The Real Message Behind Detroit's Decline

The city of Detroit has been in economic decline for decades. For much of that time its government has been mismanaged at best, and corrupt at worst.

But when Detroit finally went belly up last week, it was the city's retirement obligations that did the most to bring it down. Nearly half the city's debt, according to its emergency financial manager, is for pension, health care and other benefits promises that Detroit could not afford as its finances deteriorated, but kept offering to its workforce anyway.

Detroit's retirement debts have been at the center of negotiations between the city and its creditors, and now that the Motor City is in federal bankruptcy court, the stakes in those negotiations will get bigger. That's because Detroit's emergency manager, Kevyn Orr, has challenged the city's own assessment of its debt, essentially accusing the pension system of using risky, dubious accounting techniques to understate its true obligations. If Orr prevails in bankruptcy court with his views, the effort may have broader implications. That's the case because other state and local government pension funds employ similar questionable accounting techniques that understate their true debts and, consequently, mask the real cost of funding those benefits.

In his analysis of the city's debt Orr says that its unfunded pension obligations are about $3.5 billion, hundreds of millions more than the city pension system estimated in its last report. On top of that Detroit owes an estimated $5.7 billion to purchase future health insurance policies it promised to retirees. Detroit pays anywhere from 80 percent to 100 percent of the cost of these premiums, depending on the contracts they operated under, and since many city employees retire early, before they are eligible for Medicare, Detroit must buy them full health packages equivalent to what current workers receive. That's expensive in a city where there are twice as many retirees as active workers.

Among the city's other debts are about $101 million in accumulated vacation and sick time that workers can get paid for thanks to special provisions in their contracts negotiated with the city. Those bills typically come due when workers retire. On top of that the city owes $1.43 billion on bonds it floated to bolster its pension funds in 2005 as their financial position deteriorated.

Orr's report on the city's debt essentially accuses it of not only putting off for years dealing with its increasingly unaffordable benefits, but also employing accounting maneuvers that made the debt worse.

In 2011, for instance, as the city's financial picture worsened, its pensions funds decided to give Detroit a financial break at the expense of their own fiscal health. First they increased their projections of future investment returns to a heady 8 percent at a time when other funds were decreasing their estimates thanks to low interest rates and slow economic growth. This made the pension system seem potentially better-funded in future years, though of course it wasn't real money, just guestimates of what the pension system might earn.

Then the funds adopted a smoothing technique to calculate their assets by using an average of the money in the funds over the last seven years, stretching all the way back to before the financial market meltdown of 2008. This made the pension system seem better capitalized than it was.

After the pension system announced these and other changes, it triumphantly declared that, "The employer sponsor [that is, Detroit] of the Retirement System is likely to be pleased with the result of the above action," because it reduced the city's 2011 contribution to the system by nearly $48 million.

Orr hired his own actuaries who used less risky, more traditional private-sector accounting techniques to come up with a far worst debt scenario. It was their version of the city's pension debt that helped encourage Orr to ask for tough concessions on pensions and, when they balked along with other creditors, to put the city into bankruptcy.

Detroit's budget is in a lot worse shape than most state and local balance sheets. But pension funds in other places are using accounting maneuvers similar to Detroit's that are allowing retirement debt to build up in ways that are unsustainable.

Although many funds have been cutting their projected future investment rates, among government pensions the average still seems to be a range of 7.5 percent-to-8 percent projected returns. New Jersey, for instance, did ‘reform' in 2011 in which it cut its investment projections to a still-heady 7.9 percent, just a tick less than Detroit.

And over the last decade the giant California pension, Calpers, used various smoothing techniques to give municipalities in the Golden State a break on pension contributions at the expense of the fund, including at one time going back 15-years, all the way to the technology stock boom, to calculate its average assets.

The often arbitrary nature of state and local pension accounting is one reason why independent experts, taking a more conservative approach like Orr, have estimated that America's government worker retirement debt is two-to-three times greater than states and cities themselves admit.

Orr also seems intent on demanding significant concessions from investors in Detroit's pension debt, with good reason. These folks bought instruments designed to bolster a system that didn't have enough tax money coming into to sustain it. The investors should have been wary of the financial prospects of a government that resorted to this technique.

This too, however, is common, with thousands of so-called pension obligation bonds outstanding in America. Stockton, another bankrupt city, also issued pension bonds before going broke, and its investors are likely to take a steep haircut on this debt, too. Illinois has issued some $13 billion in pension bonds since 2003 to substitute for more than a decade of unwillingness to properly fund its pensions with taxpayer dollars.

By the standards of some places, Detroit's government pensions were not overly generous, although when you add in the perks, including healthcare for life and the ability to accrue unused vacation days, the true cost of retirement benefits were far higher than the average annual pension you see referred to in the press.

But Detroit's economic and fiscal woes go back decades, and yet even as the city hurtled toward insolvency it was unable, or unwilling, to check the rise in its retirement debt. We've seen this in other places, too, like Stockton, CA., and Central Falls, RI.

The real message of Detroit may be that some state and local governments seem incapable of dealing with the cost of their retirement benefits, even when it becomes apparent they are unsustainable, until the government is virtually insolvent. By then, taxpayers, government workers and bondholders are all losers.