Detroit as Bellwether? Maybe Not

January 24, 2014 ( – Experts agree, while there’s a good chance Detroit’s bankruptcy proceedings will set some important legal precedents, the process won’t lead a rush of cities to seek court protection from creditors.

The reasons, according to Hank Kim, executive director and counsel for the National Conference on Public Employee Retirement Systems (NCPERS), are numerous. Perhaps most important is how painfully expensive and complicated it is to actually navigate a bankruptcy. That’s true for an individual, Kim explains, but even more so for large municipals with substantial, open-ended borrowing needs to pay for future city services.

“It’s an imprecise analogy, but many of the things that you expect going through an individual bankruptcy, municipalities face the same thing, but in an even greater magnitude,” Kim says. “First, in actually going through bankruptcy proceedings, there is the cost of legal fees and other fees associated with the filing. And then, on the other side, it’s not as if you have a clean slate. As an ongoing entity with ongoing borrowing needs … there’s going to be a lasting impact there.”

Kim says the future cost of borrowing for municipals grows exponentially following a bankruptcy, reducing the financial attractiveness of entering bankruptcy for all but the most desperate city governments.

For its part, Detroit probably fits the bill. Media reports and figures released by city officials put Detroit’s total debt at about $18.5 billion. The city’s state-appointed emergency manager, Kevyn Orr, says that as much as $3.5 billion of the total represents unfunded pension liabilities (see “Detroit Pensions’ Lawsuit Against Bankruptcy Stayed”).

Others, including Bob Klaunser, an outside attorney working with Detroit’s pension funds during the mediation process, say the figure is substantially lower, probably closer to $700 million. “There’s an old joke about two actuaries,” Klaunser says of the wide gap between the city’s estimate of unfunded pension liabilities and those coming from the unions representing Detroit’s retired workers. “They’re out duck hunting in a field, and one shoots 20 yards ahead of the duck and another shoots 20 yards behind. Together they yell, we hit it!”

Kim is quick to point out other figures that paint a slightly rosier picture of Detroit’s financial health—at least when it comes to its pension debts. Both of Detroit’s public pension plans, he says, are relatively well funded and provide yearly pension payments below the national average for municipal systems. In fact, the average retired policeman or firefighter in Detroit earns $19,000 through pension payments and is ineligible for Social Security. Kim says the national average is somewhere around $22,500.

“The real story of Detroit’s demise is one of a formerly prosperous American city ravaged by unprecedented population loss, major tax base erosion, steep property value declines and a loss of economic competitiveness,” Kim says. “There’s no shortage of commentators who opine that taking benefits away from Detroit’s retirees and city workers will not solve the city’s financial problems.”

The same argument applies widely for distressed cities in the U.S., Kim says. He frequently stresses that public pensions, as a percentage of state budgets, are on average about 5% of expenditures (see "City Pensions Not the Burden Media Suggests"). That’s probably too low for most states or cities to feel entering bankruptcy is the right way to address pension debt, he explains.

“The majority of the states’ money is going to education and Medicaid expenditures, and again, on average the public pension benefits are very modest,” Kim says. “Here’s something else to note. The beneficiaries are retired police officers, teachers, and firefighters and other public servants who, when they retire, tend to stay in the jurisdiction or state in which they worked. So a lot of the money that these pensioners are getting is put right back into the local economy.”

Ongoing Mediation

If city and pension fund negotiators can agree on a liability close to $700 million, a new deal proposed by Michigan Governor Rick Snyder could go a long way in taking pension payments off the proverbial chopping block.

Snyder is recommending that the Michigan Legislature approve up to $350 million to help fund the city’s pension obligations, though he has also emphasized that the funds would come with some strings attached, including that labor unions would have to agree to drop their legal challenges to the city's bankruptcy.

Those challenges are currently waiting on an opinion from the 6th U.S. Circuit Court of Appeals on whether federal bankruptcy Judge Steven Rhodes erred when declaring, in a potentially precedent-setting decision, that Detroit is eligible for bankruptcy and that pensions can be cut in a forthcoming plan to resolve the city’s massive debt.

The state money could be merged with an additional $330 million offered up by a group of nonprofit foundations, pledged to help prevent the sale of artwork from the Detroit Institute of Arts to cover the pension liabilities.

Due to his involvement in the mediation process, Klausner couldn’t comment directly on whether that deal is likely to succeed. He did say that, whatever the outcome for Detroit, it’s common in municipal bankruptcies to see the pace of future accruals of retirement and health benefits to be reduced for city workers.

That’s in part why Orr reversed a decision last December to freeze the city’s pension funds, Klausner says (see "Pension Freeze for Detroit City Employees Delayed"). “Plan closings are far more expensive than simply limiting the future accruals in an open plan,” he explains. “That saves a lot more money. The reason why you get savings is that, looking at the remaining working lifetime of the people who are in Detroit now, they’re going to accrue pension benefits at a lower rate, and then the projected future liability of the plan is smaller. That then improves the bottom line on long-term liability.”

Here’s where the potential for precedent-setting decisions comes into play, Klausner explains. “Judge Rhodes’ decision could be read as saying he can cut both forward and backward for retirees, which would be precedent setting,” Klausner says. “In terms of future accrual of benefits, there are two active interpretations of what the Michigan constitution means [in the sections aimed at protecting pensioners], whether it is only intended to protect what has been accrued to date, representing past service, or whether changes can only be applied going forward.”

Complicating the matter, Klausner explains, is a separate Michigan court of appeals decision from a few years ago which can be read as setting limits on the way accrued benefits can be changed. In that case, it was decided that for vested participants in a pension plan, accrued benefits are those that are covered in the formula that was used to calculate benefit values on the day the participant became vested.

“So let’s say the formula was 2% [of pay] for each year of service, and the leadership decides to change the plan terms, they can change benefit accruals going forward for people who do not yet have 10 years of service, except for benefits they’ve already earned,” Klausner explains. “Whereas those people who are vested, meaning they could leave tomorrow and wait to get their benefits at a later date, they’re entitled to receive benefits according to the formula that was in use on the day that they became vested.”

Mediators are sorting out that question and many others, Klausner says, including issues regarding health benefits and whether they are entitled to the same protections as pension payments.

 The (Long) Road to Resolution

Both Kim and Klausner declined to estimate when Detroit’s pensioners will have a better sense of how they will be affected by the city’s bankruptcy.

“I could not reasonably hazard a guess,” Klausner says. “I worked on a substantial federal case involving the Kentucky retirement system earlier in my career that took literally 12 years to wrap up from the time it was filed to the day the U.S. Supreme Court issued its judgment. The federal appeals courts work on their own schedule. That’s not to suggest that they drag their feet, but you know, there are a lot of cases out there.”

Klausner adds that, with at least 30,000 active and retired Detroit employees and an additional 120,000 family members also depending on the pension funds, the uncertainty affecting so many Michigan citizens probably warrants some expedited review. But while the pension funds have petitioned the 6th Circuit for a faster review process, judge Rhodes has also weighed in, urging the circuit court not to rush such a complicated appeal.

“There’s also a federal constitutional question in here,” Klausner says. “At least 24 states allow cities to file for bankruptcy either on an unrestricted basis, or with some additional considerations, like Michigan. The general constitutional issue is, to the extent that the bankruptcy judge is in effect nullifying a provision of the Michigan constitution, on a matter which congress has said many times is not something it has the right to regulate over the states, namely state and local pensions, then we have a federalism question about the relative powers of the state and federal governments.”

Such questions could, Klausner says, push this case all the way to the U.S. Supreme Court.

“It’s essentially an issue of how one reads the Commerce Clause of Article I of the U.S. Constitution, which addresses the Congress’s right to regulate commerce among the states,” Klausner continues.” How does that balance against the 10th amendment, which provides that powers not granted to the federal government by the Constitution, nor prohibited to the states, are reserved to the states?”