By Karen Pierog

CHICAGO (Reuters) - A law aimed at shoring up two of Chicago's financially shaky public worker retirement systems violates pension protections in the Illinois constitution, a judge ruled on Friday.

The ruling is a setback for Mayor Rahm Emanuel who has repeatedly said he will not raise taxes without pension reforms. It also gives Illinois' public labor unions more leverage to resist pension cuts.

In a written opinion, Cook County Circuit Court Judge Rita Novak rejected Chicago's arguments that the 2014 law results in a net benefit because it will save the municipal and laborers' retirement systems from insolvency and that the law was backed by a majority of affected labor unions. She also took issue with Chicago's contention that it was not legally on the hook to pay pensions.

"The city's argument, premised on the notion that participants have no right vis a vis their employer to expect payment of their pension benefits, is fundamentally at odds with the supreme court's teachings," Novak wrote.

Pension payments are devouring bigger chunks of budgets for Illinois and Chicago and both face crippling spending cuts or big tax increases if those payments are not reduced. Illinois has the worst-funded pension system among U.S. states along with a $105 billion unfunded pension liability, while Chicago's unfunded liability for its four systems is $20 billion.

The city contended that without the law, the two pension systems would run out of money within 10 to 13 years and that under Illinois law, payments to retirees would be the obligation of the pension funds, not Chicago. Labor unions and retirees who sued over the law claimed it violated the state constitution's pension clause.

Chicago will appeal Novak's ruling up to the Illinois Supreme Court, according to a statement from the city's top staff attorney.

“While we are disappointed by the trial court’s ruling, we have always recognized that this matter will ultimately be resolved by the Illinois Supreme Court," said Stephen Patton.


The law, which took effect on Jan. 1, requires Chicago and affected workers to increase their pension contributions and replaces an automatic 3 percent annual cost-of-living increase for retirees with one tied to inflation. Those increases are also skipped in some years.

Novak's ruling also cited the Illinois Supreme Court's sweeping decision in May that found public sector workers have iron-clad protection against pension benefit cuts. That decision came in litigation over a 2013 law that reduced benefits for workers in state retirement systems.

Anders Lindall, a spokesman for the American Federation of State, County and Municipal Employees Council 31, called Friday's ruling a victory for city workers and retirees who receive pensions of $32,000 a year on average.

Some of the $345 million of tax-exempt bonds Chicago sold last week traded lower in the wake of the ruling, widening the spread over Municipal Market Data's benchmark triple-A yield scale to a hefty 275 basis points for bonds due in 2039 from an original spread of 253 basis points.

In documents for that bond sale, Chicago warned that the city's already-low credit ratings could fall further if the law is voided. Moody's Investors Service in May lowered the city's rating to "junk." Standard & Poor's earlier this month cut the rating to the low investment-grade level of BBB-plus because of a chronic structural deficit.

S&P said on Friday it will "likely" lower Chicago's rating within the next six months "if the city fails to incorporate pension contributions in a structurally balanced manner."

Arlene Bohner, a Fitch analyst, said a ruling by the state supreme court ultimately tossing out the law "could very well lead to a downgrade." Moody's called Novak's ruling "credit neutral" at this point.

(Additional reporting by Karl Plume in Chicago; editing by Chizu Nomiyama and Matthew Lewis)