Detroit Exits Bankruptcy with ‘Grand Bargain’ that Reduces Pensions of 23,000 City Retirees
As Detroit moves forward in its exit from bankruptcy, thousands of pension holders will see a reduction in their pension benefits.
On the heels of 16 months of negotiations with banks, bond insurers, unions and groups representing thousands of retirees, the nation’s largest municipal bankruptcy has officially come to an end.
In November, U.S. Bankruptcy Judge Steven Rhodes approved Detroit’s "Plan of Adjustment"—a two-year budget which has been implemented by the now-former emergency manager Kevyn Orr to eliminate $7 billion in debt and settle with major creditors.
As part of the restructuring plan, the city has been granted authority to implement the “Grand Bargain” to help reduce pension cuts, preserve the Detroit Institute of Arts, and start improving basic services.
Detroit’s Grand Bargain Comes with Costs
The Grand Bargain is grand in every way. Called the “cornerstone” of Detroit’s restructuring proposal by Judge Rhodes, the $660 million deal is designed to shore up Detroit's pensions using funds from the state legislature, multiple local foundations, and the Detroit Institute of Arts, a recent Metrotimes news blog reported. As part of the bargain, the DIA's collection will be handed over to a nonprofit and saved from a possible sale.
Even though the deal spared most municipal retirees deep direct pension cuts, the reductions will have a lasting impact on the 23,000 pensioners who now face a considerable loss of income and may have to apply for aid.
Under the bargain in the bankruptcy plan, cuts in monthly pensions would range from 4.5 percent to 20 percent. According to an article in the Detroit News, the state has allocated money toward a safety net to help those retirees who are most at risk of falling below the poverty line.
A story on Michigan Radio said the city is also kicking into this $55 million ‘income stabilization fund,’ to which pensioners can apply through the end of 2014 if cuts in their pensions cause them to fall below 130 percent of the federal poverty level. Pension cuts of approximately 4.5 percent affecting thousands of retirees are scheduled to take effect on March 1.
California Cities Did Not Cut Pensions
Contrast this scenario to what is happening in California: two bankrupt cities in a position to cut pensions are not planning to do so. A story in the Sacramento Bee reported that even though a court ruling enables pension benefits to be legally reduced if employers go bankrupt, both Stockton and San Bernardino have agreed to pay CalPERS—the powerful California Public Employees’ Retirement System—in full.
In the case of Stockton, Sacramento bankruptcy court Judge Christopher Klein made his ruling on October 1, in response to arguments made by creditor Franklin Templeton Investments, who disputed the fact that the city could pay CalPERS in full while giving the investment firm just 12 cents on the dollar.
One month later, however, it appeared as if Judge Klein ignored his initial ruling, approving Stockton’s reorganization plan that included intentions to continue to pay $29 million into CalPERS each year. Experts believe in his second ruling, the judge was evaluating a potential situation which could have resulted in a mass exodus of city employees if their pensions were reduced by an estimated 60 percent. Franklin Templeton is appealing the decision.
In the case of San Bernardino, the city actually withheld payments from CalPERS for several months after it filed for bankruptcy in 2012, accumulating $14 million in past-due payments. After months of legal fighting, San Bernardino and CalPERS reached a tentative agreement in June which includes repayment with interest in 24 equal installments. Starting this July, the city has been repaying CalPERS the overdue amount, already covering $4.5 million of its past-due bill.
Beyond an Underfunded Bargain?
If Detroit’s Grand Bargain falls into place as it has been laid out, retirees will continue to receive their pensions, albeit smaller, for the rest of their lives.
However, an article in the New York Times pointed out that lingering fundamental pension problems that helped land the city in bankruptcy in the first place haven’t completely been resolved. Similar to other public systems around the country, Detroit uses a funding formula that falls behind the actual cost of pensions.
The city’s pension obligations are not trivial. Even after significant cuts, Detroit’s 32,000 current and future retirees are eligible for pensions worth more than $500 million a year, the article found, more than twice the city’s recent municipal income tax receipts. Success is dependent on robust and regular investment returns that average 6.75 percent a year for the next 10 years. Shortfalls will ultimately be covered by the taxpayers.
“The city has the potential to be saddled with an underfunded pension plan,” warned Martha E.M. Kopacz, the independent fiscal expert Judge Rhodes hired to help him shed light on the feasibility of Detroit’s strategy.
In his opinion, even Judge Rhodes expressed his “greatest concern” for the city “arises from the risks that the city retains relating to pension funding.”
The city’s approach, which includes making undersize pension contributions in the near term while ramping up payments down the road, is similar to what many other cities and states do based on the recommendations of their actuaries.
These actuarial standards of practice are now converging with Detroit’s issues in debate. Actuaries are discussing whether the public will be protected from more public bankruptcies in the future with current actuarial methodology.
On this issue Judge Rhodes said, “History will judge the correctness of this finding.” Michigan must “assure that the municipalities in this state adequately fund their pension obligation. If the state fails, history will judge that this court’s approval of that settlement was a massive mistake.”
Mark Johnson, Ph.D., J.D., is a highly experienced ERISA expert. As a former ERISA Plan Managing Director and plan fiduciary for a Fortune 500 company, Dr. Johnson has practical knowledge of plan documents as well as an in-depth understanding of ERISA obligations. He works as an expert consultant and witness on 401(k), ESOP and pension fiduciary liability; retiree medical benefit coverage; third party administrator disputes; individual benefit claims; pension benefits in bankruptcy; long term disability benefits; and cash conversion balances.
ERISA Benefits Consulting, Inc. by Mark Johnson provides benefit consulting and advisory services and does not engage in the practice of law.
Copyright ERISA Benefits Consulting, Inc.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.