Pension Reform

Can Detroit Touch Pensions?

Municipal bankruptcy and public pension problems go hand in hand. Much of the discussion surrounding the most recent headline-grabbing Chapter 9 municipal bankruptcy cases focuses on the funding of public pensions. Different cities have taken varying approaches to public pension. As addressed in the State Budget Solutions’ reports, including “Municipal Bankruptcy: A Guide for Local Officials,” not all approaches to pensions in bankruptcy are successful. In some cities the wrong approach created troubling outcomes, which underscores the need for Detroit and other cities facing municipal bankruptcy to get pension reform right.

Officials in Vallejo, California, failed to negotiate with pensioners as part of its plan to emerge from bankruptcy. Now, the city faces an even larger unfunded pension liability that is eating up an even greater portion of general fund budget. Similarly, in Stockton, California, the city’s recently proposed plan to exit bankruptcy avoided the unfunded pension liability, prompting Moody’s Investors Service to further downgrade its pension obligation bonds. These examples lend credence to the argument for addressing pension benefits and liabilities under Chapter 9 bankruptcy protection, but say little about the legal ability to actually do so.

In Detroit, pensioners are among the creditors awaiting a hopefully favorable outcome. Detroit faces a minimum of $3.5 billion in unfunded pension liabilities. Put another way, Detroit city employees have earned $3.5 billion in retirement benefits that the city currently does not have the money to pay.

Pensioners are the only group of creditors directly protected by the Michigan State Constitution. Article IX, Section 24 of the Michigan State Constitution states, “The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.”

Detroit City Manager Kevyn Orr moved to readjust this debt, but some argue that any steps taken by him would be in violation of the state constitution. The reality is more complex and carries lessons for other municipalities that may face bankruptcy.

In a Wall Street Journal op-ed, bankruptcy law professor David Skeel points out that pensioners are not entitled to anything in the restructuring pensions through bankruptcy, and that earned benefits could simply disappear. Indeed, that would be both legally and morally troublesome. “As of June 30, 2012,” Skeel writes, “the assets held in trust for Detroit’s general retirement system benefits were valued at $2.16 billion. These funds are property of the retirees, much as the collateral a borrower puts up to secure a loan belongs to the lender. It is only the unfunded portion of the pensions…that is subject to restructuring.”

The first reason is simple: The U.S. Constitution authorizes Congress to enact bankruptcy law. Chapter 9 is federal law, and federal law trumps even state constitutions. Article 1, Section 8, Clause 4 of the U.S. Constitution authorizes Congress to enact “uniform laws on the subject of bankruptcies throughout the United States,” and the Supremacy Clause deems laws made by Congress in pursuance with the Constitution “the supreme law of the land.”

Another argument for the ability to restructure pension benefits under bankruptcy takes a slightly different view of the Michigan State Constitution, which grants pension benefits status as contractual obligations. What the constitution does not do, in this case, is grant that particular contractual obligation priority over the state’s other obligations that will certainly be eligible for restructuring under Chapter 9 protection.

Michigan’s Constitution adds another unique wrinkle into the fold. Article IX, Section 24 continues beyond protecting pension benefits as a contractual obligation, stating that pension benefits must be paid for in the year that the service for which they are being provided is performed. “Financial benefits arising on account of service rendered in each fiscal year shall be funded during that year and such funding shall not be used for financing unfunded accrued liabilities.”

Given this, it can be argued further that employees and retirees are protected up until the amount that benefits were put aside in the years they worked. Unfortunately, the City of Detroit’s record at putting aside enough money each year as benefits were earned is rather dismal.

There is no one-size-fits-all solution for the best way for cities to readjust pension benefits in bankruptcy. The financial and political drivers of each bankruptcy case are quite unique, and a successful emergence from Chapter 9 requires a laser-like focus on these items. But the very realistic situation in which pensioners are not a legally untouchable class of creditors as they are often assumed to be demonstrates the need for immediate action across the country to protect the promises of retirement security made to public employees before more municipalities are forced into bankruptcy.

In Depth: Pension Reform

Modern, 401(k)-style plans are now commonplace in the private sector. For state workers, however, traditional pensions are still the norm. As former Utah State Senator Dan Liljenquist wrote in Keeping the Promise: State Solutions for Government Pension Reform, this is not a partisan issue, but a math problem. State Budget…

+ Pension Reform In Depth