Not just a Detroit problem
Detroit's pension woes are in the news, but municipal employees around Michigan should not presume that their pension systems are secure.
Indeed, in most Michigan cities the underfunding problems are worse than those in Detroit.
On paper, the unfunded liabilities for Detroit's police and fire system are $147 million, and its general employee pension system underfunding comes to $838 million. That translates into 96 percent and 77 percent funded, respectively. That is, for every dollar in pension benefits earned by an employee, the city has an average of 87 cents saved.
That's not good, but the 2012 financial statements of Michigan's 35 largest cities found that 90 percent of municipal pension plans were underfunded, with total underfunding stated at $2.1 billion.
It may be even worse. Pension funding policies can mask the magnitude of underfunding.
For example, to prevent a single very good or very bad year in the stock market from skewing the value of their investments, pension systems typically use a "smoothing" method to average the values over a period of several years.
Detroit uses an eight year smoothing window. This lengthy period means that its pension fund valuations do not yet fully incorporate the effects of the great recession. At current market prices, the system's assets are $1.35 billion below their "smoothed" values.
Moreover, Michigan's cities also tend to offer retiree health care benefits to employees, even though few private sector employers provide such coverage. Unlike pensions, these benefits are not protected by the state constitution. They amount to gratuities that can be revoked at any time. Importantly, these "other post-employment benefits" are rarely prefunded.
With prefunding, employees know there's some money set aside to pay for what they were promised. Just as important, the cost of each year's service is largely paid for during the same year. When benefits go without prefunding, the certainty that benefits will be provided as advertised is diminished. This is especially the case in the Michigan cities that have lost residents and jobs. Without prefunding, the costs of long-gone government employees' service must be paid by a shrinking tax base.
Underfunding is not the only reason Detroit is seeking to trim the pensions of retirees. The city also is insolvent. That is, it lacks the cash to pay its bills when they come due — including constitutionally mandated pension prefunding contributions. Insolvency coupled with underfunding risks pensions, and the increasing costs of catching up on unfunded liabilities can drive some governments to insolvency.
It wasn't supposed to be like this.
Delegates to Michigan's 1962 constitutional convention wanted cities to pay for pensions as they are earned, and not defer the costs of current employees to future taxpayers. The provision they wrote into our current state constitution amounts to an instruction to city managers to make good, reasonable assumptions about the future value of investments made today, and deposit enough each year to cover the future costs of another year's worth of benefits earned.
The reality of underfunding shows that they have not made good assumptions, and are still assuming excessively rosy scenarios. As a first step, this should change.
Beyond that, the only sure way to avoid digging even deeper holes in the future is to follow the lead of a handful of municipalities that have closed their conventional defined benefit pension systems to new members and offer defined contribution retirement plans instead.