This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org/archives/2013/1213sciacchitano.html
This article is from the upcoming January/February 2014 issue.
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The Pension-Busters’ Playbook
The Manipulations behind the Attack on Pensions in Detroit’s Bankruptcy
In July 2013, Detroit Emergency Manager Kevyn Orr filed what could be, at $18 billion, the largest municipal bankruptcy in U.S. history. Now that a federal judge, Steven Rhodes, has ruled that the bankruptcy can proceed, a central issue will be whether the city can jettison up to $3.5 billion in accrued pension benefits owed city workers (which Orr claims are unfunded). With accrued state and municipal pension benefits protected by the Michigan constitution, Judge Rhodes’ ruling sets a chilling precedent for future municipal bankruptcies.
City pension funds—one for police and firefighters and another for non-uniformed city personnel—hotly contest Orr’s numbers. Fund documents show a combined shortfall of $977 million, $2.5 billion less than Orr claims. They also show the police and fire fund is 96% funded and the general fund is 77% funded, in contrast to Orr’s allegations of 78% and 59%, respectively.
The methodology for the Emergency Manager’s (EM) calculations takes a page from the playbook of conservatives who argue that public-sector defined-benefit pensions across the country are underfunded and should be eliminated, what one union official calls “the pension-busters’ playbook.” Like many public and private sector pensions funds, the funds assume rates of return on investments of approximately 8%. The EM lowers those assumptions by at least a full percentage point. Detroit pension funds use a common practice called smoothing to prevent sudden large losses—such as those suffered by funds across the country in 2008-9—from making funds appear more underfunded than they really are. The practice averages losses over a period of years and provides breathing space for markets to recover before recognizing, or locking in, losses. The EM rejects the fund’s use of smoothing in its calculations.
Once the size of a shortfall is determined, pension funds also routinely spread out, over a period of years, the contributions needed to eliminate any shortfall, a practice called amortization. Detroit pension funds use29- and 30-year amortization periods. The EM cuts these periods to 15 and 18 years. While this change doesn’t increase the estimates of underfunding, it does push up the size of the annual contributions that would be needed going forward, making the city’s overall budget situation appear worse as it moves into bankruptcy, thus boosting the case for cuts to pensions.
With average annual pension benefits for non-uniformed city workers of just $19,000, the problem in Detroit isn’t the generosity of city pensions. The problem is the crisis in the city’s tax base and the city’s repeated failures to make required pension contributions. Heavily dependent on the declining auto industry, Detroit has shrunk from 1.8 million residents in the 1950s to 700,000 today, and has lost fully 25% of its residents since 2000. Detroit has also been devastated by the subprime mortgage crisis. In 2004-2006, the last run-up to the crash, 75% of mortgage loans to African Americans in Detroit were subprime loans. Between 2005 and 2009, one in five Detroit homes suffered foreclosure. Ambulance response time in Detroit can be as long as long as an hour. Unemployment is close to 18%.
Orr frames pension cuts as the only viable alternative to further severe deterioration in city services. Nationally, the prospect of cuts is portrayed as the choice between paying pensioners or paying investors in Detroit municipal bonds. The explicit threat is that defaulting on payments to bondholders would not only lock Detroit out of the municipal bond market, but also raise borrowing rates for other municipalities across the country.
The Detroit group “Moratorium NOW! Coalition to Stop Foreclosures” has analyzed the role of large financial institutions in Detroit’s crisis and argues that Detroit should cease paying debt service to large banks. It takes the position that Detroit’s fiscal crisis began with the foreclosure crisis caused by subprime lending, and that large banks continue to profit from complex financial dealings with the city. Meanwhile, Detroit city workers, residents, and civil life suffer.
In 2005, Detroit issued$1.5 billion in pension obligation certificates to help fund city pensions. The certificates are held by major banks and were accompanied by complex financial arrangements called “interest rate swaps” that favored the banks. Detroit entered other swaps as well, including swaps on water and sewer bonds. The rationale was to hedge against rising future interest rates by swapping a fixed for a variable rate. When interest rates plunged to zero instead, Detroit and the many other cities with similar agreements were left paying the much higher fixed rate. The cost to Detroit of these arrangements has been estimated at close to $1 billion.
Cuts to pensions in the bankruptcy would come on top of $160 million in annual givebacks in wages, pensions, and health-care benefits agreed to by city unions in 2012. Using emergency powers granted by the state, Orr has already announced the elimination of retiree health-care benefits, which are not protected by the state constitution. He also proposes replacing the city’s current defined-benefit plans with defined-contribution plans, paying as little as ten cents on the dollar on unfunded liabilities, and eliminating cost-of-living adjustments (COLAs) for retirees. Many retirees from the city, moreover, are not covered by Social Security.
As the bankruptcy proceeds and 80,000 properties lay vacant throughout the city, Detroit’s budget problems are touted by conservatives as a microcosm of national public-sector pension problems. In fact, Detroit is a case study of an economy tied to an industry in crisis. It is a microcosm not of the unsustainability of public pensions, but of the devastation wrought by national economic policies that have sacrificed manufacturing to the needs of global capital and the finance industry, and that continue to profit those same players.