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The Looting of Detroit’s Pensions

Sunday, February 16, 2014

Giving elected officials the power to change the ways that public employees earn future benefits may make the difference in avoiding further Detroits.

A federal judge has ruled Detroit’s public employee pensions are “on the table” as part of the city’s multi-billion-dollar bankruptcy. The response from public employee unions — and, to be honest, the initial response I had — was that Detroit’s main pension plan, the General Retirement System, was reasonably well-funded and played no role in the city’s fiscal woes. Detroit’s workers had done their part, paid their contributions, and played by the rules. And so, it seemed, Detroit’s workers didn’t simply need to be paid their pension benefits to forestall poverty. They deserve these benefits, in a way that a Wall Street bond buyer who knowingly purchased Detroit’s risky debt doesn’t.

But then I looked further into what happened at the GRS. “Deserve” was no longer a term that came to mind. “Looting” may be as apt as word as any, and one that surely would have been applied had the beneficiaries of Detroit’s pension mismanagement been, say, a corporation’s top managers rather than a city’s employees. It’s hard to know what should be done about Detroit’s pensioners, many of whom would truly be impoverished if subjected to major benefit cuts. But the conventional morality play painting Detroit’s employees as mere bystanders to the city’s fiscal bankruptcy is clearly wrong.

Public employee unions point out that Detroit’s average pension benefits are low, at around $20,000 per year after a career in public service. In reality, though, Detroit’s employees got a much better deal than you’d think — and not all of it was entirely by-the-books. For instance, the GRS’s seemingly modest average benefit is drawn down by short-term employees who worked only a few years. It also excludes other benefits employees receive.

To illustrate, consider a Detroit city employee who retired after a full career of 35 years on the job. He would receive a traditional “defined benefit” pension of around two-thirds his final salary. Adding Social Security benefits, that Detroit worker could retire at around 95 percent of his prior earnings. This is a better pension than most Americans will receive and more than adequate by financial advisors’ standards.

While private sector workers must finance most of their retirement, and the average state or local government employee contributes around 6 percent of pay toward his pension, Detroit workers contributed nothing to the GRS.

And Detroit workers got this pension on the cheap: while private sector workers must finance most of their retirement, and the average state or local government employee contributes around 6 percent of pay toward his pension, Detroit workers contributed nothing to the GRS.

Moreover, Detroit city employees also had a voluntary 401(k)-style “defined contribution” plan, but with a twist: employees made their own contributions, but the city guaranteed a minimum annual return of 7.9 percent. Given that riskless U.S. Treasury bonds paid only around 2 percent and that the stock market often lost money in recent years, this was an absurdly generous guarantee — and one that reportedly left some employees with retirement accounts in the hundreds of thousands of dollars.

The GRS also offered bonus payments in good times. Both workers and retirees received so-called “13th checks” around the holidays. In addition, workers’ supplementary accounts received bonuses on top of the 7.9 percent guaranteed return, funded out of the GRS’s investments. These bonus payments reportedly topped $950 million from 1985 through 2008. If kept in the fund and allowed to earn interest, they might be worth $1.9 billion today.

One might respond that, while these bonus payments may seem inappropriate in hindsight, the GRS is still a reasonably well-funded pension plan that had nothing to do with the city’s bankruptcy. But even that story is incomplete. By 2005, then-Detroit Mayor Kwame Kilpatrick warned that the GRS was underfunded, but that raising contributions to required levels would mean layoffs among city employees. Instead, the city issued a $1.4 billion “pension obligation bond,” which made the city’s plans appear to be “fully funded.” With funding restored, the 13th checks, which had ceased for several years, began anew.

To sum up, Detroit offered its employees a generous pension plan with zero contributions, then sweetened the deal with bonus payments. When the pension became underfunded, at least in part due to those bonus payments, the city borrowed money to fund the plan. The holders of those pension obligation bonds will now lose most of what they are owed.

Much more important than getting a pound of flesh out of current retirees is giving elected officials the power to change the ways that public employees earn future benefits.

Nor were Detroit’s employees indifferent to these practices. As the Detroit Free Press reported, the GRS “was largely controlled by union officials acting as trustees,” who sponsored bonus pension payments. And, when Mayor Dennis Archer sponsored a 1996 ballot initiative to stop excess payments, the unions opposed and defeated it. Simply put, for many years Detroit public employees were the beneficiaries of poor pension governance, both from the GRS board and the elected officials ultimately responsible for it. Now they may be its victims.

Thankfully, not every public pension system is like Detroit's. Even in Detroit, the public safety plan serving police and firefighters acted more responsibly, demanding at least some employee contributions and making far fewer bonus payments.

Unfortunately, many other pension systems are like Detroit's. While poor investment returns are the main cause of pensions' underfunding today, inappropriate “benefit enhancements” play a major role. For instance, the California State Teachers' Retirement System (CalSTRS) is 67 percent funded today and faces unfunded liabilities of $71 billion. But had CalSTRS not passed a large retroactive benefit increase back in 2000, it would instead be 88 percent funded. Similarly, Illinois passed an exclusion that allowed workers to avoid early retirement benefit penalties, helping employees collect hundreds of thousands of dollars in extra benefits during their retirements, with practically all the extra costs covered by school districts. Increases to New York City pensions in 2000 added $12 billion to the system’s costs over the next decade, accounting for 40 percent of the growth in unfunded liabilities. In Atlanta, benefit increases passed in 2001 and 2005 doubled the city’s contribution rate. And individual-level abuses, such as salary spiking and double-dipping, have become known nationwide. In New Jersey, for instance, 80 percent of sheriffs are “double dippers,” meaning that they collect pensions while continuing to work. This practice costs taxpayers millions.

Detroit offered its employees a generous pension plan with zero contributions, then sweetened the deal with bonus payments.

This isn’t to say that Detroit’s pensions caused the city’s bankruptcy, which derives from a combination of economic body-blows and managerial incompetence. Even with perfectly managed pensions, the city may only have delayed insolvency. But around the country, rising pension costs in a number of cities have led to so-called “service insolvency,” cuts to basic services that can be even more damaging to citizens than outright bankruptcy.

Detroit’s pension track record hardly justifies an absolutist “no cuts” policy. Yes, low-income retirees obviously can’t be targets. But higher-income city retirees could give, perhaps through lower cost-of-living adjustments (COLAs). Much more important than getting a pound of flesh from current retirees is giving elected officials the power to change the ways that public employees earn future benefits. Private sector employers have always had this right. But in government, pension benefit formulas are interpreted as lifetime contracts beginning on an employee’s first day on the job. Greater flexibility may make the difference in avoiding further Detroits.

Public employee pensions also need better oversight. Unlike corporate pensions, public plans are unregulated except by the governments that sponsor them. And many pension trustees are either union representatives or the appointees of politicians who gained office through union support, giving a fox-regulating-the-henhouse aspect to pension oversight. Pension boards are anything but neutral players in the current debates over pension reform. While pension governance is complex, simple changes — such as making employees help pay off unfunded liabilities, as Nevada’s pensions do — would align incentives toward better management.

Detroit’s pensions present a lesson: public employees won’t turn down a good deal. It’s elected officials who have to learn to say no.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.

Join AEI on Tuesday, February 18  for “The Detroit Bankruptcy: Conflicts and Implications.”

FURTHER READING: Biggs also writes “Crony Capitalism vs. Public Pensions,” “Why Expanding Social Security Is a Bad Idea,” and “Teachers and the License Raj.” Stephen D. Eide presents “A Lesson from the Wreckage in Detroit: Retiree Health Care Is Ripe for Reform.”

Image by Dianna Ingram / Bergman Group

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