Borrowing Capital Improvement Plan Pensions Pension Litigation OPEB Liabilities and Self-Insurance Programs Rating Determinant 4: Financial Performance and Liquidity Historical Operations Page 2 January 21, 2016

3 Use of One-Time Revenues FY 2014 Financial Operations FY 2015 Financial Operations FY 2016 Financial Operations District Liquidity Position Preliminary FY 2017 Budget Discussions Bankruptcy and Special Revenue Assessment Conclusion Page 3 January 21, 2016

4 Executive Summary Kroll Bond Rating Agency (KBRA) assigns a long-term rating of BBB with a Negative outlook to the Board of Education (Board) of the City of Chicago s Unlimited Tax General Obligation Bonds (Dedicated Revenues), Series 2016A and Taxable Series 2016B. KBRA also affirms the BBB- rating and Negative outlook on the Board s outstanding Unlimited Tax General Obligation Bonds (Dedicated Alternate Revenues). This rating is based on KBRA s U.S. Local Government General Obligation Rating Methodology published May 31, KBRA s rating evaluation of the long-term credit quality of local government general obligation bonds focuses on four key rating determinants: Governance, Management Structure and Policies, Municipal Resource Base, Debt and Additional Continuing Obligations, and Financial Performance and Liquidity Position. In addition to the four key rating determinants identified in KBRA s methodology, the BBB rating with a Negative outlook on the Series 2016 Bonds also reflects KBRA s understanding, based on consultation with KBRA s external counsel, that, in the event that pledged state aid revenues were insufficient, the pledged property tax revenues that would be collected and deposited to pay the 2016 Bonds under the Alternate Revenue structure would likely be treated as special revenues in a Chapter 9 proceeding. In the process of assigning this rating, KBRA met with Board management and reviewed multiple sources of information, including an opinion provided by the Board s special counsel relating to the security of the Series 2016 Bonds. Security The Series 2016 Bonds and the Board s outstanding Bonds are Alternate Revenue Bonds issued pursuant to the Illinois Local Government Debt Reform Act (Debt Reform Act), the School Code, authorizing resolutions adopted by the (the Board), the Bond Resolution and the Trust Indentures pertaining to each Series. The Alternate Revenue Bonds are general obligations of the Board, backed by its full faith and credit and unlimited taxing power. The Bonds are further secured and payable from the Alternate Revenues pledged by the Board. These revenues consist of Pledged State Aid Revenues received by the Board on an annual basis. Pursuant to the School Code, regardless of the availability of alternate revenues, the Board is required to levy ad valorem property taxes (Pledged Taxes) against all property within the District, without limitation as to rate or amount, sufficient to pay annual debt service obligations on all Alternate Revenue Bonds. The property tax levy is established and filed with Cook County at the closing of each Bond issue, and, if not abated, property tax receipts would be collected and deposited directly with the Bond Trustee. However, to the extent sufficient Pledged State Aid Revenues have been collected and deposited with the Bond Trustee to satisfy annual debt service obligations, the Board is required to abate the ad valorem tax levy for payment of debt service. The Board has covenanted to take all actions necessary to cause the levy and extension of additional ad valorem property taxes, as necessary, to pay debt service on the Bonds. Pledged State Aid Revenues are those payments received by the Board pursuant to Article 18 of the Illinois School Code, comprising the unrestricted portion of annual State Aid appropriations. The Board receives these revenues in semi-monthly installments from August through June and the revenues are deposited by the Board into the District s General Fund. The Board then transfers sufficient pledged State Aid Revenues to the Bond Trustee by February 15 (deposit date) to make annual debt service payments on authorized Alternate Revenue Bonds. Pledged State Aid Revenues have historically provided strong Page 4 January 21, 2016

5 coverage of annual debt service requirements. Under the Trust Indenture, the Board is required to make deposits into the Trustee-held accounts on or before the deposit date in amounts equal to principal and interest due on the 2016 Bonds scheduled to be paid in the current bond year, which is an annual period beginning on December 2 of the previous calendar year and ending on December 1 of the current calendar year. Most payments related to the Board s Alternate Revenue Bonds payable from this source are due on June 1 and December 1. This deposit schedule results in debt service requirements being satisfied anywhere from approximately 4 months to 10 months in advance of the required payment dates. Following issuance of the Bonds, there will be approximately $5.2 billion in outstanding Alternate Revenue Bonds payable from unrestricted State Aid payments. After issuance of the 2016 Bonds, pro forma coverage of FY 2016 debt service requirements from unrestricted State Aid Revenues is projected to be 2.07x and coverage of maximum annual debt service by projected FY 2016 revenues is 1.48x. Annual debt service requirements increases until 2026 and then declines. Since 2010, total General State Aid (GSA) payments to the Board have declined 18% to $707.9 million in FY 2016 due to increases in the State s calculation of local available resources of the Board and it is anticipated that these revenues will decline further. Under the Trust Indenture, the authorization to issue Alternate Revenue Bonds must include a determination by the Board that coverage from pledged State Aid revenues is sufficient in each year to provide 1.10x coverage on debt service on all authorized bonds. There is no other limit on the amount of Alternate Revenue Bonds that the Board can authorize, as long as such bonds are issued in accordance with the Debt Reform Act. The Board can also issue Alternate Revenue bonds with a parity or subordinate pledge of Pledged State Aid Revenue. Alternate Revenue Bonds issued under the Debt Reform Act are authorized through a back door referendum which provides that a notice of the bond resolution is to be published in a general newspaper and provides a 30-day public comment period. This notice includes information and timeline on filing a petition against the issuance and information on the pledged alternate revenues. Based on discussion with external counsel, KBRA understands that the Appellate Court of Illinois upheld the Alternate Revenue structure in a 2002 case involving a hospital in Wood River Township (IL) which had closed. Given that there were no pledged hospital revenues available to pay debt service, the pledged property taxes were not abated and were used to pay debt service. Under Illinois law, there is no authorization for the Board to file for protection under the U.S. Bankruptcy Code. In the event that the Board becomes authorized under Illinois law to file for Chapter 9 bankruptcy relief and actually enters a Chapter 9 proceeding, it is KBRA s understanding, based on consultation with external counsel, that the pledged property tax revenues would likely be treated as special revenues as defined in the U.S. Bankruptcy Code. KBRA believes this enhances bondholder security of the 2016 Bonds. See the Bankruptcy Assessment and Special Revenues section of this report for a more detailed discussion. Use of Proceeds The Board will use the proceeds of the Series 2016 Bonds to fund capital, projects under the Board s Capital Improvement Program, to refund certain variable rate bonds, to retire tax anticipation notes (TANS) that were used to pay swap termination payments, to restructure certain outstanding Bonds for budgetary relief and to fund capitalized interest. Page 5 January 21, 2016

6 Key Rating Strengths Strong security structure with pledge of State Aid Revenues as primary source of repayment and a dedicated property tax levy as a secondary source. Dedicated tax levy, if required, is deposited directly with the Bond Trustee. Substantial tax base with deep and diverse economic base commensurate with its position as the nation s third largest city and regional economic center. Recent actions by District management to improve budget and financial management systems and procedures. Reduction in operating expenditures of $740 million since In consultation with external counsel, the view that property tax revenues (Pledged Taxes) levied under the Alternate Revenue structure and used to pay Series 2016 Bonds would likely be treated as special revenues as defined by the U.S. Bankruptcy Code confers enhanced security. Key Rating Concerns Severely challenged financial condition due to ongoing structural budgetary imbalance. Use of nonrecurring revenues to balance operations. Structural imbalance due to a limited revenue base and a largely inflexible expenditure base, including increasing levels of pension contributions. Limited options for the Board to resolve this structural imbalance without a meaningful long-term funding solution from the State. Board currently in negotiation with teacher s union on labor agreement. Union has threatened a strike. Ongoing deterioration in liquidity position with total cash in governmental funds at $109 million at end of FY Cash position projected at $33 million for end of FY Rating Summary The seven-member Chicago Board of Education serves as the governing body of the School District. The Board members serve four-year terms and are appointed by the Mayor of the City of Chicago. District enrollment was 396,683 in FY 2015, a modest 1% decline since FY The Board operated a total of 678 schools in FY 2015, including 426 elementary schools, 121 high schools and 131 charter schools. The District is coterminous with the City of Chicago. The affirmation of the BBB- and Negative outlook on existing Alternate Revenue Bonds of the Board reflects that, while KBRA recognizes the increased budgetary and liquidity pressure under which the Board is operating, KBRA views the Alternate Revenue security structure on all existing and proposed Alternate Revenue Bonds as providing significant bondholder protection for payment of debt service. The BBB rating and negative outlook on the Series 2016 Bonds reflects KBRA s assessment of the overall credit and security structure of the Board s debt and incorporates KBRA s understanding, based on consultation with KBRA external counsel, that property tax revenues (Pledged Taxes) levied under the Alternate Revenue structure would likely be treated as special revenues as defined by the U.S. Bankruptcy Code. KBRA remains concerned as to the timeliness and probability of actions by the State to provide additional resources to the Board and notes that the Board has limited options to stabilize its finances without such action. KBRA will continue to monitor actions taken to resolve the Board s budgetary deficits. KBRA also remains concerned as to the Board s marginal cash position and will closely monitor the Board s ability to borrow for cash flow purposes. All Alternate Revenue Bonds of the Board are general obligation full faith and credit obligations of the Board, backed by its unlimited taxing power. KBRA views the Alternate Revenue security structure as providing strong bondholder protection with a pledge of State Aid as the primary source of repayment and an established property tax levy as the secondary source of security. State Aid payments are required to be deposited to the Bond Trustee by February 15 of the year prior to debt service and, in the event that a Page 6 January 21, 2016

7 property tax levy needs to be extended, the property tax collections are deposited directly with the Trustee. KBRA expects the financial performance of the Board will continue to be severely challenged based on the ongoing structural deficit in its General Operating Fund and the Board s limited options for resolving this imbalance without a meaningful long-term funding solution from the State. After closing approximately $500 million of an initial $1 billion operating deficit, the FY 2016 budget currently has a budget gap of $480 million and the FY 2017 preliminary budget shows $1.1 billion budget deficit. The Board s General Operating Fund is currently projected to end FY 2016, absent action by the State with a negative unassigned fund balance over $300 million. In KBRA s view, the Board s liquidity position has deteriorated significantly from FY 2013 to FY 2015, with available cash in all governmental funds declining to $109.1 million at the end of FY 2015, as compared to $1.3 billion at the end of FY Budget pressure was significantly increased in FY 2014, when required pension contributions to the Chicago teachers pension plan more than doubled. Pension contributions levels will continue to put pressure on operations. The Illinois General Assembly has not adopted a budget for the State for FY 2016 which began July 1, The budget impasse which has existed for the last six months has stalled any consideration of longterm funding solutions to the Board s growing fiscal problems. It is uncertain when the State budget will be adopted or what actions the legislature will take regarding the Board. Prior to the current impasse, there had been some momentum among the state political leadership for additional funding for the Board. However, it seems that the budget impasse has recently obscured the policy and funding issues related to the Board. Board management states that it is committed to balancing the District s operating budget over the next two years and addressing inefficiencies where needed. KBRA will continue to monitor the FY 2016 budget process and its implications for the financial position of the Board. Since his reelection in April 2015, the Mayor has appointed five new members to the Chicago Board of Education. He also recently appointed a new Chief Executive Officer, Forrest Claypool, and made other senior management changes. Management states that these changes signal a renewed focus and sense of urgency on reducing operational inefficiencies and stabilizing District financial operations. KBRA views the Chicago Board of Education s governance and management structure and policies as providing a sound framework for managing its financial operations and debt issuance, based on formal Board policies and procedures, including policies on maintaining a balanced budget, use of one time revenues and maintenance of fund balance reserves. However, due to the significant financial challenges, the Board has not been in compliance with many of these policies over the last several years. Since 2011, the Board has made positive changes in the budget development process and has improved its ability to track and control expenditures on a departmental level. The Board has not completed development of policies and procedures to monitor and report on financial operations on a Board wide basis, which KBRA views as a weakness. The Board has no formal process for multiyear planning for operations. KBRA will continue to monitor the Board s level of compliance with its financial management policies. Recent high profile events in the City have brought into question the practices and policies of the Police Department and, by extension, the City s central administration. KBRA will continue to monitor these events and any impact on Chicago Public School operations. KBRA continues to view the Board s direct and overlapping debt as high at $7,287 on a per capita basis and at 10.0% of full value. After the Series 2016 issuance, the Board will have approximately $6.5 billion in outstanding debt, consisting primarily of General Obligation Alternate Revenue Bonds. Overlapping debt totals approximately $13.4 billion and consists of debt issued by the City of Chicago, Chicago Park District, Cook County, and the Water Reclamation District. The Board s expenditures for debt service obligations and capital leases represented 8.2% of total governmental expenditures in FY 2015, which KBRA views as moderate. However, amortization of outstanding debt is slow with 30% repaid in 10 years and 69% in 20 years. As of December 3, 2015, the Board terminated all 10 of its interest rate swap agreements and paid Page 7 January 21, 2016

8 the related termination payments. After the issuance of the Series 2016 bonds, approximately 13.9% of the Board s outstanding debt will be unhedged variable rate debt. The Board no longer has any outstanding debt that includes covenants, defaults, termination events, increased interest rates, or penalties that can be triggered by external events. The Board is currently authorized to issue $1.07 billion in Tax Anticipations Notes (TANS) at variable interest rates for cash flow purposes and currently expects to draw down a total of $935 million during FY The Board is expected to end FY 2016 with approximately $870 million of outstanding TANs that are secured by payments of property tax collections due in August 2016, which is within the revenue recognition period for FY The FY 2016 TAN authorization amount reflects an increase from $750 million in TAN borrowing in FY The Board is currently commencing discussions with banks on securing lines of credit for FY The Board has significant obligations associated with its Teacher s Pension and Retirement Fund (Pension Fund). Based on a number of factors, including investment losses, reduced contributions and changes in experience assumptions, the funded ratio for the Pension Fund has dropped from 100% at FY 2001 to 51.5% as of FY In FY 2015, the plan s funded ratio increased slightly on an actuarial basis to 51.8%. The Board s statutorily required pension contribution in FY 2012 was approximately 4.0% of total governmental expenses. In FY 2015, the Board s pension contribution rose to approximately 11.1% of total governmental expenditures. Required contributions are scheduled to rise at an average annual rate of 2.5% through KBRA views the City s municipal resource base as strong and diversified. The City is the largest in the Midwest with a population of over 2.7 million. The employment base is well diversified across industry sectors with no one sector representing a disproportionate share of total employment. Chicago is also a significant convention and tourist destination with total visitors exceeding 50 million for the first time in The City has a large park system and extensive mass transportation network for both intra-city and suburb-city commuter travel. Based on review of the four KBRA Rating Determinants included in the KBRA Methodology for rating U.S. Local Government General Obligation Bonds, KBRA has assigned Rating Determinant ratings, as summarized below: Governance and Management Structure and Policies: A- Municipal Resource or Economic Base: AA Debt and Additional Continuing Obligations: BBB Financial Performance and Liquidity: BB Outlook: Negative The Negative outlook reflects KBRA s view that the financial performance of the Board will continue to be severely challenged based on the ongoing sizeable structural deficits in its General Operating Fund and the Board s limited options for resolving this imbalance without a meaningful long-term funding solution from the State. KBRA views the Board s liquidity position as deteriorating significantly from FY 2013 to FY 2015, with available cash in all governmental funds declining to $109.1 million at the end of FY The State budget impasse which has existed for the last six months has stalled consideration of any short term or long term funding solutions to the Board s growing fiscal problems. Prior to the current impasse, there had been some momentum among the State s political leadership for additional funding for the Board; however, it seems that the budget impasse has recently obscured the policy and funding issues related to the Board. In KBRA s view, the following factors may contribute to a rating upgrade: Page 8 January 21, 2016

9 Implementation of a long term funding solution for Board operations. Trend of structural balance in the financial operations of the Board. Sustained additional State funding for Board operations. Sustained improvement in the Board s liquidity position. In KBRA s view, the following factors may contribute to a downgrade of the rating: Continued lack of action by the General Assembly to implement a long term funding solution for Board operations. Continued structural imbalance in the financial operations of the Board. Continued deterioration in liquidity position of the Board. Inability to access liquidity for cash flow purposes. Increased use of one time revenues to balance financial operations of the Board. Passage of legislation by the General Assembly which authorizes the Board to file for bankruptcy protection under the U.S. Bankruptcy Code. Rating Determinant 1: Governance and Management Structure and Policies KBRA views the Chicago Board of Education s governance and management structure and policies as providing a sound framework for managing its financial operations and debt issuance, based on formal Board policies and procedures, including policies on maintaining a balanced budget, use of one time revenues and maintenance of fund balance reserves. However, due to the financial challenges of the Board it has not been in compliance with many of these policies over the last several years. Since 2011, the Board has made positive changes in the budget development process and has improved its ability to track and control expenditures on a departmental level. The Board has not developed policies and procedures to monitor and report on financial operations on a district wide basis, which KBRA views as a weakness. The Board has no formal process for multiyear planning for operations. KBRA will continue to monitor the Board s level of compliance with its financial management policies. The Mayor has recently appointed five new members to the Chicago Board of Education. He also appointed a new Chief Executive Officer, Forrest Claypool, and made other senior management changes. Management states that these changes signal a renewed focus and sense of urgency on reducing operational inefficiencies and stabilizing District financial operations. Recent high profile events in the City have brought into question the practices and policies of the Police Department and by extension the City s central administration, KBRA will continue to monitor these events and any impact on Chicago Public School operations. The Chicago Board of Education (the Board) acts as the primary debt issuer for the Chicago Public Schools (CPS, the District). Total K-12 enrollment was 396,683 in FY 2015, which represents a 1% decline since FY The Board operated a total of 678 schools in FY 2015 including 426 elementary schools, 121 high schools and 131 charter schools. Organization of the School District The seven-member Chicago Board of Education serves as the governing body of the School District. The Board is established under the School Code and is a non-home rule unit of government. The Board members serve four year terms and are appointed by the Mayor of the City of Chicago. The appointments do not require the approval of City Council. Page 9 January 21, 2016

10 Mayor Rahm Emanuel appointed a new Board of Education after he took office in May After his reelection to a second term in April 2015, he appointed five new members to the Board, including a new Board President. The Mayor also appointed Forrest Claypool as the new Chief Executive Officer and appointed Ronald DeNard as Senior Vice President of Finance. Both Claypool and DeNard had recently been at Chicago Transit Authority. Management states that the Board has a renewed sense of focus and urgency on improving educational programming, increasing administrative efficiency and regaining fiscal stability. Management stated they have hired a number of third party financial and operational consultants to assist in reducing administrative inefficiencies and improving financial management procedures. In June 2015, the Board retained Accenture LLC to review the internal controls related to the procurement process, including sole source vendor selection. The Board initiated this review by an external source in response to the federal indictment and guilty plea of the Board s former CEO in connection with kickbacks related to the award of a sole source Board contract. Under the School Code, the Chicago Board of Education is responsible for approving the annual budget, approving contracts (including collective bargaining agreements), levying real property taxes and establishing general policies of the Board. Since May 2011, the Board has made significant changes in terms of improving educational programming, increasing capital investment in schools and modernizing financial management systems. Over the last five years, the Board has reduced expenditures by $740 million and the Board s operating performance has been better than budget in each of those years. Senior management of the Board includes the Chief Executive Officer, Chief Administrative Officer, Chief Financial Officer and General Counsel. KBRA notes that there has been a fair amount of turnover in these positions in the last several years. The Board released its FY 2015 Comprehensive Annual Financial Report (CAFR) at the end of December 2015, notably earlier than when CAFRs were released in the last several years and symbolic of the commitment and ability of the District s new leadership team to make necessary changes. Budget Process The Board is required by the Illinois School Code to adopt an annual school budget for each fiscal year no later than 60 days after the beginning of the fiscal year. The budget development process begins in the fall for the year commencing the following June 30. The Office of Management and Budget office prepares financial projections and each department prepares their budget, which includes areas for savings and efficiencies and changes in programmatic direction. The five year Capital Plan is developed along with the operating budget. Beginning in FY 2014, the District shifted to a per-pupil funding model, called Student Based Budgeting (SBB). Each year, the total funding available for schools is determined and a per-pupil rate is calculated. School budgets are released to principals as part of a series of network meetings. Principals then prepare their budgets in conjunction with their Local School Councils. After approval, the school budgets are submitted to the Office of Management and Budget. All budget data is compiled and reviewed to develop the final budget. The Board is required to hold at least two public hearings before the budget is adopted. The Board adopts a budget for each fiscal year no later than 60 days from the beginning of the fiscal year (July 1). Balanced Budget Policy The Board is required by the Illinois School Code to balance its budget each year within standards established by the Board. The Board s current policy is that all funds should be structurally balanced including spendable prior-year fund balances that are available under the terms of the Board s Fund Balance Policy. Prior year spendable fund balances can be appropriated as one time revenues in the following budget year for one time expenditures or other purposes if the spendable fund balance exceeds 5% of the operating and debt service budget. Due to the financial challenges of the Board, the level of spendable fund balances is generally below 5%. Page 10 January 21, 2016

11 Fiscal Monitoring and Reporting Management states that the Board is in the process of implementing a system for monitoring actual financial performance compared to budget on a monthly basis on a district-wide basis. When the system is implemented, management will have the tools to make end of year projections for financial performance for the district as a whole. The Office of Management and Budget (OMB) was restructured in Management states that monthly departmental reviews of actual performance to plan have been established. However, the Board does not currently produce external reporting on departmental financial performance during the year. There is currently no written policy or procedure which dictates that Board actual financial performance compared to budget be monitored on a regular basis. Mid-Year Budget Adjustment The Board has established a funds transfer and approvals policy to govern budget adjustments during the fiscal year. All transfers requiring Board approval will be reported at the monthly Board meeting. Funds may be transferred within a fund or between programs or accounts. Transfers over $1,000 must be approved by OMB and approved by the Board. Transfers may not exceed 10% of the fund during the first half of the fiscal year and no appropriation shall be reduced below an amount sufficient to cover all budgeted obligations. The Illinois School Code authorizes the Board to make additional expenditures necessary to meet emergencies or unforeseen needs. While the amendments to the budget cannot appropriate funds that exceed budgeted revenue, a two-thirds vote from the Board can facilitate a necessary expenditure or the incurrence of a necessary liability. Reserve Policy The School Code authorizes the Board to accumulate a fund balance to provide working capital to ensure uninterrupted services in the event of budgetary shortfalls and provide for capital improvements. The Board has established fund balance policies for all governmental funds, which consist of the General Operating Fund, Special Revenue Funds, Capital Projects Fund and Debt Service Funds. For the General Fund, the policy requires the Board to maintain an assigned fund balance of between 5% and 10% of the operating and debt service budgets for the new fiscal year as a stabilization fund at the time of budget adoption. The specific level will be determined by the Board. It is the Board s policy that this stabilization fund will be utilized only for unforeseen financial emergencies with approval of the Board. In the event that this reserve decreases below 5% of budget, a plan will be presented to the Board to replenish it within 12 months. Any General Operating Fund surplus will go first towards replenishing this stabilization reserve to its minimum level. Because of the financial stress the Board is facing, the CFO and the Budget Director requested an extension beyond FY 2016 for development of the plan for replenishment. The Board sets targets for certain other operating funds, including Worker s Compensation and requires that unused balances in certain funds, including the supplemental GSA (SGSA) fund, the capital projects fund and the debt service funds, be re-appropriated in the following school year. The debt service fund balance is intended to be sufficiently funded to cover potential termination, counterparty and basis point risk. The Board reviews the status of the funds annually. A report is presented by the CFO that indicates fund balances and their adherence to policy levels with a long-term plan to replenish certain fund balances, specifically the stabilization fund to prescribed levels were the balances to be depleted. Page 11 January 21, 2016

12 Use of One-Time Revenue Board policy states that the District shall not use one-time revenues to fund ongoing expenditures. Ontime revenues may be used only to support certain one-time expenditures. Revenue shall be considered to be one-time if it was not present in the prior year and is unlikely to be available in the following fiscal year. However, due to the financial condition of the District, the current FY 2016 budget relies on one-time revenues, which the Board has approved in the passage of the FY 2016 budget. Debt Management Policy The Board has established a debt management policy that provides guidance for debt management and capital planning and sets forth the parameters for issuing debt and managing the debt portfolio. Capital Improvement Plan Pursuant to State Statutes passed in 2012, the District is required to annually develop a five year and a ten year Capital Improvement Plan which identifies specific projects and related funding. The current five year Capital Improvement Plan was passed in conjunction with the release of the FY 2016 overall budget. Collective Bargaining Agreements In FY 2016, the District employs 38,094 employees. Approximately 92% of District employees are represented by seven unions that engage in collective bargaining with the Board. Approximately 67% of District employees are represented by the Chicago Teacher s Union (CTU) and 25% are represented by the six other unions. The Board s agreement with the CTU expired on June 30, The labor agreements with the remaining six unions expire at the end of FYs 2016 and The Board is currently in the process of negotiations on a new labor agreement. In mid-december, the CTU conducted a strike vote and announced that approximately 88% of union members approved a strike. Management states that CTU cannot legally strike until May of The Board and CTU are continuing to meet with a mediator in efforts to reach an agreement. State aid formulas are based upon a school year of 176 days and State aid could be reduced proportionately if the number of school days fell below that level. The Board s current schedule for the school years includes a number of days in excess of this level. The Board is currently preparing a contingency plan in the event the teachers do strike. State Fiscal Oversight of CPS The Illinois State Board of Education requires that all school districts in Illinois submit annual financial statements for review. The State has the ability to establish a financial oversight panel for school districts in the State with populations under 500,000. Given the City s population, the District would be exempt from this process. Instead, for Chicago Public Schools, the State would need the approval of both the Mayor and the Governor to establish a financial oversight panel. State Budget Impasse The Illinois General Assembly has not adopted a budget for the State for FY 2016, which began July 1, The General Assembly has authorized and Governor Rauner has signed into law the appropriations to fund State Aid as well as State Block Grants for FY The Board is currently receiving State Aid payments on time as prescribed by the School Code and it is receiving its Block Grants on a somewhat delayed basis. Though the State s budget impasse is not significantly impacting the flow of State Aid to the District, the lack of a budget has stalled consideration of any long-term funding solutions to the Board s growing fiscal challenges. It is uncertain when the State budget will be passed and what actions the legislature will take regarding the Board. Prior to the current impasse, there had been some momentum among the State political leadership to provide additional State resources to the Board. Page 12 January 21, 2016

13 In KBRA s view, the Board s governance and management structure and policies as being consistent with an A- for this Rating Determinant, which recognizes the Board s sound framework of financial management policies and procedures but also reflects the Board s lack of compliance with many of its financial management policies due to the ongoing nature of the Board s financial challenges. Rating Determinant 2: Municipal Resource Base The City of Chicago is the third largest city in the United States by population and the County Seat for Cook County. It is ranked sixth on the Global Cities Index based on business activity, human capital, information exchange, cultural experience and political engagement. It is also home to O Hare International Airport, the second busiest U.S. airport by total passenger boardings and the only U.S. airport serving as a hub for two airlines. Population Population had declined somewhat through 2010, but appears to have stabilized, with modest increases reported in recent years. The City s population grew modestly in 2014, to 2.72 million. The age dependency ratio, at 50% in 2014, was higher than that for the County and is expected to remain below comparable state and national levels. The population is highly educated, with 36.0% of the population having a B.A. or advanced degree. This is above comparable State and national levels and reflects the nature and quality of the employment base in the City. Per capita income in the City is up 13.1% from 2010 to 2014 to levels on par with the U.S. (100.4%), but still remains slightly below that of the State (95.4%). The City continues to have a high poverty level, which is about one-and-a-half times higher than State and national levels, but not inconsistent with its urban nature. Business and Commercial Tax Base The City of Chicago is one of the world s largest and most diversified economies. The Chicago-Joliet- Naperville MSA is home to over 400 corporate headquarters, more than 60 postsecondary education institutions and 22% of the world s trading activity for futures, options, and derivatives. The City is also a significant convention and tourist destination. In the 2014 summer season, Chicago s hotel revenue increased by 7% to $858.5 million, generating a record $47.9 million in hotel tax revenue. Data compiled by the City shows the number of visitors increased by over 23% between 2010 and 2013 and by 3.5% more in This helped to support job and revenue growth throughout the region. Preliminary figures for 2015 indicate that the average monthly hotel occupancy rates in the City of Chicago increased from 75.5% to 77.2%. Page 13 January 21, 2016

14 Employment The City s employment base is well diversified amongst industry sectors with the top 10 employers representing 10.8% of total employment in the Chicago MSA in Based on U.S. Bureau of Labor and Statistics for the Chicago MSA as of November 2015, trade, transportation and utilities was the largest industry sector representing 20.0% of total employment, followed by professional and business services at 18.8%, education and health services at 15.7%, and government at 11.8%. Leisure and hospitality, manufacturing and financial services were also large contributors. Crain s Chicago Business reported that Advocate Health Care was the largest employer with over 18,500 employees, followed by the University of Chicago (approximately 16,000) and J.P. Morgan Chase Bank (approximately 15,000). After merging with Cadence Health in 2014, Northwestern Memorial HealthCare grew significantly (more than 50% increase in employees) and is now the fourth largest employer. City unemployment peaked in 2010 at 11.7%, which was well above pre-recession levels but consistent with State and national trends. At November 2015, the City s unemployment rate was at 5.6%, a substantial reduction from the 2014 annual unemployment rate of 7.7%, but higher than that of the Chicago MSA, State and the U.S. Although the City experienced significant employment losses during the recessions, and has been slow to recover, a recovery has begun. The employment base is well diversified across industry sectors; with no one sector representing a disproportionate share of total employment. City of Chicago's 10 Largest Employers as of 2014 Employer Industry # of Employees Advocate Health Care Health Services 18,556 University of Chicago Higher Education 16,025 J.P. Morgan Chase Banking, Financial Services 15,015 Northwestern Memorial Hospital Health Services 14,550 United Continental Holdings Inc Airlines 14,000 Walgreen's Co Retail 13,797 AT&T Inc. Technology 13,000 Presence Health Health Services 11,279 University of Illinois at Chicago Higher Education 10,100 Abbot Laboratories Research and Development 10,000 Total 136,322 Source: City of Chicago Comprehensive Annual Financial Report Property Tax Base and Ad Valorem Limitations Substantially all of the District s taxable property falls within Cook County and the District s tax base is coterminous with that of the City. The City has a substantial tax base that exceeds $198 billion full valuation. From a peak full market valuation of nearly $330 billion in 2006, the City s tax base has declined each subsequent year through 2013, down by approximately 40% from its peak. Notably, the decline in Equalization Assessed Valuation (EAV), the base on which the property tax rate is levied, began almost three years after the decline in full market value and reflects the lag in reassessment of properties in Illinois. From its peak in 2009, equalized assessed valuation is down 26.3% through Positively, Equalized Assessed Value increased for the first time in 2014, by 4.1%, reflecting improved real estate sales and new construction, with a similar increase in full market valuation likely in The Cook County Assessor is responsible for assessing the fair market value of all taxable property within the County. Real property is reassessed every three years, with 2015 being the most recent reassessment year. Page 14 January 21, 2016

15 For assessment purposes real property is separated into various classifications generally reflecting use, i.e. residential, commercial and industrial. The classification will determine the rate at which fair market value is discounted to determine the assessed value. Once the assessed valuation has been determined, the State Department of Revenue establishes the equalization factor for the year. The equalization factor is essentially a multiplier that brings the aggregate assessed valuation for each county to the statutory requirement of 33 1/3% of fair cash value. Based upon the foregoing, KBRA views the District s Municipal Resource base as being consistent with an AA rating determinant rating supported by its sizeable taxbase, diverse and vibrant economy and employer base. Also reflecting in the AA rating determinant rating is the City s average income levels and high poverty rates. Rating Determinant 3: Debt and Additional Continuing Obligations KBRA continues to view the Board s direct and overlapping debt as high at $7,287 on a per capita basis and at 10.0% of full value. After the Series 2016 issuance, the Board will have approximately $6.5 billion in outstanding debt, consisting primarily of General Obligation Alternate Revenue Bonds. Overlapping debt totals approximately $13.4 billion and consists of debt issued by the City of Chicago, Chicago Park District, Cook County, and the Water Reclamation District. The Board s expenditures for debt service obligations and capital leases represented 8.2% of total governmental expenditures in FY 2015, which KBRA views as moderate. However, amortization of outstanding debt is slow with 30% repaid in 10 years and 69% in 20 years. As of December 3, 2015, the Board has terminated all ten of its interest rate swap agreements. Termination costs associated with these swaps totaled $234.3 million and were paid from a combination of funds from the Board s Debt Service Stabilization Fund ($142.3 million), proceeds of Tax Anticipation Notes ($86.4 million), and various other Board funds ($5.6 million). After the issuance of the Series 2016 bonds, approximately 13.9% of the Board s outstanding debt will be unhedged variable rate debt. Although this introduces interest rate risk, the Board assumes a maximum interest rate as established in the indentures, which mitigates potential interest rate volatility. The Board has no specific policy limit as to amount of variable debt it can issue. The Board s Debt Service Stabilization Fund, which supports debt service obligations, further mitigates concerns related to the Board s interest rate exposure. After the use of the Debt Service Stabilization Fund (DSSF) to make swap termination payments in December 2015, the fund had approximately $20.5 million remaining. The Board no longer has any outstanding debt that includes covenants, defaults, termination events, increased interest rates, or penalties that can be triggered by external events. The Board has significant obligations associated with its Teacher s Pension and Retirement Fund (Pension Fund). These reflect pension obligations for certified teachers and administrators of the Board. Based on a number of factors, including investment losses, reduced contributions and changes to experience assumptions, the funded ratio for the Pension Fund has dropped from 100% as of FY 2001 (ended June 30) to 51.5% as of FY By FY 2015, the plan s funded ratio increased slightly on an actuarial basis to 51.8%. The Board s statutorily required pension contribution in FY 2012 was approximately 4.0% of total governmental expenses. In FY 2015, the gross employer contribution was approximately 11.1% of total governmental expenditures. Required contributions are scheduled to rise at an average annual rate of 2.5% through As a result, annual pension contributions will represent an increasing portion of the Board s future budgets. Total fixed expenses, including debt service, pension and OPEB obligations represented 20.2% of FY 2015 total governmental expenditures, which KBRA considers high. Direct and Indirect Debt The District will have approximately $6.5 billion in outstanding direct debt after issuance of the 2016 Bonds. Of this, $6.3 billion is in the form of General Obligation Alternate Revenue Bonds which are backed Page 15 January 21, 2016

16 by the full faith and credit and unlimited taxing power of the District, and further secured by Alternate Revenues received by the District on an annual basis The Board is required to levy an ad valorem tax against all property in the District sufficient to support annual debt service requirements on all Alternate Revenue Bonds. However, to the extent the Board deposits a sufficient amount of Alternate Revenues with the Bond Trustee to fund debt service by the specific deposit dates (no later than March 1) under the respective Trust Indentures, the Board is required to abate the property tax levy for that year. In addition to General Obligation Alternate Revenue Bonds, the Board has $160 million in outstanding lease revenue bonds issued through the Public Building Commission of Chicago (PBC). Lease payment securing these bonds are payable from a separate unlimited property tax levy. Annual rental payments are made pursuant to lease agreements between the PBC and the Board. The leases are structured so that annual rentals will exceed the PBC s debt service requirement on the Bonds. Property tax receipts attributable to the PBC leases are required to be paid by the County Tax Collector directly to the PBC Bond Trustee to satisfy annual lease payments. These lease revenue bonds are not issued by the Board of Education of the City of Chicago and are not rated by KBRA. For FY 2015, debt service and capital lease requirements represented 8.2% of total governmental fund expenditures. As previously noted, amortization of debt is relatively slow at 30.0% in 10 years and 69.0% in 20 years. After issuance of the 2016 Bonds, debt service and capital lease requirements escalate from $489.5million in FY 2016 to $784.4 million in 2026 before declining. The Debt Service Stabilization Fund, which is available to fund debt service, is not specifically pledged to, or restricted for debt service purposes and the Board has not covenanted to maintain the fund. Proceeds within the fund are intended to be used to provide a cushion for potential interest rate volatility associated with its variable rate debt. The Board is subject to a statutory debt limit of 13.8% of equalized assessed value (EAV). Alternate revenue bonds do not count against the debt limit. As of FYE 2015, the Board had only $196.5 million of debt applicable to the legal debt limit. Alternate Revenue Bonds Most of the Board s fixed rate Alternate Revenue Bonds are due June 1 and December 1, while the variable rate bonds are due March 1 with monthly interest dates. Generally, debt service is funded at least four months prior to the first succeeding debt service payment date. Under the respective Trust Indentures for most of the Board s Alternate Revenue Bonds, a determination is made prior to issuance of Bonds that the alternate revenues will provide 1.10x coverage (1.25x coverage for certain revenue sources) of debt service in every year. Alternate Revenue Bonds issued under the Debt Reform Act are Page 16 January 21, 2016

17 authorized through a back door referendum which provides that a notice of the bond resolution is to be published in a general newspaper. Alternate Revenue Bonds are issued by Illinois local governmental units because voter approval is not required to issue Alternate Revenue Bonds and these amounts do not count against statutory debt limits. Management states that all of the Board s Alternate Revenue Bonds have historically been paid from the alternate revenue sources; the Board has never had to use the backup general obligation property tax levy to pay debt service. In this report, debt service coverage ratios reflect aggregate principal and interest payments secured by each Alternate Revenue source and include all debt secured by that revenue source regardless of whether the bonds are secured by that source on a standalone basis or in conjunction with another revenue source (ex: PPRT/IGA Bonds). After issuance of the Series 2016 Bonds, the Board s direct debt consisted of $5.2 billion of Alternate Revenue Bonds secured by unrestricted State Aid revenues, $22.7 million of Alternate Revenue Bonds secured by Personal Property Tax Replacement revenues (PPRT) and $459 million of Alternate Revenue Bonds secured by revenues received under an intergovernmental agreement between the City and the Board (IGA). In addition, the Board had $430.7 million of Alternate Revenue Bonds secured by a combination of PPRT/IGA revenues, $394.5 million of Alternate Revenue Bonds secured by a combination of PPRT/State Aid and $31.7 million of Alternate Revenue Bonds secured by revenues under a City Note intergovernmental agreement. The respective Trust Indentures for the Alternate Revenue Bonds with a combined pledge of PPRT/IGA or PPRT/State Aid revenues specify the allocation of debt service by revenue source. Debt Outstanding by Pledged Security as of June 30, 2015 Security Amount Outstanding [1] % of Total General State Aid (GSA) $4,734, % Intergovernmental Agreement (IGA) $459, % PPRT/IGA $430, % PPRT/GSA $394, % Lease Revenues $196, % City Note/IGA $31, % Personal Property Replacement Tax (PPRT) $22, % Total $6,269, % [1] As of December 1, 2015, there was approximately $5.8 billion of Alternate Revenue Bonds outstanding and $179.8 million of lease revenue bonds. Issuance of Series 2016 Bonds will add approximately $507.2 million of longterm debt. Source: FY 2015 Comprehensive Annual Financial Report (CAFR) As of FY 2015, the State Aid Alternate Revenue Bonds account for 78.0% of the Board s Alternate Revenue Bonds. Historically, pledged State Aid revenues have provided strong coverage of debt service requirements and the Board has not utilized the property tax levy to support debt service on outstanding Alternate Revenue Bonds. After issuance of the 2016 Bonds, coverage of FY 2016 debt service requirements from the pledged State Aid Revenues to be received in FY 2016 is 2.08x. Coverage of maximum annual debt service from FY 2016 pledged State Aid revenues is projected to be 1.48x. The Board is required to deposit sufficient State Aid revenues 4 to 10 months in advance of actual debt service payment dates, as discussed previously. Annual debt service requirements escalate from $341.1 million in FY 2016 to $478.0 million in 2026 before declining through Since 2010, General State Aid (GSA) payments to the Board have declined 18% due to increases in the State s calculation of local available resources of the Board and are anticipated to decline further. As discussed previously, the authorization to Page 17 January 21, 2016

18 issue Alternate Revenue Bonds must include a determination by the Board that pledged revenues provide at least 1.10x coverage of debt service on all authorized bonds in each year. GSA represents the major portion of State funding for public elementary and secondary schools and is distributed through two grants to school districts. The first grant is the foundation formula aid that is calculated based on a combination of state and available local resources to meet the statutory per pupil funding set at $6,119 since As the local resources of a school district increases, as measured by growth in equalized assessed valuation, among other factors, this portion of GSA decreases. The second portion of the GSA is the state aid grant for low income students, or poverty grant, which is not offset by local available resources. Out of the total GSA, the State School Code requires that the Board dedicate a minimum of $261 million annually for supplemental programs for low income students. The annual GSA amount, net of this dedicated portion, represents the unrestricted State Aid available (Pledged State Aid) pledged to pay debt service on the Alternate Revenue Bonds. GSA payments are subject to appropriation by the State General Assembly. The State has not passed an overall State budget for fiscal year 2016 beginning July 1, However, the State did pass the portion of the budget which governs education funding to school districts, including all GSA payments and district block grant payments. To date, there has been no delay in GSA payments to the Board in FY Block Grant payments are scheduled to be paid on a quarterly basis, however, receipt of these funds has been delayed in recent years. Currently, these revenues are being received on a timeframe similar to how revenues were received in FY 2015.The Board expects to receive 100% of block grant payments by the end of the revenue recognition period for FY Since FY 2010, the General Assembly has not appropriated sufficient funds to support the statutory foundation formula aid program to school districts. As a result, the Board has not received its full statutory GSA amount. Actual funding has declined from 98% of the statutory formula in FY 2010 to 87.2% in FY For FY 2016, the Board is expecting to receive 92.1% of the statutory GSA amount. The supplemental portion relating to programs for low income students has remained consistent at $261 million since The Alternate Revenue Bonds secured by a pledge of PPRT revenues have shown strong coverage from that source. As in other Alternate Revenue Bonds, under the Trust Indenture for PPRT Bonds, these alternate revenues in amounts sufficient to pay debt service in the current Bond year (December 2) are required to be on deposit with the Bond Trustee by December 31 in order for the property tax levy to be abated under the Alternate Revenue. PPRT revenues are a revenue source for local governmental units created by the State in 1979 to replace certain personal property taxes paid by businesses. The PPRT is an income tax on corporations, utilities and other businesses. The Board s share of the PPRT is statutorily fixed at 14.0% of the statewide total of PPRT distributions to local governments and is directly deposited as received with the Bond Trustee. The history of PPRT revenues received reflects statewide fluctuations in corporate income tax. Over the last five years, PPRT revenues to the Board have increased at an average annual rate of 1.0%. FY 2016 PPRT revenues of $202.0 million provide 3.47x coverage of FY 2016 debt service on all PPRT Alternate Revenue Bonds. FY 2016 PPRT revenues provide 2.91x coverage on maximum annual debt service. The Board receives PPRT revenues on an ongoing basis throughout the year. PPRT revenues are first deposited by the State directly with the Bond Trustee to fund debt service and then released to the Board for general operations. Pursuant to State law, PPRT revenues are not subject to annual appropriation. The Board s Alternate Revenue Bonds secured by IGA (Intergovernmental Agreement) revenues are first payable from a City tax levy (School Improvement and Building Tax) levied on behalf of the Board under the 1997 Intergovernmental Agreement between the City and the Board. Under the Trust Indenture for these Bonds, these alternate revenues (here, the City tax levy) in amounts sufficient to pay debt service in the current Bond year (December 2) are required extended for collection in order for the property tax levy under the Alternate Revenue structure to be abated. In FY 2016, the pledged School Building and Improvement tax levy was $91.0 million; this levy increases to $142.3 million in the years 2019 through Page 18 January 21, 2016

19 2030. The tax levy has been at $91.0 million since It is KBRA s understanding that the pledged property tax revenues under the IGA between the Board and the City will provide at least 1.0x coverage on all obligations payable from this source. The Board also has $31.7 million in Alternate Revenue Bonds outstanding secured by tax increment revenues received by the Board pursuant to a separate intergovernmental agreement (IGA) with the City. Under the Trust Indenture for these Bonds, these alternate revenues in amounts sufficient to pay debt service in the current Bond year are required to be on deposit with the Bond Trustee by February 15 in order for the property tax levy to be abated under the Alternate Revenue structure. At the time that the City Note/IGA Alternate revenue Bonds were issued, it was determined that there was 1.25x coverage of debt service in every year. Variable Rate Debt Following the issuance of the Series 2016 Bonds and refunding of certain floating rate debt into fixed rate debt, the Board s variable rate debt obligations will consist of approximately $503 million in floating rate notes (five issues) and $464 million in floating rate private placement obligations with Dexia. After the 2016 issuance, approximately 13.5% of the Board s long term debt will be variable rate. The Board s floating rate notes are index-linked plus a spread. The reset dates are either weekly or monthly in accordance with the individual bond series. The Board s private placement obligations are also index-linked and include a 75 basis point spread. Each of the floating rate note series was issued subject to a specific floating rate period that expires in either 2017 or Management indicates that it plans to convert each of these series to fixed rate as the interest rate period expires. In the event that the floating rate notes cannot be remarketed at expiration of the interest rate period, the notes are subject to a soft put and will be subject to the statutory maximum rate under Illinois law of 9.0%. KBRA notes the potential for higher interest expenses that is present within a sizable portion of the Board s debt profile, but believes the Board has the appropriate levels of management sophistication to manage these risks. It is KBRA s understanding that documents governing all of the Board s debt do not allow for the acceleration of principal payments and do not include triggers for increased interest rates or penalties under rating triggers, which KBRA views as a positive. Cash Flow Borrowing The Board is currently authorized to issue $1.07 billion in Tax Anticipations Notes (TANs) for cash flow purposes. The Board currently has outstanding $935.0 million during FY 2016 for liquidity purposes. The TANs are funded through bank lines of credit available to the Board to support its liquidity needs. The Board is expected to end FY 2016 with approximately $870 million of outstanding TANs that are secured by payments of property tax collections due in August Property taxes are collected by the Cook County tax collector and deposited directly with the TAN trustee to pay the Notes. The FY 2016 TAN authorization amount reflects an increase from $750 million in TAN borrowing in FY The Board is currently commencing discussions with banks on securing lines of credit for FY Capital Improvement Plan Pursuant to statutes enacted in 2012, the Board is required to develop a 10-year Education Facilities Master Plan together with a rolling five-year capital budget that reflects planned spending for the current year and the subsequent four years. Facility assessments are performed by an independent entity on a biannual basis. This is used to prioritize projects for funding. A comprehensive review and recommendations are presented to the Board to help inform the annual and five-year capital budget. The draft capital budget must be released by the Board on May 1 of each year. Page 19 January 21, 2016

20 The Board published an updated five-year capital plan covering FY 2016 FY The total budget for FY 2016 capital investment was approximately $178 million. The capital improvement budget included $63 million in funding from the City of Chicago and a number of other sources. The Board budgeted to provide approximately $115 million for the FY 2016 plan, which represents a $68 million decline from the expected FY 2016 capital investment documented in the FY 2015 capital plan. Given the Board s challenged financial operations, the majority of capital investment focuses on essential repairs to alleviate overcrowding, maintain safety standards, and address other urgent building needs. In August 2015, the Board additionally approved a statutorily-authorized annual capital improvement property tax levy to fund its ongoing Capital Improvement Program. The State originally authorized this levy in 2002 but the Board needed the approval of City Council to proceed with the levy, which it recently received. The initial amount generated from this levy is expected to be approximately $45.0 million in FY The Board is currently planning to leverage this property tax levy to issue bonds for capital projects. Pensions All teachers and administrators of the District participate in the Public School Teachers Pension and Retirement Fund of Chicago (Pension Fund). The Pension Fund is a single-employer, defined benefit system established by the State. As of June 30, 2015, there were 63,284 members in the Pension Fund. The Pension Fund is governed by a 12-member Board of Trustees. Six of the trustees are elected by the active teacher members, three are elected by the retired teacher members, one is elected by active principals and administrators, and two are appointed by the Board. The Board of Trustees is authorized by State Law to make investments for the Pension Fund and administer benefits. All other employees of the District participate in the Municipal Employees Annuity and Benefit Fund of Chicago (the Annuity Fund). Contributions to the Annuity Fund are made by the City of Chicago and the Board has no funding obligations associated with the Annuity Fund. Funding for the Pension Fund comes from employee and employer contributions, both of which reflect a fixed percentage of the employees annual salary. The State Pension Code provides for actuarially determined funding levels which will result in assets in the Pension Fund reaching 90% of liabilities by Although the funding requirements are actuarially based, they do not reflect GASB principles for full funding. In April of 2010, the State passed legislation that revised the pension funding provisions that had previously been in effect and provided some short-term relief on annual pension contributions. The legislation: i) reduced the Board s contribution requirements for fiscal years , ii) extended the statutory deadline to bring the ratio of the actuarially determined value of assets to its actual value to a 90% funding ratio from 2045 to 2059, and iii) established a two-tier benefit system for new employees who would became members of the Pension Fund after January 1, The new tier provided a lower level of benefits and raised the minimum retirement age by 7 years to age 67. It also reduced the cost of living adjustments (COLA) to the lower of 3% or half the change in the CPI for all urban consumers. The benefit calculation was changed to reflect eight of the last ten years of employment with a cap of $106,800 on the salary for which a pension would be calculated. As of June 30, 2015, the Pension Fund had assets valued at $10.3 billion, on an actuarial basis, and accrued liabilities of $19.9 billion, for a funding ratio of 51.8%. This is in sharp contrast to a funding ratio of 100% back in Reductions in the funding ratio reflect a number of factors including: i) investment losses incurred after the dotcom era in 2001 and 2002 and the last recession in 2009 and 2010, ii) underfunding of employer contributions, especially during the pension holiday of , iii) increases in the level of normal benefits over time, and iv) recent changes in experience assumptions like the assumed rate of return. Page 20 January 21, 2016

21 Beginning in FY 2015, the Board also reports the valuation results of the pension fund under the requirements of the Governmental Accounting Standards Board (GASB) Statements 67 and 68. As of June 30, 2015, the pension fund s fiduciary net position as a percentage of the total pension liability was approximately 51.6%. The pension plan s single equivalent discount rate was 7.75%, which is equal to the investment rate return assumption for the plan. As a result of the 2010 legislation discussed above, the Board s required contributions to the Pension Fund increased significantly in FY Gross contributions increased from $305.9 million in FY 2012 to $722.8 million in FY The Board s gross contribution includes both the statutory requirement as well as the 7.0% portion of employee contributions made by the Board. In FY 2015, the Board s gross contribution represents approximately 11.1% of total governmental expenditures. Inclusive of contributions from the State of Illinois, participating charter schools, and various federal grants, the total contribution to the plan in FY 2015 was $826.2 million. Based on current projections, the Board s required contributions will further increase at an average annual rate of 2.5%. The State Pension Code requires the State to contribute a small portion of the annual contribution, which for 2015 is 1.75% of the Board s total contribution. The State can also make additional discretionary contributions from annual appropriations. This is in furtherance of provisions in the State Pension code regarding the intent of the State to make annual contributions equivalent to 20% to 30% of the amount of annual contributions it makes to the other teachers retirement system in the State. As of June 30, 2015, approximately 16,372 employees of the District participate in the Municipal Employees Annuity and Benefit Fund (MEABF). MEABF is a cost-sharing multi-employer defined benefit pension plan managed by the City of Chicago. Active participants of MEABF are required to contribute 9.0% of pensionable salaries to the plan. The Board has historically voluntarily paid 7.0% of this contribution on behalf of participating employees; however, the Board is phasing out this contribution over the next five years. In FY 2015, the Board s contribution amounted to $38.6 million. Pension Litigation There is currently litigation pending at the State Supreme Court in response to pension reforms enacted by the State of Illinois and the City of Chicago. This litigation is not directly relevant to the Chicago Public School Teachers Pension and Retirement Fund or the reforms that became effective January 1, If, however, the State Supreme Court ultimately rules in favor of the State and City reforms, it is KBRA understanding that the Board may be able to implement further reforms that could reduce future benefits and/or contribution levels and ultimately help to improve the funding status of its Pension Fund. OPEB Liabilities and Self-Insurance Programs The Pension Fund administers the Boards retired employee Healthcare Insurance Program (HIP) which CPS funds on a pay-go basis. State law limits the amount that the Pension Fund can contribute to the Health Insurance Program to $65 million annually. By statute the Pension Fund cannot contribute more than 75% of the total health care premiums for retirees. For FY 2015, the annual required contribution was $65 million. Page 21 January 21, 2016

22 Total fixed costs for debt service, required pension contributions and pay-go OPEB contributions was $1.3 billion in FY 2015 and represented 20.2% of total governmental expenditures. Based on the foregoing, KBRA views the Board s Debt and Continuing Obligations profile as being consistent with a BBB Rating Determinant rating. This reflects the Board s relatively high debt levels and high overall fixed cost structure. KBRA views the Board s declining exposure to variable rate debt positively. This is somewhat offset, however, by the Board s growing direct debt levels and rising pension contributions. Rating Determinant 4: Financial Performance and Liquidity KBRA views the financial performance of the Board as continuing to be severely challenged based on the ongoing structural deficit in its General Operating Fund and the Board s limited options for resolving this imbalance without a meaningful long term funding solution from the State. After closing approximately $500 million of an initial $1 billion operating deficit, the FY 2016 budget currently has a budget gap of $480 million and the FY 2017 preliminary budget shows $1.1 billion budget deficit. The Board s General Operating Fund is preliminarily projected to end FY 2016, absent meaningful action from the State, with a negative unassigned fund balance of over $300 million. In KBRA s view, the Board s liquidity position has deteriorated significantly from FY 2013 to FY 2015, with available cash in all governmental funds declining to $109.1 million at the end of FY 2015, as compared to $1.3 billion at the end of FY The Illinois General Assembly has not adopted a budget for the State for FY 2016 which began July 1, The budget impasse which has existed for the last six months has stalled consideration of any short term or long term funding solutions to the Board s growing fiscal problems. It is uncertain when the State budget will be passed. Prior to the current impasse, there had been some momentum among the state political leadership for additional funding for the Board; however, it seems that the budget impasse has recently obscured the policy and funding issues related to the Board. Board management states that the Board is committed to balancing its operating budget over the next two years, and addressing inefficiencies where needed. KBRA will continue to monitor the FY 2016 budget process and its implications for the financial position of the Board. Over the last several fiscal years, the Board has utilized a range of one-time revenues to balance operations, including use of various operating reserves, a shift in revenue collections date and a change in the Board s revenue recognition period. Budget pressure was significantly increased in FY 2014, with a large increase in required pension contributions to the Chicago teachers pension plan and pension contributions levels will continue to put pressure on operations. In FY 2016, pension contributions represent 11% of FY 2015 total governmental expenditures and contributions are scheduled to increase at an annual average rate of 2.5%. In KBRA s view, the Board s ongoing structural deficit is a function of a limited revenue base over which the Board has limited control and a high, largely inflexible expenditure base, including increasing levels of pension contributions. Since 2011, Board management has improved its financial management systems and reduced operating expenditures more than $740 million, mostly in administrative and operational areas. However the Board has limited ability to increase its revenues and, in keeping with the mission to improve the quality of the District, has not significantly cut spending in education programs. The General Operating Fund is the primary operating fund of the Board and is the focus of KBRA s review. The Board budgets and operates on a modified accrual basis of accounting and the fiscal year starts July 1. Page 22 January 21, 2016

23 Historical Operations Since FY 2010, the Board s financial operations on a modified accrual basis have shown both operating surpluses and deficits and the level of available fund balance has fluctuated. The major revenue sources for the General Operating Fund include property taxes, State Aid, federal aid and personal property replacement taxes (PPRT). Property taxes accounted for 46% of General Operating Fund revenues in FY Since 1995, the Board has become subject to the provisions of the Property Tax Extension Illinois Limitation Law (PTELL) which limits the annual growth of the property tax levy to the lesser of 5% or the increase in CPI. Increases in equalized assessed valuation attributable to new construction are not subject to the limit. The Board has levied the maximum allowable increase in property taxes since Property taxes are collected by Cook County and remitted to the District. Page 23 January 21, 2016