STUMP » Articles » Detroit Bankruptcy: It's Over, But It's Not » 12 November 2014, 15:07

Last week, Detroit’s bankruptcy plan was approved, and the judge overseeing the process has given “Detroit the go-ahead to implementing its bankruptcy exit plan.

Thing is, there are several clouds looming over Detroit, the main one being its pensions

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.

…..
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.

…..
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.

Ugh.

Yes, this is a big problem.

And, unfortunately, actuaries are a part of the problem. You might want to make that bit clear.

Back to the article:

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.

Now, one of the comments on the article indicates that the level percent of payroll approach does not necessarily backload funding… if payroll is really rising in the manner assumed.

The comment, in its entirety:

ErnieConnecticut
A nice juxtaposition of the Detroit order and the ASB request for comment, and in particular the SOA response.

There is a lot of food for thought in Cramer’s letter (most particularly the plea for a regulatory body), but I think it deserves to be cited to more carefully. Cramer did not say that pension contributions calculated as a percent of an “assumed rising” payroll “backloads” funding or does “not pay down principal”. He did say that a percent of payroll amortization calculation method, if using a long amortization period, “can” result in the unfunded liability growing for some period, which is to say, it does pay down principal, but doesn’t necessarily make steady progress (footnote 3).

Still, the article does a good job of describing his bigger point, that methods permitted under ASB standards can be mixed and matched to result in a declining level of funding, and that isn’t well understood. Add in depopulation and counterfactual assumptions, and you get Detroit.
Nov. 12, 2014 at 8:29 a.m.

Mind you, the statement is from the SOA comment letter on public pensions funding, and this is the exact statement in the letter:

The fundamental problem is that ASOPs have become subject to misperception. We have seen references that meeting ASOPs ensures that a funding method produces sufficient contributions.3

……
While some funding entities are unable to declare bankruptcy, an inability to declare bankruptcy does not diminish the importance of strong risk management practice; these plans have practical limits on their ability to draw on taxpayer resources. 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.7
…….
[footnote]3 The ASOPs permit amortizations that do not pay down principal, e.g. rolling amortization methods which restart the amortization of the unfunded (surplus) every year. In addition, percent of payroll amortization methods that use long periods can grow the unfunded (surplus) amounts for many years.

……
[footnote]7 For example, public sector plans use rolling period amortization methods and/or percentage of payroll amortization methods (and sometimes will use them in combination). Neither of these practices were ever permissible under ERISA (singly or in combination) for single employer private sector plans. Public sector plans will amortize regular gains/losses (due to asset performance or actual experience over assumptions in the liability) over 30 years; ERISA never permitted gains/losses to be spread a period longer than 15 years.

Various valuation/funding practices were nixed for private DB plans (as per ERISA) because they made the plans less safe for participants in the event of a pension sponsor bankruptcy.

Why do some public DB plans still use these approaches? The obvious answer is that it makes pensions look cheaper than they actually are, or that they keep pushing off til years later what they should be paying today, but one still needs cover of a sort to get away with it.

The justification often used for these approaches is: “governments don’t go out of business.” Also, some of these governmental entities cannot file for bankruptcy.

But just because there’s no established legal bankruptcy process does not mean governments cannot go bankrupt in fact. Because they obviously do.

Just because there’s no formal bankruptcy process for states does not mean that Illinois can’t ever go bankrupt. Or California. Or New Jersey. Or Rhode Island. They can, and I won’t be surprised if several will over the next twenty years. (And no, there won’t be federal bailouts. Not all states have these problems, and certainly not to the extent of the worst players above.)

That’s why I bolded the particular statement from the SOA letter. It is an acknowledgement that there is no magical pot of money that will fill all unfunded liabilities some time in the nebulous future.

This is a problem for Detroit. Even if they didn’t have various parties suing and appealing over the bankruptcy workout, or huge fees paid to consultants and lawyers as part of the plan, they could be seeing a return to bankruptcy court when they really can’t pay the pensions.