Detroit offers many lessons for the public and private sector from how it dug itself into the deep fiscal troubles that led to its July 18 filing for Chapter 9 bankruptcy protection — and how to avoid falling into a fiscal abyss.
Detroit is no outlier. A few cities over the past year have filed for bankruptcy protection. Detroit is only the biggest one by far. But other cities and even states, such as Illinois, are on similar roads and need to apply lessons from the collapse of a once-thriving metropolis.
The challenge is to climb out of such troubles. To do so, Detroit will have to clear many hurdles, including its legacy retirement obligations, which will lead to legal challenges on the priority of public retiree benefit claims with other unsecured creditors, as well as potential challenges of constitutional protection of benefits that potentially could wind up in the Supreme Court.
Reviving its economy and revenue base looms as the biggest obstacle and will require Detroit to draw on the innovation for which it was once known.
Viewing retirement benefits alone, the ways Detroit funded such promises, including using unrealistic actuarial accounting assumptions, contributed to the city's fiscal troubles by providing a deceptively rosy picture of the funded status, leading to underpayment of contributions, which only postponed the reckoning. The city doesn't even have a good grasp of its pension obligations.
“Aggressive actuarial assumptions generate a perception that pensions are modestly underfunded.” according to a June 14 report by Kevyn Orr, Detroit emergency manager. The city's unfunded actuarial accrued liability was valued in 2011 at $643 million and “substantially understated” the true amount; it was revalued as of June 30, 2013, at $3.5 billion.
Detroit's pension benefits appear not overgenerous and not a major contributor of the deeply unfunded situation, as has been the case at some other public sector plans. In reorganization, the city should seek to persuade other creditors and the U.S. Bankruptcy Court in Detroit to avoid cutting modest benefits, although the huge total might be too tempting a target for scissors.
Proposed benefit cuts would run against a state constitutional protection of benefits, a provision other state constitutions contain. That protection likely will come under challenge, and it should. The protection cannot be enforced in the long run without risking the economic decline as businesses and residents flee to avoid such costs.
A sustainable pension system requires a thriving economy to underpin the promises. Detroit wound up with neither.
During the financial market crisis, much was made of the so-called black swan, or a major unexpected economic and market surprise that catches investors unprepared. Detroit is not a black swan; its fiscal legacy has been a long time percolating but ignored.
The Detroit General Retirement System and Detroit Fire and Police Retirement System suffered because some people who controlled the city sought to use them for their own ends.
Mismanagement of Detroit and economic forces that exposed the uncompetitiveness of its auto industry drove productive people out of the city, shrinking it to 701,475 residents in 2012 from 1.8 million in 1950.
In the face of economic and demographic upheaval, the city should have realized its defined benefit system was unsustainable and moved to a defined contribution plan.
To put public plans on a better footing, Donald L. Kohn, then vice chairman of the Federal Reserve Board, in a 2008 speech, called for use of lower valuation assumptions. Unlike in the private sector, he said public sector “accrued benefits have turned out to be riskless obligations” and thus the “only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.”
To do so would result in higher contributions, a prospect public-sector sponsors generally avoid, relying on accommodating public plan actuarial accounting that undervalues liabilities that can also encourage unaffordable increases in pension promises.
But unrealistic actuarial accounting places benefits at risk in the long run because underfunding, while masked, becomes unsustainable.
The Governmental Accounting Standards Board's new pension standards, adopted last year, while providing some needed reform to pension accounting, don't go far enough to require more economically realistic assumptions.
GASB ran into stiff opposition as it sought to revise the standards. One argument promoted the notion that public entities don't need to use so-called “financial economics” because, unlike private corporations, they don't go out of business. The Detroit bankruptcy filing should upend that belief and lead to toughening of GASB's standards to embrace realistic economic assumptions.
In addition, Detroit should give impetus to the passage of the Public Employee Pension Transparency Act, or something similar. Introduced April 23, the bill is pending in the Senate Finance Committee. While not an ERISA for public plans, the act is a modest step toward more transparency and risk management.
Michigan should use Massachusetts as a model for overseeing municipal pension plans.
A Massachusetts law enacted in 2007 provides for transferring to the Massachusetts Pension Reserves Investment Management Board control of all assets of local government retirement funds whose funded ratio and investment rate of return fail to meet certain criteria.
The bankruptcy reorganization should call for Detroit to consolidate its pension funds to reduce administrative costs and gain economies of scale, as well as provide for outsourcing fiduciary oversight to remove political influence and gain more professional investment management.
A bailout of the city's obligations by the state or federal government should be out of the question. A bailout would be unfair to taxpayers and serve as a disincentive for other public plan sponsors to meet their obligations.
Last May, Detroit contemplated selling a Vincent van Gogh self-portrait and other precious artwork in the Detroit Institute of Arts' collection as a step to pay part of the city's pension and other liabilities.
But the fiscal troubles are far too big to stop with sales of art, although that offers part of a solution to put the city on a course to revitalize its economy.
To raise revenue for its obligations, the city should turn its public infrastructure into an asset, providing opportunities for institutional investors. To pay for use of that infrastructure, the city should convert to a low-tax or tax-free zone to encourage business to set up, providing employment and economic optimism.
It is a realistic way for reviving the Motor City, which, to modify an old joke, has run out of Monet to buy Degas to make the van Gogh. n