On July 18, Detroit filed for Chapter 9 federal bankruptcy protection. At over $18 billion in liabilities, it is the country's largest-ever municipal bankruptcy case. Although there have been rampant accusations of financial mismanagement and scapegoating, the main culprit of Detroit’s woes was demographic: the city’s population, which peaked at 1.8 million in the 1950s, now stands at 700,000, as many middle-class workers and businesses fled the city, taking their tax dollars with them. Despite making severe cuts to its spending -- the police force is operating at bare bones levels, about 40 percent of the city’s streetlights are not functioning, and only a third of its ambulances were in service – the city collapsed under the weight of its obligations. Of the $18 billion owed, $11 billion is unsecured, which includes almost $6 billion in health and other benefits for retirees; more than $3 billion for retiree pensions; and about $530 million in general-obligation bonds. The 100,000 unsecured creditors will now begin the arduous process of negotiating for their slice of Detroit’s diminished pie.
What is to be learned from this tragic collapse?
1. Municipal employees across the country should take note: those pension “promises” may not be as rock-solid as you would like to think. Detroit’s Emergency Financial Manager Kevyn Orr will likely attempt to persuade a federal bankruptcy judge to invalidate the city's pension contracts, which represent more than 9,000 active and 21,000 retired city workers. It should be noted that it’s not a slam-dunk to get this through in Detroit’s case, because pension and health benefits are protected by Michigan's constitution, one of seven states that specifically ban cuts in retiree pension and benefit payments.
But municipalities don’t have to go broke to renegotiate future benefits. Unions all over the country, who are fighting to maintain pay and benefit packages for their members, must deal with the cold reality of the financial pressure under which many towns and cities are operating. If Detroit is allowed to cut payments to its retirees, city and state workers in states like California and Illinois, which also have large, unfunded pension liabilities, may use Detroit as leverage to reduce future benefits.
The one action that any municipal employee can take is to sock away extra money in tax-deferred retirement plans. Most towns and cities offer Section 457 plans, which allow workers to contribute a portion of income on a pre-tax basis. I know that many have a hard time scraping together money to do this, but if possible, it’s a good way to build an extra source of retirement income.
2. Beware of overly optimistic assumptions: Detroit’s pension fund managers had assumed a rate of return on their annual investments of 8 percent. On what planet were these folks living? Additionally, an actuarial report found that the pension funds used certain accounting practices that — while perfectly legal — downplayed the brewing problems in the systems. These actions painted a rosier picture than the reality and to what end? As you plan your own financial future, I recommend using the most conservative assumptions to avoid this kind of delusion.
3. Municipal bond investors need to know what they own. Many of you invest in municipal bonds as a way to collect income that is exempt from local, state and federal taxation. But not all municipal bonds are created equal. While I am no fan of ratings agencies, who generally have been late to ring the alarm bell when problems arise with issuers, at the very least be careful if your bond holding is rated as “junk”. Junk bonds carry more risk because the issuer may not be able to repay the debt. In return for the increased risk, bondholders demand a higher interest rate. That higher interest rate can seem alluring, especially in the current environment, but risk is risk.
One final note: while Detroit grabs headlines, it’s important to underscore that municipal bankruptcies are rare. Congress enacted a revised Municipal Bankruptcy Act in 1937 and since then, there have been only 627 municipal bankruptcies, including Detroit. For those worried about additional municipal bankruptcies, the economic recovery has improved the outlook for most American cities, but there are still some in rough shape (hello Harrisburg, PA!) In terms of spillover effect; the Detroit bankruptcy represents a mere fraction of the $3.7 trillion municipal bond market. The municipal bond market remains half the size of the corporate bond market, a third the size of the Treasury market and a sixth the size of the equity market, according to Capital Economics.