What Detroit’s Debt Problem Looks Like

by Veronique de Rugy

On Thursday, Detroit filed a petition for bankruptcy protection. It wasn’t a big surprise, because the city had talked about the possibility for a while because of its serious and persistent financial problems (mostly the product of overspending and unrealistic promises made to public employees about pension and health-care benefits, thanks to the city’s 40 different unions and rampant corruption.) The Wall Street Journal explains:

Motown’s problems have been mounting for six decades and are the result of economic decline and rule by government unions. City Hall made unsustainable promises to public employees so retirement obligations now constitute half of its $18.5 billion debt. Crime, high tax rates and lousy schools have driven middle-class families to the suburbs. Two of every five street lights are broken, only a third of its ambulances are in service, and there are 78,000 abandoned buildings. In essence, self-government collapsed.

As a result, Detroit lost almost 26 percent of its population between 2000 and 2011. Ezra Klein points to these interesting charts depicting the city’s debt, from the Detroit Free Press:

As you can see a majority of the debt comes from unfunded pension and retiree health-care obligations. The Detroit Free Press offers some insight into what happened with pensions:

The city has struggled to meet its pension obligations since the 1950s. Post-war Detroit invested heavily in infrastructure, shortchanging the pension funds to pay for those improvements. Then came the auto industry recession of the late 1950s, leaving city finances in a tailspin, and leading to the first city income tax imposition.

For elected officials, frequent defaults on pension obligations to save operating cash became something close to standard operating procedure. So far, it hasn’t affected pension checks, which are paid out of money that was invested years before. But it blows a hole in the 30-year projections and long-term solvency, and it requires bigger payments from the city than would originally have been necessary.

By 1991, for instance, a Wayne County Circuit Court judge was forcing then-Mayor Coleman Young to make $53 million in overdue payments to the pension funds. Young, attempting to plug a $50-million deficit, had delayed the payment pending a tax-credit sale.

Detroit officials have also made a habit of convincing unions to accept pension sweeteners — shorter terms of employment required, more generous multipliers, or a “13th check,” essentially an annual bonus — rather than pay increases. But that has raised pensions costs and had the unintended effect of shrinking the city’s work force to the point where employee contributions can’t keep pace with the needs of current pension recipients. The city has just 9,700 workers but 21,000 retirees drawing benefits.

There is much more at the link, including the explanation the city had to borrow $1.4 billion to catch up from the loss of pension investments due to poor management and the 2008 financial crisis

But behind this poor management there is a bigger story. That’s the fact that government accounting standards are very different from the private sector ones in that they systematically tnderestimate fund liabilities, which in turn encourages poor management practices at the municipale and state levels. Here is how:  

For accounting purposes, private pension plans use the market value of their liabilities. This rule requires future liabilities to be discounted at an interest rate that matches the risks associated with the assets; the resulting value represents the amount a private insurance company would demand to issue annuities covering all the benefits owed by a given plan. By contrast, states calculate the value of pension liabilities based on the returns they expect from investing pension assets. And on average, the states assume an unrealistically high 8 percent annual return on pension investments while the actual rate should be closer to the yield of 15-year treasury bonds. Here is why that’s so problematic.

Pension funds need to assume a certain rate of return on their current assets in order to gauge whether or not the assets held today will be enough to pay future benefits. Obviously, the assumed interest rate or rate of return has a major impact on whether a pension plan is adequately funded. Most pension plans would rather play it conservatively and assume a lower rate of return, so that they ensure that the assets they have today will be enough to cover tomorrow’s promised benefits. But the states would rather put less money up front today, so they’re pinning all their hopes of being able to pay benefits tomorrow on an 8.5 percent annual growth rate. If that 8.5 percent growth rate doesn’t come to fruition, either tomorrow’s beneficiaries will see a cut in their benefits or taxpayers will be asked to pick up the tab. It would be much more prudent to assume an adequate risk-adjusted rate of return closer to the rate offered on 15-year Treasury bonds—3.5 percent, say—and fund their plan accordingly.

An unrealistically high discount rate also means that states are highly discounting the likelihood of future payments. In other words, the states are essentially stating that there’s a low probability that they’ll have to pay their pensioners.  

As the paper mentions in its article, Detroit’s funds managers assume a rate of return on their annual investments between 7.9 and 8 percent, but no adjustments were made when they didn’t meet those hurdles, and the consequences of these poor management decisions are coming back to hunt the city. The scary thing: Detroit isn’t alone. As I wrote a few years ago:

State officials estimated their plans’ unfunded liabilities at $452 billion, with total liabilities of $2.8 trillion. But when economist Andrew Biggs of the American Enterprise Institute calculated the figure with the methods used by private-sector pensions, he found that total liabilities amount to over $5 trillion, with the unfunded liability at $3 trillion. (See Figure 1.)

Since much of government pension liabilities is off the books, most states and cities underestimate their actual debt. In Figure 2, Joshua D. Rauh, an associate professor of finance at Northwestern University, and Robert Novy-Marx, an assistant professor of finance at the University of Rochester, add Connecticut’s unfunded liability to the state’s debt. As you can see, the state’s reported debt is roughly $23 billion. The estimated value of its unfunded pension liabilities is $48.4 billion. To that amount we should add another $28.2 billion in underestimated liabilities due to poor accounting standards.

These numbers need to be updated, but I doubt they look better today than they did two years ago. And that’s for state pensions alone. What this means is that Detroit is probably the first in a series of cities finally having to face its real debt burden. (California is already starting to.)