Detroit’s Pension Problems: Not as Bad as They’re Portrayed
Detroit’s emergency manager, Kevyn Orr, claims Detroit owes $3.5 billion (pdf) to its public pension funds. This is more than five times the $640 million the funds’ actuaries estimated in 2011,1 (pdf) vaulting pensioners into the ranks of the city’s major creditors, which isn’t a good place to be. It also contributes to Orr’s claim that Detroit owes a total of $18 billion—half to retirees and workers—and that bankruptcy is the city’s only recourse.
Despite obvious socioeconomic explanations for Detroit’s woes—the Great Recession walloped a city already suffering from deindustrialization and a flight to the suburbs—it sounds plausible that Detroit’s wounds are partly self-inflicted. After all, this is a city whose former mayor can’t seem to stay out of jail. And there’s certainly a history of elected officials around the country neglecting pension contributions to avoid raising taxes to pay for public services. So the idea that Detroit lowballed its obligations to workers and retirees has the ring of “truthiness,” to borrow Stephen Colbert’s phrase.
But pension obligations don’t blow up in your face like airbags, and politicians can’t make reputable actuaries like Gabriel Roeder Smith cook the books. When politicians want to save money by shortchanging pensions, they just don’t contribute what the actuaries tell them to contribute. This may be irresponsible, but it’s fairly transparent.
Though Detroit has lived beyond its means in recent years, it didn’t do so by neglecting required contributions to its pensions: It just borrowed. Like Detroit, most states, counties and municipalities have kept up with pension contributions. They still need to gradually close the hole caused by the 2008 market downturn, but this is a manageable challenge, especially after deep cuts to pension benefits.
Admittedly, Detroit did reduce the size of its unfunded pension obligations by issuing pension obligation certificates (POCs) in 2004 and 2005 to close a shortfall created by the bursting dot-com bubble. But this didn’t make the claims disappear, it just moved them to another place on the balance sheet.2 Kil Huh, who joined me as a guest on WBUR’s On Point, theorized that the $3.5 billion in pension claims in the emergency manager’s report include these certificates. If so, Orr is double counting, because “POCs” appear again in his list of the city’s unsecured debt (see page 98 of his report (pdf)—credit goes to Reuters reporter Cate Long, blogger Aluation, and other skeptics for flagging this issue).
An additional explanation, offered by another On Point guest, Robert Pozen, is that Orr—appropriately, in Pozen’s view—assumed a lower rate of return on pension fund assets. But this alone wouldn’t do the trick, unless you assume a rate of return below even the long-term Treasury rate.
Why not check Orr’s assumptions directly? We can’t, because his figures come from “very rough preliminary guesstimates,” (pdf) which haven’t been made public. This would almost be comical if media sources weren’t so quick to accept the word of a bankruptcy lawyer appointed by a governor with an anti-union agenda over official actuarial reports.
In the end, does it matter whether Detroit shortchanged its pension funds or simply borrowed to cover budget shortfalls? In a way, it doesn’t. If Detroit had skimped on pension payments to avoid raising taxes or cutting services, this wouldn’t mean pension promises were too high and shouldn’t be honored, it would simply mean the pension bill was the one the city chose to ignore. But the details matter in this case, both because Orr’s credibility is suspect—was there a rush to bankruptcy?—and because the current story line casts unfounded suspicion on pension funds and actuaries.
Most states, counties and cities responsibly make the full actuarially required contributions to their pension funds. As a result, most funds are in decent shape despite the downturn, with an aggregate funded ratio of 76 percent in 2011 (80 percent is considered adequately funded).
Even among those deep in the red, the problem rarely has to do with accounting shenanigans—Chicago may be an exception—but is due to elected officials failing to make required contributions in full. The solution to this problem isn’t to beat up on workers, pensions, and actuaries, but rather to focus reform efforts on ensuring that politicians keep up with contributions.
Rather than addressing real problems, though, conservative attacks on public pension funds—and by extension on government employees and their unions—accuse them of conspiring to hide the true cost of pension benefits by using rosy assumptions. This kills several birds with one stone: making the problem appear much bigger than it is, getting media coverage, justifying draconian benefit cuts, and ensuring that anyone who knows better appears to be in denial—or worse, part of the cover-up. In short, pension scaremongers took a page from the anti-Social Security playbook.
The truth is less alarming but more boring. Public pension actuaries—a staid lot—hew closely to the same assumptions, which are rooted in historical experience. Thus, for example, the vast majority of actuaries, including those in Detroit, assume a rate of return on pension fund assets between 7 and 8 percent, which is below the long-run historical average but higher than recent experience. If you think recent experience should weigh more heavily, then you also lower inflation projections. Either way, you end up with an inflation-adjusted rate of return of around 4.5 percent, which is hard to get too excited about.
While there’s no guarantee that funds will achieve a 4.5 percent real rate of return going forward, contribution rates and assumptions will be gradually adjusted to reflect the new reality if they don’t. The only nasty shocks taxpayers are liable to face are the result of chronic, but transparent, underfunding by elected officials, or a rapidly shrinking workforce and tax base. The latter is obviously a problem in Detroit—and one not limited to the pension funds—but not one many cities will ever face.
2. Issuing pension obligation bonds or certificates reduces overall reported liabilities because the projected return on pension fund assets is higher than the city’s borrowing costs. Though there are legitimate questions about the wisdom of re-leveraging in this way, this can’t explain the size of the disparity between the two estimates of the city’s unfunded pension obligations.