Why Detroit Pensions are Underfunded

Plenty of blame to go around

Detroit’s bankruptcy has meant that the city’s pensioners may receive less than what they expected. This has angered a lot of people and blame has been pointed in many directions. There are a lot of reasons why Detroit’s pension systems are in poor shape and there is plenty of blame to go around.

The most basic reason that pensions are underfunded in Detroit is simple: the city did not properly fund the system. During good times, the city oversold benefits and its assumptions have proven ineffective at keeping pensions funded during bad times.

A retirement system can offer generous pensions and weather bad markets if it uses accurate assumptions and good practices. Detroit did not.

Pension board members adopt a series of assumptions with advice from its selected actuaries. These assumptions are used to predict the amount of money necessary to set aside today to pay for the pensions earned by the employees working today. If gaps between what employees have earned and what the city has set aside develop, the assumptions are also used to estimate the amounts needed to catch up. 

In the Detroit General Retirement System, returns over the past seven years have been 3.9 percent, according to my calculations based on their financial statements. The assumed rate of return was 7.9 percent. The long-term discrepancy has meant that the system is underfunded. These unfunded liabilities will be paid off over 30 years. Since the average age of members in this system is 48, this is beyond the average longevity of current employees.

In the Detroit Police and Fire Retirement System, returns over the past seven years have been 4.6 percent. The assumed rate of return was 8 percent. Unfunded liabilities will be paid off over 29 years.

Another way of dealing with volatility has been to adopt gains and losses over a moving number of years. Detroit’s asset-smoothing assumptions go for seven years. With the substantial lags between when they perform and accept their actuarial valuations, they have only recently started realizing the losses from the 2009 recession, which will continue to weigh down asset values for the next few years.

It’s very important to get this right. The Michigan Constitution mandates it. The second part of Article IX, Section 24 states, “Financial benefits arising on account of service rendered in each fiscal year shall be funded during that year…” That is, when an employee earns a dollar’s worth of pension, his or her government employer needs to set aside enough money to pay for it. Depending on the assumptions, the government might only need to set aside a quarter today to pay for that dollar later, depending on when the employee starts collecting a pension, how long they expect to collect, and how much the government can get in returns on its savings.

Those returns, however, are volatile. The constitutional language does not stipulate that pensions should be funded unless a recession happens — it says that pensions should be funded as they are earned.

Managers, however, are hesitant to change estimates about the future, even when these assumptions have been shown to be ineffective. Doing so can make the gaps appear larger or require more cash to be put in the system. Given Detroit’s insolvency, these assumptions are unlikely to change even if they have been responsible for the gaps.

On top of assumptions that have underfunded the system, the city oversold during good times. The often-lamented 13th checks depleted down city funding just as optimistic assumptions ensured underfunding during bad times.

What separates Detroit from the other governments with underfunded pensions systems is its insolvency. Other governments generally have cash to pay their debts as they come due. Detroit does not. It’s in the situation that the 1963 constitutional provision was meant to avoid. In leading the systems to this point, pension board members failed in their basic duties.

Detroit’s retirement boards are comprised of mayoral and city council appointees plus some member-elected representatives. The boards have changed and there are new people on the city council. The smoothing and return assumptions, however, remain unchanged.

One way of dealing with this is to freeze and close the pension system, a reform Emergency Manager Kevyn Orr is pursuing. Defined-contribution plans do not require politicians to make bets on the future. By converting to one of these retirement systems, Orr wants to prevent this situation from developing again.