Detroit Pension Debt is Warning for Other Cities

Driven by unsustainable retirement-benefit liabilities and mounting general-obligation debt, Detroit’s $18.5 billion bankruptcy filing represents an occurrence surely to be repeated in cities throughout the U.S.

In the end, it was not a question of what would happen, but rather when. Many governors are facing or will face the same set of limited options presented to Michigan Gov. Rick Snyder, and many will arrive at the same conclusion.

Some will surely conclude that the problem requires a federal solution. But the nation already faces unsustainable federal debt levels.

In Detroit’s case, one has to wonder whether the feds will override the normal bankruptcy hierarchy and place retiree-medical obligations ahead of bondholder obligations — thereby replicating the 2009 GM bankruptcy proceedings.

Some will argue that even if Detroit’s $5.7 billion retiree-medical liability is eliminated entirely, Obamacare will be there, in part or in whole, to absorb any such losses.

Detroit’s pension shortfall, initially estimated to be $650 million, is now estimated to be $3.5 billion. Curiously, the city has yet to release the details of these revised higher figures, provided by the actuarial-consulting firm Milliman.

This is now creating a story within a story, one separate from the unresolved controversy pitting the Michigan Constitution — which prohibits pension (contract) impairment — versus the federal bankruptcy code, which mandates appropriate treatment of all creditors.

As the amount of the pension shortfall is debated, the subsequent resolution of any pension deficits promises to be equally problematic. That is, if $3.5 billion represents 60% of the plan’s current obligations, will all current and future retirees receive 60% of their benefits?

Or will current annuitants receive, say, 100% with the reconciliation applied to future retirees? Will pensions be continued regardless of the amount of an individual’s annual pension? If the city’s obligation is ultimately sold to an insurance company to guarantee future payments, what happens if the "best offer" proposes to cover only 50% of the liability?

The bankruptcy process will eventually settle such questions, but the resolution of these questions will be precedent-setting for the next fiscally troubled city.

The reality is that many public-pension systems, such as Detroit’s, are simply not sustainable. Over the next five to 15 years, the Detroit scenario is likely to play out in a city near you.

In the end, state policies determine how much or how little pension systems are funded. In contrast, most retiree-medical plans are established on a pay-as-you-go basis. Pension funding is heading in that direction, too, despite the requirement that such systems actually be properly prefunded.

Given the financial pressures on state and local budgets, shorting the pension system — while assuming the existing assets will earn 8% per annum — is a convenient way to avoid raising taxes or cutting preferred programs.

It’s even more convenient when it allows politicians to claim that they’re "balancing" the current year’s budget as they eye the next election season.

While bankruptcy laws are based upon federal statutes, this should not suggest a federal solution is required. We need to reaffirm federalism by having any entity facing bankruptcy propose a solution within the respective city or state.

Also needed is a healthy dose of free-market economics that would allow "a market-clearing equilibrium" to occur — a prerequisite to any real private-sector investments occurring in our major cities. Absent this, the road to recovery will only be postponed, and cities will remain mired in an environment of high crime, high taxes, and failing schools.

Detroit is the leading exhibit in this continuing national saga and has embarked on a good first step. A favorable resolution from Detroit will be a model for other cities that may face this problem in the future.

This piece originally appeared in Washington Examiner

This piece originally appeared in Washington Examiner