Detroit Bankruptcy, Pensions and Taxpayers

Bankruptcies are never a good thing.  Creditors, employees, investors, and sometimes the public can suffer losses.  There is often plenty of blame to go around with much finger pointing, and Detroit’s bankruptcy is no exception.  Will Detroit signal the beginning of more major U.S. cities to file for bankruptcy under Chapter 9 of the federal law that governs municipal bankruptcies?  No one can say for certain at this time.   However, there is a common thread that Detroit shares with many other state and local governments, and that is the problem of unfunded and underfunded employee pension obligations.

Unlike the private sector where many defined benefit pension plans have been terminated or frozen, this has not been the case in the public sector.  Many private sector employers have recognized that guaranteeing employees’ retirement benefits can be unsustainable, and have shifted to defined contribution retirement plans where the burden of providing retirement benefits falls primarily on the employee.  The employer’s responsibility is primarily for the administration of the plan without guaranteeing the amount of the benefit.  An example of a defined contribution retirement plan is a 401(k) plan.  An employee’s retirement benefit under a 401(k) plan is determined by whatever amount of money is in the account when he or she retires.  Not so a pension which may be payable over the employee’s remaining lifetime or in a lump sum upon retirement which is the actuarial equivalent.  A shift to defined contribution plans in the public sector has not occurred, at least in any significance.  There are several reasons for this, most notably collective bargaining agreements and the ability of state and local governments to levy taxes.

Already, unions representing Detroit municipal employees are going to court trying to convince the bankruptcy court that employee pensions must be honored since they are written promises made under contract.  Should they win this argument this will be at the loss of creditors, investors, and Detroit taxpayers.  Assets held in trust for Detroit’s general retirement system benefits were approximately $2.16 billion at June 30, 2012.  This belongs to the employees and not subject to restructuring.  It is only the unfunded portion of the pension (estimated to be $1 to $3 billion) that is subject to restructuring.  How this is done may determine how other state and local governments proceed to deal with their underfunded pension plans.

The Pension Benefit Guaranty Corporation (PBGC), a government agency insuring pension plans in the private sector and funded with premiums from employers who sponsor pension plans, provide retirement benefits to those whose companies have gone out of business.  However, the PBGC provides benefits up to a fixed amount and does not guarantee full benefits to retirees.  The PBGC does not cover public sector plans and therefore, taxpayers may become the insurers of last resort.

It is time that public sector employers with underfunded plans think seriously about moving to defined contribution plans and terminating or freezing their defined benefit pension plans.