Detroit Bankruptcy Could Impact Other State, City Bankruptcies

Other states, cities in similar situations due to high retirement costs for public employees

Detroit, Mich. / AP
July 26, 2013

Detroit’s bankruptcy could set off a chain reaction in state capitals and city halls across the country, as lawmakers weigh burgeoning retirement costs for public employees against public services.

Retirement costs for public employees constitute roughly 50 percent of Detroit’s $18.5 billion debt, according to bankruptcy filings. The city reported a $3.5 billion shortfall on its two pension systems, along with more than $5 billion in retiree healthcare plans. It also borrowed more than $1 billion to make its contributions to the system, according to James Hohman, a pension expert with Michigan’s Mackinac Center.

A judge temporarily halted the city’s plan to escape the mounting debt through bankruptcy, citing the Michigan state constitution’s guarantee of pension benefits. The proceedings moved forward toward federal bankruptcy hearings Wednesday.

Twenty-seven other states have similar language in their state constitutions, including California, where three cities have declared bankruptcy since the great recession beneath the weight of an aging population and generous retirement benefits. However, Detroit stands apart from cities like Stockton and San Bernadino, according to University of California-San Diego professor Steven Erie, an expert in municipal fiscal failure.

"California doesn’t have the underlying demographic and economic factors that put enormous pressure on the public sector," he said. "There’s no winning strategy in Detroit … so we’re watching the case law very carefully."

Other states have made peripheral cuts to their retirement systems in an effort to cut costs. For instance, a Colorado judge allowed the state to cut cost-of-living adjustments—annual pension increases that reflect rising inflation and food prices—for its retirees.

Detroit could be the first major city to attempt cuts to principal benefits, which are often interpreted as unbreakable contractual obligations. If the city succeeds, other states with heavy pension burdens—such as Illinois with a pensions debt somewhere between $100 and $200 billion—could follow suit. If it fails, lawmakers could launch efforts to repeal those portions of the constitution.

"It’ll be interesting to see where the bankruptcy judge places deference: the creditors or retirees," Erie said. "That case law could very easily lead states—particularly red states in the heartland, south, and mountain west—to introduce legislation to amend their constitutions."

Detroit is the first major city to be forced into bankruptcy, rather than taking "elective bankruptcy" following fiscal shocks brought on by bad investments, according to Erie. American Enterprise Institute scholar Andrew Biggs agreed that Detroit is the victim of decades of mismanagement rather than bad stock market bets.

"This is a case where the prospects for recovery look pretty dim," Biggs said. "It’s a hollowed out city; the population that is left there are beneficiaries, rather than tax payers and the city doesn’t have the liquidity to even service its debt."

The average Detroit pensioner takes in about $19,000 per year, about $4,000 higher than the average social security recipient. They also retire earlier than most Americans. An estimated 40 percent of the city’s retired employees are below the age of 65; one in five is retired before 60.

The systems were not designed to sustain 30-years of retirements. Pension costs soon began to crowd out maintaining government operations. The average 911 response time grew to an hour, as the city dealt with understaffed police and fire departments. The fact that retirement costs represented 20 percent of public safety payroll played a large factor in such inefficiencies, according to Hohman, the Michigan pension expert.

"The problem is not generosity, but the reluctance of the city to properly fund it," he said. "When you have no other revenue recourse, when your tax rates are at their highest and your borrowing as much money as you can, you eventually run out of options and slash services."

Detroit attempted to tax its way out of the problem, maintaining the highest per-capita tax rate in the state, according to Hohman. It also opened up tax streams through non-residents through city casinos. It wasn’t enough to sustain city coffers.

"When you are required to pay your pension, something else has to give because you can’t double the tax rate to close the gap," Biggs said. "A larger share of the budget is going to have to go to retired firefighters, cops, and teachers, rather than working age firefighters, cops, and teachers, and there’s less money for books and equipment."

The city, along with the bankruptcy court, now has to consider whether it will pay off Wall Street, its contracts with city vendors, or the retired workforce. Those choices will come at a cost, according to the experts who spoke to the Washington Free Beacon.

Biggs, a former Social Security Administration official, said that bond holders were well-aware of the risks of investing in the beleaguered city, while retirees were kept in the dark about the fiscal health of their retirement plans.

"By and large the employees did what they were told to do. If the government didn’t do its part, then the retirees shouldn’t be forced to pay for that," he said. "I tend to think the bondholders should take a much bigger hit; if you were buying a municipal bond from Detroit, you knew what you were getting into."

Forcing bondholders to take a hit could carry long-term impacts on public policy even if Detroit is able to recover from its death spiral, according to Erie. The city could lose out on future investing opportunities that could help it achieve prosperity down the line.

"If the burden is passed on to investors, what’s the chance of Detroit getting back into the bond market in the 21st century?" he asked. "Nobody is going to want to do business in the city because they might get shorted again."

Erie and Biggs are agreed on one thing: It didn’t have to come to this.

"If we’d taken different route 20, 30 years ago, we wouldn’t have to sit here and make these choices," Biggs said. "There isn’t any quick way out, there’s no painless way out."

Published under: Detroit