The Defined Benefit Pension Death Spiral, Detroit And California Edition

The defined benefit pension plan is the ultimate mechanism yet devised by politicians to make unsustainable giveaways to favored constituencies today and hide the costs from the citizenry until long after the politicians are gone.  If not assiduously funded on real assumptions (in the real world, there is no actual example of this occurring) such plans in the public sector are forms of slow-acting Ponzi schemes that can take 50 or more years to play out to their final crash.   A few small California cities (Vallejo, Stockton, San Bernardino) have been the first to hit the wall, but now we have a much bigger crash victim:  Detroit.

On Friday Detroit, via its new emergency manager Kevyn Orr, put out a 134 page report entitled "City of Detroit Proposal for Creditors."  Follow the link to get your very own copy.  It is a real eye-opener in many respects, but mostly in revealing the extent to which vast pension liabilities have been taken on and hidden from the citizens.  

First, an overview of Detroit's finances.  Its annual budget is a bit over $1.1 billion, down from almost $1.4 billion as recently as 2008.  Trouble is, it can't raise even the $1.1 billion in taxes.  The biggest source of revenue is a city income tax of 2.5%, raising $233 million in 2012.  But that 2.5% rate is the highest in Michigan, and the number of jobs in Detroit is dropping precipitously (from 354,000 in 2000 to 280,000 in 2012), so revenue from the income tax is dropping.  Meanwhile, property values in Detroit are virtually nothing, so there is no potential for getting money from that source.  Property tax revenue has dropped from $155 million as recently as 2008 to a projected $135 million for 2013 (page 44).

As to the defined benefit pension plans, Detroit's two main plans have most recently been reporting Unfunded Actuarial Accrued Liability of around $645 million (page 31).  If you amortize that over 30 years it's around $20 million a year.  Add in the cost of new accruals at around $30 million a year, and you get a required payment of $50 million a year, which by the way, Detroit did not make last year and is not going to make this year.  But are the assumptions real?  The main assumptions are laid out at page 31 of the report, including a 7.9% interest rate for one plan and 8% for the other.  Redo the UAAL with real assumptions and now you get --  UAAL of $3.5 billion!  What does that mean in terms of a required annual payment?  Go to page 109, and the answer is -- $200 million to $350 million per year.  That's as much as 30% of revenue, when Detroit does not have enough revenue to pay operating expenses.  This is not going to happen.  Detroit has hit the wall.

The gist of this report is that Detroit is about to open a negotiation with creditors, and proposes to treat pension plans as unsecured creditors who will get an undetermined "cents on the dollar" payment pro rata with all other unsecureds.  Meanwhile, pension benefits continue to be paid, and the value of assets in the pension trusts is dropping rapidly (the value of the assets in the trusts has dropped by some $1.7 billion over the past 5 years - page 24).  So even though Detroit has hit the wall, we have a likely long negotiation ahead of us.  And even after the negotiation is concluded, it will again be a long time before we know how Detroit's retirees will fare.  Maybe the trusts will just keep paying until they run out of money, and after that, everybody gets nothing.  But any way you look at it, the majority of the existing pension promises in Detroit are illusory.  Meanwhile, it took the destruction of the city to get to this point.

Out in California,  things are almost as bad, with the wall gradually coming into view out there on the horizon for those willing to look.   Recall that back on April 2 I commented on  Paul Krugman's March 31 column about California, titled "Lessons From a Comeback." Krugman is all excited that California, having greatly raised income tax rates for high earners in a November 2012 referendum, is now predicting a budget surplus.  He's not paying attention to the fact that the tax increases were retroactive to January 1, 2012, and therefore gave the victims no opportunity to take evasive action as to the first year's income subject to the new rates.  He's also not paying any attention to the pension funding issue.  Let's see how the second year works out. 

So how are those defined benefit pension plans doing in California?  Here at Fox News on June 12, Elizabeth MacDonald reports that Moody's has now come up with its own criteria for evaluating defined benefit pension obligation.  Result?  The unfunded liabilities for state and local plans in California go from the previously-reported $128.3 billion to $328.6 billion.  On a per capita basis, that's more unfunded liability than Detroit, although California is a richer place.  Overall, they have a long way to go before they run out of cash; but individual cities and towns can be in far worse shape than the average.  For example, under the Moody's criteria, Los Angeles' funded ratio falls from 77% to 50%, almost $50 billion short.  That's rather dangerously close to death spiral territory.  But this will play out over many, many years.

And back in Illinois, the state legislature adjourned for the year without doing anything about pension funding.  The governor is trying to get them back for a special session.