On the sixth day of Detroit’s bankruptcy trial earlier this month, a comment from the city’s emergency manager, Kevyn Orr, prompted a rare question from U.S. Bankruptcy Judge Steven Rhodes. Orr was defending comments he made to retirees and city workers one month before the city filed for bankruptcy:
“I wasn’t attempting to mislead anyone,” Orr reportedly said of the June meeting. “I was trying to say we understood these issues around pensions.”
Rhodes challenged: “What would you say to that retiree now?”
“I would say that his rights are in bankruptcy now,” Orr said. “I would say that his rights are subject to the Supremacy Clause of the (U.S.) Constitution.”
“That’s a bit different than ‘sacrosanct,’ isn't it?” Rhodes said.
To the delight of public retirees and their unions, Rhodes’ questioning highlighted a shift they had been complaining about for months: that Orr went from reassuring retirees to saying their pensions were part of the problem. The truth is, there’s a lot of blame to spread around in Detroit’s bankruptcy – from corrupt politicians to unthinkably bad decisions to the Great Recession--amd no one item got the city to where it is today at roughly $18 billion in debt.
Orr and others say the city’s pension system represents $3.5 billion of that debt and the message since the July bankruptcy filing has been that the system is a big part of the problem. But the city's two pensions are actually a combined 91 percent funded (80 percent funded plans are considered financially healthy), according to Morningstar's combined 2011 valuation of the public employee pension and police/fire pension (see chart below). The fund, according to outside reports, is pretty healthy. But how it got there is another story. The pension system is not to blame for Detroit’s woes – but it’s not blameless either.
For starters, Orr’s view of Detroit’s system and the view of unions are through completely different lenses. “It’s a weird situation, a weird scenario because we’re not the problem,” said George Orzech chair of the police and fire pension board. “We don’t know why they’re attacking us.”
Orr uses a lower rate of return assumption than the retirement system does and calculates that payments will come due over a shorter period of time. Most notably, Orr’s assumptions for the plan’s unfunded liability uses a lower, more conservative market rate to value the assets and liabilities. That choice results in the plans having fewer assets and more liabilities when compared with the actuarial valuation given by the pension system, which uses a rate of return in line with what other systems use. Using the market rate is not exactly standard practice, said Morningstar Municipal Credit Analyst Rachel Barkley.
“While using it is the correct method to identify a liability in a point in time … it does magnify fluctuations in the bond market,” Barkley said in a conference call last week. “It presents a very drastically different point of view on the fundamental fiscal health of plans based on the actuarial method.”
In contrast to Orr's estimated $3.5 billion unfunded liability for both plans, the retirement system's actuaries estimate that value at $644 million.
The differences amount to a plan that is either 91 percent funded (according to the pension system actuaries) or is less than two-thirds funded, according to Orr. “There’s been a bit of an overemphasis,” said Tamara Lowin, director of research at Belle Haven Investments, referring to the picture that some have painted of the city’s unfunded liability. “The answer of what the real unfunded liability probably is somewhere between what the two parties are stating.”
But how did the pension fund of a city that (not for the first time) has been skipping out on its payments for a year get so healthy? The answer there really did contribute to Detroit’s money woes. In 2005, the city sold Pension Obligation Certificates, taxable bonds that would go directly toward easing the city’s unfunded liability. But more than half the bonds were sold as part of a swap deal designed to guarantee a roughly 6 percent interest rate for the city – Detroit sold the certificate bonds at a variable rate to creditors. The city then made a deal with banks on the interest rate for those certificates to help them keep payments stable: they agreed to pay a 6 percent rate to the bank in exchange for the bank paying Detroit the variable rate. The deal protected Detroit against skyrocketing interest rates.
But it didn't provide any protection if rates fell -- and when that happened in combination with the city's credit rating downgrade, the deal eroded and the city's debt payments shot up as a result. Now, the $1.44 billion deal is expected to cost Detroit $2.8 billion over the next 22 years, according to a Detroit Free Press analysis.
At the time, the unions joined then-Mayor Kwame Kilpatrick (who is now serving a 28-year prison sentence on un-related federal racketeering charges) in pushing for the deal. But today, the union points to that decision as a mistake by city leaders: “That’s how Detroit got itself into trouble,” said Michael Artz, associate general counsel at the American Federation of State, County and Municipal Employees. “It’s these financial deals that put them over a barrel, if you will, because of the loss of state aid and the declines in revenue.”
But those bond certificates are why Detroit’s plan is so well-funded today – in effect, the deal shifted the liability risk from the retirees to the taxpayers. And that debt is contributing to the city’s inability to provide services to its residents. According to the latest annual report from Detroit’s General Retirement System the city’s payments to that pension system had climbed to one-fifth of its total payroll expenses up until the pension certificates helped cover the unfunded liability in 2005. Then, the payments dropped to one-tenth of payroll – but they have been climbing ever since. By 2011, its pension payments accounted for nearly one-quarter of payroll. Meanwhile, since 2001, the number of active employees contributing to the system has fallen by nearly half while the number of retirees (now about 11,500) has stayed roughly the same.
It’s that kind of structure that can burden a city’s future employees and taxpayers, pitting them against retirees, said Vijay Kapoor, director of PFM’s Workforce Consulting practice. “If you don’t deal with that you may find yourself in bankruptcy and asking yourself where the money is that would make the biggest difference the most quickly: it’s in the retirees.... It tees up these intergenerational issues in a way that hasn’t been teed up before.”
Whether the city is so cash-strapped it warrants bankruptcy protection is for Rhodes to decide. Unions and other supporters have also argued that Orr’s estimated $18 billion in total debt is exaggerated as it includes shared debt from a water and sewer system that serves 40 percent of Michigan residents. Meanwhile, the city and the unions have had roughly half a dozen meetings about the pension fund’s role in the bankruptcy.
But as to whether those meetings will yield anything, Steve Kreisberg, AFSCME’s director of collective bargaining, notes employees have already made concessions: a year ago the city made a deal for reduced benefits going forward and a 10 percent paycut, Kreisberg said. “What that demonstrates is how little pensions have to do with this,” he added. “You cut them but you still declare bankruptcy a less than a year later.”