Published August 20, 2013
Labor leaders are once again squaring off with Detroit Emergency Manager Kevyn Orr, and this time it’s over the calculation of the city’s unfunded pension liabilities.
According to Orr’s estimates in July, these liabilities stand at $3.5 billion, or five-times what was previously projected leading up to Detroit’s filing last month for Chapter 9 bankruptcy protection. The city became the largest municipality to ever file for bankruptcy with an estimated $18 billion in debt.
Pension funds are challenging the city’s calculations, claiming it used “overly-conservative assumptions on the returns the funds earn on their investments,” the Wall Street Journal reports. The unions and pension funds filed an objection to the bankruptcy filing Monday, claiming their funds were calculated using actuarial projections of around 8%, according to the newspaper. Orr’s commissioned report from a consulting firm estimated projections of near 7%.
The funds and city may square off in federal court, where Detroit will have to prove it is insolvent and filed for bankruptcy in “good faith,” the WSJ reports. Next month, Detroit will begin formal mediation with its pension funds under the bankruptcy restructuring.
The question at hand is whether or not the city is truly insolvent, says Tracy Gordon, economic studies fellow at the Brookings Institution. The funds are finding fault with the assumptions Orr has made to validate the filing.
“One is a lower discount rate; the issue is the accounting rules allowed state and local governments to use expected asset returns for pension funds as a way to think about future liabilities,” Gordon says. “If you expect a high return, you think about those liabilities as being farther off into the future. The use of the 8% number was not perfect and was expected to change.”
A perfect example, Gordon explains, would be a homeowner taking out a second home mortgage and investing the funds in the stock market. If the market provided solid returns, that would be ideal, but no matter what, the debtor will still have to make payments on the second mortgage.
“Should you think of yourself as wealthy? You have taken some risk, but if it doesn’t pan out, you still have that mortgage,” Gordon says. “The issue is that it shouldn’t matter what you think you will get with the investment. The issue is how certain is the obligation that you will have to pay?”
The pension funds’ calculation of 8% return on investment was likely too high and even the city’s own estimate of 7% was overly-optimistic, says Allison Fraser, senior fellow and director of Government Finance Programs at The Heritage Foundation. The goal of the two pension funds is to protect the benefits of their nearly 30,000 beneficiaries, she says, but the figures they are using don’t take into account what has happened to funds in the wake of the recession.
“One of the things that we know has happened over the past five to six years is that many of these funds have earned significantly less than their assumptions,” Fraser says. “The history has been under 7% [ROI] in that time period. It’s hard to know, and it’s not black-and-white, but Kevyn Orr is much closer to a more realistic picture.”
If Orr and the city are correct, or at least closer to having the right number of unfunded liabilities, the next step will be establishing just how underfunded these pension plans are, she says.
“If Orr is deemed right by the judge, they can come to an agreement with the unions in mitigation,” Fraser says. “They may come to another agreement. But if they don’t the question is what will happen to current and future retirees and their benefits?”
Unfortunately for pensioners, it’s just too soon to tell.