The conclusion to Detroit’s epic bankruptcy has been met with a mixture of boosterism and wariness. Equating bankruptcy with opportunity, the local media and community leaders now see Detroit’s future as brighter than at any time in recent memory. Others emphasize how much risk remains on the horizon, particularly with regard to pensions.Neither side has it completely right. The two greatest challenges Detroit city government now faces are lingering pension debt and unreformed operations. At the same time, Detroit enacted an overhaul of its retirement system in bankruptcy that stands as a major operational reform. Detroit steered itself into insolvency by mismanaging pensions in every possible way, but it now has in place benefit plans that rank among the best-designed in the public sector. It’s critical to not oversell the Detroit bankruptcy, but this good news about pensions deserves more attention than it has received at this early stage in the post-mortem analysis.The MalfeasanceHad Detroit never been in the defined benefit pension business, it probably would never have gone bankrupt. Even with the collapse of the auto industry, rising poverty, blight and crime, the white and black middle class’ flight to the suburbs, and a legendarily dysfunctional city government, bankruptcy was not inevitable. Federal law makes it extremely difficult for cities to enter bankruptcy by imposing a cash-flow insolvency test. Massive debt is not enough. A city must be literally running out of money in order to break its contractual debt obligations in court. This is one of the most important reasons why so few of America’s many distressed cities actually go bankrupt.But Detroit was running out of money, and pensions were at the root of the problem. When Detroit filed for bankruptcy in June 2013, 60 percent of its $18 billion in obligations it listed, and 92 percent of its unsecured obligations, were somehow pension-related. The $3.5 billion in unfunded pension liabilities was just the beginning. There was also the $5.7 billion owed for retiree health insurance. This benefit, known as “OPEB” (other post-employment benefits), is common throughout the state and local sector because of the prevalence of defined benefit pensions. Pension eligibility often begins 10 or more years before Medicare eligibility, creating pressure for government employers to continue to provide gap health coverage for the years between retirement and Medicare. (Many governments also supplement Medicare after it kicks in at 65.) Detroit owed another $1.7 billion from a spectacularly imprudent attempt to backfill its pension system with funds borrowed from capital markets.This service-insolvent city couldn’t keep up with its present needs or invest in its future because of how much it was spending on the past. According to the figures used by Detroit to justify its Ch. 9 petition, “legacy costs, debt and other obligations” were set to approach 2/3 of expenditures by 2017, meaning only 1/3 of the meagre tax revenue collected by the city would actual go towards services. After having defaulted on a debt payment, Detroit filed for Chapter 9 bankruptcy protection in June 2013 to avoid its creditors.Detroit’s situation resembled that of the state and local sector as a whole in that it owed more for retirement benefits than bonded debt, and that rising pension costs were crowding out services in its budget. However, Detroit was exceptional in the degree of its fiscal distress and the amount of gimmickry, corruption and outright mismanagement through which it brought about its downfall. Where to start? Former City Treasurer Jeffrey Bealey, who served on both of the city’s pension boards, accepted thousands of dollars’ worth of gifts from people with business before the boards. Swaps related to the pension-borrowing transaction wound up costing Detroit $50 million annually (last year’s budget for the Detroit Public Library was $34 million) and nearly caused the city to lose access to its casino revenues after putting them up as collateral. Detroit’s General Retirement System (GRS) exacerbated its underfunding problems through its so-called “Annuity Savings Fund” and “13th check” programs. The former allowed employees to set up and contribute to individual accounts that were then credited with at least 8 percent in annual investment return even in years when the system lost money. The latter was for retirees, to whom the board trustees distributed a portion of any above-benchmark annual investment returns. Had the GRS not sacrificed $2 billion through these two programs, it might now be fully-funded or close to it, and beneficiaries would have faced only minimal risk of benefit cuts in bankruptcy.Bad News: The DebtThus, when Kevyn Orr was appointed Emergency Manager of Detroit in March 2013, he had good reason to focus on pensions. To understand what happened to Detroit’s pension plans in bankruptcy, it’s necessary to distinguish between how the existing debt was dealt with, and the reforms applied to the benefit programs on a going forward basis.As mentioned above, Detroit filed for bankruptcy to cut debt and free up more money for services. Orr and his team then set an additional goal of exiting bankruptcy by the fall of 2014 when, under state law, his term as emergency manager was set to conclude. Many viewed the second goal as unrealistic, but Detroit managed to settle with all major creditors by October. The “fast track” pace came at a price, however. Independent expert Martha Kopacz, who Judge Steven Rhodes hired to evaluate Detroit’s bankruptcy plan, argued that a slower pace could have led to more leverage with creditors and more time to focus on operational reforms.Settling with retirees required persuading them to agree to cuts to their accrued pension benefits. They ultimately did so because of the so-called “grand bargain” designed by Judge Gerald Rosen, the chief mediator of the case. Using a remarkably liberal interpretation of what it means to “mediate,” Rosen persuaded a series of foundations, the Detroit Institute of Arts (DIA), and Michigan state government to contribute over $800 million for the purpose of minimizing pension cuts and protecting the assets of the DIA from being sold to satisfy creditors. Thanks to these funds, Detroit’s bankruptcy plan contained only modest pension cuts (for non-uniformed workers, 4.5 percent, along with the elimination of cost of living increases and a partial clawback of some of their Annuity Savings Fund earnings; for uniformed workers, no cuts to the basic benefit, just a reduction to cost of living increases). 82 percent of uniformed pensioners voted to approve the pension cuts, and 73 percent of non-uniformed pensioners. This was a big win for the city, as it defused the threats of a drawn-out appeals process and public relations nightmare about cruelty towards retirees.Writing in the Weekly Standard last spring, bankruptcy scholar David Skeel argued that the grand bargain cast the entire bankruptcy plan’s legality into question. Federal law looks askance at giving grossly unequal treatment to creditors with an equal claim to repayment. By denying bondholders any share of the proceeds from the grand bargain, Skeel said, Detroit had engineered an illegal windfall for pensioners. Some of Detroit’s Wall Street creditors made a similar “ring-fencing the assets” argument, though they all eventually settled.But if the legal controversies over Detroit’s plan have subsided, major questions remain about its fiscal “feasibility”. Detroit is essentially going on a “pension holiday”—it’s going to free up money for services by, for now, not making any general revenue appropriations to pay down pension debt. Only in 2023 will it begin to start funding its pensions from its own revenues like a normal city does. No one’s saying the grand bargain funds should have been refused, but a return to normalcy, fiscally and administratively speaking, can’t happen soon enough for Detroit. More troublingly, the bankruptcy plan empowers the pension boards to restore benefits cut in bankruptcy should investments outperform their benchmark pace of reaching a 75 percent funding level by 2023 (78 percent for uniformed). This provision recalls the old 13th check program plans and is pure folly. All “excess” returns should be plowed back into the systems, and full funding reached as soon as possible.Good News: The New PlansBy contrast, the pension reforms Orr enacted for current and new workers are exemplary. Orr froze the old plans—no workers would continue to accrue benefits through them. The new “hybrid” plans which replaced them resemble traditional defined benefit plans in offering a certain percentage of final salary. But, like a 401k-style defined contribution plan, the benefit is no longer fully guaranteed. When the plans dip below full-funding, they begin to set off a series of triggers requiring higher contributions and benefit reductions from beneficiaries. Only after all these steps (seven for non-uniformed, nine for uniformed) have been exhausted will taxpayers be required to increase contributions. Detroit also increased the plans’ sensitivity to the risk of underfunding by adopting conservative actuarial assumptions, most notably a 6.75 percent assumed rate of return on investments. Requiring employees and retirees to bear most of the risk associated with underfunding will force them to be advocates for better pension management, instead of co-conspirators in fiscal plunder.Detroit’s hybrid plans may be unprecedented in the public sector. The 2011 Rhode Island pension reform moved employees to “stacked” benefit plans: a scaled-backed defined benefit plan with a full taxpayer guarantee, supplemented by a defined contribution component. But the more important difference between this form of “hybrid” plan and Detroit’s is that the legal status of the Rhode Island pension reform remains unsettled three years after it was passed. Rhode Island Treasurer Gina Raimondo, the architect, was determined to maximize savings, and so she applied the changes to current workers, not just future employees like most pension reforms. This made the reform susceptible to a union challenge based on contract law. At bare minimum, unions now have a strong chance at forcing a negotiated settlement. In Detroit, by contrast, bankruptcy created a quasi-apocalyptic, all-bets-are-off mindset, which Orr ably made use of to push through and secure radical change.Extensive coverage and commentary has been devoted to what “precedents” the Detroit bankruptcy may set for other struggling cities. But even prosperous cities have much to learn from Detroit’s new benefit plans. Despite the wave of pension reforms that followed the 2008 financial crisis, the traditional defined benefit plan remains standard for state and local government employers. The benefit is “defined” because it’s guaranteed by taxpayers even in the event of underfunding, and most state and local systems are still underfunded. “Crowd out” resulting from pension costs rising at a rate above annual revenue growth helps explain why governments have been so slow to rehire since the recession. State and local governments as a whole are still 600,000 jobs below their August 2008 peak of 19.8 million; the private sector, by contrast, passed its precession peak in March of this year. Crowd out also has been a factor in why, despite record low interest rates and recovering revenues, capital investment is in decline. According to the Municipal Securities Rulemaking Board, year-to-date new municipal issuance is $312 billion, compared with $336 billion by this time last year. In other words, elevated pension expenditures have prevented taxpayers from receiving benefits proportionate to recent years’ improvement in fiscal and economic conditions.Within the small but growing scholarly literature on municipal bankruptcy, there is significant dispute over whether Chapter 9 can or should enact structural reform in addition to debt adjustment. Sometimes, a bankrupt municipality really does have an isolated debt problem (Orange County, CA in 1994). But in the recent spate of high profile Chapter 9 cases (Stockton, San Bernardino, Detroit), deeper changes are called for, particularly with regard to pensions. Bankruptcy comes at a steep cost and carries enormous risks, but some reforms do seem to be easier to enact under extraordinary conditions than ordinary ones.
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Published on: December 4, 2014
Pension WarsDetroit’s Bankruptcy and Its Painful Reforms
While Detroit is not out of the woods yet, its experience points to the fact that troubled cities’ most needed structural reforms may only be possible under extraordinary circumstances.