When the judge in Detroit’s historic bankruptcy case approved the city’s exit plan on Friday, he said the deal Detroit cut with its retirees bordered on “miraculous.”Judge Rhodes is absolutely right, if the state fails, history will judge the court's approval of the settlement as a massive mistake.
Under the so-called grand bargain, foundations, the state of Michigan, the Detroit Institute of Arts and even the city’s water and sewer system have pledged hundreds of millions of dollars to bolster the municipal pension system and give the art collection new, bankruptcy-proof ownership. In return, retired workers accepted reductions to their monthly checks and other cutbacks. If all goes as planned, the grand bargain will keep the retirees’ reduced pension checks coming for the rest of their lives.
But the pension system that the settlement leaves behind has some of the same problems that plunged the city into crisis in the first place — fundamental problems that could also trip up other local governments in the coming years. Like many other public systems, it relies on a funding formula that lags the true cost of the pensions, and is predicated on a forecast investment return that the judge, Steven W. Rhodes, himself sharply questioned during the trial on Detroit’s bankruptcy plan.
Moreover, if Detroit finds itself confronting another fiscal crisis in the near future, it can no longer tap the museum’s art collection, which many saw as its top asset.
These risks might not matter if Detroit’s pension obligations were just a marginal part of the city’s finances. But they are not. Even after the benefit cuts, the city’s 32,000 current and future retirees are entitled to pensions worth more than $500 million a year — more than twice the city’s annual municipal income-tax receipts in recent years. Contributions to the system will not be nearly enough to cover these payouts, so success depends on strong, consistent investment returns, averaging at least 6.75 percent a year for the next 10 years. Any shortfall will have to ultimately be covered by the taxpayers.
In his opinion on Friday, Judge Rhodes said his “greatest concern” for the city “arises from the risks that the city retains relating to pension funding.”
Documents filed with his court show that Detroit plans to continue its past practice of making undersize pension contributions in the near term while promising to ramp them up in the future. This approach is by no means unusual; many other cities and states do it, on the advice of their actuaries. Detroit’s pension fund for general city workers, now said to be 74 percent funded, is scheduled to go into a controlled decline to just 65 percent by 2043; the police and firefighters’ fund will slide to 78 percent from 87 percent. After that, the city’s contributions are scheduled to come roaring back, bringing the plan up to 100 percent funding by 2053.
This will work, of course, as long as the city has recovered sufficiently by then. The state’s contribution to the grand bargain lasts until 2023, with the foundations and the art museum continuing to kick in until 2033. Eventually the payouts will begin to shrink some as current retirees fall off the rolls. Active workers have already shifted to a hybrid pension plan, and they will start to bear most of the new plan’s investment risk. But the city faces decades of payments for retirees under the old plan.
“The city has the potential to be saddled with an underfunded pension plan,” warned Martha E.M. Kopacz, the independent fiscal expert Judge Rhodes hired to help him determine whether Detroit’s exit strategy was feasible.
Ms. Kopacz, a senior managing director with Phoenix Management Services, did find it feasible, but expressed many reservations, especially about pensions.
“The city must be continually mindful that a root cause of the financial troubles it now experiences is the failure to properly address future pension obligations,” she said in her report. Judge Rhodes said on Friday that he agreed.
Pension concerns in Detroit coincide with a high-level debate among actuaries about their standards for funding public pensions and whether the public is adequately protected from more bankruptcies and Detroit-style disasters. The widespread practice of lowballing pension contributions today so that people will pay more down the road comes from the actuarial standards of practice.
Last month, the president of the Society of Actuaries, Errol Cramer, sent a letter to the Actuarial Standards Board expressing concern over “a misperception” on the part of the public. People have the idea, he said, that actuarial funding schedules were designed to produce enough money to pay for the pensions, “which they are not.”
All those eye-glazing board meetings, the bewildering calculations, the talk of “required contributions” and research on whether cities are paying them or not — those things have apparently confused the public into thinking that as long as an actuary follows the standards, and a city or state follows the actuary’s advice, a solvent public pension system will be the result.
Not so. To make his point, Mr. Cramer cited two popular actuarial methods, used in Detroit until now and still in many other places: “rolling amortization,” which pushes costs endlessly into the future, and pension contributions calculated as a percentage of an assumed rising payroll, which “backloads” the funding.
Those methods “do not pay down principal,” Mr. Cramer wrote.
That means they can work the same way interest-only mortgages with low teaser rates did in the subprime crisis: They can allow the growth of invisible debt, which, if not understood and managed carefully, can snowball and harm unsuspecting people.
Detroit is the prime example, and both of those actuarial methods figure in lawsuits filed in September against Gabriel Roeder Smith & Company, the actuarial firm that has advised Detroit’s pension trustees for nearly 75 years. Gabriel Roeder has said the lawsuits are based on a fundamental misunderstanding of actuaries’ roles. A spokeswoman for Detroit’s general retirement system, Tina Bassett, said that rolling amortization has been halted for the next nine years and that broad reforms have been made “to help ensure the decisions we make will provide success in the future.”
The actuarial standards of practice also permit the use of investment forecasts to discount future benefit payments into today’s dollars. Virtually all states and local bodies of government use investment assumptions this way; it makes their pension obligations look more modest and affordable than the true economic cost. The Securities and Exchange Commission bars private companies from reporting their pension liabilities that way, but it has little power over cities and states.
“We are concerned that we see many public-sector plans using practices that have not been used by private-sector plans, or that have been abandoned by private-sector plans around the world,” Mr. Cramer said. He said the Actuarial Standards Board should issue an entirely new standard for public pensions, but if it did not, then it should at least require actuaries to disclose that their standards “are not designed to provide specific regulatory oversight to the practice of plan funding.”
Mr. Cramer’s letter followed recommendations issued in February by a panel of experts and presented to the Actuarial Standards Board. The board is now gathering opinions on whether to revise its standards for public pensions; all comment letters are due by this weekend. Reactions so far have ranged widely, with some arguing that the changes would be costly and unnecessary and might confuse the public even more.
One favorable comment letter came from James Palermo, a trustee of the village of La Grange, Ill., who said better actuarial standards would help shake “a ‘trust the expert’ mind-set” that can backfire.
La Grange was one of a number of Illinois communities that had to raise taxes this year after discovering that their actuary was using an old mortality table that underestimated their police officers’ life spans, making skimpy pension contributions seem adequate.
In Detroit, the lawyer now suing the actuaries, Gerard Mantese, said he thought a faulty mortality table was also part of the problem.
Judge Rhodes said on Friday that the state would have to serve a tougher pension watchdog role. Michigan is putting $195 million into the grand-bargain pot, and in exchange Detroit’s retirees are releasing the state from any liability under its constitutional clause barring public pension cuts. Judge Rhodes said he found that settlement reasonable, but he made his misgivings clear.
“History will judge the correctness of this finding,” he said. Michigan must “assure that the municipalities in this state adequately fund their pension obligation. If the state fails, history will judge that this court’s approval of that settlement was a massive mistake.”
In my expert opinion, all this settlement did was kick the can down the road. The reforms are mostly cosmetic and will do nothing to mitigate an even bigger pension catastrophe down the road.
Why am I so critical? Because they had a golden opportunity to introduce real reforms and slay their pension dragon but all they did was put lipstick over a pension pig.
And the actuaries are out to lunch too. By permitting the use of investment forecasts to discount future benefit payments into today’s dollars, they are tacitly endorsing a dangerous and failing policy that is based on the pension rate-of-return fantasy. I would eviscerate all these actuaries in a court of law and ask them bluntly, what hopium are they smoking and what if 8% is really 0% in the next 25 years?
Please go back to read my op-ed comment for the New York Times on the public pension problem and my more recent comment on the United States of pension poverty, where I wrote the following:
My solution is to bolster defined-benefit plans for all Americans, not just public sector workers, and have the money managed by well-governed public pension funds at a state level.I am sick and tired of these rinky dink city and county pension funds that are governed by a bunch of clowns getting hosed by useless investment consultants, most of whom provide terrible advice.
I emphasize well-governed because a big part of America's looming pension disaster is the mediocre governance which has contributed to poor performance at state pension funds. I edited my last comment on the Pyramis survey of global investors to include this comment:
The other subject I broached with Pam is how the governance at the large Canadian public pension funds explains why they make most of their decisions internally. Public pension fund managers in Canada are better compensated than their global counterparts and they are supervised by independent investment boards that operate at arms-length from the government.Of course, good governance isn't enough. States need to introduce sensible reforms which reflect the fact that people are living longer and they need to introduce some form of risk-sharing in these state pension plans.
Folks, it's very simple. The global economy has serious, serious challenges ahead. The plunge in oil and commodity prices isn't just a function of the mighty greenback and oversupply. If my fears turn out right -- and they almost always do -- investors are wrong to underestimate the new "risk' of deflation and the potential for a protracted period of debt deflation and subpar growth over the next decades.
There is a reason why all those bond bears and Wall Street economists have been disastrously wrong for years claiming the bond bubble is about to burst and rates will rise. They are all underestimating the real risk of deflation coming to North America, wreaking havoc on the global economy.
And if that happens, only bonds will save your portfolio from destruction, not alternative investments that underfunded pensions are hoping will save them.
Finally, there is something else of interest in this settlement. Michael Aneiro of Barron's reports, Detroit Bankruptcy Exit Plan Is Bad For Muni Investors – Moody’s:
It’s not exactly a Charlie Gasparino versus Ron Insana Twitter fight, but the two biggest rating agencies are taking pretty different views on the impact of Detroit’s bankruptcy exit plan that a judge just confirmed today. S&P put out a statement saying the plan wouldn’t have any impact on S&P’s ratings of general obligation muni bonds, even though bondholders recovered a lot less money than expected compared to other creditors, particularly public pension recipients. By contrast, Moody’s Investors service just put out a statement saying the ruling “is generally credit negative for municipal investors because it reinforces favorable treatment of pension claims over other unsecured creditors. It also solidifies impairment of general obligation (GO) bonds.”I totally agree with Moody's and have warned in the past that Califonia's bankruptcies and pension bonds will rock the muni market. Lots of seniors investing in municipal bonds for tax reasons are not being properly informed on the hidden risks of these investments. Never mind what S&P claims.
Moody’s says the plan is bad for GO bond investors in general, and Michigan GO bondholders in particular:
These creditors accepted impairments to their debt. In the absence of clear court opinions on the strength of each pledge, investors will therefore be more likely to negotiate with distressed cities in the future.And more from Moody’s:
In confirming the plan, the court is sanctioning varying recovery rates amongst Detroit’s unsecured creditors. Reported recoveries for unsecured creditors range from an estimate of 14% for Certificates of Participation (COP) creditors to up to 82% for pension claims in real benefit terms. This disparate treatment of creditors was also a feature of the Stockton bankruptcy. These discrepancies leave investors with more questions than answers, but the emerging picture is one in which pensions have better recovery probabilities than debt in a Chapter 9 case, and municipalities exiting from bankruptcy likely retain responsibility for paying down large unfunded pension liabilities. We also note the confirmation does not affect existing settlements with Detroit creditors. Our ratings already reflect the recovery creditors will receive from those settlements.
Below, Standard & Poor’s Senior Director in U.S. Public Finance Jane Ridley discusses Detroit’s bankruptcy on Bloomberg's “Bottom Line.
Second, Conway MacKenzie's Charles Moore discusses the lessons learned from Detroit's bankruptcy process with Bloomberg's Mark Crumpton on "Bottom Line."
Lastly, Bloomberg’s Andrew Dunn discusses the Detroit bankruptcy case. He also speaks on "Bottom Line," and goes over what's next for the Motor City after this bankruptcy case.