Saving Detroit: Infrastructure and Employee Pensions

The state of Michigan has declared the city of Detroit to be bankrupt. A financial manager, Kevin Orr, has been designated as "emergency financial manager," a position with broad powers that essentially puts him in charge of the city. Where this leads no one knows. 

The various stakeholders will be making arguments before a federal bankruptcy judge. Detroit is said to have a debt of $18 billion, of which about half is said, by someone’s calculation, to be pension funding shortfall. A considerable fraction of the remainder is said to be uncovered healthcare commitments to public employees. There are two issues that need to be addressed: how to deal with the present debt, and how to make Detroit a financially viable community once more. Both must be addressed in a coherent fashion.

John Cassidy provides some perspective on Detroit’s problems in a brief article in The New Yorker: Motown Down.

"Contrary to what some commentators have been arguing, however, Detroit’s troubles can’t be traced simply to bloated payrolls and intransigent public-sector unions: decades of deindustrialization are the main culprit. The population peaked in 1950, at 1.85 million. Since then, as the auto industry declined, and almost all the city’s white residents moved to the suburbs, the population has dropped by about sixty per cent. The city’s payroll has fallen even faster. In 1951, Detroit employed nearly thirty thousand people. Today, it employs about ten thousand five hundred people, and their salaries and their benefits are hardly extravagant. Since 2010, through furloughs and other measures, the city has cut its employees’ wages by close to twenty per cent. The average municipal pension is nineteen thousand dollars a year."

Cassidy fears that Detroit will become a battleground where political conservatives can continue their attacks on unions and public-sector pensions.

"As things stand now, the proceeding could degenerate into an exercise in privatization, union busting, and the imposition of further sanctions: Orr proposed that the unfunded portion of the city’s health-care and pension benefits be cut by up to ninety per cent."

The Obama has thus far indicated that this is a situation that Michigan, Detroit, and the stakeholders will have to resolve. Cassidy argues that this stance is politically expedient, but inconsistent with federal actions in the cases of other disasters.

"Earlier this month, in the Times, Steven Rattner, who was the Obama Administration’s point man on the auto bailout, noted that people living in Detroit are no more responsible for their woes than are people who live in parts of the country devastated by Hurricane Sandy, areas that were awarded tens of billions of dollars in federal aid."

An even more relevant example might have been New Orleans after Katrina. The rebuilding of that city and the cost of securing it from the threat of other storms far exceeds anything that might be needed to get Detroit back on track. A slowly building economic disaster is no less a disaster than hurricane-induced flooding.

Cassidy correctly argues that Detroit provides the perfect example where the federal government should step in and invest in upgrading Detroit’s infrastructure so that it can once again attract businesses and residents who are looking for the excitement of city living. The auto companies received $80 billion to help them get back on their feet. Shouldn’t the city that shared their hard times also get some help?

Detroit raises the issue of how to rescue a city that has been overcome by events. How does one provide it with a new start? It also provides an opportunity to seriously consider, at a national level, how to deal with accumulating pension liabilities that everyone agrees are underfunded.

An article in The Economist provides some useful background information. Tales are told of public employees who abuse their pension plan’s terms and walk off with exorbitant retirement income. Such things do happen, but they are not the norm.

"Most public-sector workers do not benefit from such boondoggles. The average pension payment in California is around $29,000 a year; in Detroit it is $19,000. In some states, those who receive public-sector benefits do not qualify for Social Security (the federal pension scheme that applies to nearly all workers, public- and private-sector). So their pension may be their only income when they are frail."

Public-sector pensions appear overly generous only because private-pension options are so miserly. The strategy should be to preserve the legitimate benefits available to public employees and construct a path whereby private sector employees can attain something similar. The topic of conversation should not be what can be done with public pensions, but rather what can we do about private-sector pensions.

The first step is to protect Detroit’s employees and retirees from predatory political ideologues. The legal status of pension commitments is cloudy.

"....the legal protections granted to employee pensions are a matter of state, not federal, law. Courts have tended to treat pension rights in two ways: either they are deemed to be "property interests" or they are subject to the law of contract. If they are property interests, the courts seem willing to allow rights to be reduced, particularly in the case of a financial crisis."

"Where pension rights are regarded as contracts, however, change is much more difficult. The federal constitution says no state shall pass a law impairing contracts. Some courts have interpreted this to mean that pension benefits are sacrosanct. Some states, including Illinois, have constitutions saying that public-sector pensions cannot be diminished or impaired. What does this mean? Some courts have ruled that while benefits already earned must be protected, future benefits can be reduced. Others have ruled that the pension promises made when an employee starts work must be kept for the rest of his life."

It is not clear what the status of Detroit’s system is, but it must at least be considered an implied contractual agreement.

When AIG was given $182 billion of taxpayers’ money to rescue itself from its own stupidity, it was discovered that 400 AIG employees were targeted to receive $165 million of that money as bonuses for their roles in trying to destroy the world economy. The public was outraged at such arrogance. The powers in charge at the time decided that it would be inappropriate and illegal to force the violation of a contract, so the bonuses were paid.

If the financial rights of the bad-actors at AIG could be sheltered by the sanctity of contracts, why not the financial commitments to the innocent bystanders who are the public employees and retirees of Detroit?

The claim has been made that defined-benefit pension plans are too expensive for businesses. The response has been to move to defined-contribution plans (401K or 403B) where funds depend on the level of employee contribution, the wisdom of the employee’s investment decisions, and the fees extracted from the earnings by financial institutions.

This approach can be made to work, but many companies provide no such plan, and others that do, contribute so little that it is mainly the employees’ responsibility to save for the future.

In Moving to a National Retirement Plan we discussed how the equivalent of a 401K plan could be instituted at a national level with moderate contributions required from both employers and employees. In principle, existing defined-benefit plans could be converted to this national plan by funding the participants’ accounts at appropriate levels that would approximate the anticipated earned benefits.

Hopefully, Detroit’s plight will generate not precipitous action, but rather, a dialogue on how best to prepare all workers for a more stable economic future.