Don’t Stop Believin’
Just
a city boy
Born
and raised in South Detroit
He
took the midnight train goin’ anywhere
The headline news just one month ago, now usurped by the
crisis in the Middle East, was that the City of Detroit had filed for
bankruptcy claiming to be unable to meet the payments to its creditors. One of the questions asked when it first
filed was whether or not it was legal for a city to file for bankruptcy. That question seemed to be answered on a
federal level when the city of Stockton was allowed to file last April. However, a state judge ruled that the Detroit
bankruptcy petition violates the Michigan state constitution.
The
declaratory judgment came in lawsuits filed by Detroit pension funds, retirees
and workers, which sought to prevent a bankruptcy filing that would ultimately
impair retirement benefits in violation of constitutional protections for those
benefits.
Legally Detroit is at
an impasse now on its bankruptcy proceedings.
While the legal wrangling is of interest to many, of more interest to me
as an economist is the role that pension funds played in getting Detroit to
where it is. Let’s start by exploring
pensions in general, then look to the specific case of Detroit, and finish with
a little speculation about how far this might go in terms of other municipalities
meeting their pension obligations.
There are essentially two kinds of pension plans, a defined
benefit plan and a defined contribution plan.
In a defined benefit plan the benefit that a retiree receives is based
on some formula that typically includes years of service times some multiplier
per year times some final earned value.
For example, a pension may pay 2.5% per year worked times the last
year’s earnings. If someone worked
thirty years then their benefit would be 30 (years) * 2.5% (per year) * last
year’s earnings or 75% of their last year’s earnings. There are many variations on this in terms of
the multiplier or last year versus average of the last x number of years. However, all defined benefit plans carry this
in common -- Once you are retired, your employer/sponsor will pay you that
benefit for as long as you live. The
complete liability for the program falls on the employer/sponsor.
In a defined contribution plan either you, your employer, or
in combination make a defined contribution each month into a pension plan. Typically your contribution is pre-tax. Once you retire, you have that pot of money
and can pretty much choose to draw it out any way you like. Once you retire, your employer/sponsor has no
liability for you. You are on your own.
The defined benefit plan is going the way of the dinosaur in
the private sector. Employers do not
want that liability. Shareholders in public corporations do not want it either
as there is uncertainty about the present value of that future liability. The defined benefit plan, however, is alive
and well in the public sector as 88% of public employees are covered by a
defined benefit plan. The municipal
employees of Detroit are “covered” under this type of program. There are charges of abuse of the system in
that employees will work a lot of overtime their last year of work so that the
base for their pension is higher. While
that is no doubt of some concern, it is not the major reason why Detroit and
other municipalities are in trouble. A
question you may ask yourself is, if I promise to pay you x number of dollars
per year until you die, how much money will I need to set aside? Good question, even if I had to prompt you to
ask it.
Defined benefits programs can either be funded or
unfunded. In an unfunded program no
assets are set aside and the employer pays out of current revenue as
needed. This is also known as PAYGO for
pay as you go. Up until the early 1970s
about all defined benefit plans were unfunded.
Companies figured that revenue would keep growing and they would be able
to pay pensioners out of those funds. This
is essentially how Social Security works but we’ll save that for another day. As retirees started living longer the
liability of the pension payments increased and the extent of underfunding
grew. Recognizing the impending storm
the Employee Retirement Income Security Act (ERISA) was passed in 1974 that put
restrictions on private pension funds and also required them to participate in
the Pension Benefit Guaranty Corporation (PBGC) an independent agency of the
government that insures pensions. One of
the restrictions imposed on private pension funds by ERISA was that an unfunded/PAYGO
system would no longer be allowed. Thus
corporations, and probably also their employees, have to contribute to a
pension fund even if it is a defined benefit program. By the way, General Motors went from a
defined benefit program to a 401(k) in the spring of 2012. ERISA does not apply to public pension funds
and they are not insured by the PBGC.
Back to Detroit.
Detroit has a defined benefit program that is neither unfunded nor
funded. It has what is the most common
type of defined benefit fund today, an underfunded
one. Back to our question above, how
much money needs to be set aside to fund the defined benefit obligation of
Detroit and other municipalities? The
biggest uncertainty in all of this is the expected rate of return on the funds set
aside to make future payments from. If I
expect to get, say, an 8% rate of return, I need to set aside a lot less than
if I expect a 5% rate of return. Detroit’s impending financial problems led
Governor Rick Snyder to appoint Kevyn Orr as Emergency Manager of Detroit’s
finances. Mr. Orr, a former bankruptcy
attorney for the Jones Day law firm in Washington DC, says the pension fund
has underestimated the present value of its future liabilities by assuming a nearly 8% return on assets. Not all of Detroit’s problems are related to
its pension obligations. The city’s
population is half of what it was in the 1960s which has obviously reduced tax
revenue. It also has a history of
corruption and overspending in awarding contracts, former Mayor Kwame Kilpatrick
is awaiting sentencing in October 2013 for a pattern of extortion, bribery and
fraud.
Still, the pension fund is a large contributor
to the problem. Mr. Orr says Detroit has
$18 billion in debt which includes $3.5 billion in unfunded retirement
liabilities. The managers of the city pension fund said in a news release earlier
this summer that they are no more than $700 million short. Still not a comforting thought. Their disagreement hinges on the expected
return the pension fund will earn and thus what discount rate to use when
bringing future liabilities back to their present value. A conclusion on how
underfunded the pension funds are has more than academic implications as it
will impact how much of a haircut both bondholders and the city’s pensioners
are going to be asked to take.
News about Detroit’s troubles have temporarily taken a
backseat to the conflict in the middle east and A-Rod’s steroid use but it is
not a problem that will go away by ignoring it.
And, it is not Detroit’s problem alone.
Cities across the country with defined benefit programs assume they are
adequately funded because they are assuming relatively high returns. An argument over the appropriate discount
rate to arrive at the present value of the pension liability will determine in
large part what the payout of pension funds will be. The Government Accounting Standards Board
last year called for underfunded pension plans to use a discount rate in the 3
to 4 percent range. That is well less than most pension funds expect to earn
and, if followed, will likely lead to pensioners receiving less in
benefits. Don’t expect this issue to be
resolved any time soon. As unglamorous
as a defined contribution fund may be, at this point, be happy if you have one.
Looking into the future and pegging rates with a declining population contributing to the fund and rates moving all over the place sounds like these funds to to add a hedge fund. Fortunately I am a small business and my fund is my company. My wife's fund is managed by the State of Florida and it survived the recession in good shape. She has 6 months to go.
ReplyDeleteDetroit like many US cities has many aggravating factors as you stated like corruption and promising more than they could deliver with a declining populations....so on a larger scale what does that mean for those who follow the Boomer generation? What does it mean to the Boomers who outlive the actuarial calculations?
Dear Jerry. I am unfortunately a political junkie—most of my TV watching is the various poli-talk shows of all stripes so I learn both sides.
ReplyDeleteAlthough your blog pertained only to Detroit, it is not the only city underwater—some notables but not all = San Bernadino, CA; Stockton, CA; Jefferson County, AL. Some that can follow = Chicago, Philadelphia, and New York. Underfunded pensions aside, the major cause of these cities’ problems was too much spending in spite of heavy income, city, county et al tax burdens. I appreciate your focus, as an economist, on the inner workings and hidden mechanisms of pensions plans—and the thorough explanations—relative to Detroit—and I assume you intentionally intended to keep the scope narrowly on that topic and know that its pension situation was but one cause—or symptom. I assume further you did not want to venture into the political arena, so with all due respect, please allow me.
Spending in excess of excessive tax burdens is the trade mark of the Democrat Party and is a common denominator of all aforementioned cities with the possible exception of Jefferson County—it voted for Obummer in both last elections but has slightly more Rs than Ds.
Listening to the TV talking heads during the Detroit reports most Rs specifically blamed Democrats for its ruin: Elected by liberals, run by liberals, for the benefit of liberals. Ds, on the other hand, deflected blame by saying macroeconomic forces (e.g. the auto industry's failure to produce competitive products but no mention of its legacy costs) were the cause, particularly former MI governor Jennifer Granholm (D).
I would have like to have seen in your blog mention of the mathematical truth that a larger number (spending) subtracted from a smaller number (tax receipts) always results in a negative number (deficits, bankruptcy).
Charly, you on it. Let's say that a local poli has two contributors who need fat contracts for their companies. So the poli pushes through some public work stuff and his two buds are the low bidders. what next? We the program had to be funded buy some form of revenue which in turn was supported by tax dollar projections. Locally, property taxes are a primary form of income for governments. What happens when values decline, people move out and some natural catastrophe? The supporting funding source goes down and the risk of the bond goes up. The city cannot cover it by just their operating cost so they lay off a few low level people and the adventure begins.
ReplyDeleteHi, James. I scanned an article in Bloomberg/BW that said (I didn’t read the entire article) Detroit’s muni’s are not too badly affected/hurt by the bankruptcy—has something to do with the bankruptcy situation/laws. So, as you say, the funding source goes away—then how do the muni’s get repaid? I don’t see how the bond holders (mostly Goldman Sachs I think) get repaid—another taxpayer bailout in the making? Let’s see if Kevyn Orr has rabbit up his sleeve.
ReplyDeleteCharles, unlike the US Government, the City of Detroit does not have such deep pockets. Some investors will take some close haircuts.
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