Benefits, Bankruptcy and Baloney

Chapter 9 doesn't work the same as Chapters "7-Eleven" and won't solve the pension-benefit crisis.
July 8, 2010 AT 3:00 AM
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

There is a lot of big talk these days about municipal bankruptcy as the ultimate solution to state and local pension deficits. Somehow an urban legend has sprung up that says federal bankruptcy courts can and would tear up pension promises made to public employees. Although there is a sliver of truth in that idea, it's sadly mistaken in terms of how a municipal bankruptcy really works.

I'm not an attorney and this isn't legal advice. Let a bankruptcy attorney explain all the nuances. But there are some basic concepts that my regular readers and the pension vigilantes should understand better, so that the dialogue is informed and not irrational. The word "bankruptcy" makes for great rhetoric, but as far as solving the public pension problem, Chapter 9 will frustrate the pension-bashers who want the liabilities to conveniently go away.

Chapter 9 for municipal bankruptcy does not operate like Chapters 7 and 11 in the private sector. First of all, a city or county does not go out of business. Most public employers have taxing authority, and governments are chartered to operate perpetually. Elected officials may come and go, but the sovereign states and their subdivisions are expected to continue indefinitely. They may need to shrink their operations in order to live within their means, and they may need to reorganize their financial obligations through a bankruptcy proceeding, but they don't close down entirely. Chapter 11 would thus be the closest analogy, but that's where the similarities end.

Second, there is rarely a wholesale liquidation of municipal assets to pay creditors. It's possible that a federal court could sell off public buildings and facilities as part of a streamlining reorganization of functions — but only as a last resort. (When was the last time a public golf course was sold to pay the firefighters and the city clerk?) The same holds true for constitutionally and statutorily protected pension benefits earned by employees for their past service. The courts will look for other remedies first.

Job No. 1: Keep the lights on. The first task of a federal court overseeing a municipal bankruptcy is to keep the basic public services going, find sources of revenue and ways to trim costs, and then to restructure debts and creditors' claims. Bondholders may suffer a delay or a haircut in interest payments, and principal repayments might be stretched out or rescheduled. Cutting vested pension benefits before cramming down the bondholders looks pretty unlikely to me. Just think in terms of Greece and you'll get the picture, as there are some parallels.

This doesn't mean that desperate local governments will never get any relief on their employees' compensation and benefits through bankruptcy proceedings. Clearly, a court could determine that wages and current benefits for employees are just too high in light of the local labor market — but in many cases the bankruptcy court will look first to the labor arbitrators in states where contract impasses are resolved through that process. (See my companion column on labor arbitration reform.) Absent arbitration, however, employers filing under Chapter 9 could take a harder line than ever before because high unemployment leaves municipal workers with very few options in the private labor market. Pay and benefits cuts may be justifiable in a New Normal bankruptcy.

Contributions vs. cuts. If a bankruptcy court had to choose between (a) ordering higher employee contributions to their retirement plans and (b) reducing vested benefits, the courts will likely take the first option and impose higher contributions. If that requires the suspension of current labor agreements to improve the employer's cash flow, such a decision could clearly be a possibility.

Past vs. future service benefits. Along this line, it seems highly unlikely that a bankruptcy court would ever reverse vested benefits for services already performed, which is the primary obligation of the pension plan trust fund. Following the logic that the Governmental Accounting Standards Board (GASB) recently announced in its preliminary views of pension accounting, the courts will view the pension fund as a separate entity with the primary obligation for promises made, and the employer as the secondary obligor. Thus, a court's focus would likely center on what changes it could possibly impose for prospective service that could immediately reduce the employer's costs as the secondary obligor.

That takes us back to the constitutional issues framed by University of Minnesota law professor Amy Monahan's work cited in one of my previous columns. In states where the rights to future pension benefits are a gratuity or based primarily on contract law, there is arguably a stronger case for setting aside those obligations in bankruptcy proceedings. Where employees' rights to future pension accruals are expressly etched in the constitution itself, it would probably be more difficult. And where future service is unprotected by constitution, the bankruptcy court would face fewer obstacles in reducing such benefits. Monahan's paper is well worth reading for those interested in these distinctions, although she does not address bankruptcy as such.

There is also a risk that the court could order suspension of employer contributions to the pension fund to conserve cash, similar to an action to delay interest payments to bondholders. This violates the concept of sustainable operations, and ultimately weakens the pension fund but would be a possible outcome in a facts-and-circumstances situation in which liquidity dominates decisions. So employers must tread carefully with their petitions to change pension contributions.

State vs. federal constitutional rights. I have seen blogs by pro-union advocates who claim that public employees enjoy a federal constitutional protection to their future benefits even in bankruptcy, which I consider to be a flimsy claim. If there were a federal constitutional protection of contractual retirement benefits for all Americans that is immune to bankruptcy intervention, the federal Employee Retirement Income Security Act (ERISA) would not stipulate certain protections. In particular, its anti-cutback provisions protect vested benefits already earned while simultaneously and clearly allowing for (1) changes in prospective benefits and (2) the closing of pension plans. State and local governments are exempt from ERISA. The more widely shared view is that this exemption is a legislative exemption (consistent with the Supreme Court's decisions in Garcia v. San Antonio Transit, 1985 and South Carolina v. Baker, 1988) and not a constitutional exemption. The constitutional protections of pension rights enjoyed by public employees in a bankruptcy proceeding would thus derive primarily from state and not federal law.

At the end of the day, a bankruptcy court must evaluate its options for keeping an insolvent political subdivision afloat operationally. Unquestionably there would be an opportunity (and arguably a necessity) to re-open existing contracts including retirement benefit provisions. Unless the pension fund is itself grossly underfunded, there would be no reason to invade vested rights to benefits already earned. What is not so clear is whether the courts would start with benefit reductions for prospective service instead of first reducing salaries and increasing employee contribution levels. In states without a clear constitutional prohibition against prospective benefits changes, one could imagine a scenario in which the "normal cost" of services could be reduced by slashing the benefits multipliers for future service and possibly invoking a change in the age and service requirements — if early retirements are breaking the bank.

Retirees would, of course, appear front-and-center in bankruptcy proceedings to protect their interests. They would rightfully be nervous about their benefits. For many, their pension is their primary financial resource. Retirees' claims would be the most difficult benefits to set aside in a municipal bankruptcy, since the pension trust itself is the source of their income, not the municipality. The only major issue is whether their cost-of-living allowances (COLAs) could be suspended in a money-saving move, and that depends largely on plan design and state laws. If COLAs have traditionally been awarded ad hoc rather than actuarially funded, then it is more likely that a court might order the suspension of COLAs until the employers' finances are stabilized.

Retiree medical benefits are an entirely different story. Many states provide far less protection to employees and even to retirees for their post-employment medical benefits, and this may be an area where a bankruptcy court would find greater latitude to make surgical changes. If I were an employer, this is where I'd start first and seek to restructure the benefits as outlined in my prior column on OPEB reforms, with the key difference that in this context, incumbent pre-Medicare benefits and possibly retirees' dependent benefits may also become fair game in bankruptcy court.

In municipalities that operate their own single-employer pension fund (unlike the big statewide multi-employer systems), the doomsday scenario would include an imploding pension fund along with an over-extended employer. If the pension fund has accumulated such huge unfunded liabilities that it risks eventual insolvency itself, then the bankruptcy court has an entirely different problem. The annual cost to the employer of revitalizing the funding status of the pension plan, plus the skyrocketing costs of providing retiree medical benefits which typically are unfunded by the same employers, could be one of the final straws that force bankruptcy. In that case, the court would face a whole set of triage issues that become much messier.

Statewide plans: Safety in numbers. Fortunately, most of the states with large statewide systems have built funding structures that preclude the doomsday scenario. Although their unfunded liabilities have doubled in the past three years, most of these multi-employer plans (with funding ratios now averaging 70%) are nowhere close to the meltdown level that critics suggest as harbingers of bankruptcy. In this regard, the GASB's recent pronouncements have served its constituents well by alerting us all to the real costs of public pension plans that have cut corners in their funding and amortization practices. Legislators, investors and taxpayer groups should insist that local elected officials obtain actuarial estimates of the employer's future budgetary impact of the accounting changes now under consideration by GASB. Those who develop strong long-term plans to cut their cost structures in one way or another would not be likely to face a bankruptcy scenario.

Would Chapter 9ers invite a 'PERISA'? One of the likely consequences of any future wave of Chapter 9 bankruptcy petitions would be union efforts to sidestep benefits cutbacks through legislation. In California, employee unions have already pushed a bill in the state legislature to require an intermediate process that pre-empts Chapter 9. Some states already provide for state receiverships for insolvent subdivisions, which establishes a precedent that others could follow. Such receivers may be more protective and sympathetic to employees' claims than a federal bankruptcy court.

Let's not rule out the possibility that public employee unions could push Congress to extend the private-sector ERISA laws onto state and local governments. A Public Employee Income Retirement Security Act ("PERISA") has been proposed before and was beaten back by governmental employers and the public pension fund community. Collectively, municipal leaders should be wary about what they ask for. The consequence of having teetering municipalities declare bankruptcies because of runaway benefits could well turn into a loss of employer sovereignty for the vast majority of states and local governments that have kept their fiscal houses in order.

Erosion vs. bulldozers. As readers can see, this complex subject has many nuances. Attorneys on opposing sides will argue over many of the points and issues I've posted here. So will the barbershop lawyers who frequent these columns and blog them from time to time. My goal as a layman commentator is not to feign expertise on matters of law, but to encourage a more careful use of the term "bankruptcy" and a better appreciation for what will be a more likely scenario: A decade-long reduction of public services, chronic hiring and salary freezes, bigger payroll deductions for employees that reduce their real wages, and withering confidence in state and local government as a result of the ballooning costs of retirement plans and unsustainable benefits. Elected leaders and chief administrators will fix the problem incrementally over the coming decade without resorting to bankruptcy court. The earth will move by the forces of erosion, not a phalanx of benefits-bankruptcy bulldozers. This won't stop the ultimate demise of public services to pay for over-promised retirement benefits, but we don't need to be melodramatic or hyperbolic about it.