OT - Federal bankruptcy law vs. pensions backed by state constitution

Orr has to make tough decisions based on the hand dealt.  It is ridiculous for you to suggest he is immoral and unethical to offer only 10 cents on the dollar.  The city is in a tough spot and is insolvent -- meaning it does not have enough money to pay what it owes to lots and lots of companies and people and those companies and people are absolutely going to get screwed and paid out at pennies on the dollar.  The real immoral and unethical activies here are the decades of mismanagement and corruption that has destroyed the once-great city of Detroit. 

The reorganization plan will be very, very complicated.  There will be several classes of creditors (senior secured, mezzanine, priority employee, other priority, bondholders, general unsecured, etc.) and each will receive a different distribution.  I suspect that the 10% was mentioned in reference to general unsecured creditors like trade vendors, consultants, landlords, even lawyers that the City hired. 

As for returns on the pension, based on what you all have said about the MI state constitution, is the state going to be responsible for the shortfall coming out of the bankruptcy case (like the PGBC would for private pensions)??

tl;dr summary: people are confusing what entity is owed what. Detroit owes its pension $3.5B. The pensions owe retirees about $9b. The difference is the current amount of assets in the pension fund that will be unaffected by the bankruptcy. 

Longer: OK, quick lesson on different legal entities and pension underfunding. 

Basics on underfunded pensions

[Note: I'm making up all of the numbers here to illustrate the impact. There are many actuarial assumptions that go into calculating these numbers that are way beyond the scope of MGoBlog, or even most intro finance courses at business schools!]

Pensions in Detroit (as most places elsewhere in the U.S., other countries use different systems) are supposed to be pre-funded. So, every paycheck the city should set aside the money required to eventually pay the pension amount associated with that wage. Example: you get paid $50K in a year, and the city should put away $2.7K for your eventual retirement That $2.7K gets paid into a pension fund, which is a trust that takes that $2.7K and invests it, so that by the time you retire after 35 years of work it has grown, and, when collected over the course of your working career, the idea is that the accumulated contributions (plus related investment earnings) should be enough to pay out your pension until you die. 

Let's say that a typical worker making $50K a year has been contributing $2.7K/year for 35 years and has been earning 8% (Detroit's assumption, incidentally). They'd have accumulated about $500,000 when they retire, and if they live for an average of 20 years after that, the pension would perfectly be able to pay out $50K/year (and actually have a tiny surplus left over). That is how the system is supposed to work. (One important note: it works because of averages: some people will live more than 20 years and would need more money; but some people will die younger, and hence need less. Pooled together, they cancel out. That is a key benefit of pensions -- they provide insurance against outliving your savings, what is known as "longevity risk.")

However, that system is INCREDIBLY sensitive to the interest rate assumption. Remember I said you had to contribute $2.7K every year to make the math work if you can earn 8% returns? If you only earn 7% returns, you would have to contribute $3,600 every year over 35 years to make it work. At 6%, you'd have to contribute $4,800 or so. 

So, what Detroit did (partly due to elected officials and partly due to union leaders) was do a few things wrong plus become the victim of low rates. First, Detroit assumed a higher rate of return than they were likely to get. Second, they (quite famously) mismanaged the money. Third, not Detroit's fault, but interest rates have come WAY down, and investment returns are ultimately a function of the rates set by the Federal Reserve. 

The upshot is this: Detroit should have been putting $5K into the account, and instead they were putting about 2/3 of what is required to be put into the account. 

The current impact of that is that, if you use more reasonable assumptions for the rate of investment return Detroit will earn on its pension assets, it would need a little more than $9B in its pension funds to pay out to retirees. It currently only has about $5.8B. The difference is that 3.4B or so number that people are throwing around. 

Pensions and bankruptcy

The pension fund (actually, its two separate funds: one for police and fire, and one general) is a completely separate legal entity than the City of Detroit. While Detroit declared bankruptcy, its pension funds did not. The assets in those pension funds are not part of the bankruptcy proceedings -- the $5.8B in those funds that belongs to retirees is entirely safe from the bankruptcy proceedings. They are, in the industry term, "bankruptcy remote." 

However, the City of Detroit owes those funds $3.5B or so still. That $3.5B is the part that the bankruptcy could reduce substantially. If the previous 10c/dollar number thrown out stands, the pension funds obviously collect only $350M instead of $3.5B. So, they would then have $6.1B of assets in total. 

The pension would be underfunded... either it needs to reduce payments to retirees, or eventually the fund will run out of money before all of the retirees have died (shortfall risk!). The amount is simply assets/liabilities (or [5.8 current assets + 350M bankruptcy recovery = $6.1B]/9.1B of total pension liabilties = 6.1/9.1 =~ 2/3)

Even in the (unlikely) case that retirees get absolutely zero from the City of Detroit, they would still have the assets currently in the pension funds, so their "worst case" scenario is not much different than what I've already outlined: the liability is unchanged, but they'd only have their existing assets of $5.8B, so 5.8B/9.1B= 64%, so they'd take a 36% reduction instead of a 33% reduction or so. 

Who else might fill that gap?

It is NOT the Pension Benefit Guarantee Corp (PBGC). It only covers corporate pensions. Nor will it be the Federal government. It would require an act of Congress most likely. Our own beloved alumnus-President set precedent on that by famously telling New York City to "Drop Dead" when asking for a bailout: http://www.nydailynews.com/news/politics/ford-city-drop-dead-president-snub-inspired-discouraged-ex-gov-hugh-carey-article-1.947295

It could be the State of Michigan -- this will be contested both in the courts and in through the political process, almost for sure. 

Detroit will fill part of the gap (that is the 10c/dollar offer; to be negotiated in bankruptcy for sure. Detroit would probably issue new, post-bankruptcy bonds and put the proceeds into the funds to do this. Or, an alternative I'd be interested in proposing, would be that the pension could agree to take X% of the city's total tax revenues for some period of time. That would give the unions incentives to help increase the cities tax revenues, most importantly by increasing employment, helping to raise property values, etc. It would sort of be like giving them equity in the new Detroit, which is what usually happens in corporate bankruptcies.)

But if I were a betting man, I'd say that the retirees are going to bear the brunt of this. I would be awfully surprised if they didn't take a haircut of at least 25% through this process... 

but Orr is serving under a State law that says a City can file under certain circumstances - including when an Emergency Financial Manager has been appointed and the Governor signs off.  Those conditions have (I beleive) been met.  The Constitutional provision says nothing about filing for bankruptcy.  The article may have missed the point.