The federal budget showdown has eclipsed news coverage of another government having trouble paying its bills. Detroit declared bankruptcy back in July, and analysts are watching the proceedings closely. Which creditors will get paid? I suspect that pension benefits for city workers will be honored before municipal bond debt, as pensioners have a strong claim to first dibs on the city’s assets.
But that doesn’t excuse the hidden risk-taking on the part of the city’s pension managers. Megan McArdle writes about the pension fund’s past habit of distributing its “excess earnings” as bonuses to the city government and its workers.
McArdle calls this “madness,” and I agree. Public pensions usually claim to manage long-term investment risk by keeping higher-than-expected returns to cover the inevitable down years in the market. Detroit’s pension managers instead turned the above-average returns into Christmas gifts for the city, meaning taxpayers were unwittingly put entirely on the hook in case of a financial downturn.
One might wonder how the pension fund could get away with that. It’s actually simple—just treat expected returns as guaranteed. By assuming no risk that future returns would be lower than projected, Detroit’s pension fund could skim off the top and keep telling the taxpayers that the fund was healthy.
But before dismissing Detroit’s corruption as sui generis, keep something in mind: Governments at every level across the nation pull similar shenanigans. Sure, not many are so brazenly irresponsible as to pay bonuses out of their pension funds, but systematically overvaluing risky assets—e.g., pension investments, student-loan repayments, crop insurance plans—is standard practice in the public sector.
“Fair value” accounting would force governments to price market risk into their cost estimates. I know it’s one of the more yawn-inducing political movements, but it could end a lot of fiscal abuses.